Racing to Regulate Cryptocurrencies

The regulatory landscape for cryptocurrencies is fast paced, ever-changing, and hard to pin down (see Element Group report). To understand why governments are interested in regulating cryptocurrencies, background about their potential function is necessary. Cryptocurrencies enormous potential comes from the use of “public ledgers” which, through a complicated application of cryptology and software, reduce transaction costs associated with value transfer by creating independently verifiable transaction validations. The public ledger system, however, only documents transactions and ownership. The only identity recorded on the ledger is "a set of letters and numbers . . . representing the [user's] public cryptocurrency address." These addresses combine with a private key to create the crypto owner’s “wallet.” Because anyone can create an infinite number of wallets without giving up personal information, cryptocurrencies retain a high degree of anonymity, which makes them uniquely suited for transacting illicit activity. (Omri Marian, Chicago Bound).

Traditional regulatory frameworks focus on the intermediaries of transactions (i.e. financial institutions) to prevent illicit activities like money laundering. In the early days of cryptocurrencies, it was not clear what intermediaries would emerge, as intermediaries are created by the market. (Omri Marian, Chicago Bound). Since then, the largest intermediaries for cryptocurrencies that have emerged are the exchanges—online portals where cryptocurrencies can be exchanged for traditional fiat currencies. (CryptoCurrencyFacts).

Governments have deployed various methods to prevent the illicit use of cryptocurrencies while simultaneously protecting consumers. In the U.S., regulators approached the problem from an individual consumer standpoint. This approach contrasts with South Korea’s approach, which is exchange focused. But the same question is asked regardless of the approach: what exactly are cryptocurrencies? This is a “necessary first step to any regulation," but one that has proven difficult for cryptocurrencies. (Evan Hewitt, Seattle University Law Review)

In the U.S., the IRS, the Treasury’s FinCEN, the SEC, and the CFTC all have some level of involvement in cryptocurrencies. The approach of the IRS and FinCEN appears to be practice-oriented. In 2014 the IRS issued Notice 2014-21, which provides that for tax purposes virtual currencies are treated as property, despite operating like currency “[i]n some environments.” FinCEN “monitors Bitcoin and other virtual currency transfers for anti-money laundering purposes.” (CFTC). (FinCEN). The CFTC is focused on protecting consumers through education, defining future markets in the crypto context, and shutting down unregistered exchanges. (CFTC).

For the SEC, the touchstone for whether a cryptocurrency falls under agency oversight is the level of centralization. (Louise Matsakis, Wired). On June 14 the SEC’s Director of Corporation Finance stated that because of the size and level of decentralization of their networks, Bitcoin and the Ethereum network (token on this network are called Ether) would not be regulated by the SEC. (William Hinman, Securities and Exchange Commission). But the Director also explained that “simply labeling a digital asset a ‘utility token’ does not turn the asset into something that is not a security.” The difference, according to the Director, lies not only in the level of centralization but also in the purpose. When “the economic substance is the same as a conventional securities offering,” in that “funds are raised [through an ICO] with the expectation that the promoters will build their system and investors can earn a return on the instrument,” the SEC will consider these tokens securities. (William Hinman, Securities and Exchange Commission). The SEC’s position seems to be if it walks, talks, and markets like a security, then it is a security.

South Korea, another major player in the global cryptocurrency market, focuses its efforts on regulating and defining the nature of exchanges. Until July 2018, cryptocurrency exchanges in South Korea operated with a simple $40 communication vendor license. (Joseph Young, CryptoCurrencyNews). This structure prevented oversight from the country’s financial regulatory authorities. Given the potential for abuse of these highly unregulated systems, South Korea's government has chosen to regulate crypto exchanges like financial institutions and banks. (Rasmus Pihil, ToshiTimes). This new regulatory framework “will require cryptocurrency exchanges to comply with strict Know-Your-Customer (KYC) rules, Anti-Money Laundering (AML) regulations, as well as customer verification policies.” While these requirements will be onerous, they add legitimacy to cryptocurrencies and could “open the floodgates for institutional investors.”

Although each agency and government has approached the “problem” of cryptocurrencies differently, there are two prominent themes. First, while new regulations often create shocks in markets, the effect is not always negative—regulations have increased the value of certain cryptocurrencies. (Nikolai Kuznetsov, CoinTelegraph) Second, regulation may give cryptocurrencies the credibility necessary to break into the mainstream and fully realize their potential. (Kim Larkin, SouthChinaMorningPost).