Crypto Regulation and Lessons From Wall Street
FOMO and FUD are two acronyms that very fittingly describe the most dominant emotions in the mind of anybody involved in blockchain technology and crypto currencies. The fear of missing out on the next big revolution, and the back to back fear of diving into the unknown. In terms of the fears, the two biggest issues that keep us awake at night are cyber security and regulation. Security wise, as powerful as the blockchain may be, the removal of a central “middle man”, or decentralization, places great responsibility on the users themselves. The utmost care has to be taken in terms of computer security to the point where it sometimes defeats the very purpose of this technology. For example, printing your private key on physical paper and storing it in a safe seams to offset the fact that the Blockchain is an immutable architecture. If you are a business taking custody of customer private keys, the responsibility is even greater. Regulation is another constant concern. The only difference with cyber security is that there there are no firmly established and accepted standards. Businesses are fully exposed to the risk that a jurisdiction that they are operating in may close its doors without warning or that a legal grey zone suddenly turns pitch black.
The Thin Red Line
In the traditional banking world, such as in Wall Street which is where I spent the majority of my career, people are acutely aware of the lines that must no be crossed and the clear rules that must not be broken. I have seen people make mistakes many times, both intentionally and unintentionally. These did not only cause the firm heavy fines and penalties, but also people’s careers. It is this constant, but healthy, tension and nervousness that resides between bankers and regulators that is supposed to keep people in check. For instance, in the stock market shareholders don’t like it when brokerage firms push stock prices lower with large orders. It can’t be helped when you are doing it on behalf of a large customer order, but I have seen traders execute what are called illegal short sales of stocks, massively driving down a stock for a quick profit. When the entire market noticed and regulators stepped in, the firm was slapped a month long business suspension order costing the firm millions of dollars of lost revenues, and the head of the desk and trader responsible was passed on an promotion and both left the firm shortly after.
And even still, the traditional banking world could not avoid the Global Financial Crisis, which was caused by overconfidence in such things as financial engineering and the fact that financial markets will take care of themselves. This lack of oversight was what resulted in the massive growth of sophisticated structured products and derivatives, or “financial weapons of destruction”, and the rest is history. New legislation to prevent banks from acting recklessly and to protect consumers went into place globally, most notable being the Dodd-Frank Act in the US. Dodd-Frank included the Volcker Rule that restricts US banks from undertaking certain speculative businesses that are not in the benefit of their customers. Proprietary trading, which was a very lucrative business until the crisis, was one of them. MIFIDD II in Europe also aimed to increase consumer protection and transparency in investment services.To comply, brokers must provide much more data about their transactions, and asset managers have stricter obligations to insure they are being provided the cheapest services. This is a huge cost burden to the industry.
In the crypto space, however, no such tensions exists to begin with. Having no regulatory oversight leaves the door wide open for people and businesses to operate in total disregard of accountability giving birth to such things as ICO scams. This situation is clearly not ideal, regulation is necessary. Though in some cases, bad regulation can even be worse than no regulation. For example, the ultimate crypto ban decreed by China, blocking access to any crypto or ICO-related websites for all chinese inhabitants, could lead that country to miss out on the greatest technical revolution since the creation of the Internet. But the question remains, what exactly is good crypto policy?
Some of the most progressive countries in terms of implementing a regulatory framework for crypto currencies have been Japan, Singapore and Switzerland. Japan legalized “virtual currencies” and implemented a licensing system for exchanges, Singapore was one of the first to announce ICO guidelines and Switzerland has always been an ICO hub with Zug’s “Crypto Valley” leading the way. However, most regulators suffer from a lack of resources and manpower, and struggle to keep up with the rapidly changing environment (even in the above mentioned countries). It is a tremendous risk to know that a jurisdiction could decide to suddenly change all the applicable rules, especially if you already have a significant business stake.
The focus and approach for many countries are also very different. In Switzerland, there are actually no laws with regards to ICOs for example. The FINMA recently published a guideline for token categorization (payment, asset and utility). Estonia has been leading Europe’s digitalization of government services, especially using blockchain technology. Lithuania’s central bank has been issuing e-money licences called EMI, which allow operators in the EU to provide digital payment services. France passed an Ordinance that legalizes the transfer of ownership of financial securities through DLT technology and is currently setting up the application decrees to that regard. French authorities are also proactive and open to discussion concerning ICOs. They established the Unicorn program which provides projects with support and supervision.
In the US, the court order in the matter CFTC vs. Patrick K. McDonnell and CabbageTech, Corp. d/b/a Coin Drop Markets, states that virtual currencies are commodities and precisely describes the fragmented and overlapping views and jurisdiction of several american agencies, mainly the CFTC, the SEC, the Treasury Department, the DOJ, and the IRS. The SEC for example, seems to be trying to tag every ICO token as a security. Asserting that any ICO token without a working product would be deemed a security. This intuitively makes sense if you want to fit crypto currencies and ICOs into the existing financial regulatory framework. However, from the perspective of the ICOs raison d’être and blockchain philosophy, this is obviously less than ideal.
Far from Perfect
Finally, the Japanese regulators have been quick to adopt Bitcoin. The amended Payments Services Act (under the Banking Act) legalized “Virtual Currencies” as a form of payment (not to be confused with a form of legalized money because it is clearly separated), and also implemented a regulated crypto exchange licensing system. These stamps of government approval and shift of demand from China and Korea into Japan has catapulted the county’s status into the world’s biggest crypto trading center. Even in Japan, however, the regulation are far from perfect. There is a major misrepresentation in the media that Japan is a crypto heaven, or ICO free for all. This is clearly not the case. The legislation that was passed last year was intended for the adoption of digital payments, and now to cater for the needs of the very lucrative exchange business. ICOs, the funding scheme that expanded rapidly last year, was not something that was contemplated and since it “jumps over the regulatory fence”, the FSA had to require the crypto exchange license for any crypto-fiat swap including ICOs as well as Bitcoin ATMs. This one-size-fits-all approach has put a complete halt to ICOs in Japan as well as startups trying to develop payment services. Crypto tax is another huge impediment to adoption here in that profits are not treated as capital gains (20% tax) but rather as income, with the highest bracket being 55%. Tax treatment on ICOs are also problematic in that proceeds are deemed as sales revenues, therefore being slapped a 30% corporate tax. This almost makes the whole process unviable.
The Japanese regulators want to embrace crypto currencies. However, two of the world’s biggest exchange hacks happened in Japan, Mt.Gox in 2014 and the USD500mm Coincheck hack of this year. Despite the implementation of a regulated exchange licensing system, the FSA has not been able to adequately prevent such incidents and have naturally dug in their heels. With hundreds of licenses waiting to be approved and ICOs anxiously waiting for the nod of approval, the FSA is in a tough position to decide whether they need to bring down the shutters completely or not. Too harsh of a clamp down as seen in banking would not be ideal.
Because of the issues that remain around the existing regulations in Japan, there have been “grass roots” efforts to attempt to improve the laws. One of them is a group called the Blockchain Economy Alliance, led by myself and Abasa Philipps of Zilla, a long time blockchain veteran in Japan. There is a very strong shared sense of crisis within the crypto and blockchain community here that ill-implemented regulation is hindering industry growth, and could potentially kill the entire market. The exchange business are powerful, but there is a clear void that exists between them, the blockchain business community, the Japanese consumer and foreign companies that have a vested interest in seeing healthy development here. The association mandate is to create an environment that is in the best interest of the blockchain industry as a whole as well as the consumer. We believe that dialog between regulators, businesses and consumers are crucial to shape the ideal framework.
What Can We Learn
The Global Financial Crisis has left a deep and permanent scar in the traditional banking industry. Regulation became extremely strict, and compliance became a major priority for Banks rather than business. But we must not let this bitter experience spill over into the crypto/blockchain space. This new industry is one of young, ambitious entrepreneurs with a vision of the future. The legal and regulatory framework should be formulated around the spirit of guidance and support, and not to put them in a straight jacket. Regulation must help them thrive, and not wither and die.
In a recent magazine interview, France’s Finance Minister Le Maire put it very nicely with his pro crypto and pro regulation comments. He highlighted the importance of regulation in the cryptocurrency sector, stating that “No consumer or entrepreneur can carry out a transaction, can invest, or can develop a business in a regulatory vacuum.” Having said that, Le Maire also stated that blockchain will offer unprecedented opportunities for French startups to raise funds by issuing tokens in Initial Coin Offerings. “Our target is simple: enter into the world of finance of the 21st century by guaranteeing all players the necessary security for their development … we should not miss out on the blockchain revolution”, a FOMO classic.
When it comes to ICOs and crypto in general, policy makers and regulators also face a mixture of FOMO and FUD that they each balance to the best of their availability to find what they think is the optimal equilibrium. In the wild wild world of crypto, accountability needs to be put in place for sure. Having said that, we are now experiencing an era of great socio-economic change, and although the future is uncertain, just like the blockchain and crypto industry leaders have been, the regulators also need to be forward thinking, open and bold. After all, we are all trying to pave the way for a better and brighter future.