Cryptocurrencies and Regulation
Cryptocurrencies appeared in their current form just after the global financial crisis in 2008, offering the possibility of a decentralised monetary system. In brief, cryptocurrencies are digital assets that are secured through cryptography by a network of computer systems and are therefore not controlled by a central authority – like a bank or government.
Proponents of cryptocurrencies believe that digital assets offer greater privacy and autonomy, allowing transactions to occur seamlessly and anonymously across the globe. However, cryptocurrencies have proved to be a disruptive and highly volatile asset class.
The burgeoning cryptocurrency market has caused regulators to become increasingly concerned about digital currencies potential deviation from capital controls, launching crackdowns and regulatory consultations to keep the nascent market in compliance and protect the consumer.
What Are Cryptocurrencies?
Cryptocurrencies trade in digital coins or ‘tokens’, which are made up of pieces of code built in the form of a blockchain. The blockchain model also forms an open ledger of every Bitcoin transaction that takes place. Crypto assets can be bought and sold via exchanges, much like traditional stocks and bonds, or can be stored in a virtual ‘wallet’. Their value is dependent on market forces driven primarily by the people who buy and sell them, although their price has been known to fluctuate during times of political instability or widespread populism. Crucially, cryptocurrencies have the same market value in every country, making global transfers easier by eliminating exchange rates.
The oldest and most preeminent cryptocurrency is Bitcoin, which was launched in 2009. The majority of competing cryptocurrencies are based on the Bitcoin model, which operates through a process called ‘mining’ to generate new coins and authenticate transactions. Bitcoin and other alternative coins, such as Ethereum and Dogecoin, have been slowly permeating the mainstream financial market, although only a small number are traded on key exchanges.
The Growth of Cryptocurrencies
Today, it is thought that around five thousand cryptocurrencies exist. The adoption of virtual assets has sped up over the last decade and according to a recent report by Chainanalysis out of 154 countries analysed 92 percent have some sort of cryptocurrency activity. In the UK, the number of people who have bought crypto has increased by 558% since 2018, when just 3% of the population owned a cryptocurrency.
Many believe that digital assets could eventually replace traditional monetary systems. However, the uptake of digital currencies within financial services has been slow, as investors proceed with caution.
That said, a new survey shows that several large hedge funds plan to significantly increase their exposure to cryptocurrencies by 2026, ‘in a major vote of confidence for digital assets after recent price falls and plans for punitive new capital rules’.
While many prize the anonymity offered by digital currencies, others argue that their opacity establishes a breeding ground for unlawful activity. According to a report from Action Fraud, last year £63m was stolen through fake online investments, and approximately 44.7% of those scams were related to cryptocurrency investments. Although this criminal activity is not directly related to the exchange of cryptocurrency itself, governments and regulators fear that digital assets could be used to evade capital controls, potentially resulting in money laundering, market manipulation, tax evasion, illegal purchasing and/or fraud.
Due to their virtual nature many raise the concern that cryptocurrencies could be susceptible to hacking. However, most crypto assets are exceptionally difficult to hack due to the complexity of blockchain technology. Additionally, although digital currencies allow an individual to transact money without revealing their personal identity, exchanges are not untraceable – the blockchain model keeps a record of all transactions and if needed criminal activity could be tracked.
Both governments and regulators warn investors to do their research before purchasing any form of cryptocurrency. Many liken investing in crypto assets to gambling because the market can be highly unpredictable, with sharp decreases and increases in price occurring regularly.
Worryingly, cryptocurrencies have a high environmental impact. The process of ‘mining’ is extremely energy sensitive, requiring the processing power of a large number of sophisticated computers. Environmentalists have cautioned that the rise of cryptocurrencies could have a substantial impact on international efforts to cut energy consumption.
The threat of increased regulatory scrutiny is one of the most important factors affecting the value of cryptocurrencies. Lately, global regulators have begun a series of crackdowns which have particularly affected Bitcoin, causing the crypto asset to experience substantial price swings in Q1 2021. Currently, cryptocurrencies are not widely regulated beyond the borders of blockchain technology, and their legal status varies significantly from one country to the next – with most nations conflicted as to how to best regulate the digital asset.
The United Kingdom
Concern over the security of cryptocurrencies as an investment class has provoked the Financial Conduct Authority (FCA), to describe them as ‘very high risk, speculative investments’. To operate in the UK, cryptocurrencies are required to register with the FCA unless they have applied for an e-money license. However, currently only five have done so. This means that most crypto exchanges in the UK are operating without FCA rules and therefore are under no obligation to monitor or report any transactions that would be in violation of anti-money laundering (AML) rules.
Last month, UK Banks such as Barclays, Monzo and Starling Bank decided to temporarily suspend payments toward crypto exchange platforms due to a growing number of suspicious transactions. More recently, the FCA has banned Binance – the world’s largest exchange platform for cryptocurrencies – from operating in the UK.
The European Union
The EU has previously struggled to set clear and strict rules concerning cryptocurrencies, with divergences in policy occurring across nation states. However, in September 2020 the European Commission (EC) announced a regulatory proposal titled ‘Markets in Crypto Assets’ (MiCA). Currently, the proposal is making its way through the legislative process and has been subject to intense negotiation. It should eventually provide clear definitions and guiding principles for cryptocurrencies, while offering regulatory clarity.
The United States
The US has yet to devise a harmonious legal approach to crypto assets, with laws varying from state to state and federal authorities differing in their definition of the term. In recent months, under the Biden administration the US Treasury has begun formulating a plan to crackdown on the cryptocurrency market and increase regulatory scrutiny. In May 2021, the new acting comptroller of the currency, Michael Hsu, said he hoped US officials would work collectively to set a “regulatory perimeter” for cryptocurrencies. Adding that while innovations in digital payment methods showed “great promise” they also come with “risks”.
Over the coming years, it is likely that central banks and investment houses will seek to develop their own digital assets and thus standardise the use of cryptocurrencies. However, there is still a significant lack of knowledge concerning digital currencies, and many countries appear to be trying to slow down the uptake of crypto assets by portraying them as extremely risky. How much regulation to apply to cryptocurrencies will be an ongoing debate during 2021, especially due to the market’s recent volatility and popularity.
The BIS has stated that it believes Central Banks Digital Currencies (CBDC) will be healthier in terms of security and data control than private innovation. However, for emerging countries, crypto assets offer a way to bank without the need for infrastructure or government oversight.
Rutherford is the executive specialist in compliance, legal, financial crime and cyber security recruitment.