How Governments Should Regulate The Crypto Market?

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The tsunami of technological disruption stemming from cryptocurrencies requires tough decisions and implications for governments. Valued at $500 billion, the cryptocurrency market has over 1000 currencies, with at least 39 currencies that have market capitalizations above $1 billion (Cornish, 2018; Choudhury, 2017; CoinmarketCap, 2018). To benefit from the trending currencies, entire industries have risen up, including marketplaces, digital wallets, mining services, secure storage and other financial services (see Appendix 1 for the cryptocurrency ecosystem).

While cryptocurrencies are innovative but yet an unregulated investment opportunity with potential for high returns for consumers, they represent immeasurable challenges for governments and regulators, as they come along with as wide range loopholes such as taxation, fraud, monitoring, market volatility and security risks.

This report will look at the implications of cryptocurrencies on the overall market and highlight the stances of some key governments to address the underlying opportunities and challenges of cryptocurrencies. It will show some best practices that governments should consider when imposing regulation on the cryptocurrency market.

IMPACT OF CRYPTOCURRENCIES

To analyze the implications of cryptocurrencies on the wider market, we can use the PESTLE framework to identify various political, economic, social, technological, legal and environmental impact, separated into opportunities and challenges:

OPPORTUNITIES CHALLENGES
P

Political

●      As cryptocurrencies are not region-specific, there is the potential for a unified currency system across the globe via a digital currency, which is already seen to be happening to a degree with Bitcoin, watering down the need for local currencies.

●      In the past, the issuance of currency has been abused by some governments, which is one of the reasons that have led to the creation of cryptocurrencies. Cryptocurrency creates a decentralised form of currency that is not issued nor regulated by government. Consequently, the decision of the amount and type of currency is made by the customer, mitigating the risk of a single entity controlling money supply (George, 2017).

●      Cryptocurrencies are still establishing their presence and is are not used by the masses, making some governments complacent to regulate. However, many businesses are not prepared to invest in the technology without proper regulation and protections. This creates a standstill for progression with neither party willing to take the first step (HM Treasury, 2015).

●      Cryptocurrencies promote the ideology of a free-market economy driven by individuals, not government or corporations, without intermediaries. This notion ‘divorces’ transactions from the traditional money system and the supporting organisations behind it. While this gives more power to ordinary citizens, it has drastically disrupted traditional industries rooted in society such as banks, exchanges and retail which may create huge implications for the economy (CB Insights, 2018).

E

Economic

●      Cryptocurrencies will enable easier, cheaper and faster cross-border transactions, which currently costs 8% of total transfer amount and can take several days. This opens up many opportunities for more efficient international trading, stimulating economic gains (HM Treasury, 2015).

●      Cryptocurrencies are highly volatile where investors can gain or lose large sums in a matter of minutes. This instability means that the long-term viability of cryptocurrencies is unclear and is unlikely to be a substitute for fiat (traditional) money. For governments, this means reassurance and risk at the same time (New Gen Apps, 2017).

●      Seamless conversion into real-world money anonymously makes it difficult to track transactions across currencies (Murphy, 2017). There loopholes and missing data reduces the government’s ability to track suspicious economic activity leading to several cases of secret money laundering using cryptocurrency (New Gen Apps, 2017).

●      Consolidation of cryptocurrencies in the long-run may lead to one provider achieving economies of scale, and consequently re-centralisation of payment systems and potential for system-wide fraud (HM Treasury, 2015).

S

Social

●      Cryptocurrencies impact not only how we transact, but also how we store money. It creates opportunities for services that traditionally operate using fiat money (e.g. parking meters, vending machines) to accept digital tokens instead, eliminating the need to carry and produce physical money.

●      New innovations in cryptocurrency transaction processing (e.g. Lighting Network, Lightening Charge) fasten processing times and enable close-to-zero transaction fees. This will pave way for ‘micro-payments’ which can be used for new business and social purposes that previously were not profitable (e.g. internet tipping, micro-donations, micro-payroll with salaries by hourly increments) (Sundararajan, 2018).

●      There’s a steep and overwhelming learning curve for those looking to use cryptocurrency that is limiting the adoption rate. From wallets, exchanges and crypto addresses, there are many things that needs to be explained to citizens to make it ready for widespread use (SteemIt, 2017).

●      Cryptocurrencies have a history of being the currency of choice for criminal activity, including for drug and arms deals, extortion, fraud and money laundering. Forbes have called Bitcoin the “Blood Diamonds’ of the digital era“(Bloomberg, 2017) and Bloomberg reports that criminals are switching from using Bitcoin to other currencies with fewer ways to identify and track activity (Kharif, 2018). This makes it difficult for law enforcement to penalise criminal activity and identify funds coming from illegal sources as criminals can simply switch to a new currency as soon as one is under watch.

T

Technological

●      Open-source nature of cryptocurrency code allows for continuous innovation and optimisation of flaws, and improved security.

●      Cryptocurrencies provide increased privacy for the user where the payer is not required to disclose personal information to the supplier, which places less pressure for data security on the supplier.

●      Currently, the time taken to process a cryptocurrency transaction varies between wallets and transactions as the transaction must be approved by the network before it can be processed. On average, Bitcoin transactions has 6 levels of confirmations with one confirmation taking anywhere from 30 minutes to 16 hours in extreme cases (Buchko, 2017). However, there is progress made in this area to shorten the time taken.
L

Legal

●      Secure cryptography algorithm of the currencies protects against hacking and reduces risk of forged payments (Murphy, 2017). It creates greater transparency of payments with a ‘public ledger’ in the form of the blockchain that cannot be manipulated by individuals, making certain cryptocurrencies less susceptible to fraud (HM Treasury, 2015). ●      The high security risk associated with cryptocurrencies is high, either related to money being lost or stolen, but predominantly because of the vulnerabilities in context to the initial opening of a cryptocurrency wallet. While high-security accounts have emerged, this led to many users got locked out and unable to access their funds (Nova, 2018).
E

Environmental

●      The use of digital currencies has the potential to eliminate traditional paper and metal money. There are also many digital currencies emerging that prove sustainability and aim to reduce the ecological impact by being eco-friendly (Constine, 2017). ●      Cryptocurrencies require a lot of power to process transactions. A single Bitcoin transaction uses 215 kilowatt-hours of electricity to process, equivalent to an entire week of electricity consumption of an average household (Kaminska, 2018). This means more energy is required to run and maintain the machines, and consequently more capital and infrastructure is required to support these facilities (Bogost, 2017).

GOVERNMENT REACTIONS

To address the opportunities and challenges of cryptocurrencies, governments around the world have taken various stances:

Diagram 1: Government stances on cryptocurrency worldwide (Thomson Reuters, 2017)

Government stances on cryptocurrency worldwide

While in some regions, there are outright bans on cryptocurrencies at various levels, such as in Ecuador, Brazil, Nepal and Bangladesh (Kelso, 2018), some have opted for a more liberal approach that classify cryptocurrency as a type of investment, such as in US and Canada. Other governments have started to create prototypes of their own digital currency, such as in China (Dai, 2017).

From here, we will look at approaches taken by governments of China, Japan and UK and have a look on the implications each has faced from its stances towards cryptocurrency.

HEAVILY REGULATED: CHINA

Government’s approach

However, while the government has placed many restrictions on the private sector exploring the technology, the nation’s central bank itself has been working to create its own prototype cryptocurrency – a digital adaptation of the renminbi – which may become the world’s first digital currency issued by a central bank (Bloomberg, 2017).

Implications

As a consequence of China’s restrictions on cross country money transfers, citizens see cryptos as a way to circumvent foreign exchange regulations. Moreover, many big mining firms, exchanges and wallet providers have moved their operations abroad to neighbouring nations with less regulations (Bloomberg, 2017). The private sector has also voiced concerns that heavy regulations will reduce the nation’s economic competitiveness (Lee, 2018).

Besides the interest in the Central Bank’s digital currency, many skeptics raise concerns that the currency is just a digitised version of the Yuan without any inherent properties of a cryptocurrency, such as privacy and traceability (Okonya, 2017). This may lead to the currency being seen as a poor substitute for incumbent currencies and will slow adoption.

STRONG ADVOCATES: JAPAN

Government’s approach

While many of its neighbors have put restrictions on cryptocurrency, Japan has opened its doors to attract the best players of Asia’s cryptocurrency sector (Nelson, 2018). Despite several major high-profile hacks into coin exchanges, Japan has not strayed from its vision to become the ‘Bitcoin capital of the world’ (Falvey, 2018).

The Japanese government has officially approved Bitcoin as the form of acceptable payment for goods and services. They have also introduced licenses for cryptocurrency exchanges, requiring licensed operators to undergo annual audits by the Financial Services Agency (FSA). With the government’s support, the private sector has embraced the technology: urban areas in Japan boast several Bitcoin ATMs where customers can exchange Bitcoins for fiat money, some Japanese companies have begun paying employees in Bitcoin (France-Presse, 2017) and, in popular culture, a new cryptocurrency-themed J-pop girl band has even emerged with each performer in the group representing a different currency type (Ong, 2018). Estimating tax revenues from cryptocurrency sector to be over US$9 billion, Japan aims to be the first country to widely use the new technology in the mass market (Falvey, 2018).

Implications

Through the open regulations, the Japanese government aims to reignite the local economy and drive innovation in the fintech sector, which it currently views as lagging compared to peer nations, via cryptocurrency (Terazono, 2017). However, the rapid growth has attracted several large-scale hacks of coin exchange markets, including Mt. Gox, who was handling 70% of all Bitcoin transactions worldwide in 2014, going bankrupt after having $450 million worth of Bitcoins stolen, and Coincheck being under heavy scrutiny after hackers stole $530 million worth of cryptocurrencies from its users in January 2018 (Shane, 2018). Despite these setbacks, the Japan’s love of cryptocurrency has not weaned. The FSA has increased its auditing efforts and has ordered several exchanges to improve their employee training, operations and security measures (Kageyama, 2018). Afraid that the government will start clamping down on the market, exchanges have formed a new self-regulatory organization in March 2018 that will be responsible for developing standards for activities in the crypto market (Zhao, 2018).

CONSERVATIVE: UNITED KINGDOM

Government’s approach

The UK has been relatively slow to embrace cryptocurrency with the government taking a conservative approach. Over time, there has been various research undertaken to evaluate potential directions for policy regarding digital currencies with much of the regulations focusing on a crackdown on anti-money laundering, tax evasion and reducing anonymity of transactions (BBC, 2017). By 2020, the UK government aims to introduce regulation that forces traders to disclose their identities and any suspicious activity (Musaddique, 2017). Cryptocurrency firms, such as exchange platforms and wallet providers, will also be required to perform additional due diligence on transactions that are high value and coming in or out of ‘shady countries’ (Meyer, 2018). Ironically, the UK Treasury has also admitted that “there is little current evidence of [cryptocurrencies] being used to launder money, though this risk is expected to grow” (Nelson, 2018).

Implications

UK Bitcoin enthusiasts see the government’s efforts to regulate anonymity as a form of intervention, citing the irony that government-issued fiat money is the ‘most anonymous currency of all’ (Kelso, 2017). Some see government’s lack of regulation in areas outside of identity issues as complacency, stifling progress. Businesses and banks also want to see support from government to legitimize cryptocurrency transactions prior to investing in widespread use (HM Treasury, 2015).

With Brexit impending and its effects creating volatility in the Sterling, many investors are looking to bypass the struggling economy via alternative investment opportunities, such as cryptocurrencies. Fuelled by distrust towards high street banks after a series of scandals exposing corruption and mismanagement, many users, particularly Millennials, are looking towards new technology, such as cryptocurrencies, for greater transparency and market disruption (Bitwala, 2017).

While the UK government undertakes yet more research on the impact of cryptocurrencies, the lack of action and slow progress may, in the long run, demote one of the world’s biggest financial hubs to a digital laggard (Emmanuel, 2018).

BEST PRACTICE

In order for cryptocurrency to be a catalyst for innovation and economic growth, it is inevitable that: governments must take an active role in shaping regulation in a positive way. Given that cryptocurrency is likely to stay, the best outcome for policymakers is to regulate the market in a way that gives credibility for genuine business use, while curbing illicit activity and promoting good governance.

Looking at learnings from governments around the world, there are several strategies that governments can implement to shape cryptocurrency policy in a positive way:

  1. Establish advisory panel for policy development
    The cryptocurrency market, and the blockchain technology behind it, is highly complex. It’s so complex that it’s said that there are only a few hundred engineers in the world who are qualified to develop internet protocols around the technology (Manthorpe & Hussein, 2018). Therefore, it’s unrealistic that government bodies alone will be able to understand the technological advances, risks and economic impact in the long term. It is critical that governments source a variety views on the implications of policy from many angles, including technology, micro and macroeconomics, mathematics, social behavior and business, to help guide the best way forward.
  2. Regulate coin exchanges
    Just as with traditional foreign exchanges, cryptocurrency exchanges should be regulated to ensure sufficient due diligence is done and good governance is in place to protect against hacking. This will enable governments to look out for illicit activity while also curbing tax evasion (Manthorpe & Hussein, 2018).
  3. Encourage banks to support cryptocurrency market
    Once coin exchanges are regulated, the banking sector will look to support the cryptocurrency market providing accounts for exchanges and further adding credibility and security to transactions (Manthorpe & Hussein, 2018). With the banking sector involved, the government will be able to gain a better view of where money is coming from and going to, helping to monitor money laundering activity while also facilitating innovation for the banking sector.
  4. Clarify tax regulations on cryptocurrency transactions
    Governments should clarify when and how much tax should be paid when interacting with cryptocurrency (e.g. transactions, ICOs, crypto-salaries, crypto-dividends, etc). Ambiguity in this area makes it a ‘free-for-all’ that diminishes credibility of the technology while also creating more problems in the long run for regulators (e.g. people not paying the right tax, cryptocurrencies being used as tax loopholes, etc). An active role in clarifying processes will help curb any inadvertent implications.
  5. Provide due diligence frameworks for ICOs
    While many people are investing in ICOs, it is still difficult to determine whether an ICO is legitimate (Manthorpe & Hussein, 2018). It is also difficult for governments to monitor every ICO that pops up. However, to increase transparency governments can define a clear framework for what is and what is not acceptable for ICOs and provide guidance on the due diligence that should be done prior to investing.
  6. Allow industry to self-regulate
    As with Japan, governments should allow the industry to self-regulate to ensure quality standards of crypto services such as exchange markets and ICOs. This is beneficial for a number of reasons: 1) it is in the industry’s self-interest to self-regulate as they are staking their reputation on the credibility of their services; 2) it reduces the burden on the government to be continuously monitoring organisations; 3) the industry themselves will likely have better foresight of impending risks and opportunities facing the sector (Manthorpe & Hussein, 2018).
  7. Educate citizens on benefits and risk of cryptocurrency
    Regardless of government policy, those looking to invest in cryptocurrency will do so. However, the government can take a proactive role in educating citizens on the process as well as the benefits and risks associated with cryptocurrency to shape people’s views and give fair warning.
  8. Perform background checks on investors
    The government (alone or in partnership with industry organisations) should put background checks in place to verify identities of investors and deter those with illicit intentions. However, for adoption of this to succeed, it must be done in a way that is not perceived as heavy government intervention or surveillance. While there may be checks for the purchase of money, similar to many fiat money exchanges, what citizens do with it afterward should be their own choice (Manthorpe & Hussein, 2018).

Incorporating these considerations into policy, governments can create regulations that will harness the benefits of cryptocurrencies in stimulating innovation and economic growth, while providing frameworks and verifications to reduce risk and illicit behavior.