Industry self-regulation of cryptocurrencies has arrived

The industry’s first self-regulatory organization — the Virtual Commodity Association (VCA)

On Monday that several cryptocurrency exchanges have indeed signed on to what appears to be the industrys first self-regulatory organization the Virtual Commodity Association (VCA), founded by Cameron and Tyler Winklevoss of Gemini Trust Co. Initial members announced were Bittrex Inc.; bitFlyer USA Inc., a unit of Japans bitFlyer Inc.; Bitstamp Inc.; and Gemini.

Join the club

A cynic might observe that the Winklevosses have strong incentives for promoting clean exchanges as a safeguard for the fortune they staked in bitcoin following their legal settlement with Facebook. An institutional economist, however, would observe that self-regulation is effective when a group of similar entities in this case a group of cryptocurrency exchanges form a club.  Membership is confined to those who agree to adhere to a clearly defined and importantly transparent set of rules requiring the members to act in specific ways that will not harm (or indeed confer benefits on) consumers. Members of such a cryptocurrency exchange club agree to carry out trades on behalf of their consumers only under these rules. Either the other exchanges must be members of the same club or must agree explicitly to abide by the same rules for all transactions in which the club member is a party. This arrangement thereby provides safeguards to the ultimate buyers and sellers of the relevant commodities that a common set of rules will apply to all parts of the transaction, even though they dont actually know each other.

The membership fee to join the club is typically large and stands as a bond to be forfeited if the member is detected engaging in the undesired activities. Usually, membership is not automatic simply because the fee is paid; the current members can decide whether to admit a new member based on how likely they think it is that the new member can be trusted to uphold the rules. And as with other clubs, those who fail to abide by the rules are expelled in a suitably public manner that damages the malfeasant members reputation considerably.

Indeed, all modern stock exchanges had their origins in clubs of exactly this sort (albeit that over time, as more has been learned, and government regulation has gradually substituted for club rules, demutualization and private ownership of the exchanges has become feasible).

Competing for members  and better rules

The strengths of the club arrangement in the early days of trading new commodities come from the fact that initially, clubs can compete with each other in setting their rules. To recruit members clubs must attract traders, and to attract customers traders must be able to offer their customers the best protections. Clubs seeking to create a safer environment for trades via their better, more consumer-focused rules will attract more members and more trades and will be more successful than those offering lesser protections.

Furthermore, as it is not always known in advance what risks are associated with trading new commodities, it is not always clear which rules will work best either individually or in combination. However, it is certain that those most likely to know which behaviors will harm consumers and to identify when these behaviors have been engaged in are the traders themselves.

Rules set by traders who want to be successful by looking after consumer interests are more likely to be aligned with this objective than rules set by third parties that face both information asymmetries (by not being experts themselves in trading the new commodities) and being subject to lobbying by traders who are not necessarily placing consumer interests first.

Using inside knowledge to detect and sanction cheating

Moreover, as the revenues of all traders in the club will be harmed by even one of them behaving badly, and the relevant information that rules have been broken is available only to the traders, all are then incentivized to observe each other to catch bad behavior. And having gained this knowledge, they are incentivized to act promptly to identify, shame, and expel the bad risk traders to protect their collective reputation with consumers.

The clubs that are seen to be best at stamping out bad trading will almost certainly be held by consumers to be more reliable and are therefore likely to grow faster. And as club membership in the early stages typically works on the basis of one member one vote, regardless of the amount of business put through the exchange, it is harder for any one member to become powerful enough on their own to distort decision-making.

Thus, larger clubs with better rules are more likely to prevail, for the ultimate benefit of consumers. Importantly, they will almost certainly be better-placed to both sanction malfeasance in the first place and to do so in a timelier manner than third-party regulators, who have to be told of the bad behavior before they can act.

VCA meets these criteria

On first examination, it appears the VCA meets all the salient criteria to be an effective self-governance club. It will be a nonprofit entity, capitalized by its members, and will not itself trade in any markets. Its primary purpose is to facilitate the process of making, monitoring, and enforcing the rules that its members buy into when joining the club. The first meeting of the initial members is due to take place in September.

Hopefully, the VCA will be just the first of these new entities. If so, then competition between the clubs will lead to the discovery of the best rules, as well as provide sufficient assurances to customers that they can trade between currencies at low risk and garner the benefits promised by the arrival of these new payment instruments.