October 11, 2021 | Ali Abbas
Estimated reading time: 10 minutes
Regulating crypto: is this the end of the libertarian fantasy?
Regulation was anathema to the early adopters of cryptocurrency. Bitcoin, the most popular digital payment token, was created in 2009 as a decentralized, open source payment method that didn’t require central bank involvement. Instead, users could send and receive money peer-to-peer, with the settlement information made public to ensure faith in the system.
Bitcoin’s emergence dovetailed with the recovery from the 2008 financial crisis, when trust in bankers and financial watchdogs was at an all-time low. A slew of anti-money laundering, know-your-customer and other due diligence laws for the regulated sector were enacted as governments grappled to ensure lenders would never again take such risks.
A form of currency created privately, which circumvented norms, where identifying both parties to a transaction was near impossible without significant resources, was a headache that government did not want during this push to clean up banking.
Indeed, privacy was so central to the identity of Bitcoin’s early community that even its creator has remained anonymous despite several attempts to unmask whoever or whatever Satoshi Nakamoto is.
Officials tasked with restoring faith in financial institutions frequently highlighted how Bitcoin was the preferred payment method on dark web markets where drugs, weapons, and criminal services from kidnapping to murder were sold.
The regulator tasked with monitoring international responses to money laundering, the Financial Action Taskforce, repeatedly issued guidance warning governments away from adoption of cryptocurrencies, citing their use in financing terrorism and darknet markets. While the original intent for the cryptocurrency may have been pure, its immature real-world use-cases were not.
The end of the outlaw currency
Bad publicity did little to dissuade interest in digital currencies, and particularly the underlying technology, blockchain. The distributed network that records transactions on a publicly-available ledger began to draw more attention than the coin itself during the mid 2010s.
Banks poured billions into research and even rival firms partnered with each other to investigate how the properties could strengthen their operations. A whole industry exploring decentralised peer-to-peer finance products or other transfers of value and data such as settlement information, mushroomed from the buzz.
Today, although there are hundreds of different cryptocurrencies, Bitcoin still reigns supreme. It has a market capitalization exceeding the economies of some small countries, and the value of a single coin has rocketed from a few pennies to tens of thousands of dollars.
From being a funky new way of sending money to each other, the arrival of institutional investors and speculators, and the evolution of cryptocurrency exchanges, transformed Bitcoin into a trillion-dollar trading opportunity.
“Bitcoin is now considered an investable asset. It has its own idiosyncratic risk, partly because it’s still relatively new and going through an adoption phase,” said Mathew McDermott, Goldman Sachs’ global head of digital assets, in a May research note.
Earlier this year, car manufacturer Tesla added Bitcoin to its balance sheet by purchasing $1.5bn of the tokens, prompting chatter as to which other “household names” would open the door for mainstream adoption of cryptocurrency. Tesla’s chief executive (and chief publicist) Elon Musk said prospective buyers could use cryptocurrency to buy its vehicles, and such is the allure of his involvement in the scene, the former PayPal executive caused the price of another token created as a joke, dogecoin, to spike more than 5,000% by naming it in a tweet.
Regulators rarely see the funny side of celebrities and business figures hyping cryptocurrencies and have warned of the consequences for both retail investors and any individual pumping potentially fraudulent schemes.
Rather than mere corporations giving their blessing, the Holy Grail for crypto evangelists has long been a decentralized digital token becoming legal tender. And, earlier this year, El Salvador became the first country to adopt Bitcoin alongside its regular currency. This historic moment also brought about, naturally, further regulation.
“While Bitcoin’s adoption as legal tender in El Salvador may not materially affect the day-to-day use of Bitcoin in the United States, it will alter the regulatory landscape for businesses providing cryptocurrency services,” said Joel Feinberg, partner at Sidley Austin LLP. “Most notably, as a result of this foreign legislation, Bitcoin activity that was not previously considered licensable money transmission or currency exchange in several U.S. states and territories may become licensable solely by operation of existing law.”
Outliers like El Salvador aside, most nations looking at Bitcoin have no plans to adopt the cryptocurrency as a rival to their own central bank issued money, but instead consider how best to protect their citizens from financial loss. As the price of various coins has soared, so has speculation on the volatile swings in hope of striking it rich.
With the world’s economy recovering from another market-roiling crisis, depressed interest rates, and ongoing tension over rising inequality, regulators have warned that anyone dabbling in Bitcoin must be prepared to lose all their money.
Traditional stock exchanges keep regular hours, but cryptocurrency can be traded 24-7-365 via online trading houses such as Coinbase and Kraken. In order to offer those services, the exchanges had to submit to existing regulations regarding financial products, and in doing so moved Bitcoin further away from its libertarian roots.
Indeed, rather than tackling cryptocurrency head on or outright banning it (as China has done multiple times, only to later relent), the most favoured approach has been to expand existing rules to include cryptocurrency.
As far back as March of 2013, the US Treasury Department’s Financial Crimes Enforcement Network (FinCEN) issued guidance explaining which actors in the digital currency space were covered by existing regulations and how they should comply.
“FinCEN will tell you, however, that their guidance was not a new regulation, but a clarification of how their existing regulation already applied, and indeed applied from the inception of the Bitcoin network,” said Jerry Brito, executive director of cryptocurrency lobby group Coin Center.
This allows prosecutors an easier route to making cases, legal experts believe.
The U.S. Securities and Exchange Commission (SEC) considers cryptocurrencies as securities, and it applies existing securities laws as such. Retail investors are obligated to report gains and losses from crypto investments on their annual tax forms or risk a visit from the Internal Revenue Service.
The Commodities Futures Trading Commission (CFTC), by contrast views Bitcoin and the second most popular digital currency Ethereum as commodities. Cryptocurrency derivatives are legally traded on public exchanges regulated by the CFTC. Institutional investment in cryptocurrency involves buying and selling futures contracts, hedging and speculating.
“In recent months, the increased focus on cryptocurrency regulation and enforcement at both the federal and state levels demonstrates the digital currency’s place as an established component of the financial landscape,” said Jamie Boucher of Skadden Arps. “At the same time, the cryptocurrency industry has become more attuned to and engaged with government. Growth in this space appears likely to continue.”
The age of regulation
The trend of further legislating is also likely to continue, and there are signs that cryptocurrency in the US may soon be subject to its own specific set of federal laws.
In August, a $1trn Bill to increase infrastructure funding over the next eight years went before the U.S. Senate. To help pay for these expenditures, a provision was inserted imposing reporting requirements on cryptocurrency “brokers”. Such reporting would allow the Internal Revenue Service to collect an additional $28bnn tax revenue over 10 years, according to estimates.
“But the broad definition of broker — any person responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person — sparked significant backlash throughout the cryptocurrency community, resulting in several days of proposals and counterproposals among legislators,” said Boucher. “While the original definition remained in place, the debate marked the most serious consideration of a cryptocurrency issue by either chamber of Congress.”
Bitcoin groups reacted angrily to the additional reporting requirements, which they said were built on “a draconian surveillance rule that should have been ruled unconstitutional long ago” regarding the information two counterparties to certain transactions must hold on each other.
“Extending it to cryptocurrency transactions would further erode the privacy of law-abiding Americans,” said Peter Van Valkenburgh, Coin Center research director. “If this provision becomes law, it will be ripe for a constitutional challenge,” Van Valkenburgh said, adding the group “is prepared to take on that challenge”.
At the state level, individual jurisdictions are splitting with each other on their approach. Some are passing laws to attract investment, while others, notably with financial sectors such as New York and California, have indicated they want to limit cryptocurrency investment and assets.
In the UK, the retail investor protection mandate has put cryptocurrency on the plate of the Financial Conduct Authority (FCA), however tax on crypto profits is levied through HM Revenue and Customs. The FCA has a wide remit of powers, and unlike the US which splits oversight of trading between the CFTC, FinCen and SEC, it is the sole regulator and enforcer of cryptocurrency activity in Britain.
“But don’t let this apparent simplicity fool you,” said Dorothy Murray of Proskauer Rose LLP. “UK law and regulation on crypto assets can be a mixed bag of both clarity and confusion. Whether that approach becomes more or less clear in the near future will turn on what the UK government does when EU laws no longer apply.”
While crypto is quintessentially international in nature, the sting of regulation is largely at the national or sub-national levels, said Murray. “We see a notable divergence of approach at the national (and even sub-national) levels and as a result, firms and users of crypto must be ever vigilant in order to stay on top of their obligations and within the bounds of the law,” she said.
Due to the more streamlined regulatory approach, crypto banking in the UK is moving faster than across the pond. Last year the UK issued its first Authorized Payment Institution license to a crypto firm. BCB Group can offer certain cryptocurrency services like online payment processing and money transfers, across the European Economic Area.
And appetite for bold digital currency projects shows no sign of waning; in July, the European Central Bank announced a multi-year project to create a digital version of the euro, while the Federal Reserve has been conducting research on launching a blockchain-powered version of the US paper greenback dollar.
The Bank of England has also floated a central bank digital currency, and is part of a task force to develop the UK’s response to cryptoassets and distributed ledger technology.
There is a certain irony that – as wider adoption grows – central banks, who were never supposed to be involved, may have a pivotal role to play in the future of the Bitcoin economy.
It’s ironic, in some respects, that a currency that was originally designed to transcend borders and traditional financial frameworks will inevitably be brought into the same regulatory system that it sought to differentiate itself from. New innovations aren’t able to evade the regulator’s gaze forever, especially where customer’s money is at stake.
While financial regulation for crypto is no bad thing, it does strike me – as per Dorothy Murray’s comment – that there is “notable divergence” of regulatory approach at a national level.
This seems like a classic case of ‘square peg, round hole’. Yes, cryptocurrency may be a currency in its own right but – as with many areas of financial services – it does not necessarily fit the nationalistic model of financial regulation.
This leads to a broader thought – why is it that financial institutions have evolved hugely – with everything from open banking, crypto, payments etc – but financial regulators continue to use the same fragmented model to regulate such innovation. The regulations are there, but they lack any form of cross-border collaboration. This leaves compliance teams to spend hours poring over obligations to piece everything together.
Regulators across the globe will rush to regulate crypto – but will do so without harmonisation. And so, financial organisations will have to take a cross-border, jurisdiction-less currency and apply fragmented national regulations to ensure compliance. Imagine the time that could be saved – and the efficiency gained – if financial regulation was issued in one consistent (and ideally machine-readable) standard.
In the absence of regulatory standards, RegTechs – such as CUBE – apply next-generation artificial intelligence, natural language processing and machine reading to capture every regulatory change, understand it down to its lowest common denominator, make sense of it and map it to customers’ existing taxonomies, policies and controls.
If you want to make sense of emerging and in-force global regulatory obligations for cryptocurrency, CUBE has you covered.