Why cryptocurrencies would benefit from more regulation

Global regulation is tricky but potentially beneficial, as university researcher Desné Masie explains.

There are growing calls for regulation of the cryptocurrency market, which is rapidly approaching a market capitalisation of $1 trillion. But there's little agreement about the forms this should take.

If the case for government regulation is strong, the case for a clear, coordinated regulatory approach is even stronger. It 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 to balance investor protection and systemic stability with the need to protect innovation and encourage capital formation in different legal systems.

At present the regulatory environment is a muddle because there's rapid divergence in the regulation of cryptocurrencies across jurisdictions. Countries like Japan, while thorough, have a more open approach. China is more strict.

Sovereign governments need to develop coherent frameworks for cryptocurrency oversight. But solutions will only be found through international cooperation in this cross-border market.

Growing concerns

Cryptocurrencies originated as an alternative payment mechanism to traditional currencies. But they are now also traded on spot exchanges as highly speculative investment assets.

Recent spin-off crowd funding opportunities such as initial coin offerings have become a particular cause of concern. These involve startup cryptocurrency companies offering initial investment stakes in new token issues. China and Vietnam have banned them. Japan has taken a friendlier attitude while the UK and the US have adopted a wait and see approach. South Africa, like many other developing countries, offers zero protection to investors in initial coin offerings.

These different responses are due to different legal definitions of cryptocurrencies. The rapidly evolving technology behind them doesn't help the situation either.

The precise nature of an initial coin offerings depends on its structure as well as its context which can change quickly and have hybrid characteristics of financial instruments.

The definition, and hence legal treatment, of the tokens issued under an initial coin offering can be as diverse as a currency, commodity, security, property, loan, deposit, derivative or forex contract. Agreeing a taxonomy of cryptocurrencies defined by how they're used is clearly one of the most urgent tasks facing regulators.

Towards a taxonomy of cryptocurrencies

Cryptocurrency expert Lawrence Wintermeyer has argued that distributed ledger technology powered digital assets could be organised into three potential buckets: cryptocurrencies, cryptocommodities, and crypto tokens.

But the lack of harmonisation across jurisdictions is a wider problem than nomenclature.
Cryptocurrency companies sometimes use the distributed nature of these assets – which sit on digital ledgers held by multiple token holders – to argue that there is no issuer. They also sometimes argue that these assets are not securities, and that they should therefore not be subjected to a particular jurisdiction's securities laws.

There are also clear cross border regulatory gaps. What makes it difficult to reconcile these is that the assets can easily be transferred and their origins are difficult to trace. Tokens could be issued in a more token-friendly jurisdiction like Japan. The same tokens could land up in the hands of unassuming retail investors in stricter jurisdictions such as the US.

Avoiding money laundering and financial crime

This cross border confusion allows token companies to pick and choose jurisdictions with favourable rules. This could make money laundering easier.

There are a few steps governments can take to close these gaps.

They should support investment in technology that makes the provenance of tokens clearer while preserving their encryption. Regulators could then enforce an "indicator of origin" as a standard. This would make it less easy for the assets to be transferred illegally.

Offshore centres like Jersey have got a lot of bad press in recent the backlash against international financial centres. But there's a great deal to learn from well-regulated offshore jurisdictions. They are beginning to take the lead with potential applications of international best practice and corporate governance for cryptocurrencies. They offer investors in digital assets an extra set of gatekeepers' eyes, and potentially, a more calculated risk.

In jurisdictions like Jersey issuers of initial coin offerings have to jump through quite a few hoops. This includes using a regulated service provider which has to make an application to the Jersey companies registry for a consent. The service provider is among a number of requirements that provide checks in relation to anti-money laundering and countering the financing of terrorism.

Current frameworks and global co-ordination

But what could a coordinated global regulatory approach to cryptocurrencies look like?

Harmonisation 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.

A multilateral code of conduct or global convention or compact, such as those administered by the inter-governmental Financial Action Task Force on Money Laundering, or a United Nations co-ordinated approach could be model solutions.

Standard regulatory codes are particularly critical for some pockets of the investment community. For example, there has been a significant surge in the establishment of investment funds looking to invest in initial coin offerings on behalf of sophisticated investors.

Standard codes for institutional investors in the first instance, could help both regulation as well as innovation. Institutional investors, unlike retail investors, can withstand, and even benefit from, the upside of volatility over time.

For now, the poorly regulated speculative hoarding of cryptocurrencies reduces the potential of assets like this to become a public good. This ultimately affects the potential value of the tokens by amplifying volatility.

Paying attention to this is important for investors and regulators as well as issuers. There will also have to be a degree of self regulation by issuers as global regulators get up to speed.

Desné Masie is Visiting Researcher in International Political Economy at University of the Witwatersrand. This article was originally published on The Conversation. Read the original article.

Picture: Shutterstock