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Regulating cryptocurrencies: walking the tightrope

Long-time regulators world-wide took a wait-and-see attitude towards the non-regulated markets for Bitcoin and cryptocurrencies. But that is changing rapidly. With the growing popularity of the crypto market, the large number of unregulated cryptocurrencies (more than 1300, greater attention is now being paid by Governments and other stakeholders around the world.

Regulators across the world are looking at whether — and how — to regulate cryptocurrencies. As a reaction last week cryptocurrencies tumbled with the Bitcoin falling even below $6,000 after having reached a high of $20,000 on 17 December for fear of more regulation. The cryptomarket value also fell deeply from $674 billion in December to $315 billion. Also the hack of the Japanese crypto exchange Coincheck, where some hundreds of millions of dollars disappeared caused enough unrest. Up till now there is however no univocal direction in how cryptocurrencies are looked at and how to treat them. 

Why intervene in the cryptocurrency market?
It is no surprise that governments and regulators are becoming more vocal and putting together tasks forces on how to deal with it. There are compelling reasons why cryptocurrencies should be under more scrutiny by regulators and supervisors. The threat of price volatility, speculative trading and hack attacks all call for stricter regulation. Main goal of regulators is to create long-term stability afforded by common policies and elimination of fraudulent actions and practices.

  • To protect the consumer

Firstly, there is the need of tighter oversight of crypto exchanges and trading platforms from the viewpoint of investor protection. These markets are however not transparent for private investors. There are clear risks for private investors associated to price volatility, operational and security failures at crypto exchanges, market manipulation and liability  gaps. Many experts worry that the trade in Bitcoin futures, crypto funds and other highly speculative financial products will inflate a speculative bubble, while running the risk of losing all their money. In that case there is – unlike at normal currencies such as euro, dollar and yen - no public institution like governments or central banks behind it.

  • Fear of criminal activities

According to many, aside from the instability of cryptocurrency prices, these cryptocurrencies must have greater regulatory oversight in order to prevent illegal activity and illegitimate use. Aside from the instability of cryptocurrency prices, regulators are worrying about criminals who are increasingly using cryptocurrencies for activities (trading away from official channels) like fraud and manipulation, tax evasion, hacking, money laundering and funding for terrorist activities.

  • Systemic risk

There is also the systemic risk that is inherent to the crypto-economy. If it continues to grow uncontrolled there is the danger of destabilising the financial system worldwide. The overheating of the cryptocurrency market with speculative money and the wild price fluctuations have raised alarms and calls for tightening of regulations in many countries from the viewpoint of financial system stability. If the price bubble bursts, it can quickly endanger individual institutions and parts of the financial markets.  If big losses would occur this could hurt the reputation of the whole market.

Regulators are stepping in
The advent and subsequent boom of cryptocurrencies on a global scale as well as the heavy fluctuations have left many governments scrambling to find ways to deal with this new phenomenon. Regulators and other official authorities worldwide are stepping in to define how they would oversee this cryptocurrency environment (what had been to date a legally “murky” environment). Governments around the world are now looking at how to regulate Bitcoin and other cryptocurrencies.

What could they actually do: the options
There are various options to deal with cryptocurrencies, ranging from a complete ban to the other extreme of creating an own state digital currency. The options are just warn and further do nothing, complete ban, categorise as financial asset, regulate the exchanges or create a state owned crypto currency.

  • Warnings and further do nothing

Many official authorities globally including governments, regulators and central banks from the US, the EU to Asia are still not comfortable with non-fiat cryptocurrencies like Bitcoin. Regulators from many of the world's leading economies are beginning to warn the public. They are sending out investor alerts and cautionary statements about the risks of investing in these cryptocurrencies.

  • Complete ban/reject

One option is a complete ban of cryptocurrencies, so outlawing them, including a ban on all ICOs. Countries like Algeria, Morocco, Bolivia, Ecuador, Kyrgyzstan, Nepal, Vietnam and Bangladesh have issued all bans – or at least begun the process – either trading of Bitcoin or cryptocurrencies in general, in order to combat tax evasion and irresponsible trading.

In other countries, especially in Asia, the trade of cryptocurrencies is (partly) banned, such as in China and South Korea. Israel is looking to ban digital currency–based companies from trading on the Tel Aviv Stock Exchange.

  • Classify as financial asset

Another option is to treat cryptocurrencies as a financial asset, so falling under the existing regulated financial sector requirements.  The US and the European Union are coming up with a new definition for cryptocurrencies as a financial asset, property or commodity, with all net gains taxed at the same rate as normal financial assets.

  •  Regulate cryptocurrency exchanges

A fourth variant is: regulate the cryptocurrency exchanges and other trade platforms. These exchanges should at least have an official license. Another requirement is that these exchanges should also know who they are doing business with thereby meeting KYC and AML requirements. This as a way to combat illicit behaviour and ensure tax is paid.  This is just what Japanese authorities do. 

But also a number of other governments are seeking to regulate these cryptocurrency exchanges, including the European Union. Central banks in the Eurozone can also through the new EU Counterfeiting Rules require that the Bitcoin exchanges are doing business which are not malafide. This could open the doors for banks involvement, making life easier for exchanges and investors alike.

  • Create an own state cryptocurrency

The other extreme is the monetary variant. Governments could create their own state cryptocurrency, that could be used for instance to pay taxes by citizens. In this way people could benefit from  the technology innovations while calming the more instable cryptocurrencies like Bitcoin. 

A number of central banks are seriously studying whether digital currencies backed by global central banks can be used as a legal tender such as the Indian central bank. Such as Sweden’s  Riksbank , the Reserve Bank of New Zealand, the People’s Bank of China and  the Russian Central Bank. They are all studying the potential for a central bank digital currency. Countries like Venezuela, Saudi Arabia and some others have already expressed their intention to create their own crypto currency.

Most regulators are still struggling …..
The question is what should supervisors and regulators do. Regulators in many countries are struggling how to tackle the issue. Regulators in many countries are struggling how to tackle the issue. There is still a great deal of confusion amongst policy makers right now about if and how to regulate cryptocurrencies such as Bitcoin. They are grappling with ways how to control trading in these cryptocurrencies.

…. with an ongoing dilemma …
Authorities worldwide are still puzzling how to react. Thereby they are discussing the ongoing dilemma where most regulators are struggling with: how to react without “throwing the baby out with the bathwater”. Many countries have already embraced blockchain technology, the technology behind Bitcoins. They see the many benefits that could be get when adopting this technology. But these cryptocurrencies may do much harm if they remain unregulated and thus uncontrolled.

The bottom line while efficient regulation to protect investors is cryptocurrencies is needed, the way that such regulations are drafted will largely depend on their view on the potentials of the underlying technology as an innovation. In other words, what should be the best approach: how to protect consumers, combat fraud while preserving the nascent blockchain technology. It is this difference of outlook which is causing such a widespread diversity among regulators.

… taking different stances

This explains a variety of different reactions and approaches/strategies worldwide to handle the cryptomarket in their respective country, ranging from very cautious to full-scale acceptance, from doing nothing (just warn) to in-the-middle-of-the-road regulations, strict regulation to even a complete ban. We thereby see various different visions not only between countries and regions, but also inside countries themselves on how to react and what measures to be taken. 

Regulation worldwide
Up till now there has been limited regulatory action in many countries in the world as it not easy to determine who should regulate the new technology of cryptocurrencies. We see fractured attempts at either legalising or banning in specific countries especially in Asia. But it is expected that also regulators in the EU and US are likely to take a harder stance on Bitcoin and other cryptocurrencies in 2018.

Asian countries taking the lead
Countries in Asia are very active in looking ways to reign in cryptocurrencies. It is not that strange that especially countries like China and South Korea, where the majority of cryptocurrency activities takes place, have already taken drastic measures against cryptocurrencies. Together they made up for more than half the global trading volumes by some estimates. Asia’s most representative countries such as China and South Korea have taken tough stances on bitcoin and cryptocurrencies that span the entire spectrum.

Other countries like India (that has ruled out cryptocurrency as legal tender) are focused on deciding clear regulation for trading of cryptocurrencies. While Vietnam has banned payments in Bitcoin and other cryptocurrencies on the pain of heavy fines. Indonesia, Philippines and Singapore all issued state warnings urging caution among retail investors of Bitcoin and other cryptocurrencies with trading and investing in cryptocurrency. In countries like Bangladesh, Nepal, and Kyrgyzstan, using or trading virtual currencies is highly illegal and comes with harsh punishments. By contrast, Japan has regulated Bitcoin as a means of payment.

China appears to be the most stringent cryptocurrency regulator of the major Asian economies regarding cryptocurrencies. Prior to 2017, China accounted for as much as 90 percent of all global bitcoin trading.

Since than China has taken an even harder stance on Bitcoin and other digital currencies  and effectively shuttered the local Bitcoin industry. This in order to prevent the build-up of risks in these markets. Last year September China announced a blanket ban on initial coin offerings or ICOs and stopped these activities within its borders. In the same month China’s central bank also ordered/proceeded a bank account freeze associated with crypto exchanges, scared by how much capital was fleeing the country via Bitcoin. Bank of China regulators ultimately ordered those large-scale cryptocurrency exchanges in Mainland China to cease trading and shut down in mid-September, and pushed trading activities within China to over-the-counter markets. More recently there are now also widespread rumours that the central bank is moving in to curtail Bitcoin miners in the country. China may discourage bitcoin mining operations in the country by curbing their access to electricity.

South Korea               
South Korea – one of the world’s largest markets for Bitcoin, Ethereum and Ripple - already introduced bans on ICOs. Recently they also came with strict measures to tackle anonymity and money laundering in the cryptocurrency space, and review a possible capital gains tax on crypto trading taking effect from 30 January onwards. This in as a way to crack (and punish) down on financial fraud, tax evasion and money laundering.

They announced regulatory measures to ban anonymous cryptocurrency trading and regulate cryptocurrency exchanges, including banning foreigners and minors from opening new cryptocurrency accounts. The regulator would only allow trade in cryptocurrencies from these real-name bank accounts. The regulator would only allow trade in cryptocurrencies from these real-name bank accounts. All cryptocurrency investors need to establish an account under their legal name at one of the six appointed banks. The real-name rule is a significant set in the fight against money laundering and other potentially illegal activities. Cryptocurrency exchanges will be required to share users' transaction data with banks, and regulators will monitor whether banks halt anonymous transactions if exchanges refuse to provide that information. Those rules will enable banks to comply with their AML and KYC obligations.

Japan has been the most cryptocurrency-positive country, and managed to become the country that has the lion share of cryptocurrency trading/exchange activities as far as Asia is concerned. Last year, Japan revised its Payment Services Act to legally define Bitcoin and other cryptocurrencies as a legal method of payment, which makes it legal to use cryptocurrencies for payment purposes.

Japan enforced regulations and guidelines for cryptocurrency exchanges and the industry including a licensing system, requiring crypto exchange and payment providers to seek explicit approval and a licence from the Japanese Financial Services Agency. As of mid-January, Japan had 16 registered cryptocurrency exchanges, making the nation a major player in the field.

Recent events may have tempered Japanese enthusiasm for cryptocurrencies, however. The hack of the Japanese cryptocurrency exchange Coincheck on January 26, 2018, resulting in the loss of $530 million worth of NEM coins, sheds light on the problems in the security of such exchanges. It has prompted closer oversight from the Financial Services Agency (FSA), including stricter security requirements, for the protection of investors.

What is the EU doing?
Also in Europe supervisors are becoming sharper. Calls for greater cryptocurrency regulations echoed across Europe in January 2018 as well as from national governments (specially France and Germany), but also from EU organisations such as ESMA and the European Commission as well as central banks of the EU member states who are also set to follow the ESMA’s effort in 2018. European countries like Switzerland sit on the other end of the line. Switzerland appears to have an open attitude toward the cryptocurrency industry.

The European Commission has released plans to introduce measures to regulate the crypto markets. The EU plans to change the way these virtual currencies are traded by adding them to The 4AMLD (4th Anti-Money Laundering Directive). The EU want to force Bitcoin users to reveal their identities. In that way new legislation would bring cryptocurrencies in line with anti-money laundering and counter terrorist financing legislation by increasing transparency. This will give authorities the jurisdiction they need to investigate individuals, exchanges and wallets as they see fit.

As a first step, the European Commission has already added rules on bitcoin in the revision of its anti-money-laundering regime, covering firms that “are in charge of holding, storing and transferring virtual currencies.” Under this plan online platforms where cryptocurrencies are traded will be required to conduct proper due diligence on customers and report any suspicious transactions. Cryptocurrency exchanges and wallets will need to adhere to ‘Know Your Customer’ protocols and collect, process and record data on users that could be easily shared with public authorities. The new legislation is expected to come into effect after being agreed by the various national parliaments. That is expected to happen sometime in 2020.

Notwithstanding Brexit, the United Kingdom and the EU remain united in their plans to regulate cryptocurrencies.  Prime Minister Theresa May and Chancellor Philip Hammond recently have declared their intention to regulate cryptocurrencies. Similar as the EU, The U.K. Treasury had made plans aimed at ending anonymity for cryptocurrency traders.

The UK government is currently negotiating amendments to the fourth anti-money laundering directive (4th Anti-Money Laundering Directive) that will bring virtual currency exchange platforms and custodian wallet providers into anti-money laundering and counterterrorist financing regulation. This will result in these firms’ activities being overseen by national competent authorities for these areas. The Treasury is planning new legislation to expand anti-money-laundering rules that force traders on cryptocurrency exchanges to disclose their identities and report suspicious activity. It will include rules forcing traders to reveal their identities in some circumstances.

How is the US reacting?
In the US, the Commodity Futures Trading Commission (CFTC) has decreed cryptocurrency to be a commodity, and the Internal Revenue Service (IRS) now requires profit made on cryptocurrencies to be declared. The country however has yet to decide on a federal level what to do about this cryptocurrency phenomenon.

There are however rumours that the US SEC is planning to ask Congress in Washington to enable supervision on cryptocurrency trading platforms. At a hearing before the US Senate Committee on Banking, Housing and Urban Affairs on 6 February, the US Securities and Exchange Commission (SEC) and the US Commodity Futures Trading Commission (CFTC) have discussed how cryptocurrencies and ICOs should be regulated in the future.

Both regulators are “open’ to federal regulation of cryptocurrency exchanges and trading platforms. US Congress should give SEC and CFTC more power to oversee cryptocurrency exchanges. SEC believes federal overview will foster innovation while also protect investors. Nowadays US exchanges are regulated at the state level and do not fall under direct purview of either SEC or CFTC. Consequently, regulations governing these businesses vary - often greatly - from state-to-state. 

According to SEC chairman Clayton, cryptocurrency exchanges and trading platforms are functionally more like "securities, commodities, and currency exchanges and therefor to be regulated at the federal level and overseen by either the SEC or CFTC. According to SEC also ICOs should be regulated like securities offerings so falling under federal supervision. The SEC already enforced action against ICOs believed to be related to fraud.

The US government is trying to get coordinated in its efforts to regulate bitcoin. Treasury Secretary Steven Mnuchin is thereby taking the lead on bringing together federal government agencies to coordinate regulation of cryptocurrencies. In the meantime the Treasury secretary has formed a virtual currency working group of the SEC, the Fed and the Financial Crimes Enforcement Network .

And some other countries: Russia?
Also Russia is moving towards regulating cryptocurrencies. On January 25, the Finance Ministry presented a draft law to legalize cryptocurrency trading on organized trading platforms. The law, if finalized, would define tokens, establish ICO procedures and determine the legal regime for cryptocurrencies and mining.

These measures are aimed at controlling both the production and creation of crypto currencies. The law, which still needs to be validated by the government and sent to parliament, aims at “providing a definition of digital technologies used in the financial sphere”. The proposed regulation includes a part regarding cryptocurrency trading. Authorities want trading to be conducted only on licensed exchanges. At the same time, miners will have to register with the government, and mining itself will be considered as an entrepreneurial activity.

In Russia, opinions on cryptocurrencies among government officials differ. For some the proposed regulation for cryptocurrencies is too strict. The Bank of Russia opposes the motion. Nevertheless President Vladimir Putin sees the need to regulate cryptocurrency trade in Russia. Russia’s State Duma may finally approve rules governing the trade and issuance of cryptocurrencies. The new rules are likely to be cleared early this year.

A complete ban does not work
A complete ban of the crypto market is not advisable. Zero tolerance does not work given the boundless character of cryptocurrencies. There is the threat of shifting operations to friendlier jurisdictions, that have a more positive attitude towards cryptocurrencies and that may act as a safe haven. Despite a ban activity in the cryptocurrency and Bitcoin space in China, investment continued via alternative channels.  Chinese investors flooded the cryptocurrency market in other crypto friendlier countries like South Korea and India.

In anticipation of a restrictive mining policy being introduced in China, Chinese miners are eyeing expansion into Canada and European countries with cheap electricity, and traders are moving to the Hong Kong . As a result the Chinese government’s crackdown on both mining and trading is expect to have minimal impact on the global cryptocurrency industry.

Time not (yet) right for state digital currency                        
While the BIS, the central banks for central banks, recently said that policymakers will likely have to consider whether it makes sense for them to issue their own digital currency at some point, most central banks, including the Fed, the ECB, and the central bank of Australia are not overtly enthusiastic about the idea of creating a central bank issued state cryptocurrency taking a wait-and-see attitude. Also the Bank of England is still ‘a long way of creating a digital version of sterling’.

So far central banks, especially in EU and US, see no immediate threat to financial stability and so little danger for the financial system, as mainstream financial markets are isolated enough from Bitcoin and other cryptocurrencies. In terms of their market volumes, cryptocurrencies only play a niche role by comparison with the money supply of leading global currencies in circulation, so their impact on monetary policy is negligible. But that could change if proper regulation to reign in cryptocurrencies is absent.

Proper regulation: what is needed?

The various and sometimes so different approaches has the danger that worldwide there will be no level playing field worldwide. In order to ensure regulation is working Bitcoin and other cryptocurrencies, should be regulated on a global scale. Next to that governments, regulators and central bank should work with the crypto industry to get a deep understanding and take the right decisions. And regulators worldwide should follow a balanced approach, preventing any adverse impact and risks of cryptocurrencies while exploring blockchain technology side-by-side.

Global/regional regulatory cooperation is a must
National regulatory rules are likely to prove ineffective given the borderless cryptocurrencies’ global scale. Effective regulation of virtual currencies would only be achievable and effective through the greatest possible international cooperation, because the regulatory power of nation states is obviously limited. The International Monetary Fund (IMF) has therefor called for global coordination on cryptocurrencies to protect consumers against its risks. There are already a number of international initiatives.

World Economic Forum
At the World Economic Forum in Davos last January financial and political leaders discussed how governments around the world should regulate the cryptocurrency. There was a growing consensus that regulation should be on a more global level.

G20 Stability Board
France and Germany announced they would present a joint proposal for the  creation of an international framework for cryptocurrency regulations, to be discussed at the Group of 20 meeting of finance ministers and central bank chiefs in Argentina in March.

The proposal is aimed at “reducing the risks” rather than banning Bitcoin and other cryptocurrencies. This seems to hint at more regulatory measures for exchanges and other trading platforms first and foremost.

The US Financial Stability Oversight Council
The Financial Stability Oversight Council (FSOC) had formed a working group to explore the cryptocurrency marketplace and hope to work with the G20 to prevent bitcoin from becoming a digital equivalent of a “Swiss bank account.”

Asia cooperation
What can be seen as a positive step to more international cooperation is that South Korea financial regulator (FSC) is in discussion with counterparts in China and Japan towards the regulation of Bitcoins and other cryptocurrencies. The co-operation between the three Asian countries is particularly notable as they make some of the world’s largest trading market for cryptocurrencies including bitcoin.

Eurasian Economic Union (EAEU)

Even Russian prime minister Medvedev thinks that cryptocurrency regulation shouldn’t take place in one country. It should be a unified action across all countries in the Eurasian Economic Union (EAEU). He recently criticised cryptocurrencies as an economic bubble, although he said that blockchain technology will remain.

Work/cooperate with the crypto industry
As this is a new field of activity regulators can only take the correct actions if they actually understand the topic. Regulatory bodies and the cryptocurrency industry should therefor cooperate when drafting new legislation or regulation to better understand it, to be very clear about what definitions are used and to implement effective regulation. In a growing number of countries these sort of working groups are being established. But given the borderless and homeless character of cryptocurrencies, a high-level working group consisting of representatives of government authorities, regulatory bodies, blockchain experts, and crypto industry should be established on  a global scale.

Balanced approach: walking a tightrope
There is growing consensus amongst countries that one should maintain some balance in their regulation. Care should be taken so that regulations will not result in stifling the potential of their underlying technologies. Excessive regulations that could restrict the potential uses of the underlying blockchain or distributed ledger technology should be avoided.

Rather than restricting cryptocurrencies, they can be regulated in a balanced way to rein in dangerous behaviour such as hacking and fraud, while exploring blockchain side-by-side. Governments must thus walk a fine line to foster the potential of blockchain technologies - which include cryptocurrency.

Regulation is not (that) bad
Further regulatory oversight of the crypto market is not necessarily a bad thing for cryptocurrencies. In fact, a global regulatory framework should be viewed as a good thing, as well as a necessity for cryptocurrencies to reach their utmost potential.

A regulatory framework that makes sense, protecting investors and network users while curbing illegal use, should be seen as a logical next step for these currencies as they seek to become a preferred global payment method. Such regulation should not only not be feared, but it should be welcomed. If regulated properly it may bring greater legitimacy to the cryptocurrency markets could be seen as a long-term positive.

Regulation can benefit the everyday consumer, with increased security requirements on exchanges and other platforms creating a greater degree of trust and transparency. In fact, additional regulatory guidelines may make cryptocurrencies more attractive not only for investors but for retailers and merchants as well.

Other customer protections, such as proper risk disclosures regarding cryptocurrency investments, or capital standards for exchanges, will only serve to provide the cryptocurrency market with additional legitimacy.

"If, afterwards, investors and companies have more legal security working in the ecosystem, it's going to have some short-term downsides, but long term, it's going to have a really, really big boost". Gray, Chairman Bank of England


Comments: (1)

A Finextra member
A Finextra member 18 March, 2018, 15:39Be the first to give this comment the thumbs up 0 likes

Just like in any industry, to avoid any form of abuse by industry participants in the cryptocurrency space and to take full advantage of the positive effects generated by the new technology, regulatory bodies must issue regulations for cryptocurrencies.

Interestingly enough, market participants have realized that self-regulation could generate an effective impact and speed up the process towards a more clear outcome. And since collaboration is the new innovation, a balanced approach involving cooperation between regulatory and self-regulatory bodies has higher chances to instill trust and transparency in the market – 2 necessary ingredients for progress.


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