Cryptocurrency: At A Regulatory Crossroads

After months of skyrocketing values, the past month saw a precipitous drop in cryptocurrency prices, with the value nearly halving from its all-time high in April. Multiple factors are suggested to explain bitcoin’s latest plunge, including actions and comments from Elon Musk and a sell-off from “whale traders” to cash in on crypto’s bull run. Also figuring prominently into the discussion, however, are the latest actions from China to crack down on cryptocurrencies, including prohibiting banks and online payment firms from offering cryptocurrency-related services.

China’s antagonistic stance towards cryptocurrencies represents only one regime regarding decentralized cryptocurrencies. Countries across the world are struggling with the question of how to regulate a financial instrument whose very design intend for it to operate beyond the parameters of central banks. Yet as cryptocurrencies slowly creep into mainstream channels, the nascent financial instrument is nearing a crossroads: stay true to its libertarian principles operating outside regulated financial channels — or accept robust regulatory oversight if it’s to ever be treated as a means of financial settlement in everyday commerce.

The latest Chinese restrictions and ensuing market sell-off may seem to validate crypto purists’ fears of regulatory regimes, but recent literature suggests a much more complicated picture. If cryptocurrency is to move beyond its current central use case as a speculative instrument to be employed as actual payment instruments, there must be regulatory clarity offering protections and transparency akin to mainstream channels.

A Fragmented Regulatory Landscape

Broadly speaking, regulators are taking three general approaches to cryptocurrencies. One model, exemplified by countries like Switzerland, Singapore and Malta, embraces cryptocurrencies as financial instruments to be enabled and deployed, offering bespoke regulatory regimes tailored to cryptocurrencies’ unique attributes. In the case of Switzerland, cryptocurrencies have been given a special asset class designation as “utility tokens” that allows it to be used as a form of payment and be exempt from some securities regulations. Such regimes seek to cultivate crypto’s growth and become a hub for future activities.

At the opposite side of the spectrum are countries like China, Bangladesh and Bolivia that seek to severely limit or outright ban crypto activities, both as a payment instrument as well as an asset to be traded, bought, sold, and/ or mined, for reasons including cracking down on money laundering and terrorism financing, fears of market instability, and central bank desires to control money supplies.

Source: Borri and Shakhnov

In between these diametric approaches are countries who remain more cautious to fully embrace cryptocurrencies before dealing with their potential issues in transparency, taxation, as well as how to define it exactly under law. Among the countries falling in this category are the EU, Hong Kong, and the U.S. So far, such countries have prioritized implementing anti-money laundering (AML) and countering of financing of terrorism (CTF) regulations. Among the issues to be sorted out is whether to treat cryptocurrencies as securities, a currency, or a separate asset class, as well as providing consumer and investment-protection measures for the still-volatile asset.

To Evade or Embrace Regulations

Certainly, determinations that cryptocurrencies are not currencies would make it far more difficult for cryptocurrency to mature beyond an investment asset. Yet for those who believe that restrictive regulations may prevent crypto’s ascension, the emerging academic literature on such topics says otherwise. Several pieces of literature so far have suggested the impact of regulations on global and even domestic crypto markets is limited. A recent paper from Wharton’s Brian Feinstein and Kevin Werbach statistically measured the impact of cryptocurrency regulations on trading markets. Similar to other papers, the researchers searched the Reuters database for all stories involving government action concerning cryptocurrencies from 2010 through mid-2019, running statistical regressions to determine the effects of regulations on crypto market prices and trading volumes. Surprisingly, the researchers were unable to reject the null hypothesis: regulatory announcements have no impact on cryptocurrency exchange trading volumes. When it came to prices, which were a secondary area of study, while restrictive AML measures slightly depress prices, bans and determinations that crypto assets are not currencies are associated with negative price movement, albeit to a small degree.

When looking at specific regulations, it is possible to see dramatic impacts on markets, but the effect is more typically spillover to other countries than lasting impact on global crypto markets. A 2019 paper by Nicola Borri and Kirill Shakhnov studied the impacts of China’s previous 2017 de fact ban on the use of crypto. China’s antagonistic stance towards crypto stands out as the one prohibitive regime among crypto’s leading markets in trading and mining; up to 70 percent of bitcoin mining in the world is estimated to originate in China. Yet while China’s 2017 regulations led to a so-called “China shock,” in which Chinese exchanges quickly lost the vast majority of their trading volumes, much of this activity spilled over into other jurisdictions nearby, including Japan and South Korea, with increased activity in Chinese P2P exchanges, which are even harder to crack down. While crypto mining has been forced to go more underground in China, such activities continue, and VPNs and other spoofing techniques allow Chinese crypto players to evade the watchful eyes of regulators tasked with identifying crypto activities among billions of financial transactions.

Source: Borri and Shakhnov

It is difficult to disentangle the relatively minimal overall impacts that regulations have on crypto trading, as there are likely opposing forces compelling shifts one way or another. Although some investors view crypto regulations in a negative light, others may view regulatory regimes as offering greater transparency and legitimacy to operate within such markets. This view has taken greater weight among mainstream investors and companies seeking to operate in legitimized markets, according to lawyer Ariel Yosefi, partner at Herzog, Fox & Neeman who heads the firm’s technology and ecommerce regulation group.

“While in the past clients in this industry were looking for how to operate in a way that they would not be caught by regulation, now, the market is much more mature. They’re not looking for the [regulatory regimes] that you just need to incorporate a company. They are looking for places where the regulations offer a little more prestige and are reputable, so that they would be able to approach wider markets and present that they operate under a reputed regulator.”
Ariel Yosefi, partner, Herzog, Fox & Neeman

The largely cross-jurisdictional nature of crypto investments and transactions, spanning wildly differing regulatory regimes, creates a messy picture for companies seeking to operate within crypto spaces. Payment providers can operate cross-jurisdictionally to some degree and accept cryptocurrencies — but the jumbled regulatory landscape presently makes it hard and costly to operate.

“Operators will look for ways to operate cross-jurisdictionally. They will look to be established in a particular section that will make it easier to operate for them, and from that jurisdiction, they will be able to operate in any jurisdiction they can… [Disparate regulatory regimes] will prevent the smaller players to enter. But the bigger players, the bigger payment processors, they can just throw enough money at lawyers who can explain to them how to operate in each jurisdiction.”
Ariel Yosefi, partner, Herzog, Fox & Neeman

This trend is already exhibited by the payment providers who have begun to dip their toes into the crypto space. PayPal and Venmo facilitate the buying, selling and trading of cryptocurrencies, with recently announced plans to allow users to move their digital coins to third-party wallets in the near future. PayPal has also facilitated the ability for users to pay merchants cross-border in cryptocurrencies, which are converted into local currency during transactions. Although such mechanisms disappoint crypto purists, these intermediary stages are seen as necessary to protect merchants from the volatile nature of cryptocurrencies. Mastercard announced plans to accept payments in cryptocurrency on its network, with Mastercard’s executive vice president for blockchain declaring, “we are preparing right now for the future of crypto and payments.” Visa has also entered the space by beginning to allow transaction settlements using USD-pegged USD Coin.

A Crossborder Quandary

The disparate regulatory regimes towards cryptocurrencies and lack of clarity in many markets will continue to keep innovation and maturation of crypto-driven payment channels limited to such players for the time being. The differing nature of regulatory regimes — combined with the slippery nature of crypto markets — will at the same time make it difficult for prohibitive regimes to fully restrict domestic markets. As Borri’s research exemplified, stand-alone regimes are unable to effectively impose restrictions towards investment and trading without consensus from partnering countries.

“We will not see countries going alone. You see looking at the China shock in 2017 that when a country goes alone, it’s easy for investors to move operations or bypass the regulation moving into different countries. Take mining – it’s not so hard. If I know I cannot mine in China anymore, maybe it will delay things a bit, but I will open my mining factory then in Vietnam or wherever.”
Nicola Borri, Assistant Professor of Economics, LUISS Guido Carli University

Even within China, the latest restrictions in China have reportedly been met with a collective shrug by retail traders, miners and crypto finance firms accustomed already to rounds of Chinese crackdowns. Following the announcement, cryptocurrencies could still be bought from China and traded overseas. According to the NBC News report, those in China’s vast crypto mining industry were also undaunted, with industry players saying it is not difficult to convert mined coins to Chinese RMB. Although such efforts will make it nearly impossible for payment providers and ecommerce channels within China to integrate crypto in the future, speculative and trading activities will likely continue largely unabated, only offshore. The recent sell-off has in fact seen the highest daily spot volume in the crypto space ever recorded.

This raises the question again of how much regulatory fears have factored into crypto’s recent slide when considering other possible factors, like Elon Musk’s recent comments and actions in the space and the preceding bull market. From Borri’s perspective, such regulations — regardless of their actual impact — have spooked investors.

“I think it’s quite clear that the tensions we have seen in the crypto markets lately are very much due to the fear of stricter regulation. Starting with China, but also South Korea, which is another big market that’s discussing strict regulations. And I think in general in the crypto world, there is this fear that countries might decide to impose stricter regulations.”
Nicola Borri, Assistant Professor of Economics, LUISS Guido Carli University

But with the literature pouring cold water on regulations’ potentially chilling effects, not all economists are in agreement as to the nature of the recent dip, with it being too early to say decisively one way or another. Wharton’s Kevin Werbach expressed skepticism towards the degree of Chinese regulations’ impact, pointing out that China’s recent announcements were more a reiteration of its stance than any kind of significant shift, and that other confounding variables may come into play, including the significant evidence for non-organic activity in cryptocurrency trading markets.

All Roads Lead to Regulations

Regardless of the debate over crypto prohibition’s impact, both economists and lawyers in such spaces are in agreement that the next step in crypto’s evolution will require greater regulatory clarity. Although AML regulations have dominated many of the early moves by hesitant countries, Yosefi estimates that in the next two to three years, crypto regulations covering a wider array of issues in terms of payment processing and banking will see resolution among more jurisdictions, as countries begin to implement regulations and standards specific to crypto’s unique nature.

In crypto’s early years largely free of such oversight beyond the obvious AML and CTF issues, issues of fraud and security must be resolved before the conditions for mainstream acceptance are met. Among other examples, the stablecoin Tether, which purports to be pegged 1:1 to the US dollar to maintain stability, managed until recently to avoid financial disclosures proving that its reserves are fully backed by USD as advertised. Following the New York District Attorney’s decision to suspend the company and fine it US$18.5 million for “illegal activities,” Tether agreed to release quarterly information on the assets backing the stablecoin. Only then was it revealed that merely 2.9 percent of Tether is backed by USD — a far cry from the 1:1 peg it claims as proof of its stability.

Such instances of fraud and deception are not products of these assets’ characteristics themselves, but a symptom of the unresolved regulatory landscape that companies and exchanges are operating within. While regulatory regimes refusing to classify cryptocurrencies as currency may make crypto ‘s path to the mainstream more arduous — and so far, only a few jurisdictions have classified crypto as such — incisive regulations overall will enable the transparency and protections needed for crypto to truly break into the mainstream. Already, the ability to easily buy or sell bitcoin through channels such as PayPal signals a significant step in attracting potential crypto actors who otherwise would be unwilling or unable to operate through niche crypto spaces. Though a betrayal of cryptocurrencies’ founding principles, expanding regulations of crypto will facilitate the conditions for crypto to integrate with traditional financial institutions and commercial channels.

“Cryptocurrencies were born from people that have in mind a world with little regulations. But at the same time, what we know from a lot of research, history, is that markets that are not well-regulated don’t work well… I expect the regulations of these crypto exchanges will be much more similar to the regulation that we currently see for intermediaries, especially for information disclosure and capital requirements. It will make it a little more expensive, but it will make it also much safer for investors, and ultimately it will lead to this asset class becoming much more mainstream.”
Nicola Borri, Assistant Professor of Economics, LUISS Guido Carli University

As with everything crypto, nothing is certain. China, the U.S., the EU and elsewhere are on the precipice of releasing their central banks’ own digital currencies, which may serve as competitors to cryptocurrencies that regulators seek to favor over decentralized cryptocurrencies beyond their control. Lobbying from traditional banks and financial institutions, fearful of crypto’s instability and potential to render many of their services obsolete, may also dictate regulatory regimes towards hostile ends. But if the tea leaves read by lawyers and economists are correct, forthcoming regulatory regimes — and the legitimacy they bestow upon crypto assets and markets — will not signal the end of crypto’s ascension. While prohibitive regimes struggle to truly rein in crypto activities, forthcoming regulations that seek to implement protections and supervision akin to other financial instruments may signal an end to crypto’s anarcho-utopian vision. But it will be a necessary step in the next stage of crypto’s evolution: mainstream disruption.