Why the case for regulating cryptocurrencies is becoming unanswerable

A summary of the webinar of July 14 2022 entitled Why the case for regulating cryptocurrencies is becoming unanswerable.

SUMMARY

0.25: What is the case for regulating cryptocurrencies?

The dream of Satoshi Nakamoto – the replacement of inflationary central bank-issued fiat currency transformed by the lending activities of banks into commercial bank money by a trust-less and un-intermediated digital alternative – appears to be dying. 

Bitcoin itself has proved unhackable but it is not widely used as a means of payment, its price is volatile and the many imitators it has spawned are stolen regularly by bad actors. Cryptocurrency thefts, scams and hacks leading to investor losses have averaged 66 a year since the first major hack at Mt Gox in 2014.

The cryptocurrency markets are also being manipulated, chiefly by “pump and dump” schemes, in which organisers synchronise purchases of a chosen cryptocurrency to inflate its price, generate interest from other investors, and then offload the cryptocurrency for a profit. 

But this is only the most outrageous way in which the profits from cryptocurrency trading are accruing to professional traders while the losses accrue to retail investors. Far from fulfilling the dream of Nakamoto, an outcome in which retail investors supply the money and professional intermediaries collect the profits is similar to what happens to retail investors in conventional financial markets.

The market infrastructures that support cryptocurrency trading and investment have also long since proved inadequate, with unconscionable delays in settlement and indefensible surges in settlement fees. 

This has created a regulatory concern that the system might actually fail altogether, and so create instability through a backlog of unsettled transactions comparable with that which occurred in the conventional equity markets in the late 1980s. 

The increase in the size of the cryptocurrency markets between 2018 and 2021 – and their precipitate shrinkage since November 2021 – has amplified this concern. Regulators are concerned about links between cryptocurrency and conventional markets, and the increased risk of negative spillover effects in the traditional financial markets. 

Central banks, regulators and government officials are also increasingly concerned by the use of cryptocurrencies to evade tax, especially in emerging economies, where cryptocurrencies have become an important route around capital controls as well as taxes.

The extension to cryptocurrencies of the Financial Action Taskforce (FATF) Recommendations on anti-money laundering (AML) and Countering the Financing of Terrorism (CFT) in October 2018 was a first official response to this concern. 

The consequent Travel Rule – by which intermediaries must share the identities of both the sender and the receiver of a cryptocurrency payment – has caused consternation in the industry, and launched a flotilla of “solutions,” but little official action has followed.

A FATF survey of 98 jurisdictions in March 2022 found only 29 jurisdictions had actually passed a Travel Rule and 36 have yet even to start on legislation. Just 11 are enforcing the Travel Rule. There is no jurisdiction yet that is fully compliant with the FATF standards and only 12 are even largely compliant.

Which is why there is a growing consensus in official circles that cryptocurrencies need formal regulation, before retail investor losses and financial crime reach politically intolerable levels. In the mainstream parts of the cryptocurrency industry, an equivalent consensus is emerging that regulation would actually be helpful.

Why? Because they sense that the failure to regulate cryptocurrencies has inhibited institutional adoption of them. This is why the more respectable cryptocurrency exchanges and digital asset custodians have already adopted, or begun to move towards, regulated status.

Opting for regulated status is allied to a belief that exchanges and custodians can benefit from the growth of the (regulated) security token markets, currently stymied by the difficulty potential issuers and investors have in distinguishing between security tokens and cryptocurrencies. 

The growth of the security token markets in particular depends on institutional money, and institutional money at scale demands regulated status. 

Intermediaries as well as service providers are now calling for regulatory clarity. They too want to know for certain which “digital assets” are inside the regulatory perimeter and which are outside it, so they can proceed with confidence rather than simply taking legal advice on a case-by-case basis. This is even more true of institutional investors.

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5.28: What are the major jurisdictions doing to regulate cryptocurrencies?

It is impossible to assess the current status of cryptocurrency regulation in every major jurisdiction but, since minor jurisdictions tend to follow the lead set by the major jurisdictions, useful lessons about future developments can be drawn from a review of cryptocurrency regulation in five major financial markets jurisdictions (the United States (US), the United Kingdom (UK), the European Union (EU), Singapore and Switzerland) and one “offshore” centre (Liechtenstein).

The current state of regulation in these six jurisdictions is summarised in the table below. The most obvious lesson to be drawn from the table is that cryptocurrency regulation is far from harmonised. It is not surprising issuers, investors and intermediaries have to take legal advice on each and every use-case.

That said, the approach to AML and CFT is in principle if not practice harmonised in line with the 40 FATF Recommendations. In all jurisdictions, cryptocurrency exchanges, intermediaries and digital wallet service providers are required to register for AML and CFT purposes. The associated Travel Rule also requires intermediaries to exchange information on the originator and beneficiary of transfers of cryptocurrency. 

Some jurisdictions are trying to fit cryptocurrencies – and the other developments they have spawned. notably tokenisation – into existing regulatory frameworks. Others, such as the EU, Switzerland and Liechtenstein – have written new legislation to supplement existing laws or to create an entirely new corpus of law to accommodate cryptocurrencies. 

The EU, for example, has introduced a Markets in Crypto Assets Regulation (MiCA) to regulate cryptocurrency service providers and introduce a disclosure regime for the issuance, offering and admission to trading of what it calls “crypto-assets” – a definition that includes Stablecoins. The marketing of crypto assets will also be regulated under MiCA. Within the EU, cryptocurrency derivatives are already subject to regulation under the second iteration of the Markets in Financial Instruments Directive (MiFID II).

Liechtenstein, to take another example, has passed the most comprehensive “blockchain” law passed anywhere.  Its Token and Trustworthy Technology Service Providers Act (TVTG) specifies the nature of digital assets and the roles and duties of service providers. 

The United Kingdom, by contrast, has adopted a wait-and-see and piecemeal approach, banning the sale of cryptocurrency derivatives to retail investors and introducing controls on the marketing of cryptocurrencies via the Advertising Standards Authority (ASA). The regulation of Stablecoins is imminent, and the Treasury is consulting on regulating a wider range of crypto-assets.  

The State of Cryptocurrency Regulation in Six Jurisdictions

	🇬🇧	🇺🇸	🇪🇺	🇸🇬	🇨🇭	🇱🇮
	UK	US	EU	Singapore	Switzerland	Liechtenstein
Cryptocurrencies	Unregulated	Regulated	Unregulated	Unregulated	Unregulated	Regulated
Cryptocurrency derivatives	Regulated	Regulated	Regulated	Regulation dependent on structure	Regulated	Regulated
Cryptocurrency funds	Regulation dependent on structure	Regulated	Regulation dependent on structure	Regulated	Regulated	Regulated
Marketing	Supervised	Supervision dependent on structure	Supervised	Supervised	Supervision dependent on structure	Supervised
Stablecoins	Unregulated	Unregulated	Unregulated	Regulated	Regulation dependent on structure	Regulation dependent on structure
AML DD	Yes	Yes	Yes	Yes	Yes	Yes
Travel Rule	Not yet	Yes	Not yet	Yes	Yes	Yes

In the US, multiple regulatory agencies – notably the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) but also the New York Department of Financial Services (NYDFS) and numerous State-level agencies – are vying for supremacy, making it hard to monitor the state of cryptocurrency regulation.

In essence, cryptocurrencies are regulated as commodities by CFTC while tokens classified as securities under the so called-Howey Test are regulated by the Securities and Exchange Commission (SEC). Stablecoins are likely to be regulated following publication of a report on 1 November 2021 by the President’s Working Group on Financial Markets.

Singapore has permitted pure cryptocurrency business to continue via a loophole in its legislation but tokenisation projects tend to require the blessing of the Monetary Authority of Singapore (MAS). Marketing of security tokens is regulated more strictly than marketing of cryptocurrencies, though the Singaporean authorities are tightening the restrictions on promotion of cryptocurrencies.

In Switzerland, a Distributed Ledger Technology (DLT) law came into effect in two phases, in February and August 2021. It governs the tokenisation of financial instruments and imposes registration requirements on issuers and intermediaries.  Otherwise, the Swiss regulators aim to apply existing laws, topped up with regulatory guidance. 

Cryptocurrencies and cryptocurrency marketing are not yet regulated in Switzerland. Nor are cryptocurrency derivatives. Though the Financial Market Supervisory Authority (FINMA) has advised that algorithmic Stablecoins may fit its definition of a derivative and therefore be regulated as such, Stablecoins whose value is tied one-to-one to fiat currency deposits will be regulated as deposits under existing banking law. 

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13.07: Is there still an argument for regulators to “wait and see” how the cryptocurrency markets develop further before regulating them?

The period of wait-and-see is drawing to a close. The novelty of cryptocurrencies and the technology that underpins them, and the risks they create, has forced regulators everywhere to take time to assess whether cryptocurrencies can be fitted within existing legal and regulatory structures. But regulators in the EU have acted already, by introducing MiCA. Their counterparts in the United States and the United Kingdom seem poised to act, though the common law tradition does afford both countries more latitude to let market developments unfold before they step in.

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16.02: Can cryptocurrency regulation follow the usual regulatory pattern of being technology-agnostic or is cryptocurrency different from traditional financial instruments?

Regulation tends to regulate instruments and institutions, and to be agnostic about the technology that underpins them. However, the blockchain technology that underpins cryptocurrencies can make it impossible to disentangle the instrument from the technology: the technology embodies the asset and the asset has no existence independent of the technology. 

This is certainly true of “native” cryptocurrency assets issued on to blockchain networks, such as Bitcoin. It is less true of crypto-assets tied to assets in the “real” world, such as asset-backed tokens or one-to-one Stablecoins. In the case of such non-native crypto-assets, existing securities laws and regulations can be mapped on to the new instruments relatively easily.

It is also important to note the role of governance. Even a native token issued on to a blockchain network is issued and controlled by somebody or entity, and law and regulation can be applied to them. The same applies to intermediaries which trade in cryptocurrencies. 

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18.50: Should the cryptocurrency industry welcome regulation or will it crush innovation?

Some intermediaries in the cryptocurrency markets – such as the Bittrex Global cryptocurrency exchange, set up as early as 2013-14 – have always sought regulated status, on the grounds that the security and certainty supplied by regulation is essential to innovation as well as growth in the cryptocurrency markets – because it reduces the risk for issuers, investors and intermediaries. 

Jurisdictions operating from a civil law tradition (such as Liechtenstein) and a common law tradition (Gibraltar and Bermuda) have responded to that appetite for regulatory certainty by pioneering cryptocurrency laws and regulations. Far from suppressing innovation, such measures encourage it. 

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22.20: Is it possible that events have overtaken regulation of the cryptocurrency markets, in the sense that they are now exposed as a self-correcting hunt-for-yield investment mania of the kind typical of periods of low real rates of interest?

The collapse in the value of cryptocurrencies and of the Decentralised Finance (DeFi) market since November 2021, and the accompanying increase in interest rates, has prompted speculation that cryptocurrencies and DeFi are not durable innovations but here-today-gone-tomorrow speculations characteristic of periods of loose monetary policy.

The counter-argument is that blockchain technology is a general purpose technology capable of widespread diffusion throughout economies, which is already being deployed in a variety of contexts to improve productivity and efficiency within and beyond financial services. 

Bad actors have nevertheless tarnished the reputation of the cryptocurrency industry, by associating it with crime as well as speculation. Ridding the industry of bad actors, so investors and issuers can have confidence in who they are dealing with, is another argument for regulation.

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25.18: Are common law or civil law jurisdictions best placed to devise rules for the cryptocurrency markets that strike the right balance between innovation and regulation?

No regulatory jurisdiction has done work on the impact of regulation on the cryptocurrency industry, so it is hard for any regulator to be sure they are striking the right balance between increasing protection for investors and encouraging innovation by entrepreneurs. 

Regulators are torn between the economic imperative (to encourage innovation and growth) and their traditional remit (to protect investors from bad actors and events).

The UK is an example. It is a common law jurisdiction, so in theory the UK can let case law evolve in line with market developments. The UK government has also tried to position London in the vanguard of financial centres eager to accommodate crypto-assets. 

However, the Financial Conduct Authority (FCA) has proceeded in ways that contradict that ambition. It has used the FATF AML and CFT obligations to create an AML-plus regime by which intermediaries such as crypto-currency exchanges and digital wallet providers must register with the FCA. It has so far admitted only a small proportion of those have applied, under a system that is ostensibly about AML and CFT only. It suggests the regulator is largely opposed to government policy.

Paradoxically, regulators need to be more proactive rather than less. One reason bad actors have penetrated the cryptocurrency and DeFi markets so extensively is that the regulators in the major jurisdictions have stood on the sidelines for years. It is regulators in minor jurisdictions such as Gibraltar and Liechtenstein which have taken the lead. 

The risk now is of a flood of ill-considered regulatory initiatives comparable to MiCA, as the major jurisdictions try to make up for their previous neglect.  The UK might be the first major jurisdiction to make this mistake.

One way to offset the risk of ill-considered regulatory initiatives is international collaboration and coordination, orchestrated by an international regulatory body in much the same way that FATF has orchestrated international adoption of AML and CFT measures.

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35.25 Common law jurisdictions cannot simply wait for court cases to define the law and the regulations. Won’t primary legislation be necessary, even in common law jurisdictions, to define novel concepts such as Smart Contracts and decentralised autonomous organisations (DAOs)?

The common law has proved in previous instances – such as the dematerialisation of securities in the 1990s, where the solution required a complex new legal system for holding securities in custody – that it can accommodate novelties stemming from digitisation.

Whether the common law can evolve into cryptocurrencies without the need for statute law will vary by topic. Smart Contracts, for example can be accommodated within existing legal concepts, though the courts may be required to adjudicate where these conflict without recourse to legislation. 

This is especially true of the common law in England, where it is already clear that digital assets can be traded in ways recognised by the English courts – and market participants can, under the Hague Convention, be confident that their choice of English law will be recognised.

The governance problems associated with code-based DAOs can also be resolved by the development of case law. Indeed, the courts are in a good position to determine what a DAO actually is, since it is not yet clear whether a DAO is a partnership or an unincorporated association or something else.

However, the cryptocurrency markets cannot simply wait for case law to accumulate as the courts makes decisions. And regulation is not a viable alternative because ultimately it must rest on law, or regulators would make up rules willy-nilly, risking not only chaos and unpredictability but breaches of the law. 

Nevertheless, regulation has to be considered separately from law. Its purpose is to mitigate risk to the financial system and restrict activities that are harmful to consumers. The United Kingdom and Singapore, for example, are tightening restrictions on access to cryptocurrencies by retail investors.

Regulating wholesale cryptocurrency markets – which are at present almost wholly unregulated – is trickier, since a balance must be struck between preventing harm and preserving trust in the financial system and avoiding the risks of distorting the market and discouraging innovation. 

Achieving that balance is extremely difficult, as early attempts to regulate cryptocurrencies in some jurisdictions have proved. Regulators are well-advised to proceed cautiously, and on the basis of a complete understanding of what is happening in the market. What is needed is well-informed, engaged regulators determined to master what is going on.

The key lies in the application of property rights to digital assets. In July 2022 the UK Law Commission published a 529-page consultation paper which contains provisional law reform proposals to ensure that the law recognises and protects digital assets (including cryptocurrencies). Civil law jurisdictions (such as Liechtenstein and the EU) have approached the problem directly already, via new legislation.

Despite the alleged differences between jurisdictions, there are signs of convergence on a common set of legal concepts. MiCA, for example, draws heavily on the “token container” model of the Liechtenstein TVTG. International regulatory bodies such as the FATF and the International Organisation of Securities Commissions (IOSCO) can accelerate this process, without the need for an international set of regulations or a single global regulatory body.

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41.52: Is the hands-off era of Sandboxes and Safe Harbours over now – should the cryptocurrency markets expect an internationally co-ordinated torrent of regulation to wash through them? 

There is a view that regulators are poised to act. In other words, the period of experimentation in regulation – characterised by Sandboxes and Safe Harbours – is over. However, there is a counter-view which holds that experimentation has scarcely begun. 

Sandboxes, for example, have not led to novel regulatory approaches – even though their purpose is in large part to find out if existing regulations are adequate, and identify any changes that need to be made if they are not. 

Likewise, as the limited impact of the FATF Recommendations on AML and FCT demonstrate, the work of international co-ordinating bodies has also proved ineffectual. Even in the one area where cryptocurrencies are explicitly regulated, progress – after four years – is still minimal.

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50.15 Is a globally harmonised cryptocurrency regulatory regime what the global marketplace wants – and is there a downside to it?

International harmonisation can mean more than one thing. It could mean jurisdictions agree on a handful of principles. But it could also mean the detailed prescription of rules that effectively shut down the more innovative jurisdictions.  

While both common and civil law jurisdictions can accommodate declarations of principles, it is harder for civil law jurisdictions to evolve because judges are obliged to place such importance on the wording of the statute (indeed, are often obliged to distort the wording in order to make progress). 

Common law, by contrast, allows judgers to build on existing structures, reinterpreting them to meet new needs. The benefit of this is the increased certainty that flows from knowledge of existing rules, ways of thinking, case law and legal principles – as opposed to writing rules from scratch, in the manner of MiCA, which suffers from the common EU tendency to over-regulate.

The common law approach enables a regulatory system to be calibrated to the degree of risk without losing consistency or coherence. The more risky an instrument or activity, for example, the more rules should be applied to it – and vice-versa for less risky instruments and activities. 

At present, regulation is led by smaller jurisdictions such as Bermuda, Gibraltar and Liechtenstein. The real test of harmonisation lies in the future, when MiCA is bedded down and the US and the UK have had regulatory regimes in place for a few years.  

Since the regulatory approaches are likely to vary, it will be easier to tell by then which is successful and which is not. It may be that the offshore pioneers are overtaken, partly because they chose to move early, and were overtaken by market developments.

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1.01.07: Is the best way to regulate cryptocurrencies by instrument, by institution or by activities or by all three? 

One difficulty in regulating cryptocurrencies is the lack of agreement on definitions. The FATF, for example, prefers the term “virtual asset.” The EU, on the other hand, refers to “crypto assets.” Both terms cover a wide variety of digital instruments. Different jurisdictions, as well as different regulatory authorities, use the same terms to refer to different things. 

Agreement on a common taxonomy is therefore an essential pre-requisite to any statement of common international principles on the regulation of cryptocurrencies, let alone intelligent regulation of the various activities undertaken by market participants in those instruments at the level of individual jurisdictions.

Inevitably, however, digital assets will continue to proliferate, and a large of regulation must remain dynamic and regulators quick to adapt to new developments.  That argues for a principles-based approach rather than a prescriptive one.

The UK Financial Services Act of 1986 (FSA 1986), which drew a distinction between instruments and activities in those instruments and appointed three self-regulatory organisations under a single statutory regulator, is a potential model to follow.  It made it clear to market participants that, if they conducted any activity in a regulated instrument, they were regulated. 

Provided the varieties of cryptocurrency can be fitted into established definitions of financial instruments, it would be possible to regulate firms that list or trade or custody those instruments under English law without the need for fresh primary legislation. 

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