In June, Facebook announced its plan to create a global, private cryptocurrency, backed by a reserve of assets and held by a network of reputed companies. In the backdrop of changing dynamics of cryptocurrencies, countries world over are grappling with assessing what could be an optimal framework for cryptocurrency regulation. In this post, Pandey, Priyadarshini, and Seshadri examine the regulatory approaches that have thus far been adopted around the world.
In June this year, Facebook released a white paper formally announcing the proposal to launch Libra – a global and private cryptocurrency. The cryptocurrency is expected to be built on secure blockchain technology and backed by a reserve of assets (such as fiat currencies). A Libra Association, consisting of reputed companies like Uber, Lyft, and Vodafone in addition to Facebook, will govern the ecosystem around this new cryptocurrency.
Cryptocurrencies, along with their underlying technology of distributed ledgers (DLT) or blockchains, offer the promise of several beneficial applications in financial and non-financial fields. But they also pose serious challenges to regulators, governments, and the society at large. For instance, decentralised and distributed networks along with immutability of data provide disintermediation, and cheaper as well as more secure ways for making payments. But the lack of intrinsic value, speculative activity, and pseudonymity (fictional identity) offered by cryptocurrencies threaten effective criminal law enforcements. Their ability to transcend national borders, coupled with difficulties in detection, pose jurisdictional concerns impacting effective protection of consumers and investors. They may also threaten key central bank functions of monetary supply and capital controls, thereby affecting financial stability. For example, since central banks’ cannot exercise control over private cryptocurrency, their ability to monitor inflow and outflow of foreign exchange and thereby implement capital controls would be compromised. Further, difficulties in classifying cryptocurrencies (as securities, currencies, commodities), and the rapid pace of developments in the field exacerbate the challenges in determining risks and crafting appropriate regulatory responses.
The second generation of cryptocurrencies, or Stablecoins, like Libra, add yet another dimension. By addressing the concerns around intrinsic value and volatility associated with first-generation cryptocurrencies, they may gain wider acceptance. This in turn may heighten the risks to the stability of the financial system. For instance, it is feared that widespread adoption of Stablecoins like Libra could potentially hamper the conduct of Central Banks’ monetary policy, especially, targeting of inflation. Libra has left governments and regulators around the world hastening to assess its economic implications. A number of prominent payment companies have also exited the Libra Association recently over varied concerns including that of privacy.
It may be useful at this juncture to examine regulatory approaches that major economies have thus far adopted around the world towards cryptocurrencies.
Permissive regulatory frameworks
The development of cryptocurrencies and the associated underlying technologies has been viewed by some countries as an opportunity for fostering economic growth and generating jobs. While being cognisant of such opportunities, they have sought to ring-fence the risks such as money laundering and terrorism financing through regulation by either extending their existing legal and regulatory frameworks to cryptocurrencies or alternatively, by introducing bespoke regulations targeting cryptocurrencies and related activities.
Where countries have sought to extend their existing legal and regulatory frameworks, they have done so in two ways: One, by issuing regulatory guidance on the applicability of their existing laws and regulations to cryptocurrencies (generally, with the corollary that those falling outside the regulatory perimeter would thus remain unregulated, with related activities being unprotected). For example, in the UK, the Financial Conduct Authority (FCA) publishes guidance to clarify the crypto-asset activities falling within the regulatory perimeter and those falling outside.
Two, by explicitly amending their existing laws and regulations to include cryptocurrency activities or transactions. An example of the second approach is Japan where regulations governing the purchase, sale, intermediation of purchase and sale, and provision of exchange services for cryptocurrencies were introduced through amendments to the already existing Payment Services Act, 2009. Similarly, the Securities Exchange Commission (SEC), the capital markets regulator in the US, requires registration of all cryptocurrency trading platforms which meet its definition of an ‘exchange’.
In contrast, countries like Malta and France have introduced bespoke legal or regulatory frameworks to specifically cover cryptocurrency activities or transactions, or cover wider fields like fintech of which cryptocurrency forms a part. Malta has notified an elaborate regime for cryptocurrencies, namely, the Virtual Financial Assets Act (VFAA), Malta Digital Innovation Authority (MDIA), and Innovative Technology Arrangement and Services Act (ITAS) for cryptocurrencies and blockchain. The objective is to provide regulatory certainty to businesses while affording protection to the common users of virtual currencies. France too has adopted a specific regulatory framework providing an optional licensing regime for Initial Coin Offerings (ICOs).1 Several benefits accrue to investors and issuers by opting for this regime. For instance, banks are forbidden from barring licensed issuers from opening bank accounts – a practice reportedly followed by banks despite the absence of a specific ban.
Restrictive regulatory frameworks
Not all countries however welcome the advent of cryptocurrencies even as they express support for the use of the underlying DLT or blockchain technology in varied areas ranging from healthcare to land records. Bolivia and Bangladesh are among countries that have banned cryptocurrencies in their jurisdictions. Among major economies, China and India have imposed highly restrictive regimes including prohibition on use of cryptocurrencies for payments, trading, and investment. Financial institutions have also been barred from facilitating cryptocurrency transactions.
Regulatory frameworks in evolution
Thus, broadly, two principal regulatory responses – permissive and restrictive – have emerged towards cryptocurrencies. However, there are nuances within. For instance, some permissive regulatory regimes like France and Malta illustrate a proactive approach of framing regulations specifically to stimulate cryptocurrency related activities in their jurisdictions. Other permissive regimes like Japan and the US appear to take a measured approach, identifying risks arising from cryptocurrencies and extending their existing regulatory frameworks to cover them. While the US directly regulates crypto-market infrastructure and intermediaries like exchanges by bringing them within regulatory perimeter, South Korea currently does this indirectly through financial institutions who oversee regulation of exchanges and platforms. In the case of restrictive regimes, China permits the holding of cryptocurrencies - Chinese courts have, in certain cases, recognised cryptocurrencies as digital property - while India proposes to outlaw even possession of cryptocurrencies in its proposed draft law.
In addition to such inter-jurisdictional differences, there also exist intra-jurisdictional ambiguities, perhaps best illustrated in the definitional challenges concerning cryptocurrencies. If a cryptocurrency satisfies the Howey test in the US, it is classified as a ‘security’ and the SEC’s regulatory framework, including licensing and disclosure norms, become applicable. On the other hand, the US commodities trading regulator, the Commodity Futures Trading Commission (CFTC), treats cryptocurrencies as commodities - a position supported by the US District Court for the District of Massachusetts. Both the chiefs – of CFTC and SEC – however agree the field of cryptocurrencies is dynamic, and the nature of these assets could undergo changes through the course of their development. They also note that where the parameters of security are not met, the cryptocurrency would be treated as a commodity.
Regimes also vary in terms of maturity. US treats cryptocurrencies as property for levy of federal taxes while South Korea is yet to make up its mind.
Regulation of cryptocurrencies is typically sought through -
- Classification of cryptocurrencies in three broad categories of asset, commodity, and currency.
- Retrofitting existing regulations through amendments or issuance of guidance or, evolving bespoke regulations aimed specifically at cryptocurrencies or a larger field of which it is a part, like fintech.
- Regulation and oversight over crypto-market infrastructure/intermediaries like cryptocurrency exchanges and trading platforms.
- Licensing or registration of such infrastructure/intermediaries, KYC (know your customer) procedures and disclosures around their activities to address information asymmetries.
- Ringfencing risks in relation to money laundering and financing of terrorism.
The adoption of a particular regulatory approach – restrictive or permissive – appears to revolve around the risk assessments by governments based largely on factors such as the sophistication of the country’s financial system, State capacity, and the underlying political philosophy. The key motivations appear to lie in the perceived harm to consumers and investors; the enhanced risks of facilitation of criminal activities like money laundering and terrorism financing; and the potential compromise to the ability to implement capital controls. The outbreak of various ICO scams defrauding general public have aggravated the skepticism. It has been noted that countries at lower levels of technological development face difficulties in harnessing the benefits of new technological developments while containing the associated risks. Another factor that is noted to impede considered decisions on appropriate and timely regulation is the lack of complete and accurate information necessary to make a thorough assessment of systemic vulnerabilities.
Thus, the regulatory landscape is fragmented with different approaches and varying degrees of regulation and/or restrictions. Some recognise specific use cases only; others are more liberal. It is also in a state of flux. For instance, pursuant to widespread scams, South Korea has banned ICOs recently.
However, the lack of uniform standards across jurisdictions, for instance, on classification and treatment of cryptocurrencies, may compromise the ability to effectively counter risks. Since cryptocurrencies straddle national boundaries, a fragmented regulatory landscape provides opportunities for regulatory arbitrage, perhaps best illustrated by the attempts to implement restrictions. The cross-border nature coupled with pseudonymity and difficulties in detection allow cryptocurrency activities to easily circumvent restrictions. In China, platforms and exchanges have simply moved to more liberal jurisdictions while continuing to offer services in China. Further, Virtual Private Networks (VPNs)2 have been used to circumvent bans on trading in cryptocurrencies. Restrictions may also drive cryptocurrency transactions underground leading to greater difficulties in detection of crimes and enforcement of laws. A restrictive regulatory regime also precludes countries from leveraging the beneficial aspects of cryptocurrency such as its application in reducing delays and costs in cross-border payments. Further, indecisive or reactive regulatory approaches contribute to policy and regulatory uncertainty. For instance, Thailand initially permitted cryptocurrency activities before placing severe restrictions which were then rolled back again on popular demand.
Effective regulation of cryptocurrencies may therefore benefit from harmonisation of regulatory approaches in key areas. This is already emerging. No major economy recognises cryptocurrencies as legal tender. International standard setting bodies like Financial Action Task Force (FATF) and Financial Stability Board (FSB) are enabling convergence on certain risk areas regardless of regulatory stance, such as money laundering and terrorism financing. Countries are also in favour of the underlying technology, that is, DLTs and blockchain, irrespective of their regulatory stance towards cryptocurrencies. Other areas which may benefit from harmonisation include standards for access to financial services and systems including consumer and investor protection.
Thus, as noted above, the regulatory frameworks governing cryptocurrencies are evolving. Given the resistance of cryptocurrencies to detection and enforcement, approaches that keep the channels of information and detection open may be best suited. Further, given the speed of technological developments in this area, approaches would also need to be nimble and agile to address risks while exploiting potential benefits.
- France has recently enacted the PACTE legislation (Action Plan for Business Growth and Transformation) which, among other things, introduces the possibility for Initial Coin Offering (ICO) issuers to apply for an optional visa from the French Financial Markets Authorities (AMF) for a public offering of tokens. To apply for an AMF visa, ICO issuers are required to draft an information document (‘white paper’) which is clear, accurate, and not misleading, and which allows investors to understand the risks of the offering. The AMF visa confers both recognition of reliability and protection both for investors and issuers.
- A virtual private network (VPN) is programming that creates a safe, encrypted connection over a less secure network, such as the public internet.