Pressing need for regulating cryptocurrencies

Different approaches to cryptocurrencies across jurisdictions cause disparity in the understanding and classification of digital assets

This series of commentary on cryptocurrencies previously discussed basics (ABLJ, November-December 2021: Cryptocurrencies in India: fad or future?) and delved into India’s move to tax virtual digital asset transactions (ABLJ, January-February 2022: Taxation, legality of cryptocurrency in India). In this article – the third of this series – the authors gaze into their crystal ball and discuss possible scenarios of where this business-industry is headed.

NEED FOR REGULATION?

There is a perception that regulation is antithetical to cryptocurrency, stymying growth of innovation. That is not necessarily true. Implementation of the EU General Data Protection Regulation has contributed immensely to innovation around data security measures.

Closer to home in India is the example of the 2021 IT (Intermediary Guidelines and Digital Media Ethics Code) Rules. Prior to these rules, there was no standard for determining classification of content on over the top (OTT) online platforms, and as a result, OTT platforms and producers were subjected to unnecessary litigation and harassment. Not only is there now greater certainty with these rules, but they have also led to a greater push towards innovation.

Specifically in relation to finance (given its sensitive nature and need for control and standards both countrywide and cross-border), regulation of financial markets or businesses is difficult to argue against. Necessity for state control stems from the security or assurance required of consumers or the general public – ensuring against scams and controlling money laundering. This has led to the proliferation of regulation to address and control cryptocurrency mining, introduction, circulation and spending.

Regulators worldwide, especially in the technology domain, are increasingly responsive to the changes in economic, social and technical conditions. However, given that these changes are constantly in flux and dynamic, the regulators are still playing a reactive instead of proactive role.

Environmental, social and governance (ESG) concerns, for example, have become a real consideration for all regulators in forming new laws. Taking a leaf out of the Organisation for Economic Co-operation and Development advisory guidelines on regulatory reform and innovation, it will be important for regulators to ensure there is:

1. Understanding of the regulation or technology linkages;
2. Introduction of competition;
3. Streamlining of regulations – no country can afford to have a barrage of regulations, which are duplicative, onerous in nature and do not interact with one another;
4. Reliance on technology-driving approaches; and
5. International harmonisation.

This last consideration is tricky, especially with the differential approach – caused primarily on account of the difference in understanding and classification – in cryptocurrencies. Harmonisation of this approach needs principally to rely upon a common understanding of imposing technology risk management requirements on the financial institutions for safe and sound use of technology to deliver financial services and protect data.

WORLDWIDE EFFORTS

Singapore recently passed new legislation requiring virtual asset service providers that only do business overseas to be licensed. This bears in mind the need for regulation around anti-money laundering and countering the financing of terrorism, as well as the level of awareness that exists in the minds of consumers about managing expectations around cryptocurrencies.

The country is performing a balancing act when it allows a regulatory regime to manage and govern the industry, while also discouraging the public from cryptocurrency trading. This move accentuates the vigilant approach of the city-state and reinforces their intent to ensure that financial institutions bolster the security and resilience of digital services.

It is also in line with the OECD guidelines, which advise governments to plug existing gaps and keep abreast of new risks emerging from the convergence of technology and conventional formats.

In the US, discussion around cryptocurrencies, particularly stablecoins, has gained a lot of prominence in the past couple of years. The Securities Exchange Commission (SEC) has just committed to partner with the Commodity Futures Trading Commission to address platforms trading crypto-based security tokens and commodity tokens. US regulators do not intend to treat this market any differently from traditional regulated exchanges, merely because the underlying technology is different.

As threats to consumers persistently rise – with more than USD14 billion worth of cryptos scammed in 2021 alone – investors are required to be protected with the same vigour. Much like its counterpart in Singapore, the SEC’s Office of Investor Education and Advocacy, and the Retail Strategy Task Force, constantly update and issue bulletins to educate investors about risks with accounts that pay interest on crypto-asset deposits.

In November 2021, the President’s Working Group on Financial Markets issued a report on risks stemming from stablecoins. It found they are currently used “to facilitate trading, lending, or borrowing of other digital assets” – but could theoretically be used to create a “faster, more efficient and more inclusive payments” system.

It went on to add that where stablecoins “involve complex relationships or significant amounts of leverage, there may also be risks to the broader financial system”. What is striking to note is that while traditional systems have found some ways to mitigate the risks (by way of imposition of liquidity requirements, or ensuring deposit insurances for bank accounts), stablecoins do not have such protections.

For now, it is important to note that while there are distinctions between securities, commodities, non-fungible tokens (NFTs) and stablecoins, this classification is by no means exhaustive or final. Simultaneously, there is continued insistence and effort to have existing statutory authorities play a greater role in regulating crypto assets. Various thinktanks have made appeals to the US Congress to desist from carving crypto assets out of existing laws.

In the Middle East, meanwhile, a spurt in regulations across the Gulf Co-operation Council region attempts to welcome players from across the globe to set up bases, seek licences and registrations, and host exchanges in their jurisdictions. This has evinced the interest of many crypto players to study such regulations closely and consider moving operations.

WAY FORWARD

As regulatory frameworks around cryptocurrencies spawn across many jurisdictions to modulate transactions and consumer behaviour, a certain degree of harmonisation and standardisation across regimes will be vital – to establish co-operative legislative agencies or groups for the enforcement of policies, and avoid the creation of safe havens common to money laundering legislation schemes.

Mere introduction of a taxation regime for crypto assets will not be limited to assessing whether tax laws would be applicable to crypto transactions, but also extend to determining if a crypto-asset owner can potentially evade those laws by hiding their identities or assets. With anonymity of transactions prevalent over blockchain and digital wallets – where the underlying owner’s identity is not disclosed or cannot be truly mapped – the entire exercise will be replete with inconsistencies and futile.

At this juncture, upcoming laws should be technology agnostic, and must steer clear from categorisation of the types of cryptocurrencies, to leave some wiggle room for regulation of such new proofs of work. It will also be left to the device of the regulators to have mechanisms in place for the assessment of technology risk management for the financial institutions.

With the option of a particular digital asset being subject to regulation by several authorities and departments, there is a requirement for the inter-governmental bodies and political-economic unions to consider having dedicated work groups that substantiate and supplement the gaps in identifying risks and enforcement mechanisms in this integrated economy. With the current level of consumer acceptance and willingness among regulators, we must take the current when it serves, or lose our ventures.