Regulation in the Age of Cryptocurrencies

Blockchain technology is ushering in a new epoch of monetary oversight, creating opportunities and challenges for regulators in a world disrupted by the advent of cryptocurrencies.

As of today, according to CoinMarketCap, the current market capitalisation of Bitcoin and all other cryptocurrencies stands at USD409 billion. 193 cryptocurrency exchanges are now operating globally, located in many jurisdictions from South Korea to the Seychelles.

ICOs (initial coin offerings) have also flourished as a fundraising method. ICO funding for the first quarter of 2018 was USD6.3 billion, almost 20 percent higher than the previous year, according to Coindesk.

The regulatory response to this burgeoning sector has been inconsistent, and relatively schizophrenic.

On one side of the coin, scarcely a week passes without a regulator taking enforcement action against a cryptocurrency exchange or issuing warnings against cryptocurrencies and ICOs.

However, alongside this regulatory concern, governments from Sweden to China are embracing digital currencies at a national level, to give them more power and greater control over monetary policy.

Policing the Wild Frontier

Cryptocurrencies were created to compete with central banks. The Bitcoin ethos enshrines the concept of decentralised governance, designed to bypass regulated, established systems.

In recent years, cryptocurrencies have also attracted investment in payments infrastructure built on their software protocols, including centralised and decentralised exchanges and wallet providers.

The explosion of interest in cryptocurrency trading is in a large part due to the introduction of ICOs. This innovative funding method allows startups to raise money by selling tokens representing an interest in their business proposition in return for cryptocurrencies such as Bitcoin or Ether.

The sky-high volumes raised by some of these ICOs such as Telegram (which is aiming to raise USD2 billion) have attracted regulatory attention as to whether ICOs offer sufficient protection to consumers and pose any systemic risks to the financial markets.

Given the complex matrix of securities law, tax, data privacy and other legal issues involved, and the rapidly evolving cryptocurrency trading environment, it is no wonder that regulators are struggling to develop a consistent approach to mitigate risks.

Varying regulatory approaches

China appears to be the most stringent cryptocurrency regulator, instituting a nationwide ban on internet and mobile access to all things related to cryptocurrency trading and ICOs – despite the fact that Chinese bitcoin miners made up over 50 percent of the worldwide mining activity in 2017.

Japan and Australia have taken steps to regulate cryptocurrency exchanges in a bid to counter illicit uses of cryptocurrencies. Exchanges must follow a registration requirement, maintain an AML/CTF (anti-money laundering / countering terrorist financing) programme, and follow certain reporting requirements for suspicious transactions.

The United States SEC (Securities and Exchange Commission) has halted several ICOs, charging some founders with securities laws violations.

In April, the New York Attorney General’s Office sent letters to 13 major cryptocurrency exchanges requesting detailed information on their operations, internal controls and safeguards to protect customer assets. In a public statement, Attorney General Eric Schneiderman explained that the inquiry was targeted at promoting the accountability and transparency in the virtual currency marketplace that investors and consumers deserve.

Some market participants are policing their own behaviour. In Japan, a group of 16 licensed cryptocurrency exchanges have banded together to form a new self-regulatory organisation. The development comes as cryptocurrency exchanges in Japan try to restore customer confidence, following a hack in January 2018 which saw USD530 million in NEM tokens stolen from the Coincheck exchange.

Banking in the shadows

Regulators are also increasingly worried about the ML/TF (money laundering / terrorist financing) risks associated with cryptocurrencies.

At the supranational level, the FATF (Financial Action Task Force) has acknowledged that establishing consistent guidance across all jurisdictions globally is essential to maintain AML/CTF standards. This is especially given the borderless nature of exchanges, where activities may be carried out without seeming to be based in any particular jurisdiction.

The FATF has focused on fiat-crypto exchanges, which pose the highest risks due to their interaction with regulated financial systems. Some countries, such as Taiwan, Malaysia and South Korea, have also recently proposed regulations modelled after existing AML rules in the financial sector.

In response to the regulatory uncertainty, there are reports that a large number of banks in Asia have closed down the existing bank accounts of cryptocurrency exchanges and crypto-related businesses. This may in part be due to the challenges of dealing with crypto-related customers which would likely be characterised as high risk, which require enhanced due diligence measures to be applied. Banks may also be unsure about how to measure and assess the risks of banking such customers.

However, there is the risk that these actions could force cryptocurrency exchanges into the shadows of less regulated jurisdictions. This would leave them outside of the effective control and oversight of regulators in the major jurisdictions in which they operate.

There is also a concern that the denial of access to regulated payment systems and its accompanying AML/CTF standards could lead to a poorer competition environment, and also damage major jurisdictions keen to advance an innovation-led growth strategy.

Decentralised exchange models are also emerging in a bid to evade regulatory controls and resolve the banking issues. Placing the onus for KYC (know-your-client) obligations on the end user runs the risk that cryptocurrency trading will be further driven underground.

Last week, Chile’s Free Market Court ruled that two Chilean banks, Bank Itau and Banco del Estado, must reopen the bank accounts of a cryptocurrency exchange,, which had been closed for concerns over money laundering.

In Asia, the RBI (Reserve Bank of India) recently announced that the institutions under its regulatory domain are prohibited from engaging with crypto-related firms. This prompted aspiring exchange CoinRecoil to file a petition with the High Court of Delhi in hopes of overturning the decision, with the next hearing scheduled for May.

Getting this balance right is a significant challenge for regulators. Interest in cryptocurrency trading continues to grow, with a fifth of finance firms considering getting into cryptocurrency trading within the next year, according to a Thomson Reuters poll of 400 firms.

Digital currencies as a panacea

At the other end of the scale, central banks are looking to capitalise on the opportunities presented by digital currencies.

According to a 2017 paper issued by the Hoover Institution, sovereign digital currencies have the potential to transform all aspects of the monetary system and facilitate the systematic and transparent conduct of monetary policies.

In particular, economists have noted that a well-designed sovereign digital currency may be used as a stable unit of account, a practically costless medium of exchange, and a secure store of value. Replacing cash with digital currency could also give central banks an option to lower interest rates below zero per cent in response to severe adverse shocks.

Experts have also opined that the widespread use of digital currencies, and the obsolescence of paper currency, would discourage tax evasion, money laundering, and other illicit activities made easier by paper currencies. This is especially pertinent for developing economies where tax evasion is rampant.

In developing economies, sovereign digital currencies could also broaden financial inclusion by making a digital payment method available to many more people.

There are two basic approaches that a sovereign digital currency could be used. One approach, which is analogous to physical cash, would be for a central bank to issue currency as digital tokens, which would then circulate as a payment method among businesses and individuals and might only rarely be redeposited funds back at the central bank. This approach would use a blockchain to verify and track transactions.

The second approach, analogous to debit cards, would be for businesses and individuals to hold accounts directly at the central bank or at supervised financial institutions. The payment method would be enabled by the central bank debiting the payer’s account and crediting the payee’s account. This could have wide-ranging implications for monetary policy and financial stability.

The rise of sovereign digital currencies also raises new and complex issues on cross-border trading and investment in sovereign digital currencies.

Venezuela, Iran and Russia’s announcements that they were considering launching sovereign digital currencies sparked a furore in the market given that all three countries are subject to American sanctions.

Venezuela’s proposed launch of a petro currency backed by oil was shortly followed by a US executive order barring all US-based financial transactions involving petro.

There are also important cybersecurity and liquidity issues to consider. In the event of a cybersecurity hack, a centralised central bank blockchain could represent a single point of failure that could make the entire financial system vulnerable to hacking or sabotage.

Bracing for the future

As of now, a unified global response is still some way off. In March, the G20 countries’ central banks agreed to monitor cryptocurrency developments, but stopped short of implementing any specific action.

The OECD (Organisation for Economic Co-operation and Development) has also called for cooperation on studying the tax consequences of cryptocurrencies.

As cryptocurrencies encroach on traditional spheres of regulators’ authority, it is also likely that regulators will move towards greater oversight and regulation of the industry.

Equally, it seems to be only a matter of time before sovereign digital currencies gain wider mainstream acceptance, despite the risks involved.

One thing however is becoming abundantly clear. It is unlikely that the final regulatory picture will look anything like the original ethos of competition, decentralisation and openness that the creators of digital currencies espoused.

Herbert Smith Freehills provides tailored legal services to fintech sector participants including incumbent banks, growing fintech businesses, asset managers, payment firms and technology services providers. Its in-house expertise includes practice areas such as corporate law, technology, cyber security, data protection/GDPR and financial services regulation.

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