Originally published by the IFC Review on August 31, 2022.
Although created well over a decade ago, the cryptocurrency industry is still very much nascent. That said, the pace of adoption has rapidly accelerated in recent years, forcing policymakers to finally think about how to establish a legal and regulatory framework for the sector.
The full list of issues implicated by mainstream adoption of cryptocurrency that lawmakers will need to address are too numerous to list, but what follows are four of the most significant areas in which they are being forced to provide rules and guidance, along with the ways in which their efforts may be warped to serve either other industry participants or governments themselves instead of consumers and the economy as a whole.
Stablecoins
Stablecoins have a vital role in the functioning of the current cryptocurrency ecosystem. Intended to maintain the value of a reserve asset, such as the US dollar, they are frequently used by traders as they enter and exit positions. Stablecoins are also used for borrowing and lending through decentralised finance, for money transfers, or as a less volatile option than other cryptocurrencies to escape from unstable or tyrannical governments.
Different types of stablecoins offer their own pros and cons and may require different regulatory approaches. Asset-backed stablecoins like Tether (USDT), Circle’s USD Coin (USDC), and MakerDAO’s DAI are over-collateralised – by fiat reserves in the case of USDT and USDC, and by other cryptocurrencies in the case of DAI. The latter is an example of a decentralised stablecoin that operates solely through interaction with smart contracts. In contrast, centralised coins like USDT and USDC are seen by some crypto natives as more vulnerable to abuse or mismanagement.
Algorithmic stablecoins are another type of coin that seek to maintain their peg through the regulation of supply rather than backing by fiat or crypto assets. Before its famous implosion in May and the loss of its peg, Terra’s UST was the third largest stablecoin by market cap and the most successful algorithmic stablecoin to date. That success, in turn, meant its eventual collapse – in what some suspect was a coordinated attack – was all the more devastating to the market. Crypto hedge fund Three Arrows Capital was heavily invested in Terra and subsequently bankrupted. Lenders Voyager Digital and Celsius have also gone under.
What are regulators likely to make of all this? The answer depends upon the degree to which lawmakers might seek to exploit events to their favour.
Whether Terra was deliberately attacked or merely poorly conceived doesn’t much matter. In the end a financial innovation was attempted and ultimately found wanting. That could be considered the market working as intended, albeit messily.
The policy risk is that lawmakers become risk-adverse and overregulate to the point of stifling innovation. A Biden administration report issued late last year warned of potential systemic risks to the US financial system and called for “legislation [to] provide for supervision on a consolidated basis; prudential standards; and, potentially, access to appropriate components of the federal safety net,” but also that “would prohibit other entities from issuing payment stablecoins.”
Stablecoins were always going to end up in the sights of regulators sooner rather than later given their broad financial implications. The fact that money-issuing is in direct competition with a function on which governments prefer to maintain a monopoly, however, raises concern that lawmakers may be motivated by more than just consumer protection or the health of financial sectors.
The UK is promising legislative action soon, and among US lawmakers, there appears consensus that the lack of regulatory clarity is a problem. Whether that problem is addressed through modest steps, like recent legislation introduced by Sen. Pat Toomey to mandate audits, or a more sweeping overhaul – and assertion of broad government control over the issuance and management of stablecoins – remains to be seen.
Securities Or Commodities
The question of whether or when to treat cryptocurrencies as securities is hardly new but remains far from settled. For instance, the inability of US agencies to craft and articulate clear guidance often leaves Americans singled out by crypto companies fearful of being tangled up in an onerous and arbitrary system of regulation by enforcement.
The ongoing prosecution of Ripple is a case in point. Its native token, XRP, is alleged by the Securities and Exchange Commission (SEC) to be an unregistered security. But the agencies’ case is muddied by inconsistent statements, opaque criteria, and persistent government defiance of judicial orders. As a result, no one has any clue what constitutes a security in the US when it comes to cryptocurrencies, which is not a competitive place for any country to be in.
The SEC also has denied every request to establish a spot Bitcoin Exchange Traded Fund (ETF), allowing only for futures ETFs thus far. Many want access to a fund that holds actual Bitcoin and that can be bought and sold in tax-advantaged retirement or investment accounts, and there’s reason to believe that providing a spot ETF in the US would open the market to institutional and retail investors currently on the sidelines.
Part of the problem is a lack of clear lines of authority. If Bitcoin is a commodity, for instance, then the Commodity Futures Trading Commission has primary jurisdiction, and the SEC would need to collaborate to approve an ETF. But given that the SEC has said that its concerns involve potential for market manipulation and consumer protection, and that one way they see to address those concerns would be for exchanges to essentially open all their data to the SEC, it appears to be more a question of expanding the financial surveillance state and protecting agency power.
Tired of the agency’s games, Grayscale Investments has a lawsuit pending against the SEC regarding its continued denial of spot approvals. A ruling is expected within a year and could even force the legislators to act in a more concerted manner rather than waiting for a court to act for them. It’s worth noting that Canada, Singapore, Brazil, and Australia have approved spot ETFs without issue.
The best thing for the market and its participants would be clear and simple rules that don’t impose onerous compliance burdens. The consistent refusal of the SEC to provide any such rules, or even comply with judicial orders to supply deliberative documents, raises questions about whose interest the agency is serving.
Anti-Money Laundering
At the end of June, the EU announced initial agreement on anti-money laundering rules for cryptocurrency transactions. The rules would require customer identity verification for all transfers, no matter the size, when made between regulated service providers. However, after significant industry backlash following a proposal in March to expand the bill to include transactions between unhosted wallets, meaning those managed by individuals instead of through an exchange or other provider, they were left out of the final proposal.
For now, the EU won’t require money laundering checks on all payments to private wallets. But there’s no reason to think regulators won’t push for more once they get the current proposal across the line. The history of anti-money laundering rules is one of constant expansion despite considerable evidence that the rules simply do not work.
Financial crime expert Ronald Pol concluded in a study published last year that global anti-money laundering efforts could be “the world’s least effective policy experiment.” Compliance costs for banks and other businesses, as much as US$180 billion per year according to a survey of professional published by LexisNexis, dwarf the amount of illicit money captured.
Efforts to impose this failed regime on cryptocurrency are explainable in two primary ways. First, legacy financial institutions, having largely given up on improving their own situation, want to saddle crypto start-ups with the same onerous rules that have so bloated much of today’s financial infrastructure and left it unrewarding for consumers. Second, governments see crypto as a threat to long-standing efforts to impose perpetual and pervasive financial surveillance.
The EU has for decades propelled global efforts to eradicate financial privacy and require jurisdictions to enable widespread surveillance, often under the guise of furthering tax collection. So aggressive has been this effort that it has all but consumed the agenda of the Organisation for Economic Cooperation and Development in recent decades.
Contrary to much conventional wisdom, there’s little evidence that cryptocurrency is much used for moving illicit funds. Most coins are ill-suited for it given that every transfer is publicly posted. All it takes is one connection of an individual to a particular account and entire transaction histories can be reconstructed. Government-issued cash currencies are much more attractive to serious criminals.
Decentralised Finance
The emergence of decentralised finance (DeFi) probably represents the most consequential development in the sector since Bitcoin’s creation. Smart contracts that operate on transparent rules allow for lending and borrowing without need for middlemen and all the costly infrastructure that they require.
Right now, DeFi is primarily used by crypto investors to leverage the value of other crypto assets without disposing of them. But it’s only a matter of time until the gap between real world assets and digital representation is bridged and anyone has access to these tools.
Lawmakers will face significant challenges attempting to accommodate such disruptive technology in a sector as heavily regulated as finance. First, they’ll need to acquire the expertise necessary to even understand the issues at play. Then they’ll need to navigate an influx of special interest pressure from an industry that may not be keen to allow emergence of a technology that renders much of their existing infrastructure worthless while offering consumers faster service and higher returns.
Moreover, how does the tendency of regulators to impose the responsibility of enforcement on private actors work when an industry is automated and decentralised? And how will the “code is law” ethos of crypto stand up to scrutiny from existing legal systems?
Conclusion
There are many more legal and regulatory issues surrounding cryptocurrencies than mentioned here. Most countries, for instance, treat cryptocurrencies as assets, but El Salvador and the Central African Republic consider Bitcoin to be legal tender. What knock on effects will we see if and when other countries follow suit? But how the aforementioned issues are approached by lawmakers and regulatory authorities, and whether they prioritise innovation and growth over government control and self-interest, will determine how the next decade of cryptocurrency development unfolds.
