Continuing our series of blog posts that explore the intersection of the crypto ecosystem, regulation and RegTech, we spoke with Dr. Iwa Salami, an expert in financial regulation and law from the University of East London.
Why are regulatory authorities paying more and more attention to regulating cryptoassets?
At the heart of the original philosophy behind cryptocurrency was the ability to evade regulation and to facilitate libertarian perspectives on the freedom of transactions without regulatory oversight. As transacting with cryptocurrencies largely hides the identities of transacting parties, they have been of interest to people seeking to transact illegalities.
These illicit transactions drew cryptocurrencies to the attention of regulatory authorities who were interested in curbing their use on platforms such as the dark web. Authorities also increasingly recognised the potential for cryptocurrencies to be used to facilitate financial crime, such as money laundering and terrorism financing.
If we look at other aspects of the development of cryptocurrencies, the question “Should we be looking at them as a medium of exchange, i.e. as money, or as assets, or as commodities?” arises. The answer to this question determines how they should be regulated and whether we should be concerned about the risks they pose to financial stability. More recently regulators have focused on the investor protection and financial stability implications of their usage, and here the exposure of mainstream financial institutions to cryptocurrencies and cryptoassets is of concern.
What impact might this have on the crypto world?
Bitcoin – the king of all cryptos – is notable for its volatility and this has attracted huge calls for regulatory intervention, highlighted by the price of Bitcoin hitting almost $20,000 in late 2017. Regulatory reaction across the globe resulted in the plummeting of the price of cryptocurrencies. Any discussions about the regulation of cryptoassets is likely to affect their price.
As the new uses of cryptocurrencies emerge, the focus of how they should or will be regulated will change. As stated earlier, the regulation of crypto was originally designed to prevent criminal activities such as money laundering and terrorism financing risks. The emphasis here was on getting cryptocurrency exchanges and wallet providers complying with KYC and CDD requirements. These requirements were also the basis for provisions such as the 5th Anti-Money Laundering Directive (5AMLD). Now, however, new activities involving the use of these cryptocurrencies have emerged, such as cryptocurrency tumbler/mixing services. These activities are not covered by 5ALMD, thus making it obsolete even before the implementation date of January 2020 in EU Member States.
Another factor to consider is that new exchanges that are more willing to be regulated exist alongside existing exchanges that have previously been unregulated. This poses issues such as how will these exchanges achieve compliance? With which rules – local or global? The transactions by their very nature operate cross-border, therefore regulation is only as good as the strength of regulation in the other jurisdictions where transacting parties are based.
What are the advantages or disadvantages of crypto currencies being regulated?
If the intention behind using cryptocurrencies is not to facilitate criminal activities, I can see only advantages from regulation which will make them more legitimate both as an asset class and as a medium of exchange.
Regulation of exchanges would tackle problems associated with cryptocurrencies facilitating financial crime and would also ensure investor protection, as well as preventing potential market manipulation arising from bigger financial institutions trading crypto assets. It would also ensure that the financial stability implications of their connectedness with mainstream financial institutions is regulated – potentially manifested by the amount of mainstream financial institutions holding and trading them. Effective regulation, of course, again would only be as good as the robustness of the coordination of global regulation of cryptocurrencies and cryptocurrency exchanges.
The advantages of regulations would impact three main areas – investor protection, financial stability, and financial crime.
Regulation would need to plug the existing gaps in investor protection, giving rise to the following considerations:
- To what extent should the regulation of exchanges comprise a detailed provision on corporate governance structures to avoid cases such as Quadriga CX, the criticisms of Bitfinex and its relationship with the Tether cryptocurrency?
- Should regulation cover cyber security breaches which lead to huge investor losses? If so, should exchanges be required to hold capital to mitigate operational risks resulting from potential security breaches, especially given the plethora of exchange hacks that have occurred since the inception of bitcoin?
- The rules around crypto assets/currencies and token offerings (security tokens and equity tokens) should be clarified and, preferably, with global minimum standards set.
Whilst these are issues for domestic regulators, given the cross-jurisdictional nature of most transactions on cryptocurrency exchanges, global coordination in addressing these issues would be even more useful. I raised this in an article published in ‘the Conversation’ in November 2017, and it appears as if international standard setters, including the International Organization of Securities Commissions (IOSCO) and the Basel Committee on Banking Supervision (BCBS), are now looking at these issues.
For financial stability, the key issue is the level of exposure of financial institutions to crypto-assets/currencies.
In March 2019, the BCBS (the global standard-setter for the prudential regulation of banks) stated that crypto-assets and the trading platforms offering them could “increase risks” for lenders. The Committee called for banks to increase transparency by making public disclosure of their exposure to cryptoassets. This statement appears to be a U-turn from the previous position this time last year, where the Financial Stability Board (the global monitor of global financial system, of which BCBS is a member) stated that cryptocurrencies do not pose any risk to global financial stability at that time.
At the moment, the market capitalisation of all cryptocurrencies is not significant enough to shake the international financial system, but this is certainly something to keep an eye on. Standard-setters would need to know precisely what exposures systemically important financial institutions have to cryptoassets, in order to be able to set the capital requirements for such exposures under, possibly, a Basel III revision.
Crypto exchanges need to fulfil KYC requirements due to issues around money laundering and the potential for terrorism financing. This would include the monitoring of all transactions occurring on their exchanges – trading and exchanging – in order to know when to investigate further or even submit suspicious activity reports (SARs).
But I suppose that the huge challenge here is the cross-border dimensions of the transactions occurring on cryptocurrency exchanges. Jurisdictions with no, or weak, regulatory oversight of exchanges would be more conducive for parties wishing to transact illegalities. Cryptocurrency exchanges in countries with weak AML regulation receive nearly 5% of their payments directly from criminal sources. Hence exchanges in countries with weak financial regulation, typically in less developed countries are more prone to money laundering, as well as terrorism financing. Robust regulation in one jurisdiction is only as good as the strength of the regulation in other jurisdictions. This is why a coordinated global approach to regulation is vital.
What should the government response be to privacy coins?
Privacy coins – Monero, Zcash and Dash – are characterised by the difficulty in identifying parties transacting with them, making it very difficult to track their origins and the parties moving them and therefore they are more susceptible to money laundering, terrorism financing and other crimes governments want to crack down on. It, of course, facilitates their use on platforms on the dark web to transact all sorts of illegalities.
The question here is the strength of regulatory technology solutions in tracking/cracking the identities behind these privacy coins. Existing solutions such as Chainalysis are successfully tracking transactions on Bitcoin and Ethereum blockchains. If robust RegTech solutions are instituted, then legitimate dimensions for their usage – such as facilitating transactions among legitimate institutions and businesses and the need to protect trade secrets and the like – would make the existence of privacy coins useful. However, I think governments would need to be able to strike the right balance between the protection of privacy rights, whether of businesses or individuals, and the protection of national security, for example – especially when such coins can be used to facilitate crimes such as terrorism financing.
What are the threats with crypto exchanges?
Here, as stated earlier, the threat is really about knowing who is transacting on these exchanges. Fulfilling KYC requirements is vital for the crypto exchanges, otherwise this will have implications for money laundering and other related criminal activities.
Thus, regulating cryptocurrency exchanges is quite significant when considering regulating cryptocurrency in general. Crypto exchanges are the key point of interaction between the cryptocurrency ecosystem and fiat currency. Their regulation might also make systemically important financial institutions more willing to transact with them or businesses linked with them.
Should security tokens be treated as securities? What about exchange tokens and utility tokens?
If security tokens derive their value from external, tradable assets and are accessible to retail investors and as such behave as securities, they should be regulated as securities.
With respect to exchange tokens – FCA terminology for cryptocurrencies such as Bitcoin, Ethereum etc – my take on these is that they are not money because they do not fulfil the three functions of money: a medium of exchange, a store of value and a unit of account. Nonetheless, for as long as there is a market for exchange tokens, for example on private platforms on the Dark Web, they will always be in use and more so if they are convertible to fiat currency. If exchange tokens cannot be converted into fiat currency, I think their usefulness would be limited. However, I think they should be regulated to the extent that they are traded as financial assets and have implications for investors.
Utility tokens are used within the platform of the organisation issuing them so as long as the organisation issuing them is regulated, I do not think direct regulation is essential. If, however, they become tradable as securities, then this should necessitate regulation to protect investors.
Dr. Iwa Salami is an expert in financial law and regulation and her current research focuses on FinTech regulation. Her interest in this topic grew from the realisation of the potential that FinTech has in tackling global challenges, particularly through its facilitation of financial inclusion through mechanisms to reach the unbanked such as the introduction of MPesa and the growth and success of mobile payments in Kenya and other East Asian countries.
During the course of her FinTech and financial inclusion research, Bitcoin and other cryptocurrencies emerged, and she is now exploring the benefits and challenges of crypto currencies and the role that regulation, and in particular RegTech, can play in addressing these challenges.