Cryptocurrencies: Regulating the new economy

Key areas of regulations
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As an increasing number of people get involved with cryptocurrencies in some way, particularly retail rather than professional investors, regulators have taken a keen eye on the industry.

But it’s not just bitcoin they are looking at. The crypto-space has continued to develop with initial coin offerings (ICO), as CNBC explained in its last feature, and blockchain technology beginning to be used in large corporations.

The developments have brought a varied response from regulators across the world in a number of different areas. Each authority has looked at various parts of the crypto-world from mining to trading and assessed how they should be regulated. Here’s a quick breakdown of each of the areas regulators have been looking at.

Exchanges, trading and mining

Regulation around this relates to the way that cryptocurrencies are traded. There’s a big debate in several jurisdictions about how to classify cryptocurrencies. Are they commodities or securities? The way they are classed will determine how they are regulated under current laws.

Some countries have moved to introduce new regulation in this area.

Another area of focus for regulators has been mining operations. Mining is the process CNBC explained in its previous feature on blockchain of how cryptocurrency transactions are validated on the blockchain. Mining involves purpose-built computers and large electricity consumption, something that has concerned governments, particularly in China.

Crowdfunding and ICOs

Initial coin offerings (ICOs) are a way for companies to raise money by issuing a new digital token in exchange for cryptocurrency such as bitcoin or ether. CNBC took an in-depth look at the process, which has often proved controversial due to a number of scams where founders of fake companies have run off with money.

There is a clear risk with ICOs. Many of the companies are looking to raise money without having any products made yet. In several jurisdictions, regulation around ICOs is in a grey area, but some countries have looked to bring them into the regulatory fold.

Financial products

With the growth of cryptocurrencies, professional investors are looking to get into the space. But cryptocurrency exchanges have often been perceived as risky due to numerous hacks and the often unregulated nature of trading on these exchanges. As a result there’s been a drive to bring regulated financial products onto the traditional market.

An example is the bitcoin futures products in the U.S. offered by the CME and CBOE. But getting financial products on the market hasn’t been easy. In the U.S., numerous attempts to get a bitcoin exchange-traded fund (ETF) launched have not been even successful.

CNBC takes a look at how different countries are treating the emerging technology and how some smaller nations are trying to establish themselves as the new crypto hubs.

The Asian powerhouses
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Asian investors have always been major players in cryptocurrency trading, particularly with bitcoin. Over the past few years, different Asian countries have been the dominant players in the cryptocurrency markets. A few years back it was China. Then a regulatory clampdown on cryptocurrencies in the world’s second-largest economy changed that. Japan and South Korea took over as the largest drivers of the crypto-markets thanks to favorable regulation.

Let’s take a look at how legislation has developed in the three big Asia markets for cryptocurrency.

China

In 2013, China was one of the biggest drivers of the bitcoin price, when it was trading just over $1,000. This was of course before many of the new digital tokens — of which there are over 1,000 now — had come to market. The Chinese saw it at the time as an alternative investment to the stock market and housing market that were becoming increasingly risky.

But since then, Chinese regulators have come down hard on cryptocurrencies. In 2014, the People’s Bank of China (PBOC), which is the country’s central bank, ordered banks and payment companies to close accounts opened by operators of websites that trade in virtual currencies. This meant exchanges could not have accounts with banks.

In 2017, China outright banned initial coin offerings (ICOs). The group of regulators that issued the ban provided a list of 60 major ICO platforms for local financial watchdogs to inspect. That same year, China’s biggest cryptocurrency exchanges halted trading for domestic customers at the behest of the government. At the beginning of 2018, China moved to block foreign trading platforms operating in China.

“To prevent financial risks, China will step up measures to remove any onshore or offshore platforms related to virtual currency trading or ICOs,” said an article published in February by Financial News, a publication affiliated to the PBOC.

China continued to turn the screw on other parts of the crypto-industry. In January 2018, a task force made up of numerous Chinese government agencies was instructing local authorities to urge miners to end their activities, according to a report in the Financial Times.

Bitcoin mining “consumes a large amount of electricity and also encourages a spirit of speculation in ‘virtual currencies’, ” according to the document seen by the FT.

The clampdown by Beijing has meant changes to the Chinese cryptocurrency market. For example, Chinese mining company Bitmain moved its regional headquarters to Singapore and also opened up mining operations in Canada and Switzerland to mitigate the regulatory moves. And exchanges have also moved jurisdiction. Huobi, which was once one of the world’s largest cryptocurrency exchanges moved out of China to set up operations in Japan.

South Korea

South Korea is another major cryptocurrency market and in the past few months, regulators have veered between considering shutting down exchanges to now bringing them into the legal fold. The authorities’ main concerns were with the amount of speculation around cryptocurrency trading and worries that they could be being used for illegal activities.

In December 2017, the South Korean Financial Services Commission (FSC), the country’s financial regulator, prohibited cryptocurrency exchanges from issuing new trading accounts. The watchdog then said it was considering shutting down some domestic digital currency exchanges. A petition asking the government to hold back on “unreasonable” regulation then surfaced. The regulators responded by saying it would take firm legal action against “illegal acts” regarding cryptocurrency trading.

“The measures are aimed at minimizing the side effects such as money-laundering and tax evasion using cryptocurrencies.”
South Korea FSC

Since then, South Korea brought in rules clarifying its stance on the crypto-industry. These include only allowing exchanges to have customers that use bank accounts with their real names, requiring exchanges to have separate bank accounts for handling customer money and their own operational expenses, and pushing financial companies to share a list of overseas cryptocurrency exchanges that they are linked to.

“The measures are aimed at minimizing the side effects such as money-laundering and tax evasion using cryptocurrencies. We would like to stress that these are not intended to formally institutionalize cryptocurrency exchanges, or facilitate cryptocurrency trading through the exchanges,” the FSC said in a statement in January 2018.

The FSC then underwent an organizational reshuffle to create a new division called the Financial Innovation Bureau. It is tasked with policy initiatives for “financial innovation” which includes new developments like cryptocurrencies. Far from shutting the door on the crypto-industry, South Korea is now looking to bring the new industry into the regulatory fold.

Japan

As China clamped down on the crypto-industry, Japan saw an opportunity to take a lead by introducing policy that was seen as welcoming for cryptocurrencies. In early 2017, Japan allowed merchants to legally accept bitcoin as a payment. The country’s regulator known as the Financial Services Agency (FSA) then recognized a number of cryptocurrency exchanges as registered and legal operators.

But a number of high-profile exchange hacks took place. One of the biggest was on Japanese exchange Coincheck, which had more than $500 million worth of cryptocurrency stolen from it. The FSA followed up by issuing punishment notices to several exchanges and even forcing some to halt their business.

Japan is still looking into the right way to regulate cryptocurrencies and blockchain technology. In April 2018, a government-backed research group put forward some proposals to regulate ICOs.

Regulation in the West
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While Asia has been a big driver of cryptocurrency interest and mining power, the U.S. has become an increasingly important market while parts of Europe are starting to dip their toe in the water. But most of the major economies in the West haven’t introduced any specific laws around the crypto-industry. Instead, they have focused on warning investors about the risk of ICOs and cryptocurrency trading.

However, this could be about to change with a number of regulators hinting that regulation could be coming this year.

United States

The U.S. approach to regulating the crypto-industry has been to work within its current laws rather than introduce new ones, as well as highlighting the risks of people involved in ICOs and trading.

At the end of 2017, the Securities and Exchange Commission (SEC), the regulator in the U.S., issued a warning to investors.

“A number of concerns have been raised regarding the cryptocurrency and ICO markets, including that, as they are currently operating, there is substantially less investor protection than in our traditional securities markets, with correspondingly greater opportunities for fraud and manipulation,” the regulator said in a statement.

A lot of debate in the U.S. has been about how to class cryptocurrencies. At the moment, the SEC says that bitcoin and ether are not securities. The watchdog uses a method called the “Howey Test” to decide if something is a security. The ruling comes from a 1946 U.S. Supreme Court case that classifies a security as an investment of money in a common enterprise, in which the investor expects profits primarily from others' efforts.

While bitcoin and ether may not be securities, the SEC said that some coins created out of ICOs might be.

"A token, a digital asset, where I give you my money and you go off and make a venture, and in return for giving you my money I say 'you can get a return' that is a security and we regulate that," SEC Chairman Jay Clayton told CNBC in an interview earlier this year. "We regulate the offering of that security and regulate the trading of that security."

Clayton said that the SEC won’t change securities laws to cater to cryptocurrencies. To that end, some founders behind fraud ICOs have been prosecuted by the SEC. In April 2018, the SEC charged two founders of a cryptocurrency firm that was endorsed by champion boxer Floyd Mayweather, with carrying out a fraudulent ICO.

But it’s not just the ICO markets that U.S. regulators are looking at. There has been recent rising interest from professional institutional investors wanting to get involved in the cryptocurrency space. But the lack of regulation and difficulty in buying crypto-assets on exchanges has put them off. Many feel that the regulations do not offer enough protection. So these investors have been looking to traditional financial instruments to help them invest in digital coins.

One of those products that was launched last year was bitcoin futures. Both the CME and CBOE launched futures last year. This is a product that tracks the price of bitcoin but investors aren’t actually buying any of the digital currency. It theoretically allows them to short, or bet against, bitcoin. So far, futures have been the extent of professional products in the U.S.

There has also been a drive to introduce a product known as a bitcoin exchange-traded fund (ETF) onto the market. An ETF is a security that tracks the price of an asset, in this case bitcoin, and is listed on a stock exchange. The biggest proponents of a bitcoin ETF in the U.S. are Cameron and Tyler Winklevoss, founders of crypto exchange Gemini. They have tried twice to get a bitcoin ETF listed, but have been slapped down both times by the SEC.

Bitcoin investors are currently in wait and see mode in the U.S. about the SEC’s next steps.

United Kingdom

The U.K.’s stance on cryptocurrencies has very much mirrored the U.S. — no new legislation but numerous warnings about the risks associated with digital coins.

Last year the Financial Conduct Authority (FCA), the financial watchdog in Britain, released a statement outlining the risks of investing in ICOs.

“ICOs are very high-risk, speculative investments,” the FCA said. It highlighted the fact that ICOs are highly unregulated, offer no investor protection, have big price volatility and could be the source of fraud. Whether an ICO falls within the regulatory purview of the FCA is decided on a case-by-case basis. Many will fall outside of regulation but those that involve regulated investments or firms involved in conducting regulated activities may be subject to the FCA’s rules.

“Some ICOs feature parallels with Initial Public Offerings (IPOs), private placement of securities, crowdfunding or even collective investment schemes. Some tokens may also constitute transferable securities and therefore may fall within the prospectus regime,” the FCA said in a statement in 2017. This is a similar stance to the SEC in the U.S.

“Striking the right balance between regulating digital currencies to provide adequate protection for consumers and businesses, whilst not stifling innovation, is crucial.”
Nicky Morgan, chair of the Treasury Committee

British lawmakers have also been taking a keen interest in the crypto-space. In February, U.K. Parliament’s Treasury Committee, which is made up of various politicians, launched an inquiry into digital currencies and distributed ledger technology or blockchain. The aim is to examine the impact of the new technology and scrutinize the regulatory response so far from the FCA and the Bank of England, the U.K’s central bank.

“Striking the right balance between regulating digital currencies to provide adequate protection for consumers and businesses, whilst not stifling innovation, is crucial. As part of the inquiry, we will explore how this can be achieved,” Nicky Morgan, chair of the Treasury Committee and member of parliament, said in a statement at the time.

The FCA is now working with the Treasury Committee and the Bank of England to establish policy on cryptocurrencies which is set to be published later on in 2018.

European Union

The European Union (EU) consists of 28 separate nations all of which have their own view on cryptocurrency regulation, but there appears to be a drive from the top to create a harmonized approach to the nascent industry, though in practise that could be hard to do.

Earlier this year, the European Supervisory Authorities for securities, banking and insurance and pensions, released a statement warning consumers about the dangers of virtual currencies.

“VCs (virtual currencies) such as bitcoin, are subject to extreme price volatility and have shown clear signs of a pricing bubble and consumers buying VCs should be aware that there is a high risk that they will lose a large amount, or even all, of the money invested,” the authorities said in a joint statement in February.

On the legislation front, lawmakers in the EU have passed a new bill that aims to tackle money laundering and virtual currencies come under this. The so-called Anti-Money Laundering Directive was agreed in April and aims to stop people moving money through companies registered in the EU while the real owners are somewhere else in the world. Part of the law requires digital currency exchanges and wallets to apply customer due diligence controls like banks. This includes verifying customers.

While this is not a specific piece of legislation to tackle the entire blockchain and cryptocurrency space, it’s a starting point. The law will come into effect in the next year and a half.

The emerging hubs
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While major nations have been debating their policies toward blockchain and cryptocurrencies, some smaller nations and territories have been moving quickly to establish themselves as new crypto-hubs by introducing legislation to bring crypto-assets, ICOs and new blockchain technologies into the regulatory fold.

Gibraltar

Gibraltar is a British Overseas Territory in Europe with a population of around 33,000 people. But it’s trying to become one of the most important places for start-ups in the blockchain and crypto world.

In January 2018, it introduced a law known as the Distributed Ledger Technology Regulatory Framework or DLT Framework. Any firm carrying out business with the use of blockchain or DLT for “storing or transmitting value belonging to others” needs to be authorized by Gibraltar’s financial regulator.

“The purpose of it (the DLT Framework) is to create a new form of commercial activity. We are going to regulate it in a safe environment, seeking quality firms to come to GIbraltar in a way not to stifle innovation, but to proactively support it,” Albert Isola, minister of commerce for Gibraltar told CNBC in an interview. “This is not a short term thing.”

Here’s some of the key parts of the law:

  • A business must provide clear and accurate information to customers around risks.
  • A DLT provider must have enough financial resources to ensure that it can be run in a “sound and safe” manner with capital levels being monitored to make sure it can achieve its objectives.
  • A company must take “all reasonable precautions” to protect customer assets in their custody against “unexpected eventualities and threats
  • A DLT firm must apply “adequate” anti-money laundering and counter terrorist financing protocols.

Isola said the government in Gibraltar has introduced a legal framework because it believes the technology has a long-term future.

“I think that the technology is extremely powerful. I think it’s here to stay. I think it's going to get bigger as it cranks up usage and scalability,” Isola said. “But the technology is so powerful that people are being forced to use it in areas where it's not regulated. DLT business could start in an unregulated environment. If any business that will take place in Gibraltar that carries risk, as this one does, it needs to be regulated.”

Malta

Malta, a small island country in the middle of the Mediterranean, is another place that has begun legislating cryptocurrencies and blockchain technology. In July, Malta’s government passed three new laws related to cryptocurrencies.

The first is the Malta Digital Innovation Authority Act which establishes the newly-formed Digital Innovation Authority Department. This department is responsible for certifying DLT platforms and to manage the legal protection of users engaging with these companies.

Second is the Virtual Financial Assets Act which will regulate all ICOs launched in Malta as well as trading on cryptocurrency exchanges.

And the final bill, known as the Innovative Technology Arrangement and Services Act, will be responsible for the registration of technology providers and their services.

“I think that blockchain technology, DLT and cryptocurrency is where innovation is happening right now and we are very glad that Malta can offer the first jurisdiction in the world to regulate this sector. We are excited about what this will lead to in the future,” Joseph Muscat, Malta’s Prime Minister, told Forbes in July.

Switzerland

Switzerland is another country that has sought to establish itself as the place to be for cryptocurrency start-ups but its regulation hasn’t always matched up to its aspiration.

The canton of Zug, just outside Zurich, has established a cluster of blockchain and cryptocurrency companies called “Crypto Valley.” The area has business friendly policies such as a low tax rate. Another significant development came in July when SIX, the swiss stock exchange, announced plans to introduce a cryptocurrency trading platform to make it easier for professional investors to get involved in the space.

Politicians have also sounded positive about the future of Switzerland as a hub for the nascent industry. The country’s Economics Minister Johann Schneider-Ammann said Switzerland wants “to be the crypto-nation,” according to comments reported by the Financial Times.

But the country hasn’t really introduced any legislation specific to the crypto industry. FINMA, the Swiss financial regulator has however published some guidelines on ICOs, but with the view of applying current financial market laws to the new fundraising technique. Similar to other countries like the U.S., FINMA says that financial market rules will be applied to Swiss ICOs on a case-by-case basis. The regulator said that it will focus on the purpose and function of each digital token and whether they are tradeable or transferable. Anti-money laundering legislation could also apply.

Despite a drive to become a “crypto-nation,” the regulation and infrastructure has not always helped. Earlier this year, a number of Swiss banks closed accounts it held for cryptocurrency-related companies. This forced those companies to find banks in other nations competing to become crypto-hubs, like Lichenstein.

Reuters reported that some companies had asked the Swiss National Bank (SNB) to intervene. But the SNB told the companies to go to FINMA. The regulator said that it is has held talks with the SNB and Swiss Bankers’ Association to help ease the issue.

Bermuda

Bermuda, a small island in the North Atlantic Ocean, is moving forward with its own laws in the crypto industry.

The territory’s Premier David Burt introduced a few pieces of legislation designed to lay out how businesses wishing to carry out an ICO should conduct themselves. The latest piece of regulation laid out earlier this year, outlines the information that a company needs to provide during the ICO process. This includes the requirement to provide a description of the project, how the ICO will be financed, the technical standard of the digital asset that will be issued, and a verification of the identity of participants in the fundraising.

“We continue to communicate to the world that Bermuda is a significant option for fintech (financial technology) related businesses and that we have expeditiously developed rules and regulations which ensure that fintech companies and their activities are well-regulated, within a safe environment for the industry to grow, whilst also ensuring that this new regulatory environment protects consumers and the reputation of this jurisdiction,” Burt said.

What next?

Around the world, regulators and governments are trying to figure out what the future of cryptocurrencies and the blockchain looks like. It’s not clear cut. Some countries like China have come down hard on the nascent industries while others, mainly small nations and territories have welcomed it with open arms. Each one is approaching the technology differently. But one thing that is clear is that over the course of 2018 and certainly 2019, new legislation will come into play that brings cryptocurrencies and the blockchain into the regulatory fold.

Credits
Writer: Arjun Kharpal
Design and code: Bryn Bache
Editor: Matt Clinch
Images: CNBC and Getty Images