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09/06/2017

The Changing Landscape of Global Cryptocurrency Regulations

The latest regulation news about cryptocurrency ! 

What is a Cryptocurrency?

In 2014, when blockchain and cryptocurrency first began gaining public attention, Sia Partners released a piece on digital currencies in order to address pressing questions about this new activity. Although cryptocurrency has grown exponentially since, the regulations continue to remain relatively undeveloped. For those still unsure of what the trending buzz word “cryptocurrency” means, it refers to a digital asset or currency using cryptography to secure the transactions and control the creation of additional units of currency. [1] The use of blockchain technology has facilitated the use and growth of cryptocurrencies by creating a public ledger that records cryptocurrency transactions.

Cryptocurrencies have been at the forefront of mainstream media after the value of two of the largest vendors’ products, Bitcoin and Ethereum, soared 410% ytd and 2,500% ytd, respectively. This astronomical rise in value has caught the eyes of Wall Street and investors globally. Despite its growth, this wealth remains relatively unbounded by laws and is new for regulators. Regardless, cryptocurrencies are creating a new source of wealth for millions of people worldwide.

Bitcoin, the most popular and well known cryptocurrency, was initially recognized for its prowess on the Black Market (e.g. Dark Web) as a major form of payment for illegal goods. In the wake of its stunning growth over the past year, the currency has been legitimized in the eyes of mainstream media. The legitimization of Bitcoin and other cryptocurrencies has posed questions and issues for regulators on a global scale. Criminal use of Bitcoin has decreased on the Dark Web, but risks of money laundering and other illicit transactions remain present, and there is some question about Bitcoin’s ability to efficiently handle large global transaction volume fast enough.

Since cryptocurrencies began to gain mainstream attention, several authoritative bodies began responding to these concerns. Such action has included the FBI’s preparation of an intelligence assessment, the SEC’s issuance of a pointed warning about investment schemes using virtual currencies (including so called ICOs or Initial Coin Offerings), and a U.S. Senate hearing on virtual currencies.[2] As recently as July 25, 2017, the SEC opened an investigation of ICOs and found them to be subject to US securities laws. In light of these diverse actions, however, domestic and global regulators are still debating on how to best proceed with supervision of cryptocurrency activity.

 

Cryptocurrency Crimes and Threats to the Financial System

The elusive nature of cryptocurrency and associated risks is largely founded in its decentralized public ledger system called blockchain. The Bitcoin blockchain offers public and private networks; in private networks, participant identity is known beforehand, but in public networks anyone is able to access and write data to and from the ledger. Transactions are validated through miners: anyone who completes a complex math problem, aka “proof-of-work”, then engage exchanges under the premise that their demanding efforts confirm the transaction’s legitimacy[3]. Inevitably, this public configuration has given rise to illegal trading. The race for creating an anonymous cryptocurrency has already ensued, which provides further opportunities for increasingly untraceable exchanges that facilitate illicit transactions[4]. Furthermore, the public forum complicates standard KYC policies because the complex and decentralized web of exchanges can make tracing users extremely difficult.

Beyond the risk of illegal activity, cryptocurrency’s extreme volatility poses a second threat to the financial system. The value of cryptocurrencies is based on supply and demand and lacks a central repository or state-backing to stabilize possible fluctuations. Should a computer crash and wipe out remnants of virtual transactions, cryptocurrencies can experience significant changes in worth.[5] The negative impacts of such instability have already occurred on multiple occasions, especially at the hands of cybersecurity breaches. In 2014, a massive cybersecurity heist stole over 800,000 Bitcoins, or about a $500 million, from the Japanese exchange, Mt. Gox. Mt. Gox lost its status as the world’s largest Bitcoin firm, filed for bankruptcy, which caused significant losses for customers of the exchange.[6] Additionally in September 2015, 30-year-old Frenchman Mark Karpelès was arrested and charged with fraud and embezzlement of $390 million from Mt. Gox. In August 2016, Bitcoin prices fell sharply after the Hong Kong-based digital-currency exchange, Bitfinex, lost $65 million Bitcoin to alleged hacking. Broadcast of the news incited heavy trading with Bitcoin’s value dropping 12% in one day.[7] The hack ranks as one of the largest thefts in Bitcoin’s short history and occurred just months after an apparent theft of approximately $60 million in Ethereum.

Many of the crimes committed by using cryptocurrencies occurred via the Dark Web and online market places for illegal goods. The most infamous of the online illegal market places was Silk Road. The website ran for three years and fostered over 1.5 million transactions. Silk Road was notorious for the sale of narcotics, and other illegal activity and transactions conducted in Bitcoin[8]

Aside from illegal goods purchased with cryptocurrencies, there is also a risk of fraud and financial crimes. In September 2015, 33-year-old American Trendon Shavers pleaded guilty to running a $150 million Ponzi scheme—the first Bitcoin securities fraud case.  US Attorney Preet Bharara commented on the matter, saying,

“Applying a modern spin to an age-old fraud, Trendon Shavers used a bitcoin business to run a classic Ponzi scheme. Shavers raised money in the form of bitcoins by promising spectacular returns and personal guarantees, when all he was really doing was paying back old investors with new investors’ bitcoins.”[9]

Regulators have taken notice of legal infractions committed in the cryptocurrency space and subsequently moved to create international and domestic policies in order to prevent future cryptocurrency crimes. Criminals using cryptocurrencies to launder money are now embedded in various industries such as payments, marketplaces (Ebay, Amazon, etc), and banking.

 

Domestic Regulation Initiatives

In 2013, such criminal activity experienced a decline when the FBI shut down Silk Road and seized $28.5 million in Bitcoin. In June of 2015, the government took further action to crack down on the autonomous nature of the cryptocurrency industry when the NYSDFS created the nation’s first official, legal response called the BitLicense. The law requires cryptocurrencies to comply with AML, KYC, and other monetary transmission regulations, defines what constitutes virtual currency activities, and requires involved parties to apply for a license.[10]  Application fees are $5,000 and non-refundable if declined. Due to these heavy compliance burdens, many companies have withdrawn NY operations or shut down completely. Cryptocurrency trading platforms Poloniex and Bitfinex no longer operate in the State of New York.

 

Following suit, the SEC denied additional domestic cryptocurrency activities. In March 2017, the SEC rejected Cameron and Tyler Winklevoss’ request for an exchange-traded fund based on Bitcoin. The SEC was concerned that the lack of transparency leaves investors subject to fraud and manipulation. On the federal level, no bills have been submitted regarding cryptocurrencies. However, in September 2016 the US House of Representatives proposed non-binding Resolution 835, promoting economic growth nationally. While the document is not a bill and cannot become law, it calls on Congress to create a national policy for specific technology, including digital currencies and blockchain. On July 25, 2017, the US SEC, found that ICOs “Initial Coin Offerings” are subject to US securities laws. However, the SEC isn’t pressing charges on the recent ICO for Decentralized Autonomous Organization (“DAO“), but the investigation signals a heightened interest by the SEC into cryptocurrency regulations.[11] 

Other transactions have been barred by banking establishments, including JP Morgan which prohibits customers from using virtual currency. In early April 2017, Bitfinex sued Wells Fargo & Co., claiming the bank had refused to process certain Bitcoin transactions through Taiwanese banks. A week later, Bitfinex redacted the claims, recognizing that Wells Fargo is not legally obligated to serve all customers. Wells Fargo declined to comment, but added itself to the list of banks hesitant to adopt virtual currency into their systems.[12] In addition, Bitfinex was also fined $75,000 by US Commodity FTC for failing to register as a commodities exchange. Thus, while cryptocurrency is not banned, attitudes of banks and the government demonstrates the current resistance to fully assimilate them into the financial system. 

The State of Arizona also recently passed a bill that explicitly defines and supports blockchain technology for public use. On March 29, 2017, the State Governor signed House Bill 2417 into law which was enacted immediately. The legislation defines both blockchain and smart contracts, while declaring that all data tied to a blockchain is "considered to be in an electronic format and to be an electronic record," which is acceptable for use by the state.

“Blockchain technology’ means distributed ledger technology that uses a distributed, decentralized, shared and replicated ledger, which may be public or private, permissioned or permissionless, or driven by tokenized crypto economics or tokenless. The data on the ledger is protected with cryptography, is immutable and auditable and provides an uncensored truth.”- Arizona House Bill 2417

Despite the State of Hawaii recently re-classifying businesses using cryptocurrency as Money Transmitters, forcing Coinbase to stop business within the state, the Hawaiian state legislature is close to passing House Bill 1481. The tourism focused bill, considers several ways in which Bitcoin and blockchain technology can help the State develop economically. “Digital currencies such as bitcoin have broad benefits for Hawaii,” the bill reads. While awaiting a vote by both branches, the bill has passed several committees.

“A large portion of Hawaii's tourism market comes from Asia where the use of bitcoin as a virtual currency is expanding.  Hawaii has the unique opportunity to explore the use of blockchain technology to make it easier for visitors to consume local goods and services and to drive the tourism economy.”- Hawaii House Bill 148[13]

As the number of states putting forward similar bills and legislation grows, a more holistic regulatory environment for cryptocurrency is anticipated. Watching their peer governments, other states will likely recognize the benefits from enacting cryptocurrency regulation and identify a need to implement their own.

 

International Regulation Initiatives

In early January 2017, Interpol hosted the Digital Currencies & Money Laundering conference in Qatar. Approximately 400 participants from regulatory agencies and private industries from 60 nations assembled to discuss the state of controls on cryptocurrencies. Interpol’s Director of Police Service, Tim Morris, raised the issue that digital currencies remain unregulated within nations and across borders. Albeit daunting, Sia Partners believes that this environment creates a need for coordination between international law enforcement and the private sector in order to curtail illegal activities.

One issue surrounding consistent regulation of virtual currencies involves the question of cryptocurrency’s definition; some states do not identify the digital wealth as a form of currency, but rather a commodity. In previous years, most European nations did not consider virtual wealth to fulfill the definition of a currency, and states took varying approaches to implement quasi-control; Sweden obligated cryptocurrency forums to register with the financial supervisor, Germany required that cryptocurrency fulfill authorization elements outlined in the German Banking Act (KWG), while France mandated that exchanges report all bitcoin transactions and validate the identities of involved parties. In 2015, the Australian Senate moved to amend the definition by reclassifying cryptocurrency from a barter to a currency in order to unify the perception as well as reduce double taxation. Soon after in October 2016, the European Union harmonized the treatment of Bitcoin in a similar manner. Following this definition synchronization, the European Parliament proposed a new directive in January 2017 intending to prevent money laundering and terrorist financing via cryptocurrencies. The extended rules necessitate that virtual currency exchanges and wallets fall under suspicious activity.

The wariness of cryptocurrency that Europe expresses through this directive has been echoed for several years in China. In 2015, the hub of cryptocurrency exchanges suffered a downturn when the Chinese government banned all virtual currency activities. Consequently, the cryptocurrency markets experienced a worldwide depression and the prices of cryptocurrencies plummeted. Since this strict ban, however, China has re-entered the market as the government has shifted its positon from abolition to regulation. Government interference has not been a ruse either; in January, the People’s Bank of China (PBOC) investigated the three biggest cryptocurrency companies: CTCC, Huobi, and OKCoin.[14] The investigation was sparked after the companies planned to begin charging 0.2% on all customer transactions in late January 2017, under the justification that the fees would decrease market manipulation and severe volatility resulting from increased regulation. Many Chinese citizens use cryptocurrency trading as an indirect way to exchange the domestic currency, Renminbi, into foreign currencies. The Chinese government does not want its citizens to pull money out of China and redirect their wealth into the virtual world, resulting in a capital outflow and economic losses for the state. The PBOC warned they would shut down the companies should operations fail to comply with anti-money laundering and foreign exchange standards. Ultimately, the PBOC found the companies guilty of margin financing and insufficient controls to prevent money laundering. Subsequently, in March 2017, China released a draft of proposed legislation that mandates Chinese Bitcoin exchanges adhere to all current banking and AML laws as well as gathering information on client identity (KYC)[15].

Not all regulation should be seen by Bitcoin providers as a cause for alarm. Like other nations, Japan also adopted regulation for cryptocurrency in April 2017, with the intention of preventing money laundering and protecting users against large market collapses like Mt. Gox. Simultaneously, the government awarded cryptocurrency the status of a normal form of payment. The cryptocurrency has even found space and acceptance in Japan’s food and retail industries. With their acceptance and regulation in place, Japan has laid the groundwork needed to provide a more stable climate for cryptocurrency expansion. Indeed, Japan’s state acceptance caused a rise in interested and confident users who could now invest with the security of their government’s stamp of approval.

Japan, China, Europe, and Australia showcase the varying attitudes of developed nations towards cryptocurrency, but the virtual currencies provide a separate appeal for developing nations. In Venezuela, cryptocurrency is a “safe haven”. The faltering oil industry has caused severe economic downturn, for petroleum comprises 90% of Venezuela’s exports. As the International Monetary Fund projects that inflation could reach 1600% in Venezuela by the end of this year, people have turned to money that still holds confidence. Venezuela’s largest Bitcoin provider, SurBitcoin, reports the user base has expanded from hundreds of customers in 2014, to over 85,000 at the end of last year. Furthermore, certain businesses now only accept cryptocurrency as payment. The economic conditions in Venezuela offer an alternative and more positive display of the possibilities cryptocurrency holds to assist and gain traction in states’ financial systems. [16] This demonstrates how an economy such as Venezuela’s, can propel international acceptance of cryptocurrencies.

 

Conclusion

Cryptocurrency has gained considerable ground and popularity as a legitimate form of payment since its inception in 2009: developing countries seek cryptocurrencies as an escape from inflation, criminals leverage its nature and limited regulation to conduct illicit business, and, despite value fluctuations, the industry has received a surge in the number of users. Recognizing this, many governments have shifted from banning and ignoring cryptocurrencies towards implementing certain baseline regulations. Such laws aim to decrease the potential for criminal activity and instability as well as grant governments the ability to crack down on violators, exemplified with the PBOC’s investigation of China’s leading cryptocurrency exchanges.

The Japanese government arguably has created the best foundation for facilitating a stable future with cryptocurrency through their support of the virtual currency as a normal form of money in tandem with established regulations. Although acceptance of cryptocurrency varies across nations and private institutions, blockchain is generally recognized as a technology with useful potential outside of cryptocurrency transactions. Future controls on cryptocurrencies are generally trending towards tightened regulation that focuses on requiring exchange licensing and validation as well as AML, KYC, and other money transmission protections.

Cryptocurrencies’ transferability, anonymous and decentralized nature, and lack of transparency drives indicates the need for comprehensive international and domestic regulations. The full scope of the future regulatory environment remains to be seen, but regulators are accepting that outlawing or ignorance of cryptocurrencies is futile and potentially harmful to businesses. Virtual currencies have gained far too much popularity to be evicted from the economy anytime soon, but with tightened, unified controls, a safe cryptocurrency environment may be feasible.

 

 
  • Key Takeaways

    • Major concerns revolve around cryptocurrency’s volatility and loopholes for money laundering and other illicit transactions
    • Recent SEC investigations are signaling potential regulations
    • Many nations that initially rejected permitting cryptocurrencies have shifted towards acceptance with regulatory oversight.
    • Establishing government acceptance and laws around cryptocurrency are key to its stable future, as seen in Japan
    • Irrespective of the cryptocurrency debate, the innovative blockchain technology is recognized as holding a diverse potential for applications outside virtual currency
    • Existing and future regulation focuses on implementing KYC, AML, and other money transmission laws as well as exchange licensing requirements 
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