Five things about regulation: Why is it so hard to classify Bitcoin?

Tensions continue this week as regulators grapple whether Bitcoin is a digital asset or digital currency.

Kate Rhodes, KRC explores the fundamental tensions between ‘industry’ and key regulatory stakeholders struggling to classify Bitcoin (BTC) as a digital asset or digital currency. The global approach towards regulating digital assets is largely inconsistent, leading to consumer protection issues and regulatory arbitrage.

There is a disagreement at global level in the regulatory treatment of BTC, and whether it is a digital asset or digital currency. Many regulators err on the side of caution and maintain that BTC behaves like an asset, and not a currency.

Here are five issues that frequently crop up with defining digital assets:

1.Central banks and governments struggle as BTC defies the traditional definition for ‘fiat’ (government-backed currency)

Fiat currencies have a central bank and reserve to stabilise their value. Unlike fiat, digital assets such as BTC are finite in their supply, and their market interactions set the price. The base rate for lending fiat currencies is set by the government backing them, who also acts as lender of last resort. Most digital currencies do not have a central bank or reserve to back or stabilise their value, a base lending rate, or a lender of last resort. ‘Stable coins’ like Tether are coming under fire, with renewed pressures for digital assets to be backed by other existing assets which are not digital, e.g fiat or property.

Despite the current political instability in Europe relating to Brexit, Angela Merkel’s end of term in Germany and criticisms of France’s Emmanuel Macron for the recent riots in Paris, fiat currencies such as the Euro still demonstrate greater economic security and stability than digital currencies. This is one of the primary reasons why central banks and governments are battling with the mass adoption of digital currencies.

2. Tax authorities struggle over lack of clarity over taxation status for BTC

*Please note the following paragraphs are opinions only and do not offer tax advice to the reader.

Lack of clarity relating to the tax classification of digital assets and BTC in multiple jurisdictions also adds to the problem.

In the U.K., the biggest current tax issue under the existing regime relates to classifying BTC in relation to its usage status. If trading BTC, the income tax regime applies, but if investing BTC, the capital gains tax applies. Furthermore, the current guidance also acknowledges that an individual may be also be gambling. HM Revenues and Customs (HMRC) is expected to consult in early 2019 with further clarification in relation to digital assets later in the year. Much, it seems, depends on user context.

In the U.S, BTC is treated as property. For example, if an employee is paid in BTC, the value of the BTC at the time of invoice is what would be reported, even if the BTC remains unsold. The value of what the BTC is worth when the employee was paid is deemed the purchase price, so if the BTC is sold at a later date, the difference is taxable. At a federal level, BTC is considered property for tax purposes.

There are many states that are ‘pro’ BTC however there are significant state by state differences. In Wyoming last week a controversial pro blockchain finance bill was passed 13–1 with heavy opposition from the banking industry. In Ohio, taxes can be paid in BTC. In New York. where BitLicences issued by the New York State Department of Financial Services can be obtained for regulated digital currency activities.

3. Fundamentally, digital ‘currencies’ behave like ‘assets’

Many respected policy thought leaders support the notion that digital currencies be treated as analogous to traditional assets and securities, or traditional currencies.

If digital assets, e.g. BTC, are to be regulated as assets, they need to be regulated as a financial instrument, e.g. in Europe, under the European Union legislative framework regulating financial markets — the Markets in Financial Instruments Directive (MIFIDII). Amongst its many aims, MIFIDII seeks to offer greater protection for investors and transparency into all asset classes: equities, fixed income, exchange traded funds and foreign exchange. Regulators are actively seeking greater protection and transparency in the field of digital assets, in order to ensure consumer protection.

If BTC is to be deemed a digital currency, then it needs to be subject to supplementary regulatory constraints as foreign exchange markets and foreign exchange (forex) trading. Classified as a digital currency, BTC would not be subject to the same taxation regime as it was if it were deemed an asset.

Other regulatory and legal issues relating to the status of digital assets include: Should tokens be regulated as investments? Is a prospectus or other offering document required? Even if the tokens are not securities, there may be other regulatory consequences. Indeed, in the US, when a token sale is sold as a temporary security under Regulation D, there are many requirements related to the offering documents that the project needs to be aware of in order to substantiate the claims they are making.

4. Harmonised global standards are required in order to avoid regulatory arbitrage, and at the moment there is little global alignment in treatment of BTC

There is a schism at a global level in the regulatory treatment of BTC, and whether it is a digital asset or digital currency.

What it means to be a ‘regulated’ investment or instrument changes from one jurisdiction to the other. Indeed, the terms for either ‘security’ or ‘utility’ token are not recognised in legal or regulatory categories in many jurisdictions.

Despite regulatory arbitrage being the lifeblood in financial services for years, it can also be problematic. In the event of multiple jurisdictions hosting different regulatory regimes, regulatory arbitrage means companies may go offshore and set up shop in another jurisdiction. For example, if a U.K business moves to Malta as it deems the blockchain and digital asset regulatory regime ‘friendlier,’ investors may also go offshore. As a consequence, there may be a potential future loss of taxation revenue, as well as increased consumer protection risks e.g. non-accredited and or unsophisticated investors based and domiciled in the UK investing large amounts into ICOs being run out of Malta.

In the European Union, it will be interesting to see how effective the newly formed International Association for Trusted Blockchain Applications (IATBA) will set Europe’s strategy and develop industry guidelines and protocol for both blockchain and digital assets. Global alignment of policy towards regulating digital assets is critical in order to avoid regulatory arbitrage.

5. Massive concerns about consumer protection

Both U.K. and U.S. regulators have surveyed digital assets and found them lacking in basic customer protections. Due to these concerns and issues around basic KYC and AML, regulatory enforcement against exchanges and brokers who facilitated trading in unregistered commodities and securities are increasing in the short term. This regulatory scrutiny will continue to have a strong effect on the price of digital asset and the ICO market.

Each digital asset is different and there is currently no generally accepted standardised model given they may fulfil different commercial factions. Until legislative clarity is achieved, both the judiciary and regulators should be encouraged to conduct their analysis on a case by case basis. It will be interesting to monitor what the outcome of conversations at the G20 next week will hold in relation to digital assets.

Kate Rhodes is founder of KRC www.katerhodesconsulting.com. For feedback or questions on this article please email kate@katerhodesconsultancy.com

Disclaimer: Kate Rhodes Consulting Limited (KRC) is a limited liability company registered in England and Wales registered company number 11649091. KRC offers consultancy services only. KRC does not represent, warrant or guarantee the use of its materials and or its services will lead to a particular outcome or result. KRC does not accept any liability for negative consequences that any individual or company may incur upon utilising KRC’s consultancy services. KRC does not offer legal and or financial advice. You should consult your professional adviser for legal or other advice. Whilst every reasonable effort has been taken by the author to ensure that its contents represent an accurate and not misleading portrayal of the issues considered herein at the date of writing, many of the topics considered in it are subject to current political, regulatory and legal debate, and risk. Accordingly, there can be no guarantee that the contents of this document, and any statements set out in it, will not be challenged, corrected, overruled or contradicted in the future.

© Kate Rhodes 2018

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