Regulating crypto

The expanding adoption of cryptocurrency and its decentralised nature is posing challenges for regulators and back office workers
by Rebecca Campbell

1px
CANADA US LATIN UK SWITZERLAND CHINA JAPAN SINGAPORE AUSTRALIA
Click on the crypto symbols to view regulatory developments in that area

Key terms

Stablecoin: Defined in our article on ‘The cryptocraze’ as “a type of cryptocurrency tied to another asset such as fiat to stabilise its price”

Decentralised autonomous organisation: An organisation with no central leadership, based on open-source code, that automates decisions and enables crypto transactions

Non-fungible token: A unique unit of data that lives on the blockchain and can’t be replicated

Zero-knowledge proof: A method of proving to a verifier that they have knowledge of some information without revealing the information

View key: A secure way of enabling someone to view a person’s funds and transactions

Currently, there’s no underlying regulation for cryptocurrency and other cryptoassets (crypto), given that most projects are run by code that isn’t controlled by a single entity. Building a regulatory framework is a massive task, involving many stakeholders and going beyond the household name of crypto: bitcoin. The likes of stablecoins, decentralised autonomous organisations (DAOs), non-fungible tokens (NFTs), and blockchains will need to be addressed in some form by regulators – see boxout for definitions.

With an unregulated market, investors are often faced with the effects of low trading volumes and intense volatility. Regulating crypto can have a positive impact on the market, says Arpit Agrawal, co-founder and chief engineering officer at Cion Digital, a crypto infrastructure startup based in India but with a global reach. This impact “will increase trust in crypto assets and cause a high inflow of capital from institutions and high-net-worth individuals as well as family offices”, he says.

Crypto regulation can protect investors and prevent fraudulent activities while enabling companies to grow. At the same time, regulation needs to hit the right balance. If it’s too invasive, explains Miles Paschini, CEO at FV Bank, a global digital bank, “it will stunt or stop growth of an important sector”.

Routes to regulation

With the challenges posed by crypto continually evaluated by regulators and policymakers, many governments are choosing different routes to regulation. 

China, for instance, in June 2021 banned crypto mining, forcing miners to ship or sell their mining equipment elsewhere. And in September 2021 it announced that all cryptocurrency transactions are illegal.

The US is also taking a stance. In March 2022, President Biden signed an executive order providing a whole-of-government strategy on crypto after asking federal agencies to determine their risks and opportunities. This follows action in 2021 by crypto advocates, who were able to stall a US federal government bill on how closely to regulate the crypto sector. Opposition came from the likes of Jack Dorsey, co-founder and former CEO of Twitter, and Brian Brooks, CEO of Bitfury Group, an emerging technologies company. Brooks was also the former Acting Comptroller of the Currency during the Trump administration.

Any time a nation-state lists its intention to adopt crypto in some capacity, it further legitimises the digital asset sector, says Justin Hartzman, co-founder and CEO of CoinSmart, a crypto trading platform. 

Operational implications But there are tax implications to consider. On 1 February 2022, India announced a 30% tax on gains from crypto and revealed a timeline for the launch of its central bank digital currency (CBDC). And in January 2022, Thailand scrapped plans to issue a 15% capital gains tax on crypto holdings after a public backlash.

According to Dr Amber Ghaddar, co-founder of AllianceBlock, a platform that is bringing together traditional finance and decentralised finance (DeFi), it’s very difficult to apply old rules to a new game.

“As we saw with the US infrastructure bill [Infrastructure Investment and Jobs Act – includes a section on ‘reporting of digital assets], the relative novelty of digital assets makes it operationally quasi-impossible,” she adds. “Ideally, a standardised approach with a shared understanding of equivalence and recognition between jurisdictions for the long-term adoption and development of the market will be applied.”
It’s very difficult to apply old rules to a new game

Aside from the issue of taxation, other components to consider with crypto regulation include consumer protection, financial stability, and market integrity. Despite blockchain being based on principles of transparency, many crypto businesses operate under false pretences with no regard for consumer protection, says Amber.

“This can lead to events that massively affect market integrity, such as ‘rug pulls’, where project developers abandon a project and run away with investors’ funds,” she adds. NFT project BlockVerse is an example of a rug pull. Based on the Minecraft universe, BlockVerse was promoted as a play-to-earn NFT game. However, after selling out in eight minutes, bringing in 500 ETH, the developers reportedly disappeared, closing the project’s Discord and Twitter channels in the process. “Increased disclosure and ‘doxing’, whereby the identity of those conducting malpractice is revealed by hackers, should be used to enhance consumer protection,” says Amber.

Regarding market integrity and financial stability, Amber, a former JP Morgan banker, explains many are concerned that increased regulations might result in large amounts of trading activity crossing borders into less regulated jurisdictions, stifling the growth of the crypto asset class. But she adds that there’s no evidence to suggest this is the case. With financial stability, the main risk, according to Amber, is a spillover effect stemming from stablecoins. A significant fall in crypto valuations could see investor sentiment changing more broadly, prompting them to sell assets they deem too risky. Amber says that increased monitoring and regulation are needed to counter this.

This regulation should be comprehensive and globally coordinated, according to a December 2021 blog post by the International Monetary Fund. It calls for the Financial Stability Board to “develop a global framework comprising standards for regulation of crypto assets”, with the objective of providing “a comprehensive and coordinated approach to managing risks to financial stability and market conduct that can be consistently applied across jurisdictions, while minimising the potential for regulatory arbitrage, or moving activity to jurisdictions with easier requirements.”

What does regulation of crypto mean operationally?

Regulating crypto can come in many forms, with the most likely controls on ‘know your customer’ (KYC) and anti-money laundering (AML) rules. There is also the Financial Action Task Force’s (FATF) travel rule, which was applied to crypto companies in 2019, and is designed to prevent money laundering and terrorist financing. The travel rule means that crypto asset providers need to collect and share customer data of both the originator and the beneficiary for transactions over US$1,000/€1,000. The operational implications of this include handling data with care and due diligence, given that the receiving crypto asset provider needs to retain the information for five years after the transaction completion.

Justin Hartzman says that regulating crypto is necessary to keep the sector growing, adding that “right now that involves strict KYC and AML compliance, and is no different than what we currently see with traditional financial firms”. Justin adds that any company operating within the crypto sector in 2022 needs to be fully compliant with the appropriate regulation and that the “Wild West days of crypto are long behind us”.

Regulations can come from the securities side, restricting those who can invest in crypto and those who can issue instruments, says Miles Paschini. However, he’s of the view that the latter option is the worst type of regulation as this will make investing available to accredited investors only, thereby defeating the purpose of making financial options available to more people.

“Lastly, regulation on taxation, if crypto and blockchain are to continue to drive innovation, will need to be reasonable,” adds Miles.

Operational issues of paying dividends in bitcoin

Blockchain-focused company BTCS saw its shares rise in January 2022 following the announcement that it was offering to pay dividends in bitcoin.

For those who haven’t entered the crypto space fully, bitcoin dividends deliver exposure without investing outright. According to Arpit Agrawal, while the process may seem difficult and complicated, it’s not. 

“Transactions with bitcoin do require some additional measures, but it ensures each transaction is safe and validated as well as nearly impossible to alter through hacking,” he adds.

The main complication that may occur when paying bitcoin in dividends arises from the need for the receiver to set up a bitcoin wallet (a series of numbers and letters – keys – that allow access to bitcoins), says Amber.

“Currently, decentralised infrastructure operates in parallel to traditional infrastructure, which can lead to complications with regard to custody, ease of portfolio management, risk management, and portfolio analytics,” she adds.

Complications with risk management include phishing attacks, tricking users into uploading their crypto wallets and entering a password on a website.

Operational challenges of new developments led by blockchain

Blockchain enables organisations to reduce costs, introduces new systems of trust where users can send value directly to each other without middlemen, boosts efficiency and transparency, helps distribute finance, and organises the flow of operations. The importance of this technology is evident by the amount of money being spent on blockchain solutions – US$6.6bn in 2021, according to the International Data Corporation Worldwide Blockchain Spending Guide, with a five-year compound annual growth rate of 48% from 2020 to 2024, reaching US$19bn by 2024. At the same time, functionality, security, user experience, regulation, and taxation all play a role in how quickly and easily blockchain technology is adopted by traditional firms, says Justin.

“While there will always be operational risks in adopting innovative technology, areas such as integrated crypto payment applications will undoubtedly accelerate in the coming years so long as regulation remains favourable to the sector,” he adds.

Miles agrees and explains that embedding payments into applications and other operations is the perfect fit for blockchain as it’s programmable and verifiable and doesn’t present an operational hurdle.

“The challenges will come from overreaching regulation that makes things like KYC and taxation too costly, or too difficult to manage, such that the benefits of using the blockchain are outweighed by the costs of the regulatory burden,” says Miles.

Stocks and shares on the blockchain?

Transparency and accountability are two of the benefits that blockchain is providing to businesses. Whether it’s solving supply chain issues, delivering proof of records for transactions, ensuring that smart contracts are met, or using blockchain for equities, blockchain technology is seeing increasing demand for various businesses.

“With regards to taxation, the inherent transparency of blockchains will make it easier for bodies like the IRS and HMRC to audit tax reports,” says Amber. But she notes that it’s important to bear in mind that if a public blockchain is in use, transaction costs and network congestion might result in a decreased value proposition.

Increased transparency will also make regulation and tax collection easier. Arpit states, though, that wallets interacting with smart contracts need to have gone through KYC authorisation and users’ privacy should be prioritised.

“Technologies such as zero-knowledge proof can help to preserve users’ privacy and maintain transparency of transactions at the same time,” he says. “Another solution is to have a ‘view key’ that the user can provide to government authorities to view sensitive information related to their transactions”.

Distributing dividends, stocks, and assets would be almost instantaneous, while the public nature of blockchain technology means tax avoidance would be greatly reduced. While some believe that regulating the market will take away the decentralised nature of crypto, it’s necessary to look at the bigger picture and see where it’s going. Looking ahead, it seems that regulating the market will occur, and with that will come greater trust, more use cases, and a better understanding of what crypto is.

Seen a blog, news story or discussion online that you think might interest CISI members? Email fred.heritage@wardour.co.uk.
Published: 09 May 2022
Categories:
  • Operations
  • Risk
  • International regulation
  • Fintech
  • Compliance
Tags:
  • DeFi
  • dividends
  • AML
  • KYC
  • digital assets
  • digital currency
  • investing
  • blockchain
  • ethereum
  • cryptocurrency
  • cryptoasset

No Comments

Sign in to leave a comment

Leave a comment