The Three Pillars of Cryptocurrency Regulation
What should a regulatory framework for crypto cover? Laws nations should write — and how to enforce them.
As an asset class, cryptocurrencies raise a whole host of regulatory questions, spanning illegal transactions à la Silk Road to consumer protection. Today, while there have been innovative regulatory approaches, crypto often suffers from austere regulatory environments, most recently with India’s proposed 10-year jail sentences for so much as holding cryptocurrency.
I believe that approaches like India’s blanket ban fail to capture the incredible promise that this asset class has. In this article, I hope to present a framework to understand cryptocurrency regulation that I believe offer a more effective regulatory structure for this burgeoning technology.
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Specifically, I lay out three “pillars”: private law, public law and law enforcement, which I hope can serve as a model for cryptocurrency regulation to countries pondering this question.
Can We Regulate Cryptocurrencies At All?
An emphatic yes.
Before I delve into concrete policy proposals, I wanted to address the misconception that blockchain and cryptocurrencies, as private decentralized networks, are fundamentally incompatible with the law. This couldn’t be further from the truth. I contend that blockchain, and cryptocurrencies by extension, are inextricably linked to the law. As Wharton professor Kevin Werbach notes in his paper “Verify, but Trust,” blockchain and the law go hand-in-hand because they are both fundamentally systems to develop trust. In reference to the title of the paper, blockchains offer an efficient form of verification, but it is only with the backing of the legal system does it effectively promote trust.
A common concern raised by lawmakers is the fact that as such a nascent and emerging technology, laws are too rigid to adapt to its new, decentralized style of commerce.
However, history has clearly proven otherwise.
In an often-drawn-upon comparison, one can parallel the emergence of the blockchain and cryptocurrency to the Internet; after all, they’re both foundational technologies. The internet in the 1990s was similarly thought of as a lawless and difficult-to-regulate arena, however, laws have quickly caught up. This has been done to the point that any effort to circumvent the legal system — be it copyright infringement or financial crimes — have been invariably met by stringent regulations. The same can be said about blockchain and cryptocurrency. While it may appear to be difficult to adapt to at first, history has shown that it is most certainly possible and will happen with greater blockchain adoption.
The Three Pillars
As to concrete proposals to regulate cryptocurrencies, I propose a three-pronged approach, each dealing with a specific section of the law. I believe that the matter can be subdivided into questions of public law (consumer protection, securities law and the like), private law (liability and contract law) and law enforcement.
Pillar 1: Public Law
A common question faced by regulators globally is how to classify a cryptocurrency. Even in the United States, a country with a relatively advanced system to regulate cryptocurrencies, different governing bodies classify cryptocurrencies differently. To the IRS, cryptocurrency is property. To the SEC, cryptocurrency is a security. To the CFTC, it’s a commodity. And so forth. As such, I believe the correct approach is to go down to first principles — understanding financial regulation from a practical and functional perspective.
Turning to fundamental precedents like SEC v. Howey and the 1933 Securities Act, the core function of such regulation is to enable greater disclosures and transparency to investors. These principles can be applied towards Initial Coin Offering (ICO) regulation.
As Kevin Werbach said in his article Trust but Verify, “Token sales represent a sudden, grand experiment in caveat emptor securities offerings, targeting retail investors all around the world”. Given the fact that the speculative gains from Bitcoin in December 2017 drew a number of relatively financially unfamiliar retail investors towards cryptocurrency, the “buyer beware” nature of cryptocurrency presents a hurdle from a consumer protection standpoint. As such, the first pillar I propose in my recommended regulatory framework is a bill that mandates registration of ICOs with the equivalent body of America’s SEC. Incorporating this over and above existing securities law will ensure that investors are well-informed and protected while investing in cryptocurrencies.
Continuing the idea of public law, issues of criminal applications of cryptocurrency are another reason countries are reluctant to encourage the trade of cryptocurrency transactions. With the emergence of currencies like Monero, which offer far greater extents of privacy and anonymity compared to Bitcoin and Ether, regulators are concerned that the money can be used to nefarious ends. However, as Werbach notes, “The notion that activity on a blockchain cannot be subject to legal enforcement died with the arrest of Ross Ulbricht, if not before.”
Ross Ulbricht ran the infamous Silk Road, which was a black market that used bitcoin as a means of settlement. Ultimately, law enforcement was able to arrest him and shutter the market. While any technological innovation, be it the internet or blockchain, will find a way to be used nefariously, the Ulbricht example stands to show that systems of accountability eventually catch up. Methods to trace criminal activity will be addressed in the section on law enforcement.
However, on the note of public law, policing criminal uses of cryptocurrency is a question of classification. For instance, what would classify as an illegal money flow? Does the equivalent of the FBI or the SEC hold jurisdiction? To answer it plainly, as Werbach answers,
“Services that look like a duck and quack like a duck should be regulated as ducks”
As such, legislatures should adopt common-sense classification measures to broaden the purview of the equivalents of the SEC and the FBI. This would allow them to effectively police cryptocurrency Ponzi schemes and cryptocurrency terrorist financing activity respectively.
Pillar 2: Private Law
Turning to the second pillar of my regulatory framework — private law — blockchain is uniquely positioned in that it’s feasible to “make the code more law-like.” This means intertwining the legal system with smart contracts, either tacitly or explicitly. A smart contract fundamentally relies on trust in the code, and coders can err. The most (in)famous example of this is the case of the Decentralized Autonomous Organization or DAO. The DAO was an organization that functioned purely on smart contracts on Ethereum. As it happened, the code was flawed and allowed an individual to siphon off an estimated $50M of Ether from the system. Of course, this was entirely unintended, however, it was permitted by the code. As the code was immutably placed on the blockchain, ultimately the only way to stop this theft was by a hard fork in the network.
An interesting solution proposed in Werbach’s “Trust but Verify” is to bake arbitration clauses into the smart contract. These terms can come into effect in dire cases like the DAO hack. Interestingly, some speculate that this can result in the development of the “rule-of-law-as-a-service, a programmable complement” to court systems. From a legislative standpoint, governments can consider mandating the incorporation of these arbitration clauses into contracts to avoid issues like the DAO hack. Furthermore, to stay at the forefront of regulation in this rapidly evolving field, they can consider proposals like that of Antonopolous and Morgan (2016) to create a decentralized arbitration network designed specifically for blockchain disputes. This would allow arbitration disputes themselves to be executed peer-to-peer on the blockchain.
Pillar 3: Law Enforcement
Turning finally to law enforcement, the new manifestations of electronic crimes require specialized forms of enforcement. I believe the correct steps are a compilation of best practices internationally. Specifically, I want to call attention to a study by the University of Swansea, which discussed how law enforcement successfully shuttered two illegal cryptomarkets — AlphaBay and Hansa Market. Much like Silk Road, these markets involved the trade of illicit goods and services. A cooperative effort between American, Dutch and German law enforcement led to not only the shuttering of the site but also the arrest of administrators.
On June 20th, 2017, Dutch authorities were able to infiltrate Hansa Market. Instead of shutting it immediately, though, they decided to keep it open without alerting users or disrupting sales, thereby gathering information about customers and suppliers. Parallelly, a few weeks after, American law enforcement infiltrated and shuttered AlphaBay. This resulted in a migration of customers from AlphaBay to the compromised Hansa Market; they saw an eightfold increase in registrations. Ultimately, a whole month after Hansa was initially compromised by the Dutch, the FBI and Europol released a joint statement indicating that Hansa Market and AlphaBay had been successfully infiltrated. On the whole, the operation gave law enforcement data of 200,000 customers, 40,000 vendors, and 350,000 listings.
I wanted to stress the strategic takeaways from this operation, specifically regarding changing perceptions of trust and managing cross-market migration. This operation had a considerable impact on the level of trust customers and suppliers had in illicit crypto markets. While the initial announcement of shuttering AlphaBay raised suspicions, it was the combination of that and the compromising of Hansa Market that destroyed customers’ trust in illicit crypto markets. This meant that a sizeable share of these customers became ultimately less likely to ever rejoin an illicit market for fear that law enforcement has covertly infiltrated the site and is collecting data. Furthermore, the operation also calls attention to how users migrate between illicit markets. The fact that so many AlphaBay users migrated to Hansa underscores the need for concerted and coordinated law enforcement operations; one-off shuttering of markets will only lead to a number of others mushrooming.
In terms of deriving recommendations from this, I propose that the cyber-crime division of a country’s law enforcement division should be trained to specifically target blockchain and cryptocurrency crimes. Furthermore, countries should work to join consortia like the one described above to contribute to the international effort to combat financial crime on the blockchain. This proposed branch can work on a best-practices approach from the AlphaBay case and similar intelligence operations.
On the whole, cryptocurrency technology offers tremendous promise, and fears surrounding an inability to regulate them must not be a barrier to adoption. I believe the framework I’ve proposed, drawing upon ideas from public law, private law and law enforcement, would offer a skeleton upon which nations can develop upon to ensure that this promising technology is disseminated and implemented safely.
Bibliography
Afilipoaie and Shortis, “Crypto-Market Enforcement, New Strategy and Tactics”, Swansea University, June 2018
CNN, “How FBI Caught Russ Ulricht”, October 5, 2013, https://www.cnn.com/2013/10/04/world/americas/silk-road-ross-ulbricht/index.html
Coin Telegraph, “Is India About to Reverse Its Coin Trade Ban?” July 18, 2018 https://cointelegraph.com/news/is-india-about-to-reverse-its-crypto-trade-ban
Economic Times, “RBI bans Bitcoins, other virtual currencies, prohibits any dealing with banks”, April 6, 2018. https://economictimes.indiatimes.com/industry/banking/finance/banking/india-shuts-down-bitcoins-other-virtual-currencies-prohibits-any-dealing-with-banks/articleshow/63627611.cms
Economic Times, “Your Bank Will Not Allow You to Buy Bitcoins Anymore”, April 6, 2018, https://economictimes.indiatimes.com/wealth/personal-finance-news/your-bank-will-not-allow-you-to-buy-bitcoins-anymore/articleshow/63627123.cms
Raconteur, “Indian Crypto Caution Could Stifle Innovation”, June 21, 2018, https://www.raconteur.net/finance/india-cryptocurrency-caution
SEC v. Howey Co., 328 U.S. 293 (1946).
Securities Act of 1933, 15 U.S.C. § 77a
Times of India, “First Time in India Bitcoin Traders Raided in Ahmedabad”, December 27, 2013. https://timesofindia.indiatimes.com/business/india-business/First-time-in-India-bitcoin-traders-raided-in-Ahmedabad/articleshow/28008526.cms
Werbach, Kevin, Trust, But Verify: Why the Blockchain Needs the Law (August 1, 2017). Berkeley Technology Law Journal, Forthcoming.
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