Cryptocurrency and Regulation: Do we need it?
Cryptocurrency holders have long held conflicting views about the legal status of their assets. On the one hand, holding crypto is a declaration of independence from global financial oppressors, so its legal status is irrelevant. On the other hand, the desire for legitimacy and the potential economic benefits offered by it — particularly to early adopters — means that even some of the longest-bearded, most mountain-dwelling crypto OGs have donned suits and sit at the table with their perceived oppressors.
Like it or not, the meteoric rise and fall of the aggregate crypto market cap in 2017 and 2018 was largely influenced by regulation: the lack of it, the threat of it, the implementation of it, and the need for it.
Starting with the lack of regulation, the huge influx of capital fueled by the ICO boom was only possible because of the absence of laws. Billions in pent-up money held by people all over the world who were hungry for a slice of the tech-profit-pie that was previously consumed exclusively by Silicon Valley VCs, was able to flood the market precisely because it wasn’t held back by pesky regulation.
As the billions piled on though, regulators became increasingly concerned (read: increasingly active). Statements were made, and some laws were indeed passed, but global regulatory consensus — particularly as it relates to some of the more complex issues (such as whether a token should be considered a security) — is still a long way off.
From government’s perspective, regulation is said to be needed to 1) prevent money-laundering, 2) protect the financial system, and 3) protect buyers (citizens). All attempts at regulation use one or more of the above as their justification.
Regarding 1) — preventing money-laundering — the principal tool used by regulators is the enforcement of Know-Your-Customer (KYC) data collection and Anti-Money-Laundering (AML) standards. Crypto-exchanges in various jurisdictions have thus increasingly been pressured or regulated into collecting data on their users and handing that data over to authorities. Notably, long time KYC hold-out ShapeShift, in September, announced it would be implementing mandatory KYC to allow the use of its services (starting October 1st). A statement by ShapeShift founder (and bonafide crypto OG) Erik Voorhees indicates the move was made in response to increasing pressure by regulatory bodies in the US: “To the extent that digital asset technology remains a legal grey area, we need to be prudent and thoughtful in our approach as we navigate the regulatory environment.”
Unsurprisingly, the G20’s first major coordinated crypto-regulation effort is centered around setting and enforcing KYC data collection and AML standards. The group of finance ministers and central bank governors from the EU and 19 of the world’s largest economies issued a communiqué in July setting an October deadline for the associated Financial Action Task Force(which includes administrators from an additional 16 countries) to “clarify…how its standards apply to crypto-assets” and to draft binding rules for crypto exchanges located in any of the signatory countries. In other words, we are very likely to see the emergence of a global regulatory framework for enforcing KYC and AML in the very near future.
Even though the actual amount of money laundered through cryptocurrencies is relatively small, and even though cryptocurrency transactions are in fact easier to track than cash (so far), regulators claim to fear that the amount of money laundered through crypto could get out of hand. The effort to fight money laundering is, according to the dominant narrative, closely tied to counter-terrorism. This adds to the perceived justification for collecting the national IDs and physical addresses of crypto holders.
However, the real reason regulators want to force all crypto-exchanges to engage in data collection on their users is that exchanges are critical to figuring out how banks interact with cryptocurrency and how taxes will eventually be collected. In other words, the global enforcement of KYC is what will allow the maintenance of the status quo (governments staying in charge).
This brings us to the very much connected second reason governments insist on regulation: protecting the financial system. Here regulators are supposed to draft rules that will prevent systemic risks from building up to the point that the entire financial system could collapse. Regulation in this regard was supposed to prevent, for example, the 2008 financial crisis. As it relates to the crypto space, the aim of regulation is to make sure whatever is built on the emerging decentralized framework isn’t allowed to get to the point of causing the kind of society-level collapse that requires a government bail-out (as was the case when banks were bailed-out starting in 2009).
At this point it’s important to remember that, at its core, crypto represents an existential risk to most governments. If, for example, an upgraded truly anonymous version of Bitcoin overtook the USD as the world’s reserve currency, it could very well lead to the elimination America’s ability to maintain global power through economic hegemony. Make no mistake: we are talking about the potential for a serious global power realignment.
On this issue there is a divergence in the crypto community. On the one hand we have the revolutionists who stay true to their message of sound money and decentralization of power as the catalysts for the creation of no less than a new world order. On the other, we have a combination of those looking to work within the system to make more incremental change plus those looking merely to profit.
Starting from the revolutionary perspective, crypto evangelist (and yes, bonafide crypto OG) Andreas Antonopoulos argues that we shouldn’t attempt to fit cryptocurrency into the existing financial system because doing so may destroy the whole point of the technology. He points to the increasing “Wall-Streetization” of crypto — defined as the drive to build financial products that eliminate the inherent scarcity of a given cryptocurrency — as a threat to crypto-independence. Antonopoulos is against, for example, any proposed Bitcoin Exchange Traded Fund (ETF) that is not strictly physically settled in Bitcoin (such as the proposed VanEck/SolidX ETF which would be cash settled rather than physically settled). An ETF of this nature, claims Antonopoulos, risks centralizing control of Bitcoin: “It’s not going to be the end of Bitcoin, it’s just going to cause manipulation of the prices. It is going to cause manipulation of the debates about scaling decisions, and if there are forks it is going to give these parties a very large determining voice in forks. Eventually you’re going to see them split off and form their own corporate version of Bitcoin,” he said in July on his popular video series Bitcoin Q&A.
The argument goes that as more value within Bitcoin is held by institutions rather than by individuals holding their own private keys, those institutions gain a bigger say over what “Bitcoin” is and how it evolves. This becomes a problem because later if, for example, a Bitcoin Improvement Protocol proposes upgrading Bitcoin to enable real transaction anonymity, a few centralized institutions who have outsized control through their monetary clout may reject the upgrade because it doesn’t align with their interests. In other words, no revolution.
On the other hand, the lure of working within the financial system is strong. The arguments in favor of embracing regulation focus on building value through the creation of legal trust and protection (rather than through pure cryptographic “trustlessness” and mathematical protection).
Supporters of regulation talk of the so-called “institutional investors” who can finally enter the market once the right regulations are in place. By meeting the internal and external compliance requirements of publicly traded companies, endowments, brokerage houses and so on, regulation can open the door to a new wave of money entering the space. Considering that global pension funds, sovereign wealth funds, endowments and foundations, mutual funds and insurance funds account for $131 trillion of global wealth, according toresearch by Willis Towers Watson, and that none of those funds currently have a way to allocate money to the emerging crypto-asset class, it’s reasonable to assume that when the tools are in place to allow allocation from such “institutions”, an influx of money will ensue.
Other arguments in favor of regulation include enabling the de-risking of the broader market, which would hasten blockchain adoption by large enterprise users. As crypto moves out of the shadows, it becomes more acceptable for global brands to associate themselves with it. Additionally, for entrepreneurs pitching projects, clear regulation adds to the perceived trustworthiness for prospective investors. Not only that but without clear rules many entrepreneurs will inevitably sit on the sidelines for fear of innocently running afoul of the law. Even those who do take the risk, face difficulties proving their reliability and trustworthiness to prospective investors. This leaves the space to only the most risk-averse, making it difficult for crypto to shed its Wild West image.
This brings us to the final commonly cited reason that regulation is needed from the perspective of government — protecting investors from scams. Here, actions taken by regulators thus far have varied from blanket bans on ICOs (as in the case of China) to the reactionary drafting of polar-opposite laissez-faire regulation by opportunistic jurisdictions.
In the US, EU and most G20 countries, however, concrete regulatory progress has not been made — and the lack of clarity is often cited as a primary reason for the bear market conditions endured by crypto-traders in 2018.
As with most debates, the definition of terms must first be settled. Critical to this debate is whether or not to define certain cryptocurrencies as securities. Subjecting cryptocurrencies to securities laws burdens holders with onerous reporting requirements that threaten to destroy the potential value and utility of many — if not most — of the decentralized projects either proposed or under development. With founders potentially on the hook for securities violations, unfavorable regulation could easily put into question the very existence of a large portion of these projects.
Thanks to a regulatory roller coaster in the US, crypto-stakeholders and market watchers the world over have been subjected to concomitant market volatility. At first the Securities and Exchange Commission (SEC) implied that all “utility tokens” were actually securities, only to later soften its stance. In alandmark speech in June, William Hinman, the SEC’s director of the Division of Corporate Finance, answered a question that had been nagging the Ethereum community: while ether might have been a security at the time of its 2014 ICO, it does not meet that definition today because of how it functions within the Ethereum network.
Regulatory authorities, it seems, are beginning to accept that, when tokens have a clearly functional role within a blockchain network, it’s better to manage them using existing consumer protection and AML laws than subject them to onerous securities regulation. The difficulty comes in attempting to define the cut-off between security and utility: what level of platform functionality is required for a token to earn exempt utility status?
Beyond securities laws exemptions, regulators also need to agree on strategies to apply existing consumer protection laws to ensure that ICO issuers are held responsible for promises made to people who put money into their token sales.
These are complicated questions but regulatory bodies have been slow or reluctant to issue clear guidance. A meeting of European finance ministers in Viena in September, for example, resulted in no clear decisions. The ministers agreed only that crypto-assets don’t currently threaten the financial system and that they’ll wait for the outcome of a thorough analysis by European authorities before deciding on any further regulatory action.
However, while regulators in some countries have been slow to act, others are capitalizing on what could be a once-in-regulatory-lifetime opportunity to attract innovators and become a tech hub for the emerging Web 3.0. Countries such as Malta, Liechtenstein, Switzerland, Singapore, and more, have all being vying at various levels to be so called crypto-havens. The Swiss Financial Market Supervisory Authority for example came up with a usefultaxonomy that divides tokens into three categories: payment tokens, utility tokens, and asset tokens, with only the latter being subject to securities laws.
Some exchanges have been nimble enough to play regulatory arbitrage within this landscape. Binance, which originally had its servers in China, preempted China’s ICO ban by moving them (overnight) to Hong Kong before relocating to Tokyo, then again to Malta — all within a 6-month period. Hedge funds and other stakeholders have been playing the same game. New York state’s “BitLicense” legislation for instance resulted in an exodus of crypto-business from the state. More recently, after US-based crypto-hedge fund Arrington XRP was subpoenaed, it announced it would stop investing in the US and “pivot to Asia.”
In the past, regulators in dominant markets like the US and EU could rise above such problems. The sheer amount of money raised within their borders left other global actors with little option but to comply with their rules to ensure access to their markets. With foreign capital markets deeper in the age of globalization, however, and with the advent of the ICO as a fund-raising platform, globally distributed blockchain development teams are deciding that they can comfortably raise all they need from Asian and other investors outside of traditional regulatory frameworks.
In summary, government regulation isn’t likely to appeal to crypto-purists, but for entrepreneurs and investors, it is likely to mark a new, more profitable and more stable period. Holding their private keys and waiting for the next global economic collapse may end up producing generational wealth for the purists. Meanwhile, for those waiting for crypto to go prime-time within the existing financial system, keeping an eye on the regulations is essential for determining when and where to allocate capital.
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