On Thursday, Prime Minister Theresa May suggested at Davos that the U.K. will be scrutinizing cryptocurrencies, due to concerns about their use in criminal activity. She wasn't specific. This followed a joint op-ed on 24 January 2018, by the chairs of both the Securities and Exchange Commission and the U.S. Commodities and Futures Trading Commission in the Wall Street Journal calling for increased regulation of the cryptocurrency industry due to concerns about investor protection and the avoidance of oversight. French President Emmanuel Macron went further at Davos, calling for a common international approach to regulating Bitcoin.
While there are growing calls for regulation of the cryptocurrency market, which is rapidly approaching a market capitalisation of $1trillion, there is little agreement about the forms this should take. Cryptocurrencies based on distributed ledger technology (DLT) originated as payment facilitation alternatives to traditional currencies but are now also traded on spot exchanges as highly speculative investment assets. Recent spin-off crowdfunding opportunities such as initial coin offerings (ICOs), in which start-up cryptocurrency companies offer pre-allocated investment stakes in new token issues have been a particular cause of concern.
Macron is right: If the case for any government regulation here is strong, the case for a coordinated regulatory approach is even stronger. A clear, coordinated regulatory approach would increase the flow of institutional capital into cryptocurrency markets, and that would further strengthen corporate governance in cryptocurrency companies.
The trick for regulators is balancing considerations of investor protection and systemic stability with the need to protect innovation and encourage capital formation in a multijurisdictional setting.
At present the regulatory environment is a muddle. There has been a rapid divergence in regulation of cryptocurrencies and ICOs across jurisdictions. There have been outright bans of ICOs in China, Korea and Vietnam, much friendlier approaches in Japan, and the wait-and-see approach of the U.K. and the U.S., while South Africa offers zero protection to ICO investors. This is due to the varying definitions of the legal nature of cryptocurrencies and ICO tokens across jurisdictions, and the rapidly evolving use cases of DLT-related market activities.
The precise nature of an ICO depends not only on its structure, but also its context, which can change very quickly and have hybrid characteristics of financial instruments. The definition, and hence legal treatment, of the tokens issued under an ICO could therefore be as diverse as a currency, commodity, security, property, loan, deposit, derivative or forex contract. Agreeing a taxonomy of cryptocurrencies defined by their use cases is clearly one of the most urgent tasks facing regulators.
Cryptocurrency expert Lawrence Wintermeyer has argued that DLT digital assets could be organised into three potential buckets: cryptocurrencies, cryptocommodities, and cryptotokens. In this categorisation, cryptocurrencies are currencies, cryptocommodities are utilities and cryptotokens are securities.
The lack of harmonization across jurisdictions is a wider problem than nomenclature though, it is problematic specifically because the nature of these assets is cross-border.
Cryptocurrency companies sometimes use the distributed nature of these assets -- which sit on digital ledgers held by multiple token holders - to make the argument that there is no issuer, or that they are not securities, and are therefore not subject to a particular jurisdiction's securities laws.
Regulatory lawyers such as Dilmun Leach of Collas Crill note that ICOs raise a number of cross-border regulatory questions, in relation to: the home jurisdiction of the "issuer" or operator, where investors are located, and the location of any services providers. Leach says "given the number of ICOs launched and the amount of capital raised (reported to be more than $1.3 billion) and action taken by the SEC, it is not clear that adequate consideration has been given to regulatory matters".
Yet another major concern in relation to the cross-border nature of these assets, is how easily transferrable they are, and how difficult their origins are to trace. Jurisdiction shopping by token companies could see them being issued in less onerous jurisdictions like Japan, and the resultant backflow could land them in the hands of unassuming retail investors in stricter jurisdictions such as the U.S.
Cross-border fungibility, which allows token companies to pick and choose jurisdictions with regulatory rules that are favourable to them obviously also makes money laundering easier.
Governments should support investment into technological development of blockchain that makes their provenance clearer while preserving their encryption, and then regulators could enforce an indicator of origin as a standard. This will inhibit the ease of illicit transferability of these assets.
For the moment, for all the bad press that off-shore centers have received lately, there is much to learn about potential applications of international best practice and corporate governance for cryptocurrencies, from well-regulated jurisdictions such as Jersey, which offers investors in digital assets an extra set of gatekeepers' eyes, and ostensibly, a more calculated risk. In a Jersey ICO the issuer itself requires a consent from the Jersey companies registry, and the issuer is required to be administered by a suitably regulated corporate services provider who will be required to, for example, conduct checks in relation to anti-money laundering and countering the financing of terrorism.
But what could a co-ordinated global regulatory approach to cryptocurrencies look like? Harmonization via a code of conduct or voluntary signatory to a global compact could certainly stop token companies from cherry-picking jurisdictions to their advantage. Not being signatories to the codes would place token companies outside the market.
Standard regulatory codes are particularly critical for the investment community, which has noted a significant surge in the establishment of investment funds looking to invest in ICOs on behalf of sophisticated investors. This may assist in regulation and innovation. Institutional investors, unlike retail investors, can withstand, and even benefit from, tokens' volatility upside over time.
Regulatory Lawyer Tyler Kirk of WSGR argues a critical mass of assets with a long time-horizon and higher corporate governance standards will help start-ups with the capital support and scrutiny to make their investments more impactful. Institutional money could also alleviate the climate impact of bitcoin, which is extremely energy intensive. The poorly regulated speculative hoarding of cryptocurrencies reduces the potential of DLT assets to become a public good, and ultimately, affects the potential value of the tokens themselves, by amplifying volatility.
Paying attention to these cautions, is however, not only important for investors and regulators: issuers too, should to be aware of the legalities of ICOs and other DLT investments. Certainly, as global regulators get up to speed there will have to be a degree of self-regulation by issuers.
Dr Desné Masie is an economist specialising in financial markets at the Wits School of Governance