Cryptocurrency is here to stay, so where do we go from here?

Cryptocurrencies have already proven in their short history their ability to be an enigma for investors globally. 

2/21/2019 12:00:00 AM

For the allure of their sparse regulation, absence of third party intermediaries and central governance, regrettably cryptocurrencies have caught the attention of fraudsters and other opportunistic criminals. This article will examine the key regulatory and security issues surrounding cryptocurrencies in relation to money laundering, the raising of capital through ICOs and concerns of their volatility.

Money Laundering

Pseudonymity of transactions – Cryptocurrency transactions bypass the regulated banking system and can be conducted pseudonymously i.e. under a false identity. A Bitcoin wallet can be opened under any identity, as compared with the proof of identity required when opening a bank account.

The Dark Web's currency of choice – Bitcoin in particular has become the preferred currency of criminals with which to purchase illicit goods on the Dark Web. Purchases are made using a TOR network, which hides the IP address of users, adding another layer of untraceability and also causes jurisdictional issues as to which country's regulations should apply where wrongdoing is discovered.

The EU's fifth anti-money laundering directive ("5AMLD") - For the first time, cryptocurrency exchanges and wallets will be included within the definition of "obliged entities" under 5AMLD. When EU Member States implement the directive by January 2020, these entities will be required to undertake customer due diligence (including KYC) and transaction monitoring, in addition to recording and reporting suspicious activity and to register with financial supervisory authorities within their domestic jurisdictions.

This is a clear step forward towards achieving a harmonised global regulatory approach to, as the EU's stance has shifted from a "wait-and-see" approach to one more in line with that of the US. Whilst removing some anonymity and efficiency at the point of exchange, these measures will inject a reassuring degree of trust for its users and investors. Beyond that, most Governments are taking a "light-touch" approach to regulation and consumer protection.

Initial Coin Offerings ("ICOs")

ICOs are a cost-effective, efficient and innovative way of crowdfunding, facilitated by the use of Distributed Ledger Technology ("DLT"). Investors are provided with tokens in exchange for fiat or virtual currency, which typically take the form of either traditional securities (e.g. shares) or "utility tokens". These are either exchanged for cryptocurrency or for services/products of the company at some point in the future.

Variance of "utility tokens" – The diversity of tokens offered in ICOs makes them inherently challenging to regulate universally. Rather, they are typically dealt with on a case-by-case basis.

Disclosure obligations – Unfortunately in the field of ICOs, disclosure requirements barely exist, as opposed to issuing an IPO. The key question is whether the token is to be considered a transferable security to the public. UK regulators have tended to treat cryptocurrency as a commodity, thereby not triggering such requirements. The US applies a notably broader definition of securities (applying the Howey test) than that of the UK[1] and EU[2]. There is a slim chance that prospectus obligations will be engaged under FSMA, however the FCA's view is that cryptocurrencies such as Bitcoin are generally not "specified investments" for these purposes.

In its DLT Discussion paper, the FCA emphasised the importance of promoters providing sufficient disclosure to enable potential investors to make an informed decision. It is unlikely that investors will have access to UK regulatory protections such as the Financial Services Compensation Scheme and Ombudsman Service if the value of their tokens plummets.

Susceptibility to cyberattacks - The value of cryptocurrency is inextricably linked to its resilience to hackers. For example, on 17 July 2017, CoinDash launched an ICO, but $7m worth of investment (in Ethereum) was lost after the website was hacked. Such instances are not uncommon, which deflates investor confidence.

Jurisdictional barriers - Issuers must also ensure that their ICOs are compliant with the regulations of foreign jurisdictions given that the Chinese government declared ICOs illegal in 2017, with a similar approach taken by South Korea.

Volatility

Sensitivity to economic and legal factors – The domination of cryptocurrency value by short-termist and speculative trading sentiment was a major contributor to the "Bitcoin Bubble" in 2017. Between July 2010 and December 2017, Bitcoin's value rocketed from just $0.06 to $19,300. Government legislative intervention in China caused the price of Bitcoin to slump by 20% in 2017. And last year nearly $40bn was wiped off the value of cryptocurrencies in just two days after Goldman Sachs delayed plans to launch a cryptocurrency trading desk. Therefore a key concern of the FCA is that unsophisticated investors are being sold complex, volatile products, which the Bank of England views as "inherently risky" investments.

No underlying asset or central bank – As most cryptocurrencies do not have an underlying asset ("Gold Standard", "Silver Standard") and are not controlled by a central bank, the value of cryptocurrency is prescribed purely by supply and demand, rather than being stabilised by government policy. This removes a layer of stability for investors. There has been some movement by some central banks to consider digital currencies.

There is an advantage in that some cryptocurrencies seem to be more stable than traditional currencies in emerging markets such as Venezuela. They also provide a certainty of exchange rate platforms if trades are all made in a particular currency.

A second Bitcoin Bubble? – Some have predicted the potential emergence of a second bubble in China, as the preferred means of circumventing China's strict capital controls, which currently prohibits transfers of currency worth more than $50,000 out of the country.

Conclusion

Lack of consumer protection in relation to ICOs and cryptocurrency trading generally is still to be properly addressed. With many Western governments taking a neutral regulatory position, the People's Bank of China is exploring a state-backed cryptocurrency. Such a concept may well alleviate risks, allowing suspicious activity to be better monitored, but should be careful not to stifle financial innovation and the freedom that has contributed to the success of cryptocurrencies.

[1] Section 85 Financial Services and Markets Act 2000

[2] Regulation (EU) 2017/1129 of the European Parliament and of the Council

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