Regulating cryptocurrencies

Cryptocurrencies like bitcoin, blockchain technology and initial coin offerings (ICOs) have been the buzzwords in the tech sphere for the past couple of years.

With a rapid speculative bubble developing around bitcoin, the topics have not only transcended the limited space of the technophile but also created a mainstream investment buzz.

Yet public knowledge about blockchain, the technology on which cryptocurrencies are based, and its potential uses and risks is still limited.

Opinions are divided as to how successful blockchain technology and cryptocurrencies will be in the long run and if practical, real-world applications will live up to the hype.

Jude Scott, the chief executive officer of Cayman Finance, differentiates between cryptocurrency and the underlying blockchain, also known as distributed ledger technology.

“The technology itself is absolutely amazing, it is revolutionizing and will fully revolutionize the financial services industry,” he told the Caymanian Bar association in April at a CBA seminar on the new technology.

Scott believes cryptocurrencies will ultimately become a separate derivative asset class that hedge funds and other investors will invest in. However, he does not think cryptocurrencies will ever fully replace regular, government-issued fiat currencies.

The head of Cayman’s financial services association said some larger banks are currently using cryptocurrencies internally for cross-border transfer as a temporary “stop gap.” In the future this will be replaced by peer-to-peer transactions to take full advantage of low costs, no intermediaries and the borderless nature of the technology.

The next big use will be in closed groups, Scott predicts.

“This could be islandwide in Cayman, with something like a Caycoin that can be used to pay for services locally,” he says.

The hypothetical Caycoin would pay electronically for services in different industries like any other currency, he said. Alternatively, its use could be confined to specific industries like healthcare, where tokens or coins could be exchanged for value in a specific sector of the economy.

Regulation

The current limitations of cryptocurrencies and blockchain technology are based on their anonymous and unregulated nature, which makes it difficult to enforce regular compliance, like anti-money laundering and know-your-customer measures. It also creates uncertainty for investors who do not know if and when regulators are going to clamp down on the new technologies.

Scott said regulation attempts have come in waves. In a first wave, countries tried to apply existing legislation to the new technologies. In the current second wave, countries are actively adopting the technologies and attempting to adjust legislation and regulations.

Bermuda, for instance, is proposing standalone legislation that will introduce a statutory framework for the offering of digital assets, including legislation for virtual currency businesses, a digital identification platform and a virtual currency exchange.

Scott believes new legislation alone will not be enough.

“I think we have to get to Wave 3, where we accept that aspects of the technology do need to change,” Scott said. “Our regulation cannot work in this current environment because it is based on regulating transactions through intermediaries.”

Changes could include having a single point of entry requiring certified identification to use cryptocurrencies. This would solve a number of problems from a regulatory and enforcement standpoint and create an attachment point, which also solves the issue of taxation, the Cayman Finance chief executive said.

There is so far no international consensus on the prudent regulation of cryptocurrencies. They have been treated as a commodity, a currency, a security and even as legal tender. Meanwhile, central banks are trying to create a central bank digital asset.

Cayman’s government has not yet made a definitive statement as to how it will designate cryptocurrencies under the law. However, the Cayman Islands Monetary Authority has created a working group with members from government and the private sector that has made certain recommendations for government’s consideration, said Rayford Britton, CIMA’s deputy head of policy.

What is clear, said Britton, is that anti-money laundering standards apply.

“Financial services providers that touch virtual currencies should make an assessment of the product and the activity against the Proceeds of Crime Law and the Money Laundering Regulations,” he said.

Initial coin offerings

In April, the Cayman Islands Monetary Authority cautioned investors over the potential risks of investments in initial coin offerings, and all forms of virtual currency.

ICOs are a type of fundraising in which a startup company creates new virtual coins or tokens and sells them to the public to raise capital.

Cayman’s financial regulator said while initial coin offerings promise high returns, they also have a high potential for financial loss and fraud.

In contrast to a share offering, ICO’s do not provide equity or ownership rights in a company.

Harneys partner Matt Taber likened the sale of coins or tokens in an ICO to elements of a traditional Kickstarter campaign, in which investors help fund the development of consumer product and in return will be the first recipients of the product together with other perks.

In an ICO fundraising, tokens are sold on a blockchain, most commonly Ethereum. In many cases, the tokens represent future access to a company’s product or service and are not designed as investments.

As a result, these utility tokens could be exempt from securities regulations. However, the price explosion and increasing tradability of bitcoin and Ethereum has attracted many new investors and bad actors.

In its advisory, CIMA warned that certain ICOs may be in breach of regulations which could cause investors to lose all their money. There is also the risk of incomplete information, exaggerated expected returns, price volatility, limited opportunities to resell the virtual currency, hacking attacks, fraud and limited regulatory protection.

In some documented cases, the regulator said, money raised through an ICO disappeared without a trace.

Echoing CIMA’s concerns, Samuel Banks, a partner at Appleby, noted that what started out as a method of raising capital for start-ups without giving up control has now increasingly given rise to fraud.

Speaking at the Caymanian Bar Association seminar, he said the days of the utility token, which gives access to a network or certain functions that “may or may not ever eventualize” are almost gone.

Instead, he believes, we will see a rise in the sale of securities tokens, tradable assets that represent a share in a company.

The security token model would raise capital from accredited investors by making a pitch directly to the market and bypassing venture capital. It promises immediate capital for the fundraisers and immediate liquidity for investors who would be able to sell on their security tokens to other accredited investors.

However, for that to happen, there has to be an element of identity verification, Banks said. “KYC is a necessary impediment.”

As a foundation of regulation, he suggested a local infrastructure, for example at the company registry, that would allow for the issuance of physical and digital identification.

NO COMMENTS