Cryptocurrency Regulation: A Conflicting Yet Converging Future

March 23, 2020

The global policy debate around cryptocurrencies is intensifying along two separate, but often contradictory avenues. Global politicians remain resolutely opposed to any challenge to the existing fiat currency money supply as evidenced last year by the stern resistance to Facebook's proposed Libra stable coin initiative. But regulators are slowly cracking the door open to more and more potential uses of digital money, affording crypto assets greater credibility.

The latest regulator to weigh in on the debate is Hester Peirce, a commissioner of the Securities and Exchange Commission (SEC), who has earned the sobriquet “Cyber Mom” online for her public support of cryptocurrencies. In a speech last month, she raised the point that the SEC is currently assessing the issue against rule precedents and definitions set in 1946 and that perhaps a set of fresh and contemporary rules are warranted. As we’ve touched on previously , the SEC is currently focused on an agenda of rule modernization. As part of that push, Commissioner Peirce proposed creating a three-year regulatory “safe harbor” in which token issuers would be exempt from certain US securities registration requirements, such as EDGAR regulatory filings. This would allow issuers time and breathing space to develop a decentralized network, saving applicants (and the SEC) the cost, complexity, and uncertainty of operating with the expectation of “No Action” letters on crypto and token issuances.   

No sure thing

While this development is a positive step in legitimizing certain types of crypto assets, it should be noted that Peirce is only one of five SEC commissioners, and this proposal faces an uncertain future. Rival US regulatory agencies such as the Commodity Futures Trading Commission (CFTC) and the Federal Reserve also are jockeying to regulate cryptocurrencies. Congress is also proposing laws to restrict or enable their usage. Even Peirce’s boss, SEC Chairman Jay Clayton, is on record as saying that cybercurrencies need better regulation before they can be traded, so the passage from Crypto-Mom’s speech to hard policy is unlikely to be quick or smooth.

The US is the main cryptocurrency market

The absence of rules and regulations has not been a hindrance to the growth of the US crypto market with the bulk of cryptocurrency transactions taking place in the US. With investor appetite for cryptocurrency on the rise, more and more companies are keen to serve them, including an increasingly number of traditional asset managers entering the fray. However, a well-defined SEC regulation would surely bolster activity as crypto moves from market margins into the mainstream.  

Beyond the US, other countries and regions are adopting a wait-and-see approach. The EU currently has an open public consultation on an EU framework for markets in crypto-assets seeking feedback on potential use of crypto-assets as well as several definition and classification questions by March 19.  Covering 117 distinct questions on a variety of topics, it’s fair to say EU policymakers have a number of areas they wish to clarify before entering any hard rulemaking phase.   

In framing it’s fifth Anti-Money Laundering Directive (AMLD5), the EU specifically set out requirements on certain cryptocurrency transactions, namely cash to crypto transactions. The inclusion of crypto in this regulation is seen as a double-edged sword by many. On the one hand, the new rules require crypto exchanges and custodial providers to register with their local regulator and implement enhanced anti-money laundering procedures. On the other hand, the directive is viewed positively by many crypto advocates, who argue that the industry now has a hard set of money-laundering rules and know-your-customer rules with which to work. The inclusion of a robust regulatory framework could lead to increased levels of trust, which may spur greater interest from institutional investors. 

With EU-wide regulation still some time off, Germany has recently taken a lead in implementing steps to legally recognize cryptocurrencies. Germany moved to apply some regulations to fill the policy vacuum at national level, recognizing the increasingly investor popularity of the asset type. Crypto assets such as security tokens and digital currencies were incorporated into the German Banking Act last July, and the rules took effect on January 1, 2020. They allow companies that do not provide other banking or financial services to obtain a cryptocurrency custody license from the country's financial regulator, BaFIN. In one its first cryptocurrency actions, BaFIN granted a Berlin startup called Fundament approval for a $280 million tokenized real estate bond issue using the Ethereum distributed ledger technology known as blockchain.   

While there are positives to be drawn from these early regulatory developments, for the most part, it's still the potential illegal use of cryptocurrencies that remains top of mind in Europe as well as in the US. France and Germany felt obliged to issue a joint communique in September last year saying that Facebook's proposed Libra project failed to convince them that the risks of investor fraud, financial security, and terrorism financing have been resolved. “We believe that no private entity can claim monetary power, which is inherent to the sovereignty of nations,” they said.

The G7 also released a report in October 2019 that examined so-called stablecoins, like Libra, which are tied to a basket of fiat currencies or commodities to reduce volatility. The report urged caution, concluding that “The G7 believes that no global stablecoin project should begin operation until the legal, regulatory and oversight challenges, and risks are resolved.”

ECB develops its own cryptocurrency

If nothing else, the global outcry surrounding Facebook's Libra proposal has prompted supranational authorities such as the European Central Bank (ECB)and the Bank for International Settlements to start looking into the creation of central bank-based digital currencies as an alternative. In December, the ECB published a “proof of concept” for an anonymous, central bank-issued digital currency and ECB President Christine Lagarde said the bank was accelerating its cryptocurrency program. Similar projects are underway in Canada, Sweden, Singapore, and other countries.

While for now this hodgepodge of projects, papers, and plans may seem in conflict, but the two opposing strands of cryptocurrency regulation may eventually coalesce into a workable solution. The very fact that multiple regulators continue to frame paths towards regulating various uses of digital currencies and distributed ledger technology, their legitimacy by association naturally increases. However, it is evident that governments are unlikely to grant private firms the ability to issue cross-border currencies since they believe disruption of the fiat currencies reduces national sovereignty. As such, a digital currency controlled by central banks but dispersed and intermediated by other financial institutions for international payments may be the more likely outcome.

While the current flurry of regulatory activity seems conflicting and confusing, it is an indicator that overall policymakers are charting a course towards a legislative and regulatory framework which may provide a strong and stable foundation for crypto assets to flourish.  Watch this space. 

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