Cryptocurrencies ended 2017 on a high; as more people put money in them, exchanges sprung up all over the world and new cryptocurrency-based products were developed. However, several high-profile crypto exchange hacks, as well as cases of illicit financial flows and businesses, are using cryptos as the medium of exchange; thus, they have put the market under increased scrutiny as 2018 kicks into gear.
Now, some of the cryptocurrencies have pulled back from their all-time highs; thus, the issue of cryptocurrency regulation is on the front burner. Industry stakeholders and governments struggle to find common ground on the way forward.
Role of Regulation in Financial Markets
History is replete with circumstances were investment vehicles were sold to the public, followed by spectacular crashes. But the defining moment was the stock market crash of 1929 in the US; this led to the formation of the Securities and Exchange Commission in 1934.
The SEC served as a body to oversee the activities of listed companies, provide a reporting standard for financial disclosures and monitor market practice; many companies whose stocks crashed in the 1929 financial market holocaust had misrepresented the true state of their businesses and financial projections to investors.
Since 1929, there have been several market booms and crashes. The most recent market crash that assumed a truly global scale occurred in 2008. Central to this crash was the fact that it involved a novel type of market instruments called collateralized debt obligations (CDOs); these invested in credit default swaps and other assets tied to the US subprime mortgage market.
However, these instruments were not regulated. Many investors who bought them did not really know how these derivative instruments worked. Also, the banks that issued these assets did not know the full extent of contagion that these assets could bring to the market. Therefore, when the subprime mortgage market collapsed, the impact was felt globally.
The Problem with new Assets
These assets are often not properly understood and are not regulated when they hit the markets.
On one hand, you have investors who, to a large extent, do not really know how the fundamentals of these assets work and what drives prices.
On the other hand, you have regulators who are either unwilling to stifle the markets by undue regulation or prefer to watch from afar. Usually, only a few regulators take the bull by the horn and stamp their regulatory authority on these markets.
This was the situation that confronted traders and regulators when binary options were launched in 2008. While the US clearly defined and regulated its binary options market, regulators in other parts of the world did not deem them worthy of being called ‘financial instruments’ and left them unregulated.
Yet, binary options traders felt they were dealing with financial assets. With no government oversight or industry self-regulation, the wolves took over and today that market is in dire straits.
We now find ourselves in a situation where blockchain technology, originally created for use as platforms or networks on which smart contracts could be run within an ecosystem and paid for using the cryptocurrency of that ecosystem, has now been used to create products that are being marketed and sold to investors as financial instruments.
Tokens, ICOs, new cryptos and CFDs based on cryptocurrencies are now being traded as financial assets and in many cases, with no regulation whatsoever.
What Can Be Regulated in the Cryptocurrency Ecosystem?
There have been loud calls to “regulate” cryptocurrencies from various quarters; however, there seems to be a lack of consensus as to what actions would constitute “regulation” of the cryptocurrency markets.
To some governments, regulation means requiring cryptocurrency exchanges to collect documentation from their traders to know who they are, where they source their funds and where they live.
For some other regulators, regulation means completely shutting down exchanges and everything to do with cryptos altogether. Some countries are still trying to define what regulated cryptocurrency markets would look like in their jurisdictions.
Presently, the standards of global Bitcoin regulations are as different as night is from the day when you move from one hub to another.
So what really will cryptocurrency regulation look like?
Will it mean that some countries would ban the crypto coins in use today completely, in favour of having just one state-sponsored cryptocurrency?
Would it mean pushing enthusiasts away from cryptocurrency trading and towards adopting cryptos as controllable digital payment systems that would work hand-in-hand with fiat currencies? The recent announcement of the advent of LitePay, the world’s first official cryptocurrency-based e-commerce solution that will allow merchants accept Litecoin on their sites, seems to be a major step in this direction.
Would we see widespread adoption of existing cryptocurrencies as trading assets subject to the same financial regulations as stocks, currencies, and commodities?
Would we see cryptos being regulated as both financial assets and alternative media of exchange to fiat currencies? Probably not and even if this were the case, it would take several years for existing players in global finance to warm up to this idea.
We should also mention that tax authorities all over the world seem to be taking more than a passing interest in the cryptocurrency market. The need to generate revenue through taxation of cryptocurrency trading profits may also be a factor that will influence regulator actions in the cryptocurrency space.
Global State of Cryptocurrency Regulations
The concluding part of this article discusses policy direction on global Bitcoin regulation and general cryptocurrency regulation from the major hubs where cryptocurrencies command a lot of trading interest.
Presently, there is no clarity in policy direction as far as cryptocurrency regulation in the US is concerned. As per US regulations, cryptocurrency regulatory signals from the SEC and the Commodities and Futures Trading Commission (CFTC) seem to be at variance. The declaration by the Internal Revenue Service (IRS) which views cryptocurrencies as taxable property and not as currencies has added another dimension to the situation.
The SEC declares that it has not approved any cryptocurrency-based assets for trading. This effectively means that from the SEC’s point of view, Initial Coin Offerings (ICOs), ETFs and other crypto assets are not approved for trading in the US by the SEC.
On the other hand, the CFTC views Bitcoin as a commodity and has not only licensed Bitcoin futures for trading on the CBOE and CME, it has also licensed exchanges to offer cryptocurrency assets for trading (GDAX and Gemini). The CFTC also has enforcement powers and has used this to initiate prosecution of two cases where it was thought that cryptocurrency Ponzi schemes were in operation.
Concerns that cryptocurrencies could be used for money laundering have been voiced by law enforcement agencies in the US. Arrests and Bitcoin seizures have been made. The big banks (Goldman Sachs and JPMorgan Chase) have also banned their credit and debit cards from being used to fund cryptocurrency trading accounts.
It would seem that the US is still trying to define some sort of policy direction for cryptocurrencies, given that many Americans are trading them with offshore exchanges as well as the registered local exchanges.
China’s position can best be described as one of protectionism. Given that Alibaba, Baidu and Weibo have thrived in the local market where Amazon, Google and Facebook have been reined in by government fiat, it is not entirely surprising to see that China has made powerful moves to curb cryptocurrency activity of all kinds, while giving surreptitious support to “Chinese Ethereum” Neo, a cryptocurrency created by …you guessed right, a Chinese-born developer known as Da Hongfei!
China’s cheap and abundant power supply, cheap labour and abundance of factories which churn out equipment that can be used for cryptocurrency mining had over the years, led to an influx of miners and exchanges.
However, a sweeping ban in September 2017 which targeted new ICOs asked local exchanges to shut down caused a major upheaval in this market. Many exchanges have moved to nearby Hong Kong to operate. However, there is no official prohibition of cryptocurrency trading activity.
China is also open to blockchain technology, but only if it is used to create a state-backed cryptocurrency. Trials and test-runs have been done by the Chinese central bank.
It can be said that China’s policy on cryptocurrency regulation seems to be moving in the same protectionist direction that it has assumed in the digital space. The state would prefer to have a cryptocurrency it owns and controls, and would prefer to do away with “Western” cryptocurrencies.
South Korea is a major player in the cryptocurrency markets because it holds a large population of traders who buy and sell on cryptocurrency exchanges. The country also hosts some major exchanges.
This has however created some problems, as South Korea’s spy agency has indicated that some of the crypto heists done on local exchanges were the handwork of its northern neighbours.
This prompted a January 2018 announcement by the South Korean Justice Ministry that it planned to close down all cryptocurrency exchanges in the country. However, the Finance Ministry has since toned down the content of that announcement, indicating that no decision on this had been made.
These two announcements caused turmoil in the crypto markets, and allegations that government officials had benefited from insider trading arising from the effects of these two announcements are being investigated.
Presently, no final decision has been made and markets are watching the situation closely.
Digital currencies are recognized as a means of payment in Japan. The Virtual Currency Act, a law sponsored by the Japanese regulator classifies Bitcoin as a financial asset and a digital payment method. The Japanese Financial Services Agency (JFSA) has granted 11 cryptocurrency exchange licenses and has mandated that the same Know Your Customer (KYC) requirements of other markets be applied to cryptocurrency exchanges.
Presently, Bitcoin is accepted in more than 4,500 stores. This puts Japan as about the only country where a policy direction on cryptocurrency regulations is in place.
UK legislators are presently considering legislation which will require cryptocurrency exchanges to implement full KYC protocols. The debate is ongoing.
There is no doubt that there will be major policy changes in terms of global cryptocurrency regulations. However, the scope of what will change is not clear. Clearly, regulation means different things to different regulators.
By standards of US regulators, cryptocurrencies may have to remain under the CFTC’s guidelines. China and South Korea may have very different ideas as will the rest of the world. But there is a general consensus: price action on cryptocurrencies will be largely determined in 2018 by regulation (or the lack of it).