Crypto-Regulation: A Balancing Act

CRYPTO-REGULATION: A BALANCING ACT

By William Watts

CRYPTO-REGULATION: A BALANCING ACT

Crypto-regulation: A balancing act a Cryptocurrency, the conceptual brainchild of Bitcoin creator Satoshi Nakamoto, has erupted into a financial revolution. With its seeds quietly sowed in the midst of the worst financial crisis the world has ever seen, the monetary technology is now snapping at the heels of Wall Street and central banks alike – with mixed responses from both. Between the critical punts fired by JP Morgan’s Jamie Dimon (Imbert 2017) and the optimism of SEC Chairman Jay Clayton (Suberg 2019), it is becoming abundantly clear that cryptocurrencies must be regulated effectively – and quickly. However, when considering the partisan and anti-establishment vision of Nakamoto, there is a difficult balance to be struck in order to satisfy the interests of ordinary citizens, investors, financial regulators, and entire nations. On one hand, overregulation could trigger a futile collapse of the affected currencies as consumers lose the benefit of financial autonomy and digital security – contradicting the heart of the concept. Alternatively, sparse regulation will be fruitless in protecting consumers from huge price volatility, frequent scams and collateral damage caused by an increase in cyber-attacks.

However, regardless of any discussion about regulatory balance, evidence of inherent vulnerability for cryptocurrencies and their stakeholders raises a poignant question: are cryptocurrencies even worth saving?

Worthy of regulation?

To understand why we must protect the genuine existence of cryptocurrencies within our economy, and to prevent them retreating into the illicit shadows of underground markets, we must first understand the benefits they may reap. All cryptocurrencies and crypto-assets must be backed by blockchain technology (a type of distributive ledger technology) in order for the currency to operate on a completely decentralised basis that circumvents the need for a middleman. The permanent ledger means that transactions are added consecutively to a ‘chain’ of transactions which cannot be manipulated by any party – not even the creator. Aside from the benefits of cryptocurrencies themselves, the application of blockchain is boundless. Already, distributive ledger technology is being used to protect landowners in Honduras who are susceptible to land title fraud from corrupt state officials (Jean-René 2017); peer-to-peer networks have the benefit of being indisputable – even to those at the highest level of government. This could be a revolutionary change to nations who suffer from corruption. Equally, when considering wealthy democracies such as the UK, the hole which crypto has an opportunity to fill is deep-rooted within a lack of trust in the financial system. The majority of the British public still doesn’t trust banks (White 2018), despite over a decade passing since RBS was bailed out by the UK government at a cost of almost £45 billion, which only goes to show the damage caused by the 2008 financial crash. Cryptocurrency is an attractive proposition for those who find it difficult to place their trust in these intermediaries, and wish for full autonomy over what belongs to them. Consequently, they seem like an asset worth regulating.

Cryptocurrency is an attractive proposition for those who find it difficult to place their trust in these intermediaries, and wish for full autonomy over what belongs to them.

The issue of genuine currencies

Taking Dr Raja Ignatova’s $4 billion OneCoin scam as an example (Bartlett 2019), the usual watertight security and privacy of cryptocurrencies disappear when it is revealed there is actually no blockchain technology underpinning it. In genuine cryptocurrencies, transactions have public witnesses which make cyber-attacks more difficult, not to mention the vast number of distributed copies that need to be attacked simultaneously – making malicious changes by a single party incredibly difficult. Should these ‘imitation’ cryptocurrencies become commonplace by seeping through the cracks of weak regulation, it will cause paranoia within investors and consumers. This will inevitably lead to intermediaries creating platforms which distribute genuine currencies that have been verified independently – meaning we will have come full circle and are back to dealing with middlemen. To make matters even worse, increased adoption of cryptocurrencies which are generated and controlled by third parties, as opposed to the state, means that accountability is hugely reduced. Large banks, who already lack a golden reputation, don’t have the option of disappearing if a large scam is exposed – they must face the media and the courts. A shady creator under the alias of a “legitimate” cryptocurrency can easily withdraw billions of pounds worth of investments and make a run for it, disappearing in the shadows of offshore accounts and various money laundering schemes while avoiding accountability altogether.

A shady creator under the alias of a “legitimate” cryptocurrency can easily withdraw billions of pounds worth of investments and make a run for it, disappearing in the shadows of offshore accounts and various money laundering schemes while avoiding accountability altogether.

A government verification scheme for proving genuine cryptocurrencies would seem like the ideal answer, especially for those who are just looking to dip their toes in the shallow end of cryptocurrency investment and will likely put their money towards large, reputable cryptoassets. As usual, purists will enter the scene with the typical laissez-faire reasoning of blocking out any state intervention in order to avoid corrupting the freedom of creators to establish independent currencies, concerned that tightening the market will lead to reduced consumer choice. There is merit to this argument. The legal principle of caveat emptor (buyer beware) lies at the heart of bargain-hunting platforms such as eBay and Gumtree, where buyers accept the tradeoff of purchases from unverified buyers in return for lower prices and greater choice; why shouldn’t crypto owners have the right to a similar proposition?

Problems of jurisdiction

Questioning whether an action falls within the sphere of authoritative power is a conundrum which isn’t exactly new to the law. Problems of jurisdiction within the regulation of cryptocurrency is mainly centred around whether financial authorities are able to exercise regulatory power over certain currencies.

In light of this issue, the US have already encountered difficulty in claiming jurisdiction over some currencies. The Howey Test used by the SEC ascertains whether a transaction is an example of an “investment contract”, thus classifying as a security and therefore establishing jurisdiction over, in this case, the cryptocurrency in question (Frankenfield 2019). So far, Bitcoin hasn’t qualified as a security due to its speculative nature – meaning that the SEC has no power to regulate it. Similarly, across the pond, the FCA have decided they won’t regulate Bitcoin either, as it is defined as an “exchange token” which doesn’t fall under their scope (Partz 2019). This will come as a relief to crypto-enthusiasts who are concerned about “back doors” theory (Hansen 2017) which involves a desire from the authorities to influence commercial crypto standards and insert vulnerabilities to create weakness and exercise more control. For a technological marvel that prides itself on being immune to state control, this would be a living nightmare.

That said, hesitation to impose jurisdiction over certain currencies may also come as a disappointment for investors and advocates. Alongside financial authorities sending the signal they are not yet prepared to take cryptocurrencies seriously, decisions to turn down regulation mean that the volatility of currencies will continue to be an issue as fraud and uncertainty persist. Ultimately, the implementation of crypto into the system is still a long way off.

The alignment of crypto with the current financial system

The reluctance of the FCA to impose regulation on the crypto kingpins is a clear message that cryptocurrency integration is slightly beyond being ‘just on the horizon’. Essentially, the largest hurdle for legislators is that current rules on financial conduct gravitate around fiat currencies (money declared by a country as legal tender) which are distributed by a centralised institution – perfectly contrasted to the “decentralised revolution” of crypto-assets. As such, the scope for change is huge as regulation needs to be created, not just adapted or expanded.

One of the main issues with cryptocurrency trading platforms is the current ability they have to absolve themselves from liability towards customers, meaning they have no legal burden to protect customers from fraud (Massad 2019). Other financial sectors such as securities, derivatives and banking cannot evade liability through exemption clauses, and will be liable for fraud or misrepresentation. The law could even go a step further. Concerns over the illicit use of cryptocurrencies derives largely from Bitcoin’s role as a method of payment on the notorious Silk Road, which ended up being valued at over a billion dollars. Imposing vicarious liability on cryptocurrency developers would mean they would be legally responsible for the activities their currency was interacting with – incentivising them to take reasonable steps to avoid certain markets. This could involve vetting buyers of the coin and monitoring their transactions while freezing suspicious activity. Of course, discretion of the courts would need to be generous in order to prevent excessive liability on crypto-developers and to ensure there was still an incentive to enter the market.

One of the main issues with cryptocurrency trading platforms is the current ability they have to absolve themselves from liability towards customers, meaning they have no legal burden to protect customers from fraud (Massad 2019).

A future of dynamic equilibrium

So, is crypto-regulation doomed to fail? Or can we reach a future of regulatory balance which will thrust us into a “decentralised revolution”? While utopian balance between the interests of the state and the individual is evidently impossible here, just as it is on the majority of matters, there is a glimmer of hope for a system which can successfully incorporate cryptocurrency. That said, like any sort of divisive matter, this is one which requires both sides to compromise. For any proposition of regulation there is always the recurring argument that the operation of cryptocurrencies is not to be interfered with by the state. However, crypto-advocates cannot expect cryptocurrencies, which often pose various threats to the financial system, to flourish if the state does not have some sort of input with how they interact with the economy and the people. For mainstream adoption, regulation is an absolute must. It would be a shame for Nakamoto’s brainchild to pass away before seeing adulthood.

...crypto-advocates cannot expect cryptocurrencies, which often pose various threats to the financial system, to flourish if the state does not have some sort of input with how they interact with the economy and the people.

References

Bartlett, Jamie. 2019. The Missing Cryptoqueen. November 4.

Frankenfield, Jake. 2019. Howey Test. June 25. Accessed February 19, 2020. https://www.investopedia.com/terms/h/howey-test.asp.

Hansen, Dr Marit. 2017. Why crypto regulation is doomed to fail. Kiel, January 4.

Imbert, Fred. 2017. JPMorgan CEO Jamie Dimon says bitcoin is a ‘fraud’ that will eventually blow up. September 12. Accessed February 17, 2020. https:// www.cnbc.com/2017/09/12/jpmorgan-ceo-jamie-dimon-raises-flag-on-tradingrevenue-sees-20-percent-fall-for-the-third-quarter.html.

Jean-René. 2017. Honduras: end of land title fraud, thanks to blockchain technology. September 15. Accessed February 17, 2020. https://medium.com/@ JeanRene_K/honduras-end-of-land-title-fraud-thanks-to-blockchain-technologyfc7aede49998.

Massad, Timothy. 2019. It’s Time to Strengthen the Regulation of Crypto-Assets . Thesis, Harvard: Brookings.

O’Grady, Sean. 2018. Migrants sending money home are being charged far too much – it’s time we stopped taking their hard-earned cash. November 20. Accessed February 23, 2020. https://www.independent.co.uk/voices/unescoremittances-migrants-money-abroad-foreign-aid-a8642876.html.

Partz, Helen. 2019. UK Financial Regulator FCA Won’t Regulate Bitcoin and Ether. July 31. Accessed February 19, 2020. https://cointelegraph.com/news/uk-financialregulator-fca-wont-regulate-bitcoin-and-ether.

Suberg, William. 2019. SEC Cryptocurrency Approach ‘Measured,’ Chairman Clayton Tells Senate. December 11. Accessed February 17, 2020. https:// cointelegraph.com/news/sec-cryptocurrency-approach-measured-chairmanclayton-tells-senate.

White, Lawrence. 2018. British public don’t trust banks 10 years after crisis, survey finds. August 6. Accessed February 18, 2020. https://uk.reuters.com/article/ uk-britain-banks/british-public-dont-trust-banks-10-years-after-crisis-surveyfinds-idUKKBN1L11EL.