Hadar Y. Jabotinsky & Roee Sarel

Volume 74, Issue 2, 433-488

Everybody is talking about cryptocurrencies. These digital tokens, which started in a one-asset market, have swiftly ballooned into a massive and diverse “cryptomarket.” The cryptomarket is still mostly unregulated, but this is about to change. With President Biden’s adoption of the Executive Order on Ensuring Responsible Development of Digital Assets, regulatory initiatives are being adopted abroad, and global regulation looms ahead. In light of the expected regulatory changes, two important questions emerge: is there a clear rationale for legal intervention in the cryptomarket? And if so, what type of regulation is optimal?

This Article is the first to consider how to regulate the cryptomarket through an empirical analysis of how the COVID-19 crisis affected the cryptomarket. We take a two-step approach to answer these pivotal questions. First, we analyze empirical evidence from the early days of the COVID-19 pandemic to better understand the risks posed by the cryptomarket when a crisis emerges. Second, we apply a law-and-economics approach to identify which market failures are consistent with the data and derive novel regulatory lessons. Our empirical analysis reveals an interesting pattern: investors initially shifted funds to the cryptomarket when the pandemic erupted, but then made a U-turn and diverted funds out of cryptocurrencies, leading to a plunge in the market. We maintain that such investor behavior can have both rational and behavioral explanations, which in turn affects the optimal choice of regulation.

Accordingly, we map each rational and behavioral explanation onto potential market failures by surveying different possible interpretations of our findings, such as substitution effects between traditional markets and the cryptomarket, exploitation of investors in the form of pump-and-dump schemes, and other criminal activities. We then discuss how each type of failure can serve as justification for regulation and derive regulatory lessons on how to best intervene in the cryptomarket depending on the source of the market failure.