1. EXECUTIVE SUMMARY
The current level of regulation governing cryptocurrencies is not sufficient to deal with the risks posed by their use. In finding the correct level of regulation needed to legitimise the crypto market, regulators face a difficult task to ensure that they do not suppress the innovation and development of the technology underpinning cryptocurrencies through overly-stringent regulation.
Cryptocurrencies should be regulated in the same way as the conventional securities that they most closely resemble. A blanket-approach to all crypto-assets would fail to create an effective regime and could potentially lead to over-zealous regulation. The industry would benefit from a universal approach from regulators around the world due to the ease at which cryptocurrencies can be moved globally.
2. WHAT IS MEANT BY CRYPTOCURRENCY?
Cryptocurrencies are digital currencies in which encryption techniques are used to regulate the generation of units of currency and verify the transfer of funds, operating independently of a central bank. The decentralisation of these currencies is a major attraction and is achieved by a peer-to-peer network upon which two users directly interact with each other, without the need for a third-party. This works through distributed ledger technology (typically a blockchain) that serves as a public financial transaction database.
Blockchain is a technology that equates to a self-verifying record of transactions between parties that requires no intermediaries and no institutional record keeper. As transactions occur, ‘blocks’ are created but are only added to the chain if they are verified and approved by the majority of the users on the network. Altering an existing block has a domino effect as they are all linked together, meaning changing one block changes every block in the chain. The network is therefore easily able to recognise any fraudulent activity and prevent its addition to the chain.
Some cryptocurrencies, such as Bitcoin, operate like conventional money: they provide a medium of exchange; unit of account; and a store of value. However, as the technology underpinning cryptocurrencies has evolved, many now represent other rights as well. Some are therefore much more similar to financial products like securities and derivatives than to currencies. This has led to the term “crypto-asset” emerging to describe them.
3. CURRENT CHALLENGES FACING THE MARKET
3.1. Price manipulation
The biggest issue in the cryptocurrency market is excess volatility. The most prominent reason for this high volatility is the activities of “whales”. These are individuals with large holdings of cryptocurrencies. They are able to place large “buy orders” to stir up the interest of smaller investors. This inevitably leads to the price going up. Once the price hits a level that favours the bigger investors, they cash in on the price and the price drastically falls. “Whales” can thus manipulate the price without actually investing in the market. The lack of position price limits on cryptocurrency exchanges is a key reason for this activity. Such limits would discourage the movement of large buy/sell positions in the market and would reduce the activity of “whales”, thus reducing volatility in the market. The introduction of exchange-traded funds (ETFs) has added to the volatility in the market due to the increased liquidity that ETFs provide.
This volatility will not help the technology's adoption into everyday life. Vendors could potentially make huge losses if the value of the Bitcoin they receive fora product falls in value by 20–30%. This adds a level of uncertainty to transactions, which businesses hate.
3.2. Transaction Delays
The scalability of blockchain technology has been questioned by experts., The technology ought to make transactions occur faster, but as more people join the network and more transactions occur, the chains become longer and take much longer to be approved. Given the volatility of the market, delays can be extremely costly. PayPal manages 193 transactions per second, Visa does 1667, while bitcoin manages only 7 per second. The only way to improve this is to work on the scalability of the system. A solution is to incentivise those who approve transactions by offering greater rewards. However, this would increase the cost of transacting in cryptocurrencies and would hamper the evolution of the technology.
3.3. Imminent Regulation
Another challenge that faces the cryptocurrency market is the imminent influx of regulation. There is a risk that players in the market may discontinue or become outlawed by the government. However, there are many in the industry who think this presents a great opportunity to the market. They say that the correct level of regulation in the market could help to legitimise cryptocurrencies and bring them into mainstream finance.
4. CURRENT CHALLENGES FACING THE REGULATORS
Regulators must find the correct balance to ensure they do not hamper the innovation in the industry, whilst ensuring that consumers are adequately protected. To do this, they must find answers to three questions:
1. What are crypto-assets?
2. How should day-to-day risks be managed?
3. Do they pose a threat to financial stability?
4.1. What are crypto-assets?
As mentioned above, some cryptos function like regular national currencies and others are more similar to financial products such as securities or derivatives. At the moment, there is no agreement on the classification of these assets. They should not be treated with a blanket approach across the board. They should be regulated in accordance with the conventional products that they most closely resemble. This is the approach of Finma, the Swiss regulator, who in February announced plans to regulate Initial Coin Offerings (ICOs) based on their actual function.
4.2. Management of day-to-day risks
To protect consumers from the risks posed by using cryptocurrencies, regulators must find a way to manage to day-to-day risks that confront crypto-users and where to target this regulation. The most obvious place to start implementing change is on the exchanges where fiat currency is exchanged for cryptocurrencies. These exchanges should be required to apply similar standards to those of banks, including requiring identification from all customers and keeping a record of all transactions. This is the stance of several countries, including the EU and Australia. Numerous exchanges have voluntarily introduced know-your-customer rules whereby you can only participate in the exchange after proving your identity.
Regulators are not unanimous about the level of consumer protection that should be offered. Some view consumers’ exposure to risk as their own gamble to take, others want to shield investors from harm. Given the complexity of these financial instruments, some believe that only those who are better at judging risk and interpreting complex financial information should be able to invest.
4.3. Financial Stability
Due to the size of cryptocurrencies relative to the financial system, they do not currently pose a material threat to financial stability. The market capitalisation of cryptocurrencies is $353bn which is under 5% of global GDP. Compare this to the valuations of technology stocks at the height of the dotcom boom that was about a third of global GDP, and the value of credit default swaps prior to the global financial crisis in 2008 was 100%. That said, regulators should monitor the factors that could increase systemic risk in the market, such as how highly leveraged crypto-investors are.
5. RISKS ASSOCIATED WITH CRYPTOCURRENCIES
5.1. Money Laundering and terrorist financing
In July 2017, Alexander Vinnik, A Russian citizen who operates the bitcoin exchange BTC-e, was accused by US authorities of laundering over $4bn for criminal activities ranging from computer hacking to drug trafficking. Cryptocurrencies are very attractive tools for criminals as all transactions bypass the regulated banking system, making the tracking of money very difficult for authorities. These transactions can be spread across multiple jurisdictions, creating uncertainty amongst national authorities as to which country has the power to launch a criminal investigation and which country’s anti-money laundering regulations should be applied.
5.2. Tax evasion
Trading crypto can be highly profitable. Therefore, authorities are keen to levy capital-gains tax on any profits. However, because most crypto-exchanges have allowed users to participate in the market anonymously, there is no reliable data on crypto-evasion. Whilst regulators have a lot of more basic points to consider (such as the definition of these assets), some countries are beginning to set up their pursuit of tax evaders. In February, the IRS successfully obtained a court order to force Coinbase, one of the largest crypto-exchanges, to release the identities of 13,000 customers.
5.3. Security risks
Bitcoin exchanges are digital and therefore vulnerable to hackers, operational glitches and malware. There can also be breaches of digital storage and customer digital wallets (a software program that interacts with the blockchain to enable users to send and receive cryptocurrencies and monitor their balance). Regulators do not currently have the capability to recover lost funds. The built-in anonymity features of cryptocurrency, as well as the fact that it is not a regulated marketplace, mean that once a coin is stolen, the victims of such security breaches are left with no remedy.
5.4. Mitigation
These risks can be mitigated with effective policies. However, authorities will be faced with trade-offs, for example strengthening security using more advanced cryptography to reduce systems’ vulnerability to cyber-attacks could make it easier for criminals to hide their illegal activity.
The anonymity feature of cryptocurrencies allows criminals to remain unidentifiable and poses a real problem for authorities who are trying to deal with money laundering and other criminal offences. The implementation of “Know-Your-Customer” (KYC) requirements for crypto-exchanges is the first step towards mitigating this risk. These requirements force users to provide a form of identification upon signing up to exchanges and would allow authorities to trace the illegal transfer of currencies. However, this system will only be effective if all exchanges worldwide are forced to comply with them.
6. ARTICLE ANALYSIS
6.1. Are Central Banks reacting too late?
The worry for central banks is that they may lose the ability to influence the money supply and therefore implement effective monetary policy. Since this is a key mechanism by which they stimulate and contract the economy, they may cease to have sufficient impact during downturns in the economic cycle. Currently, cash is used for just 8% of transactions globally. In light of the recent global financial crisis, the public are still wary of the solvency of commercial banks and officials are concerned that cryptocurrencies could soon fill that void.
Central banks are not reacting too late. The general opinion, as expressed in the IMF’s Global Financial Stability Report, is that cryptocurrencies are not set to replace traditional currencies any time soon as they do not satisfy the three functions of money. They may act as a store of value, but their use as a medium of exchange has been limited and their excessive volatility prevents them from being a reliable unit of account. Central banks around the world also echo Mark Carney’s remarks about the crypto market’s size being too small to pose a legitimate threat to global financial instability. The total market capitalisation is less than 5% of the combined balance sheets of the world’s four largest central banks.
6.2. Central Bank adoption of Crypto-technology
The article suggests that rather than protecting investors by regulating the cryptocurrency market, central banks are more interested in attempting to adopt the technology for their own purposes.
Today, the only way for the public to hold central bank money is cash. To hold a digitised version of that holding, one must convert the central bank liability into a commercial bank liability by depositing the cash at a bank. A central bank cryptocurrency (CBCC) would allow consumers to hold central bank liabilities in digital form. The attraction of this to consumers is to avoid the credit risk associated with commercial bank liabilities. However, making central bank accounts widely available would achieve the same outcome. The benefit of a CBBC is that it would still provide anonymity. The question is whether the general public really value the anonymity benefits of a cryptocurrency.
Central bankers are not so worried about the approach of the cryptocurrency market capitalisation relative to fiat as they are about how the blockchain undermined third-party institutions, like themselves.
To classify central bank’s investigations into issuing a CBCC as “self-interest” is perhaps a little unfair. A CBCC would enable central banks to adopt alternative forms of monetary policy. For example, they could institute negative nominal interest rates simply by reducing balances on the electronic wallets of consumers held at the bank thereby charging the rate on all money in circulation within any economy. This would incentivise consumers to spend and consequently stimulate the economy. This is not possible in an economy where consumers can hold physical cash. Another option for central banks would be “helicopter drops” of money whereby they could make lump sum transfers to all households. This would only be possible if all citizens in an economy had electronic wallets to receive the payment from the central bank. Thus, by utilising the technology behind cryptocurrencies central banks would more effectively be able to manipulate the economy. This would help create financial and economic stability, which would benefit businesses and consumers greatly in times of economic turmoil.
However, the Bank for International Settlements has warned that a CBCC could result in “digital runs”, whereby the public would run to the central bank in times of panic. This potentially poses a significant threat to financial stability as the bank would have much less capacity to affect the money supply.
Central banks see the uses of distributed ledger technology, but worry about the abuses virtual money can be put to outside the official system (criminal money laundering and the sale of illegal goods and financial instability)
7. DOES THE CURRENT AND PROPOSED REGULATION SUFFICIENTLY MITIGATE THE RISKS POSED BY THE USE OF CRYPTOCURRENCY?
7.1. The general prohibition approach
Many countries have banned or severely restricted the use of cryptocurrencies in their jurisdictions. China, which had one of the most active crypto-asset markets recently banned exchanges, financial institutions and payment processors from handling them. China, along with Russia, also prohibit ICOs altogether. Russia has also stated that the ‘official currency is the ruble, and introduction of all other monetary units and money substitutes are prohibited’.
China and Columbia have prohibited banks and third-party payment providers from accepting, using or selling virtual currencies, ensuring that financial and payment institutions cannot be involved in cryptocurrency transactions.
This approach should not be widely adopted as it is not an effective approach to regulating the market. This is due to the fact that cryptocurrencies: exist online; are global; and have the anonymity feature. These allow users to circumvent the bans altogether. Furthermore, if widely adopted, such stringent rules risk suppressing the innovation of the technology underpinning cryptocurrencies.
7.2. Other approaches
Most countries are yet to make any material steps toward regulating cryptocurrencies as they strive to reach an understanding of the currencies in order to come up with coherent regulation. There is currently an extensive list of the many ways in which regulators are approaching the issues discussed above. The lack of any harmony in the approaches of authorities limits the effect of the regulation. This is particularly pertinent for tax laws. If criminals have the opportunity to exploit differences in national laws, much like with corporate tax laws, this could lead to the creation of “crypto-havens” and regulators would have failed to make any positive difference. Legitimate users will be deterred from participating in the market if criminals are allowed to operate freely in it. This would hamper the market as a whole.
Proponents of cryptocurrencies believe that they are the future of the financial system. Therefore, crypto-assets should be held to the same standards as the rest of the financial system. More jurisdictions should follow the example set by the EU and US in requiring crypto exchanges to meet the same anti-money laundering and counter-terrorism standards as other institutions.
7.3. Initial Coin Offerings
Swiss regulators are planning to implement regulation at the birth of cryptocurrencies, i.e. at Initial Coin Offerings. In the same way that Initial Public Offerings involve the issue of shares to investors in exchange for fiat currency, ICOs involve the transfer of tokens to investors typically in exchange for cryptocurrencies such as Bitcoin. As the start-up issuing the tokens grows, these tokens are meant to increase in value. ICOs are typically void as highly speculative and risky, and some even represent Ponzi-schemes and result in investors being scammed of their investments.
Regulators should investigate each new ICO and determine how to classify the tokens. Tokens resembling traditional currencies should be regulated to prevent fraudulent behaviour. Whereas others that resemble more complex securities should be regulated accordingly. Additional disclosures should be required to mitigate the risks posed by Ponzi-coins, such as information regarding what cyber audits were conducted prior to the offering, what kind of distributed ledger is being used and details of who developed the coin.
This approach should allow room for innovation and not stifle the development of the technology behind cryptocurrencies whilst also allowing regulators to protect the public and allow them to limit systemic-risks in the financial system. Regulators should not act in haste to implement regulations, but should instead ensure that their plans will be effective and will help to legitimise cryptocurrencies and bring them into the mainstream financial system.
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