Sitting on the fence appears to be the policy of many countries when it comes to regulating the $700bn cryptocurrrency industry. Yet while cryptocurrencies do offer potential benefits, such as lowering transaction costs, reducing payment time frames and improving financial inclusion, they also raise significant security, consumer protection and financial crime concerns.
Earlier this year, Christine Lagarde, head of the International Monetary Fund (IMF), stoked the debate when she stated that international regulatory action on cryptocurrencies such as Bitcoin, Litecoin, Ethereum, Zcash, Dash and Ripple (utility tokens also known as user tokens or app coins) was “inevitable”.
Hot on the heels of Ms Lagarde’s commentary came a G20 summit in Argentina in March 2018 which saw the world’s economic leaders ponder the cryptocurrency regulation question – an issue which Frederico Sturzenegger, Argentina’s Central Bank chief, declared “needed to be examined”. Although the summit resulted in no firm commitments, aside from setting a July 2018 deadline for the first step toward unified regulation of cryptocurrencies, the propensity for leaders to refer to them as “crypto-assets” perhaps gives a clue as to the direction future talks may take.
If regulation is therefore a matter of when and not if, the overriding question is the shape the regulation should take. “The conundrum, as opposed to the solution, is clear,” says Chris Warren-Smith, a partner at Morgan Lewis. “On the one hand, there is a clear need to prevent cryptocurrencies being used for criminal and terrorist purposes. On the other, regulation needs to be effective and should not stifle innovation.”
According to Alexander Larsen, president of Baldwin Global Risk Services Ltd and an Institute of Risk Management (IRM) spokesperson, regulation is needed in areas such as transparency and taxation, in order to protect consumers against fraudulent initial coin offerings (ICOs) and ensure exchanges have sufficient liquidity and security. “When it comes to criminal activity, however, cryptocurrencies offer an advantage over traditional currencies,” he suggests. “With proper regulation that supports law enforcement with fraud and crime, along with training, facilities and infrastructure, it is possible to track transactions, and therefore track crime.”
Others, such as Joel Emery, a strategy consultant at Lupercal Capital, believe that the underlying distributed ledger technology of many cryptocurrencies can be more transparent than conventional transaction technologies, despite the cryptocurrency market’s ‘reputation’ as a platform for illegal activity. “This reputation is potentially a by-product of current regulatory efforts, rather than the market itself,” he says. “In jurisdictions that have embraced crypto-technology, such as Japan, well-designed cryptocurrency regulations can bring greater trust and stability and attract broader participation in the market.”
With cryptocurrencies proliferating worldwide, regulation must also have a global reach. But this is a challenging prospect for regulators, given the different approaches countries have to legislative issues. Ofir Beigel, founder and chief executive of 99Bitcoins.com, attributes much of the challenge facing regulators to the inertia often displayed by regulators themselves.
“The biggest difficulty is that cryptocurrencies are something new, something that does not fit entirely into the categories the likes of the Securities and Exchange Commission (SEC) is familiar with,” suggests Mr Beigel. “Regulators know that there is a lot at stake, because regulating the cryptocurrency market the wrong way could lead to many start-ups leaving the country or stopping the huge growth and innovation this new market can bring.”
According to Jill Lorimer, a partner at Kingsley Napley LLP, the main regulatory challenge posed by cryptocurrencies is that, unlike regular currencies, there is no centralised authority monitoring money transfers. In addition, the fact that cryptocurrencies can be transferred virtually instantaneously across international boundaries raises significant concerns. Also a problem is the anonymity issue.
“While most cryptocurrencies do not offer true anonymity, as there is no absolute guarantee that the real-life identities of users will remain private, the reality is that it is an extremely difficult and time-consuming task to work out the real-life user behind a Bitcoin address,” says Ms Lorimer. “As new cryptocurrencies are launched with strong claims of real anonymity for users, there is likely to be an arms race between cryptocurrency innovators on the one hand and regulators and law enforcement agents on the other, as each seek to develop systems of increasing sophistication.”
For Mr Larsen, regulation of cryptocurrencies should focus on ensuring that sufficient checks are made on ICO owners and backers. “ICOs should be made to follow similar requirements as companies looking to list on the stock exchange,” he says. “There is also a need for stringent security requirements as regards cyber hacking and data loss for ICOs and exchanges. There have been a number of incidents in the recent past whereby funds or tokens have been stolen from ICOs or exchanges.” That said, Mr Larsen also expects many countries to regulate in a crypto-friendly way in order to attract ICOs and cryptocurrency companies to their jurisdiction.
Constructing a legislative framework strong enough to cope with cryptocurrencies but which does not simultaneously straightjacket innovation is likely to be something of a balancing act for regulators. For many, the key word is flexibility.
“Not all cryptocurrencies are the same, so regulation should not treat them as such,” opines Mr Emery. “There is significant variety between the commercial purposes, legal rights and general features of different cryptocurrency tokens. Some are effectively shares in a company, some are a form of platform access right, some are commodity-like investments and others are effectively forms of money. The character of a particular cryptocurrency, not just the underlying technology, should inform how laws are applied.”
For Mr Emery, regulators need to strike a nuanced balance between effectively ensuring compliance and legal protections for participants, while avoiding overregulation that limits the industry’s growth. “On top of this, enforcement in the cryptocurrency space can be challenging and there are major problems with ensuring practical compliance,” he says. “Conventional regulatory frameworks that have thus far captured cryptocurrency activities, such as laws governing IPO-style securities issues and certain money transmission rules, have typically been designed to address major multinationals, with significant resources.”
And while attempting to regulate a market which already has a large number of well-established cryptocurrencies may seem akin to closing the stable door after the horse has bolted, the drive toward regulation continues nevertheless.
Money laundering solution
One issue that undoubtedly exists within the cryptocurrency sphere is that of money laundering. That said, the extent of the problem is largely unclear. Indeed, while some jurisdictions have imposed anti-money laundering (AML) and counter-terrorist financing (CTF) obligations on cryptocurrency trading exchanges, others implement AML voluntarily.
“Nobody can be sure about the extent of the use of cryptocurrencies in money laundering, save to say that it is real and is happening,” says Mr Warren-Smith. “As the market continues to develop and offer opportunities for illicit activity, it becomes more central to developing strategies to curb that activity.”
While money laundering is certainly an issue, research does suggest that illicit use accounts for only a relatively small proportion of current cryptocurrency market activity. “To my knowledge, it is far less extensive than what the media, for example, makes of it,” suggests Mr Beigel. “Research undertaken in Japan, where the cryptocurrency market is booming, has revealed that only 1 percent of money laundering in the country is done with cryptocurrencies.”
In fact, the undetermined extent of the association between cryptocurrencies and money laundering highlights a deeper issue with the rapidly-evolving market. “Cryptocurrencies have lacked extensive bodies of research, boundaries and trusted information providers,” explains Mr Emery. “As is often the case, once concerns like money laundering are raised, they become widely accepted as fact without true examination, and markets and the public react before the nature of the issue has been fully analysed.”
The cryptocurrency money laundering that does take place, suggests Mr Larsen, is on account of law enforcement agencies’ limited understanding of blockchain technology. “Privacy coins apart, cryptocurrencies are an extremely ineffective method of laundering money or transferring funds for illegal activities due to the fact that all transactions are recorded and searchable. Some would argue that a world where fiat currency is replaced with cryptocurrency would be a far safer one with regard to illegal activity or money laundering,” he says.
Taming complexity, volatility and unpredictability
With most legal regimes yet to effectively address cryptocurrency activity, the extent of the regulation in this area remains unclear. This is changing, however, with governments, authorities and researchers making steady progress toward understanding the industry and amending laws as appropriate.
“Regulators in developed economies generally have shied away from cryptocurrency regulation, so it will be interesting to see the response to the G20’s call for progress,” says Kim Larkin, a solicitor at Charltons Law. In the meantime, the G20 has pledged to apply the standards of the Financial Action Task Force (FATF) – an intergovernmental body set up to fight money laundering and terrorist financing – to the monitoring of cryptocurrencies and their risks.
A further indication of the likely shape of things came with the launch of another task force, this one in the UK. Made up of representatives from the Treasury, the Bank of England and the Financial Conduct Authority (FCA), the task force will, according to chancellor Philip Hammond, “help the UK to manage the risks around crypto assets, as well as harnessing the potential benefits of the underlying technology”. In addition, Bank of England governor Mark Carney has also acknowledged the potentially transformative potential of blockchain, which underlies cryptocurrencies, while calling for regulation.
“The major reason that regulators have not been more proactive in regulating cryptocurrencies is probably because, as Mark Carney has suggested, they are not perceived to present systemic risk,” continues Ms Larkin. “It is also probable that major regulators, such as the SEC and the FCA, will not take any major steps toward cryptocurrency regulation in the short term. Instead, they are more likely to take regulatory action in cases of fraud and clear breaches of securities laws.”
Complex, volatile and unpredictable, regulating the world of cryptocurrencies will undoubtedly take considerable time and resources. Some even characterise the process as the start of a revolution. “We have to remember that we are just at the beginning,” says Mr Beigel. “Email was invented in 1972, yet it took over 20 years until people started using it. The same thing will happen with cryptocurrencies. In this world, it is well known that user experience, complexity and monetary responsibility are the issues to confront.”
As the international approach to cryptocurrency regulation gravitates toward centre stage and acquires somewhat more clarity, the industry is at a crossroads. With regulation now virtually inevitable – a question of when, not if – all interested parties need to choose a path and get on board to ensure that regulation is uncompromising but fair.
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