Cryptocurrencies and ICOs: Enacting a lean regulation
Written by Jérémy Koffi, Boran TOBELEM and Maxime Delavallee
As a disruptive technology, the blockchain creates a paradox by generating substantial value for society while at the same time endangering the societal well-being.
Through its ability to certify in real-time immutable operations within a “permissionless” distributed architecture, the blockchain answers most of the current challenges arising from the digital economy, including data security and concentration of market power. Either operated by Proof-of-Work, or by Proof-of-Concept, the blockchain enables the implementation of a distributed collective governance. As no central entity is needed to administrate a system of operations, the blockchain enables to avoid concentration of data and market power on the one hand, and to decrease the risk of a data breach on the other hand. Additionally, its immutability deletes the risk of falsification and malicious modification of the preregistered operations.
While the distributed ledger characteristic has been legally recognized in the past years by most developed countries, the legal grasp of its extended concepts is subject to less consistency. As such, whereas the blockchain in itself can theoretically optimize the administration of every type of organization, its derived features such as cryptocurrencies and Initial Coin Offering (ICO) bring out legal loopholes implying an agile regulatory response. Operationally applying the characteristics of the blockchain, cryptocurrencies establish a new governing transaction system based on desintermediation and autoregulation through pre-programmed lines of code. If these features might imply at first glance intuitive efficiencies for money creation and management, financial regulation ineluctably needs to be adapted in order to maximize this potential.
Often considered as a regular financial security from the legal standpoint, cryptocurrencies are in fact applied to broader use cases. Issued through ICOs, most of these private moneys are rather used as digital assets assigning a specific role to their owner, thus enabling the governance of their related network. From this gap between the practical application and the legal recognition, cryptocurrencies bring out multidimensional risks and challenges at both national and international scales. Keeping these issues under control implies a clear legal definition of such an asset class in order to define an ad-hoc set of adapted binding laws and regulatory practices.
While the Financial Stability Board (FSB) announced during the last G20 Finance Ministers Meeting that cryptocurrencies were not endangering the financial stability –putting forward the fact that these crypto-assets represent only 1% of the world GDP, their exponential growth in volume and their drastically volatile fluctuations invite to reflection.
Risks and challenges
A legal grey zone
Designing a cross-jurisdictional legal framework focused on cryptocurrency is a prerequisite for an effective regulation and needs to be addressed as expeditiously as possible. As of today, cryptocurrencies fall into a legal grey zone, the lack of a clear legislation concerning their control, incites governments to arbitrarily chose their legal framework. In France for instance, the legal basis is quite fragmented and relies on two legislations. According to the Prudential Supervision and Resolution Authority (ACPR), the purchasing and selling of cryptocurrencies in exchange for physical ones, is regulated by the European Directive on Payment Services while illegal activities fall under the scope of the fourth Anti-Money Laundering EU Directive. These legislations are quite inadequate; they were not specifically drafted to regulate cryptocurrencies but rather to control exchanges from virtual to physical currencies. Furthermore, the cross-national dimension and high scalability of cryptocurrency transactions raises an issue concerning the legal framework to adopt in potential cases of international disputes.
It therefore appears that by focusing on regulating the physical world, the current legal framework falls short in dealing with the challenges of our expanding virtual environment. The establishment of common definitions and set of law regulating virtual money at the international scale is needed to address the cross-jurisdictional boundaries nature of cryptocurrencies.
User’s protection
Cryptocurrencies have quickly evolved from a trading to an investment tool. Today, through Initial Coin Offering, users can buy tokens to finance the development of a blockchain project. The issue with this type of investments is that private companies often lack transparency. This can create a situation of asymmetry of information in which the investor will adopt an irrational speculative behavior. Indeed, sellers can use ICOs to scam investors by adopting a “pump-and-dump” behavior. Through misleading positive statements, sellers overestimate the value of their coin to drive up investments before dumping it and retrieve profit. The danger of this scam is amplified by the legal deficiency regarding the protection of investors on the cyber-space. In fact, token owners are not legally entitled to receive the benefits of the funded project. As of today, the redistribution of dividends is automatically conducted through technological programming, however the investor is not backed by any legal obligations. The question thus remains unclear whereas any judicial prosecution can be conducted against a private entity to protect investors’ rights in case of abuse.
Anonymity or how to get away with crime
While being a very appealing feature of the cryptocurrency’s technology, the anonymous nature of transactions can lead to the proliferation of illicit activities. Last July, the two websites of AlphaBay and Hansa have been shut down after a joint evaluation by the FBI, the Drug Enforcement Administration and Europol, for being platforms of drugs, weapons, as well as other citizens’ confidential data exchanges. In addition to the purchasing of illegal goods, anonymity enables users to launder their dirty physical money into clean non-traceable cryptocurrencies. Furthermore, the inherent anonymous system of virtual currency can favor tax evasion as it is easier to escape from the scope of tax authorities. While it remains possible for tax administration to scrutinize exchanges from physical currency to cryptocurrency, it is much trickier to control the added value produced through exchanges of cryptocurrencies on the cyber market. Despite the difficulty to assess the scale of the “dark side” of the internet, the French Minister of Foreign Affairs Gérard Collomb recently expressed a great deal of concerns regarding the evolution of these unregulated trading practices, stating that “every day, a bit more crime will be funded by virtual currencies”.
Systemic risks
The original mandate of cryptocurrency is clear: exchanging money and raising funds without being supervised by conventional regulation institutions. This money of a new kind challenges the current structure of our global financial system and puts into question states and banks monopoly over monetary policies. Despite the fact that many policy makers consider the systemic implications of cryptocurrencies on the financial system as quite limited — their use being marginal compared with physical currencies — one may fear that their further development will radically change the regulating role of banks and even the state, weakening their grasp on the monetary system and ultimately their power.
In the light of the aforementioned risks, it seems that a comprehensive an agile regulation which takes into account the specificities of the digital world needs to be put in place. The following part suggests some policy recommendations to tackle these current challenges.
The need for an agile regulation of cryptocurrencies and ICOs
Considering the current early stage of development of cryptocurrencies and ICOs, the main regulatory challenge is to implement a regulation enabling a less anarchic evolution of crypto-assets by protecting investors without harming innovation at the same time. The regulation of cryptocurrencies and ICOs then needs to maintain minimal interferences with the sector to let it grow but equally necessitates to promote the safest environment.
Recommandation 1
The first way to achieve this goal is to encourage a dialog between entrepreneurs and public regulators in order to guarantee a transparent development of crypto-assets businesses through periodic consultations organized by regulatory bodies. This would allow regulators to closely follow the evolution of this newborn environment. The global scale of this ecosystem implies that this dialog should be set through both national and international regulatory authorities. At the international level, it would be relevant to initiate diplomatic discussions through worldwide organizations such as the OECD for instance, and to create a special task-force to monitor and anticipate the evolution of blockchain-related projects.
Recommandation 2
Another required measure would be to impose the redaction of a consistent white paper to every ICO. This document should at least identify the mission of the related project, its roadmap, the moral representative for the ICO and the rights attributed by the delivered tokens. Such obligation would increase transparency in the sector and push for more autoregulation of the stakeholders, which would mechanically imply more rational investments.
Recommandation 3
Finally, a more advanced step but that still keeps enough regulatory space for innovation is to establish mandatory and optional certifications for blockchain projects, at least at the state level through financial regulatory bodies such as the “Autorité des marchés financiers” (AMF) in France. Again, innovation needs to be protected. The mandatory certification would then serve as a proof of the project’s credibility and ability to be operated, while preserving as much time and administrative resources as possible. It should materialize as a right to operate. The optional certification would work as a rating system evaluating the risk-innovation ratio. This additional certification should serve as a way to ensure for the public the quality of their projects. These two types of certification would then participate in the foundation of safe, trustful and transparent business models.
The three measures explained upfront do not enclose cryptocurrencies and ICOs in a precise legal definition. Considering the constant iterative evolution of crypto-assets, these interim policy recommendations are in fact driven by the main objective of first fully grasping the implications of blockchain extended concepts before establishing later a clear and more rigid regulatory framework.
Based on the disruptive features of the blockchain, cryptocurrencies may lead to a new economic paradigm. It might be too soon to give a concrete and objective definition of cryptocurrencies and ICOs without harming the creativity and the innovation of stakeholders, but regarding their fast growth, a clear legal cut will have to be provided relatively quickly. An advanced regulatory framework cannot indeed be designed without a sound legal definition. In the following years and because the economic phenomenon of crypto-assets crosses borders, it must be the role of international bodies to clearly define them. In order to perform this task, an international forum -preferably made through a global organization such as the OECD- gathering all the relevant stakeholders should be built. It would then be a source of transparency, coordination and global regulation for a potential radical change in the economy at a planetary scale.
— — — — —
Sources
Autorité des Marchés Financiers (2018). Summary of replies to the public consultation on Initial Coin Offerings (ICOs) and update on the UNICORN Programme
Barlow, John P. (1996). The Declaration of the Independence of the Cyberspace (WEF)
Blemus, Stéphane (2017). Law and Blockchain: a legal perspective on current regulatory trends worldwide
Brennan, Sarah (2018, CoinDesk). Contortions for Compliance: Life Under New York’s BitLicense
Boisseau, Laurence (2017, Les Echos), “ICO en Europe : publication d’une charte de bonne conduite”
Business Insider, “Only 48% of IOCs were successful last year — buy startups still managed to raise $5.6 billion”
Drey, Fabien (2018). Blockchain et régulation, vaste programme !
Glover, John (Bloomberg, 2018). “Growth of Crypto-Assets May Threaten Financial System, FSB Says”
Journal du Net (JDN) (2018) “Les arnaques aux crypto-monnaies se suivent mais ne se ressemblent pas“
Kakavand, Hossein and Kost de Sevres, Nicolette. The Blockchain Revolution — An Analysis of Regulation and Technology Related to Distributed Ledger Technologies
Kiviat, Trevor (2015). Beyond Bitcoin: Issues in Regulating Blockchain Transactions
Mills, Austin (2017). An Introduction to Blockchain Technology and its Legal Implications
Nakamoto, Satoshi (2008). Bitcoin: A Peer-to-Peer Cash System
Odin, Paul (2017). Decoding Blockchain Legal Issues — A Financial Law Perspective
Paperon, Pierre (LinkedIn, 2018). Blockchain + 2018, l’année 1 de l’après-capitalisme ?
