Coinfirm, a regtech firm in digital currencies, recently published the results of a survey that showed only 14 percent of 216 global cryptocurrency exchanges are licensed by regulators. The low coverage may not surprise anyone when considering the frequency of thefts, frauds and market manipulations that crypto exchanges in many jurisdictions disclose publicly.
The statistic partly reflects the fact that regulators and supervisory bodies around the world are still getting to grips with how to regulate crypto currencies (assets) and associated financial intermediaries. They face a number of challenges in their task:
1. Leveraging financial innovation while mitigating risks. Regulators and businesses must work to understand the other side’s position as they cooperate to create regulatory standards. Imposition of stringent risk mitigation rules on crypto exchanges and trading platforms may force them to relocate to a more lightly regulated jurisdiction. Inconsistencies arise when governments around the world are taking different approaches to cryptocurrencies, applying different definitions and focusing on different policy objectives.
2. Status of cryptocurrencies unclear. Distinctions between different types of crypto assets and their legal status remain vague and unsettled. Today’s securities laws came into existence long before the invention of digital currencies. The Securities and Exchange Commission applies the Howey test to determine whether an investment token constitutes a security, which comes from a 1946 case linked to oranges. Certain SEC officials however concede that two types of cryptocurrencies, Bitocin and Ether, are not securities.
3. Fragmentation of U.S. regulatory system. In addition to having multiple regulators at the federal level, the U.S. financial system allocates responsibility for regulation between the states and federal agencies. The impact on cryptocurrency regulation was considered in March 2019 Economic Study from the Brooking Institution titled “It’s Time to Strengthen the Regulation of Crypto-Assets”. The author Timothy Massad, a former chairman of the CFTC, points to gaps in the regulation of crypto-assets that Congress needs to fix.
Massad writes in his introduction:“All crypto-asset trading websites should post the same warning, because the gap — in regulation — is wide and dangerous. As a result, fraud is significant, and investor protection is weak. The gap is a product of our functional — some would say fragmented — regulatory system. While a few agencies have some jurisdiction, no one has sufficient authority, and the gap happens to be where trading activity is greatest”
4. Financial technology innovation. Early stage innovations in financial technology such as crypto assets tend to be less mature and robust, which can allow users to circumvent or evade internal controls. Further, crypto exchanges can take on multiple functions – they serve as marketplaces, brokers, custodians and even proprietary holders of assets. That can lead to heightened risks of conflict of interest which are hard to police. Third party tools to ensure trade or account surveillance are less available compared to stock and commodity exchanges.
Such regulatory gaps are contributing to continued threats to market integrity and investor protection in cryptocurrency markets. A Bloomberg Businessweek article on July 25, 2019 discussed the problem of manipulation of trades on crypto exchanges. The writer commented “Major exchanges that trade traditional assets, such as stocks, are heavily regulated. Crypto exchanges mostly are not, and investors have no way of knowing whether the trading volume and prices they report reflect real activity or market manipulation.” Regulators are said to be scrambling to get on top of the problem.
In May 2019, I attended a “Business in Blockchain” conference hosted by the MIT Technology Review in collaboration with the MIT Media Lab. A panel session featured Catlin Long from the Wyoming Blockchain Coalition, Gary Gensler, former CFTC chairman, now teaching at MIT Sloan School of Management, and Peter Van Valkenburgh, Director of Research, Coin Center. The session focused on how the legal and regulatory environment is adapting to the arrival of cryptocurrencies.
There was discussion about states across the country looking to take the lead on digital asset regulation as a way to invite businesses to move into their area. Caitlin Long referred to Wyoming passing 13 blockchain-friendly laws, and developing a regulatory framework that establishes direct property rights, ensuring that those who own cryptocurrency are protected. Their emphasis is on protecting consumers from insolvency of the exchange or custodian.
As a contrast, the activities of the SEC and CFTC around crypto-assets have been directed to use of their enforcement powers to prosecute fraud, or the avoidance of applicable regulation, while issuing warnings to the public about potential frauds. Gary Gensler indicated that the emphasis of regulators should be on investor protection through setting guardrails that prevent market manipulation such as from front running and double dipping. This is achieved in his view by extending national level regulation to trading platforms that offer security tokens or similar investment instruments, as well as those that list commodities such as Bitcoin.
We mentioned earlier the efforts of inter-governmental agencies on harmonization of regulatory standards for crypto assets and financial intermediaries. A leading initiative has been undertaken by the International Monetary Fund (IMF) as part of a broader review of overall fintech trends and international developments. Jointly with the World Bank, the IMF has been examining the risks and benefits of financial technologies, or FinTech, from a policy perspective.
To further the debate, the two organizations published in October 2018 a set of high-level principles for regulation that aim to reap the benefits of new financial technology without increasing risks to the financial system. This paper, known as the Bali Fintech Agenda, highlights the need for international coordination to avoid regulatory arbitrage and a “race to the bottom”. The same message should be heard by U.S. policy makers as they seek to close the gaps between the states and federal supervisors on the oversight of crypto assets & exchanges.
The IMF followed up with a policy paper in June 2019 identifying key fintech-related issues that merit further attention.
In regard to the regulatory approach to crypto assets, the paper noted that the classification of crypto assets according to their characteristics (securities, payments, utilities) varies between jurisdictions. They also noted that some jurisdictions have taken measures to regulate and supervise crypto-asset service providers (such as exchanges) while others are in the process of consulting with stakeholders or weighing their policy options (for example the U.S.)
Officials at the IMF in public remarks have gone further and stated that it would be misguided to imagine that crypto-assets are currently beyond the reach of regulation. (Tobias Adrian, IMF Financial Counsellor and Director of the Monetary and Capital at IMF Fintech Roundtable, April 2018). He says that international principles for financial regulation— such as those of governance, auditing, client asset segregation, minimum capital, outsourcing, cyber-security, and disclosure— already address identified risks and thus should be applied today to publicly offered crypto-assets and exchanges. Moreover, “Applying such principles will help authorities address the new risks more quickly and more consistently” Tobias Adrian concluded.