The first question that needs to be answered is, are regulations necessary in the blockchain industry?
Then, if this one turns out to be yes, what is the limit of regulation, and finally, who or whom is it in the interest of regulating?
In the modern, interconnected world, regulation of financial technology is a growing issue. Blockchain, by the very nature of its technological underpinnings, is even more so.
The complexity behind cryptocurrencies requires regulators to understand their individual peculiarities, needs and nuances when regulating them. The variety of tokens in recent years makes it necessary how to legally define a stablecoin, a fungible token, a non-fungible token, or a utility token.
The breakneck speed at which the industry is evolving, with billions of dollars invested in software development, leaves behind in controls even the most centralized and authoritarian regimes, which are only catching up with developments that took place years ago.
The steady increase of new cryptocurrencies, today 5,468 listed on CoinMarketCap, is reflected in a capitalization of nearly $1,500 trillion, equaling the GDP of Australia or Spain, World Bank, year 2019.
Gone are the days of dismissing the rise of cryptocurrencies, treating them as a fad immersed in a small volatile bubble that would only affect a tiny sector of the economy. Instead, the new focus is to be prepared for global markets, financing and, most importantly, economic and financial implications.
The central power understands that the growth of adoption could cause a tsunami in the economy in the face of crisis events, if production, trading and holding standards were not in place.
Historically, regulation of the cryptocurrency sector has been based on three main pillars: customer protection, crime prevention and anti-money laundering procedures. Since the mid-2010s, regulators have been given enough arguments for clear and vivid violations of all three pillars.
In the trading environment there is no way of knowing whether major exchanges inflate their volumes by granting special access and zero fees to market makers. Even the exchanges themselves have no way of knowing if a group of users are related or conducting multiple transactions with each other to inflate prices or volumes. There are hundreds, if not thousands, of influencers, pump and dump chat rooms, trading apps and the like to achieve this end.
One of the first targets of regulation were exchanges and token issuers, or virtual asset service providers (VASP), as they are legally known. And with good reason: the top five exchange hacks alone have siphoned off nearly $1.5 billion, taking advantage of technological vulnerabilities and human error. It is also estimated that the top 10 ICO scams took nearly $700 million from customers.
A recent Trezor report shows reported incidents and estimated losses in the crypto ecosystem. Hacking incidents are in the majority, followed by scams. But estimated losses, between phishing and scams, are estimated to take 63% of the stolen amounts.
Countries and their regulatory actions
In the German-speaking part of the European Union, which includes Germany, Switzerland and Austria, there has been a big push to implement legislation that distinguishes between security, payment and utility tokens. This builds on the fact that Switzerland has already embraced the scene in an innovative way, with the Crypto Valley in Zug serving as a haven for many projects since the middle of the last decade.
The UK, for its part, chose to crack down not so much on cryptoassets per se, but on cryptocurrencies packaged as various financial assets, such as futures, which violate existing regulations if they are not expressly authorized to operate.
In the United States, progress is much slower. A Department of Justice report cited a staggering eight different groups with regulatory oversight, each of which classifies cryptocurrencies slightly differently: one as a commodity, another as a property or even as a security, which means complications for any new project that wants to develop in that country.
Federal supervision over the fledgling industry now falls to the SEC’s FinHub division. Originally formed in 2018, the office has been growing in power and expanding its role over the SEC’s crypto strategy.
Singapore, on the other hand, has been driving the conversation about the global reach of not only crypto companies, but the technology itself. Provisions included in the 2019 regulation have expanded its rules to include the overseas activities of companies based in the country.
Japan’s relationship with cryptocurrencies has been particularly volatile. Its borders saw some of the biggest and earliest cryptocurrency disasters. It started early with the Mt. Gox scandal in 2014, in which hackers made off with more than $460 million in BTC. Just four years later, Japan’s local scene would be rocked by another cryptocurrency exchange disaster, with thieves this time making off with more than $500 million in NEM tokens.
Despite these clear and brutal examples of the vulnerabilities faced by VASP, Japan’s approach remained pragmatic and futuristic. The island has had a nearly three-year head start in incorporating cryptocurrency custodians and businesses into its mainstream economy. Last year, Japanese authorities enacted one of their strictest exchange regulations to date, while adding additional protection for customers.
The trend that is starting to be seen around the world is the rise of independent, cryptocurrency-focused regulatory bodies. Japan has recently announced that it will create not one, but two committees to oversee the cryptocurrency sector, the Japan STO Association and the Japan Crypto and Virtual Asset Exchange Association.
China is a country where, the siege of the blockchain industry, shows ups and downs. Every now and then, the communist government inflicts pressure. It was in the middle of May this year that the government announced that it will restrict cryptocurrency transactions in all its financial entities. The new regulation according to which financial entities cannot provide savings or token trust services, nor issue any financial products linked to virtual money. Exchanges and initial offerings with cryptocurrencies are also prohibited. However, individual holdings of cryptocurrencies are not prohibited.
Arguing high energy consumption, energy use for Bitcoin mining has recently been banned in certain provinces, which has led to a significant drain of miners. It is estimated that 65% of mining is located in China.
The global nature of the industry makes it difficult to control
Jurisdiction is a problem for the regulator. Globally, there are only suggestions from supranational bodies, and agreements between countries, but there is not (yet) the possibility of a global regulator with the power to act.
When the author of the token can be determined, or where the token is traded, the regulator can impose rules.
Although so far local regulations have mostly been crafted by countries to control their national interests, the growing role of supranational organizations in shaping the global industry cannot be ignored. The best example of supranational organizations shaping the policy response to the cryptocurrency boom is the Financial Action Task Force (FATF).
The Financial Action Task Force, is an intergovernmental institution created in 1989 by the then G8. The purpose of FATF is to develop policies to help combat money laundering and terrorist financing. The FATF Secretariat is based at the OECD headquarters in Paris.
The FATF guidelines seek, among other measures, to block cryptocurrency withdrawals to private wallets. In other words, transactions should only take place between highly limited and legally regulated exchanges or services, being a highly restrictive policy, as far as trading and individual holding of tokens is concerned.
Known as the “trip rule”, this has been a common requirement of banks for several years, and means that cryptoasset holders must pass on to the recipient, the name and details of customers moving money to another platform. However, while this measure is a frequent feature of traditional finance, it is onerous for smaller cryptocurrency exchanges that do not have the same administrative power as banks. In addition, there are several issues with the definition of a VASP, which the FATF has indicated could mean an individual, depending on the nature of the transaction and the interpretation of each member’s jurisdiction.
Another supranational organization showing signs of increasingly unified and broad involvement in this industry is the European Union. Until recently, it was the responsibility of individual countries within the Union to issue cryptocurrency directives and guidelines. In September 2020, the European Commission announced the creation of the Digital Finance Package (DFP) and the Markets for Cryptoassets (MiCA), which, when implemented in 2024, will constitute the most comprehensive and far-reaching regulation in the cryptocurrency world to date.
What will happen to privacy currencies?
The creation of cryptocurrencies had its roots in the cypherpunk philosophy, for the total independence of individuals, privacy, and the break with the pre-existing financial world.
Under this same concept, blockchains were designed with low or no traceability of their operations, the best known being Monero (XMR), ZCash (ZEC), PIVX (PIVX), Horizen (ZEN), or Verge (XVG). Unlike Bitcoin, where its transactions can be tracked, but without identifying (in principle) their holders, technologies were developed to obfuscate them, such as Whirlpool in the Samourai Wallet, which uses CoinJoin, a method to join different transactions from multiple people into a single transaction.
This type of technology is not well received by regulators, as it inhibits their control.
Regulatory moves by South Korean regulators illustrate this point. In late 2020, the local government banned asset-based exchanges, which it considers “dark currencies.” This is representative of an ongoing trend, to stifle privacy-centric innovation.
DeFi
The DeFi (decentralized finance) ecosystem makes understanding the industry even more complicated, as it adds instruments and financial structures built on cryptocurrencies and their networks.
The collapse that occurred at MakerDAO in March 2020, due to the enormous selling pressure caused by the global COVID-19 pandemic, for example, triggered a governance overhaul that has spread throughout the crypto space. There is an awareness of “self-regulation” in this regard.
Exploits (abuses of design flaws) in flash lending, have also been a cause of major losses.
Surely the requirement of IT audit processes for smart contracts, and risk planning for the entire industry, will be part of regulators’ regulations to anticipate crises.
Final words
The vision of an independent and decentralized economy of some of the most fervent promoters of cryptocurrencies, seems nothing more than a pipe dream in 2020. Let’s face it, the regulatory phase is just beginning, and the more cryptocurrencies become popular, the more the central power’s interest in attending to its specialty, that of issuing rules, will grow.
Thus, we must keep a close eye on the direction cryptocurrency regulation takes. It is likely to be uneven across countries and regions
How to consider an excessive regulation, or a lax one? What are the limits of these. Prohibitions are also regulations, only more extreme.
Undoubtedly, the limit is the privacy and property rights of individuals.
