Cryptocurrencies have advanced the boundaries of current laws and compelled a changing approach to regulation.
In this report I will analyse and evaluate the risks and challenges financial regulation is facing in light of the global cryptocurrency boom in today’s market.
What is Cryptocurrency?
Cryptocurrency is a medium of exchange, created and stored electronically in a blockchain. It does this by using a very complicated encryption technique to control the creation of monetary units and to verify the transfer of funds. Essentially, it is a database system with limited entries that no one can ever change without satisfying specific conditions.
To understand what cryptocurrency truly means, one must also understand the underlying technology that lays the foundation on which this digital revolution has unveiled.
Cryptocurrency evolved from an accident created by Satoshi Nakamoto who developed the most known cryptocurrency, Bitcoin. In 2008, Satoshi announced that he found a way to build a decentralized digital cash system; peer-to-peer electronic cash system.
The difference between a centralized system and a decentralized one is key to understanding why this has changed the way the market wants to operate and appealed to so many, across the world.
To realize digital cash, you need a payment network with accounts, balances and transactions. One major problem that every payment network needs to solve is the idea of double-spending. To prevent one entity spending the same amount twice. This is usually done by central server who keeps record of all these transactions and balances. This is the fundamentals of our current banking system who manage this server and validates and ensures that double spending does not happen.
In a decentralized network, you don’t have this server. For transactions and balances to be verified it relies on every single peer within the network to do this job. Every peer in the network needs to have a list or complete consensus with all transactions to check if future transactions are valid or whether it is an attempt to double spend the same money.
Confirmation is a critical concept in cryptocurrencies. Only miners can confirm transactions. Miners are computers that solve the complex algorithms which is called cryptography. Cryptography is what secures all these transactions and has allowed cryptocurrency believers to claim it is ‘un-hackable.’ The idea that a system has been created which is so secure is an interesting concept as there is economic importance surrounding why it has been globally accepted.
It was in the wake of the financial crisis that led people to lose trust within the current central banking system. The banks held the money of all the people and it was due to the way in which the money was managed which led to the collapse of the financial markets. Therefore, the common view was that we needed a new form of currency which would mitigate the risk of putting our full trust in the central banking system.
Miners take the transactions, stamp and verify them as legit transactions and subsequently spreads them across the network. After a miner has approved the transaction then every node has to add it to its database. This then makes the transaction part of the blockchain which cannot be altered.
The large acceptance of cryptocurrency and the breakthrough made of effectively developing a system that works has propelled this market causing a lot of distress amongst governments and especially financial regulators.
Challenges facing the crypto market
There are loads of factors and analysis that can be done to pinpoint the challenges posed by cryptocurrency, but this report will touch upon only the key issues.
Is the expansion of the market too big to control?
The current boom of cryptocurrency has taken the world by surprise. It is not only first world countries but also third world, less developed countries that are trying to develop ways in using cryptocurrency. The fact the currency is digital and is less costly, has meant that ordinary people only need access to the internet allowing them to buy and trade cryptocurrencies. Also, the technology of blockchain has allowed these different companies to develop cryptocurrencies for specific purposes which means it is not only affecting the financial industry but also other industries such as engineering, technology, insurance, utilities and many more. As a result the demand for cryptocurrencies has rapidly increased in the last few years. Governments and financial regulators alike did not really pay attention initially but due to rapid expansion of the market has forced them to pay attention. Some commentators have said they are acting too late and that the market has expanded and developed so much recently that it has been argued that the regulators reactionary involvement is will cause innovation to stifle.
Should cryptocurrencies be adopted within the current regulatory framework?
Regulators across the globe are now attempting to mitigate the risks posed by cryptocurrencies which is giving rise to the question of how to effectively implement the framework. Some countries’ regulators have penalised certain firms saying that the activity of certain cryptocurrencies falls within the existing definition relating to currency as we know it, fiat or commodity currency. On the other hand, other commentators are stating that the current framework does not touch upon the technicalities of cryptocurrencies and the way in which it is being used. For example, in the UK there is discussion whether a firm providing services relating to specific cryptocurrencies is conducting a regulated activity under FSMA 2000. The argument is that you are advising on services dealing with financial markets. This essentially gives rise to regulation due to potential investors worries of the transparency of these investments and the advice given by these specialised cryptocurrency fintech firms. Regulators are facing the immediate issue of not thoroughly understanding the technology and the way in which firms are providing these services by using cryptocurrency. Once regulators have a better understanding they should be better equipped to deal with the regulatory pressures they are currently facing.
Should all cryptocurrencies be regulated?
Part of the challenge regulators are facing could be minimised by firstly distinguishing whether all cryptocurrencies should be regulated. As stated above, it could be argued that the regulators, banks and government are reacting too late and thus the challenge ahead is far too great to effectively mitigate the risks posed. Cryptocurrencies is a broad area and has scope for so much more in today’s ever-changing digital world. There is mostly consensus around the whole industry claiming that the blockchain technology is here to say and that we have only touched the surface in terms of what it can develop too in terms of affecting change in many more industries.
There are few different cryptocurrencies such as;
- Privacy Coins
- Securities
- Utility Tokens
- Digital Currency
They all have different functions and capabilities tailored for their intended use in different sectors and industries.
Privacy coins implement functionality to hide each persons identity when making the transactions. They also can keep your wallet anonymous and/or hide the balances of the transactions.
Privacy coins are very difficult to regulate because the whole point of the attraction to using these coins is because you can completely anonymise yourself from the transaction and keep things hidden. The counter argument is the risk posed to the market which opens the doors for criminal activity and other nefarious activities using privacy coins as a method of not getting caught.
Cryptocurrencies can be seen as securities which is another regulatory challenge. The types of coins that fall under this category are wide but not all coins easily fit within the definition. For example, the larger more established coins such as Bitcoin, Ethereum do not pose the same sort of consumer risks, however some smaller coins do. Each coin would have to be evaluated on a case by case basis. If a coin does fall under securities regulation, then it could be subject to a lot of due diligence and ultimately costs rendering commercially unfeasible.
Initial coin offerings (‘ICO’) arguably is the most challenging aspect of cryptocurrency. An ICO is a method of raising funds for certain projects. The ICO is like a token given in return for fiat or virtual currencies such as Bitcoin. Normally you would set up an ICO with an accompanying white paper outlining the project and in return investors will fund the project. The investors are hoping that the project is a success which in turn will hike the price of the token in return which will inevitably be worth a lot more than their initial investment. The risk posed through ICO are that there is no security for investors who invest there money that is worth something for essentially something that has no value. The project could fail which would mean the investors money is lost and regulators have compared an ICO to the known method of initial public offerings (IPO). ICO firms are arguing it is not the same but investors and consumers are calling for more transparency in these projects so investors know the associated risks for them to make an informed decision whether to invest or not.
Digital coins or digital gold are the labels given to coins such as Bitcoin. Commentators have long argued that it is not a currency because it has no value. They have said the whole cryptocurrency is just a bubble waiting to burst, causing the market to collapse and people should stay well away. The problem here is that the market was unregulated and decentralysed and is still increasing. If more and more people buy into this idea then the supply and demand will increase which inevitably leads to the current value. Bitcoin for example is limited to a total supply of 21 million coins. The cap on these coins also help to increase and add to its value. However, Bitcoin and others are essentially just virtual with no central backing or comparative of value such as gold, silver. The current boom leading to its current value depends upon, supply and demand, security and flexibility it provides as an alternative to the traditional method.
Risks posed by Cryptocurrency
There are many risks associated with the use of cryptocurrency not only to the current systems in place but as a whole to the consumer and investors.
Value, volatility and stability
Cryptocurrencies have been described as eco-systems in their own right. While this decentralization renders bitcoin free from government manipulation or interference, there is no central authority that ensures the process runs smoothly and or the actual value of bitcoin.
The key difference between national currencies and cryptocurrencies is that there is no government or asset like gold that backs the value of the coin. It is for this reason that many say it is a ‘bubble’ waiting to burst. There are many sceptics that wonder why people have bought into cryptocurrency as essentially you are buying into virtually nothing. Normal currency in which the stock markets trade on such as the dollar is backed by government and they set the value against the federal reserve which consists of assets of value such as gold. This makes your money have value and thus you have the security of this value to fall back on. However, cryptocurrencies pose a threat to consumers and investors because they rely on their own knowledge of the market and whether or not it is a worthwhile investment or coin. An investor or consumer does not know what the real value of the coin is and can potentially lose its assets that hold real value and in exchange get nothing. This has been a common problem recently as more new currencies emerge.
In addition, the financial volatility of each cryptocurrency is increasingly difficult to measure. In a centralised market the market value of a currency is set from the outset and you are able to compare data and economics of countries to understand whether an investment is worthwhile. In the cryptocurrency market, due to the boom that is happening with bitcoin and others shows how volatile the market is as prices of the coin go up and down drastically within the last few years. The volatility is dependant on supply and demand and therefore leaving the market open to manipulation by more experienced cryptocurrency individuals. This volatility could lead to a market crash causing consumers and investors on a global scale to be affected drastically. This in turn could lead to economic crisis and cause the real markets to crash as a result.
Privacy, fraud and counterfeiting
Another big issue is the link between the privacy features attached to cryptocurrency and how that aggravates fraud and counterfeiting. While many cryptocurrency believers see the huge benefits of having privacy in transactions there are risks of fraud and counterfeiting that undermine the benefits.
Prior to the rise in trading of cryptocurrencies, bitcoin was used for criminal activity on the dark web. This allowed criminals to hide behind their virtual currency in an un-regulated market and purchase weapons, drugs and more. The privacy feature allows a individual to not be traced and thus can benefit from the wide scale use of cryptocurrencies as it will be harder to trace as the network grows.
Similarly, this has opened the door for fraudsters and counterfeiting to increase. Cryptocurrency value was derived from its security features of cryptography which was labelled ‘un-hackable’. Recently, Kaspersky found that it was easy for counterfeiters to copy the bitcoin transactions and re-direct transactions to their wallets. This meant that people who thought were paying for a bitcoin was not receiving anything in return for the consideration given. This is unwelcome news for the cryptocurrency world as this has caused the currency to plummet in value reiterating the volatility.
Also there has been a rise in ponzi schemes such as ICO and new coins, which has specifically enraged investors in recent years. Due to lack of security and transparency it is extremely difficult to distinguish a valid cryptocurrency from a ponzi scheme. Financial regulators and securities regulation are very conscious of this because one of the main factors that are allowing these schemes to surface and gain tremendous amount of investment is down to lack of institutionalisation backed by securities like in other sovereign commodities.
Conclusion
Cryptocurrency is definitely here to stay, the issue is whether it will in all aspects of it. As evaluated in this report, the technology of blockchain is a system that has great global potential in solving many of the first world problems we have today in improving our ways of finance, business and many more industries. Regulation does pose a great risk to the innovation of developing the system to the next level but with careful analysis and evaluation with the right balance can achieve what the industry desires. The security, volatility and value of the currency can be mitigated successfully through institutionalisation, but it has to be done sparingly and within reasonableness. Many commentators are against regulation of cryptocurrencies as they believe it will be the cause for the failure for cryptocurrency. However, without some sort of framework being introduced the world of cryptocurrency can inevitably lead to failure without some rules. A cryptocurrency that aspires to become part of the mainstream financial system may have to satisfy a wide divergent criteria. It would need to be mathematically complex to ensure it upholds its security features which will deter fraud and hackers which could be further advanced by regulation. Once institutional money is injected and there are rules in which certain cryptocurrencies are used such as transparency rules for ICO, then it will further deter fraudulent coins and ponsi-schemes. At the same time there has to be balance of complexity so that the ordinary consumer can understand how to operate within the crypto world in order to see the benefit, which translates to keeping it decentralised nature but with adequate consumer safeguards and protection. Also, it needs to preserve user anonymity to a certain degree but without being a facility for tax evasion and other nefarious activities. It will be difficult for regulators and governments involvement here to effectively mitigate the risk while not stifling innovation. Although it can be achieved by either developing a framework for these specific areas of cryptocurrency such as having a sort of centralized network which encourages registers of licenced cryptocurrency exchanges and implementing risk models throughout the process to ensure there are layers of protection to hopefully deter this type of activity. It is evident that criminal activity is always going to be there and it cannot be completely eradicated but if cryptocurrency is going to be a success it needs to be understood and accepted widely for it to develop properly and safely. Overall, regulation to a certain degree will be welcomed and if done properly can open the world to a whole new virtual reality that will transform the way the world operates.
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