Setting Up The Stage

In a previous article, I discussed the relationship between the crypto industry and modern state institutions, exploring the possibility of preserving crypto's core values without threatening established states’ prerogatives like the monopoly over the monetary system and the military. A narrow yet viable route to reconcile these conflicting requirements is conceivable, and it may be facilitated by certain crucial infrastructure components, with zero-knowledge proofs standing out as a primary candidate.

The ideas presented in that article are relevant and complementary to the present discussion. While the first article considered the ideological and symbolic payoffs at stake in the confrontation between the crypto industry and governments, this piece approaches this relationship from an economic/rational perspective. Specifically, it delves into the costs and benefits that various outcomes of this confrontation may have for both sides. To achieve this, it employs game theory, particularly the Exit, Voice, Loyalty (EVL) game, as a tool to gain deeper insights into the decisions of the involved parties.

The EVL model is an extensive form game that examines interactions typically involving negative changes to one player's environment by another player. The two players are usually represented as the Citizen and the State. The game starts with the Citizen reacting to the negative change, which could be a new policy or law introduced by the State, and it unfolds sequentially like a chess game. The Citizen's initial possible responses are to Comply (abide by the new rule or law), Exit (avoid the new policy by taking some alternative action, like moving money abroad to avoid a new tax), or use Voice (complain or participate in other more or less organized ways to protest against the new law). The game concludes if the Citizen selects Exit or Comply. However, when the Citizen opts for Voice, it becomes the State's turn to decide between ignoring or responding (acknowledging the Citizen's concerns and reconsidering the new policy).

The EVL game can help us better understand and perhaps predict the outcome of the ongoing conflict between the crypto industry, represented by two major exchanges (Coinbase and Binance.US) and the US government, represented by the Securities and Exchange Commission (SEC), the federal agency that has been most active in confronting the crypto industry. The background move that ignites the game is the SEC’s commitment to introduce a new regulatory framework that categorizes most tokens as securities, excluding BTC and ETH, due to their ascertained decentralized nature. If such legislation were to pass, it would have significant implications for US-based exchanges like Coinbase and Binance.US. These exchanges would have to comply with various rules and regulations that apply to securities brokers and dealers, such as registering with the SEC, filing periodic reports, conducting audits, maintaining records, implementing anti-money laundering and customer protection measures, and paying trading fees to the SEC. As Coinbase team puts it in their 2022 Annual Report to the SEC:

Further, we believe increasingly strict legal and regulatory requirements and additional regulatory investigations and enforcement, any of which could occur or intensify, may continue to result in changes to our business, as well as increased costs, and supervision and examination for ourselves, our agents, and service providers. Moreover, new laws, regulations, or interpretations may result in additional litigation, regulatory investigations, and enforcement or other actions, including preventing or delaying us from offering certain products or services offered by our competitors or could impact how we offer such products and services. Adverse changes to, or our failure to comply with, any laws and regulations have had, and may continue to have, an adverse effect on our reputation and brand and our business, operating results, and financial condition.

Alternatively, crypto exchanges might opt to stop trading tokens considered securities by the SEC or relocate their operations to jurisdictions with more favourable crypto regulations. Nevertheless, these options could also entail risks and trade-offs, such as losing market share and customer loyalty, particularly if other nations do not adopt similarly stringent measures.

It's important to note that the two exchanges considered, Coinbase and Binance.US, occupy different market positions, with Coinbase deriving most of its revenue from the US market while Binance holds a dominant position internationally. These differing market conditions produce different cost-benefit structures, which in turn are expected to lead to different outcomes of the EVL game.

In summary, this real-world scenario provides a unique opportunity for a practical application of the theoretical framework of the EVL game. Unlike the typical EVL game, which relies on assumptions about variable values and relationships in payoffs, in this case, we can utilize real-life, specific data to set up and solve the game.

Setting Up the EVL Game

An extensive form game consists of choice nodes linked in a sequence. Choice nodes are points at which a player must choose an action. The choice nodes are linked to other choice nodes or outcomes by branches. The branches represent the actions that can be taken at each choice node. The branches lead to either another choice node or a terminal node. A terminal node is a place where the game ends. Each terminal node represents a possible outcome of the game and is labelled with the payoffs earned by each player in that outcome. The entire specification of choice nodes and branches is called a game tree because it resembles a tree.

The Exit, Voice, Loyalty game tree, as depicted in 'Principles of Comparative Politics'.

Variables

In adapting the traditional game model to mirror the ongoing real-life situation, I've introduced and modified variables and payoffs for a more accurate representation.

I represents the value of the benefit regulators took from the crypto industry. In this context, it is equivalent to the yearly revenue from the entire US market (encompassing all tokens). Unlike the conventional EVL model, I is not symmetrical for both parties (in the traditional game, 1 is the value of the benefit, either earned by the Citizen or the State, depending on the outcome). This assumption arises from the belief that if the new regulatory framework were enacted, crypto exchanges would cease trading most assets, resulting in no earnings for the SEC. For references to 2022 revenue, here for Coinbase and here for Binance.US.
L represents the value of the crypto industry for the US government if the crypto industry complies and tokens are securities. This value is operationalized using the 2022 federal income tax rate (21%) for BTC and ETH, the only two tokens that wouldn’t be considered securities and hence could be traded. No fees on securities, which currently are set as $8 per $1 million traded, are factored in, as it is assumed that exchanges would rather delist tokens categorized as securities than face the compliance and monetary costs associated with trading them. The percentage of trading represented by ETH and BTC for Coinbase can be found here and for Binance.US here.
L1 represents the value of the crypto industry for the US government in the event that the SEC decides to listen to the exchanges’ lobbying efforts and tokens are not considered securities. In this case, the SEC would not earn fees from the trading volume of these assets but would gain more in terms of net income tax (21% federal income tax on the full revenue from the US, I).
E represents the value of Exit, operationalized as the 2022 revenue generated internationally (US excluded). To estimate Coinbase's revenue breakdown by geography, you can refer to this source, and for Binance.US, you can find relevant information here.
c the cost of using voice is represented by the cost of lobbying the US Congress in 2022. Source here.
p stands for the revenue generated from trading ETH and BTC in the US in 2022, assuming that these are the only assets left if the SEC prevails and the crypto industry complies. I assume it's the same percentage of trading volume for these tokens.

Strategies and Payoffs

It’s now possible to use these variables to express the payoff formulas for each player:

exit: Should Coinbase and Binance.US opt for an immediate exit, they would retain revenue solely from business conducted outside the United States (E). In this scenario, the SEC would not generate any revenue since all crypto-related activity would relocate outside the United States. This diverges from the traditional game model, where the State typically gains the payoff associated with the extracted benefit. The assumption of a payoff equal to zero holds unless the SEC views implementing strict regulations as a victory in itself, irrespective of how many companies it impacts and how much business and revenue it loses.
comply: If Coinbase and Binance.US decided to comply immediately, they could earn revenue from BTC and ETH trading only (p), given that they would be compelled, or it would be economically convenient, to delist other assets, now considered securities. Their overseas revenue would also remain intact (E). The SEC could earn income tax, albeit limited (L), compared to that generated if the exchanges could trade all assets (L1). In the traditional game model, the Citizen is assigned a payoff of 0, while the State receives a combined payoff of I+L. I assigned p+L to the exchange, because those components of the revenue should still be factored in, and I chose not to assign the SEC the payoff I because that represents the value earned by the exchange, which wouldn’t transfer to the SEC in case of compliance (like perhaps a tax in the traditional EVL game). In other words, in this particular instantiation, the payoffs are not symmetrical, and the game is a non-zero-sum game.
lobby_answer: In the event of a successful lobbying effort and the classification of tokens as non-securities, Coinbase and Binance.US would have the potential to continue enjoying revenue from all trading pairs. The SEC would benefit from substantial income taxes generated by the two thriving businesses, although it would not gain fees from securities trading. Exchanges are assigned a payoff equivalent to their domestic and international revenue, as a domestic win wouldn’t necessitate renouncing the international business. This differs from the traditional EVL game, where the Citizen's successful use of Voice automatically excludes the payoff associated with Exit (E). Once again, the payoffs are not mutually exclusive, leading to a non-zero-sum game.
lobby_exit: In the case of an unsuccessful lobbying effort and the subsequent decision to exit the United States, Coinbase and Binance would incur the cost of lobbying (c) while continuing to enjoy the economic upside from overseas activities (E). The SEC wouldn’t obtain any material benefit from this outcome.
lobby_comply: In the event of an unsuccessful lobbying effort and the eventual decision to comply with the new SEC regulatory framework, and assuming that all tokens classified as securities would be delisted, Coinbase and Binance.US would only be able to retain the revenue generated by BTC and ETH and would face the cost of lobbying, c. Their overseas revenue (E) would remain unaffected. The SEC could earn income tax, but limited (L) compared to the full ones generated if the exchanges could trade all assets (L1).

Assumptions

While this case study provides substantial real-world data to construct the game model, certain choices and assumptions are required.

I have chosen to ignore a considerable yet challenging-to-quantify cost that the SEC and the US would incur should the crypto industry decide to relocate (Exit). This cost would come from the missed jobs and economic output generated by the open-source industry, which Electric Capital estimates in the range of trillions of dollars. It’s also hard to estimate the positive spillovers that blockchain R&D would have on other sectors, including advancement in cryptography (e.g., zero-knowledge technology) or improvements in the financial industry.
Similarly, it’s hard to factor in the amplifying effects of a positive regulatory framework on the exchange businesses, as more users would be encouraged to participate.
The potential cascading impact of either positive or negative legislation in a major market like the United States on other countries has also been disregarded in this analysis.
Finally, this study exclusively considered economic payoffs since they are easily quantifiable. For instance, the symbolic value of remaining in the US, especially for an exchange like Coinbase, funded and led by an American citizen, is ignored. Similarly, the ideological value of preserving the fundamental elements of the blockchain (decentralization, permissionless access, open-source) can be safely ignored because the player Citizen is here represented by two centralized exchanges that run on proprietary services and implement KYC and AML procedures, which makes them more similar to traditional web2 companies.

Representing the EVL Game

This is how the EVL game can be represented with its nodes (the players), edges (the choices) and the associated newly defined payoffs:

As previously discussed, the generic variables can be replaced with actual numerical values taken from the real-life scenario:

What immediately stands out from these data is that Coinbase’s overseas revenue represents a small portion of its total revenue, as the exchange has a small market share outside the US. Moreover, it’s still uncertain whether it will be able to recoup most of it in the coming months, despite the major effort placed in the so-called ‘Go Broad, Go Deep’ strategy for international expansion. Almost specularly, Binance.US revenue pales compared to Binance's global revenue, illustrating a situation where the exchange struggles to gain significant market shares within the US.

Notably, Coinbase's lobbying expenses significantly outweigh those of Binance.US, indicating differing degrees of commitment to this strategy. It's possible that Binance.US and other exchanges, recognizing Coinbase's strong interest in influencing US crypto policy and sharing the conviction that crypto-friendly regulations benefit the entire industry, may opt for a more passive approach and limit their lobbying efforts, becoming somewhat free riders.

Solving the EVL Game

Based on the numerical payoffs, we would expect that the choices made by the two exchanges would differ, leading to a distinct approach to solving the EVL game. EVL games can be solved using backward induction, a method used to compute subgame perfect equilibria in sequential games. The method consists of starting from the last node and choosing the outcome that maximizes the payoff while also anticipating the most likely choice by the other player.

In these applications of the EVL game, the last choice belongs to the exchanges, which would choose to comply over exit if the SEC rejected its requests and went ahead with a hostile regulatory framework. Even if it predicts that the exchange would comply, the SEC, at the preceding node, would still obtain a higher payoff by choosing to answer since conceding a favourable regulatory framework would have a higher economic payoff than implementing a strict regulation and eventually having the exchange remain in the US but with less economic activity. This is because, with the two exchanges fully operational in the US, the US federal government could earn more in federal income tax and benefit from the overall wealth generated by the two companies (employment, positive externalities, edge in tech innovation, etc.). Based on this assumption, the exchange would, as its first move, choose to lobby because it would expect that, based on purely economic interests, the SEC and the US government would choose to accommodate crypto’s requests and create an appealing environment for the industry to prosper. The subgame perfect equilibrium for this game is: (Lobby, Comply; Answer).

Contrary to initial expectations, and despite their contrasting cost/benefit structures and market positions, the EVL game and its corresponding payoff structure reveal that there's no discernible difference in incentives between Coinbase and Binance.US, and the solution to the game is the same. These findings reflect real-life observations as both exchanges have, for years, been engaged in discussions with the US government in the rational belief that a rigorous but favourable regulation would benefit the two sides and the US economy as a whole.

While the absolute payoffs suggest that the most likely outcomes are identical for both exchanges, the key distinction lies in the margin between the highest payoff and the other options. Notably, Coinbase stands to gain significantly more from lobbying compared to any other outcome (with a payoff over 1.5 times that of the second-best option, Comply). On the other hand, Binance.US is less dependent on lobbying and could achieve similar payoffs by either adhering to strict regulations or exiting the US market entirely. This unique nuance plays a pivotal role in influencing their future strategies.

For instance, if lobbying the U.S. government becomes increasingly costly, Binance might choose to give up and either comply with stringent regulations or withdraw from the US market altogether. However, if regulatory compliance also became more complex and expensive or legal challenges from agencies like the SEC escalated, Binance would probably be better off with a temporary exit from the US market. A concrete example of this strategic adjustment can be observed in Binance.US's recent suspension of dollar deposits and withdrawals, citing the SEC's "extremely aggressive and intimidating tactics," making banking partners hesitant to engage with the crypto sector. These decisions are expected to erode Binance's market share in the US, reducing its appetite for prolonged regulatory battles. On the other hand, Coinbase has been sustaining considerable costs to remain compliant and be able to keep pushing toward a better regulatory framework. For instance, for the year ended December 31, 2022, Coinbase faced an increase of $75.1 million in settlement costs largely due to a one-time settlement cost accrual of $50 million with NYDFS and an additional increase of $71 million in professional services due to higher legal fees related to litigation, regulatory, compliance and business consulting. This overall $146.1 million in costs associated with settlement and compliance are not factored in in the present analysis as part of the cost (c) of lobbying, albeit having a considerable weight on crypto exchanges’ future strategies.

While the exchanges’ observed behaviour mirrors the one predicted by the game, the SEC's unyielding commitment to the crypto industry crackdown is a notable deviation from the anticipated outcomes in our application of the EVL game. The SEC's most favourable economic outcome would be achieved through cooperative engagement with the crypto industry (answer). This collaboration would involve the creation of a well-balanced and favourable regulatory framework, providing ample operational freedom on which the industry could flourish while ensuring essential user protections. However, the SEC's current stance and actions defy conventional economic rationality, arousing suspicions of an unwarranted agenda and strengthening arguments that ideological motivations may be at play.

Charting a Course for the Future

The game-theory analysis proposed in this article offers an optimistic perspective on the ongoing regulatory struggle in the cryptocurrency industry. Unlike the theoretical assumptions in Exit, Voice, Loyalty (EVL) games, this real-world data application produces a non-zero-sum game where everyone can benefit economically by fostering a favourable regulatory framework that nurtures the crypto industry's growth within the United States.

Interestingly, the actions of both Coinbase and Binance.US closely follow the game’s predictions, emphasizing the rationality of their lobbying efforts. Nevertheless, the durability of this situation depends on various factors, including the escalating costs associated with lobbying, lawsuits, and overall compliance. It's conceivable that should these costs continue to grow, Binance.US may ultimately choose to exit the U.S. market, while Coinbase might persist in its endeavours and potentially even comply with the new regulatory framework. In stark contrast with these rational strategies, the actions of the SEC appear to deviate from the rational behaviour predicted by the game, highlighting inconsistency in its approach.

While Coinbase and Binance.US only partially represent the blockchain industry and its values, centralized exchanges are still necessary as they facilitate on and off-ramp and provide a bridge between fiat and crypto. Moreover, Chainalysis’ latest data reveal that North America accounts for nearly a quarter of global transaction volume, underlining the substantial influence of this region on the entire industry.

The choices made in this pivotal regulatory arena undeniably set a precedent that will shape the future of the blockchain and cryptocurrency industry worldwide.