In general, the broad aim of regulation is to organise the relationship between persons and to protect their rights and interests in society. However as we have discovered, this has not been the case within the cryptocurrency space.
It has been almost 15 years since Satoshi Nakamoto published the Bitcoin whitepaper. Since then, this seminal document posted on a mailing list, catalysed the emergence of an entirely new-transnational field. Considering the substantial time that has passed and the widespread popularity of cryptocurrencies, one would expect regulators to have at least figured out ‘how’ and ‘what’ to regulate, right? But it appears not so. Regulators do not seem to want to provide long-term, serious solutions, but rather a collection of outdated bandages of reactions that mostly portray the illusion of a solution, with not-so-hidden intentions in mind.
The cryptocurrency ecosystem itself has often been compared to the Wild West. Nevertheless, this also applies to its journey to be regulated. A journey full of ill-suited regulatory approaches that resulted in a plethora of dilemmas. We explore this tension between the technology and regulation in our latest paper “Shaping Cryptocurrency Gatekeepers with a Regulatory ‘Trial and Error’”, with a primary focus on the Financial Action Task Force’s recommendations, and the EU’s 5th Anti-Money Laundering Directive.
Historically speaking, it was only after the rising popularity of the Silk Road and the collapse of the most popular (at the time) exchange Mt. Gox, that regulators realised that they needed to take action. The advertised main objective here is the curbing of criminal activity and providing regulatory protection to consumers/users. However, until only recently, most of the regulatory steps taken by most regulators choosing to act, were approaches mainly targeting money laundering and terrorist financing, with other limited initiatives here and there. Whilst this approach might have had some potential benefits, it was not 1. comprehensive, 2. global, 3. stable/constant, or 4. tailored to address the specific risks and characteristics of cryptocurrencies. In other words, different regulators have been testing diverse approaches, simultaneously, without engaging with one another, and without properly acknowledging the true needs and risks of the ecosystem.
What can inappropriate regulations incite?
In our paper, we argue that the aforementioned has been causing more harm than good in many ways. Below, we go over some of these issues:
- As a start, the actions taken were not decisions made on a global scale, but mostly individual decisions made within some jurisdictions. We are a long way away from establishing a global consensus on regulation. This allows criminals or cryptocurrency service providers (such as exchanges and custodians) who do not want to comply to easily circumvent compliance by going on a shopping trip to find other “welcoming” jurisdictions.
- Many regulators chose to take action via anti-money laundering and counter-terrorist financing (AML/CFT) policies. Here, they applied exactly the same regulations implemented on the existing financial system to cryptocurrency service providers. What is the issue here? Well, these regulations are the results of years of testing and specific tailoring for the classical notion of financial services. Yet, cryptocurrencies depict an insurgent field that mandates its own tailoring. This is true even in the case of adopting pre-existing regulatory regimes compared to the creation of whole new independent frameworks. The nonconformity of this approach which lacks tailoring is reflected by the low compliance levels in practice. Furthermore, AML/CFT policies, which are meant to be robust and strict, are often questioned in terms of effectiveness. The question here is, if these policies are not optimally potent in the classical financial system (that they are designed for), how can we expect them to be effective with cryptocurrencies?
- When some jurisdictions choose to adopt regulations and others do not (or have not yet), we are faced with “The Sunrise Issue”. Here, service providers encounter a challenge relating to compliance and their perspective relationship with other counterparties, particularly those located in jurisdictions that do not implement similar cryptocurrency regulations. In other words, the Sunrise Issue prompts the question about the nature of the relationship between compliant and non-compliant service providers. This is particularly true when it comes to rules such as the Travel Rule (the Travel Rule per the Financial Action Task Force’s recommendation 16 requires service providers ‘VASPs’ to obtain, hold, and transmit both originator and beneficiary information when conducting transactions). Should compliant service providers share user and transaction information with those who are not? Should compliant service providers even deal with those who are not?
- Terms and definitions are often underrated when discussing impact and importance. But what if we tell you otherwise? In the legal world, terms and definitions play a pivotal role in determining the scope of the law, and hence, ascertaining what is subjected to the law. For instance, a country might decide to choose a unique term (e.g. cryptoassets, virtual assets, virtual currency, digital currency, etc.) or a different characterisation (is it a security? a commodity? a property? or an entirely new type of property referred to as ‘data objects’ per the Law Commission’s recommendation?). Here, the lack of certainty and consensus on terms and definitions often constitutes the first hurdle in creating a globally harmonised framework. If different jurisdictions define and characterise cryptocurrencies in unaligned ways, then creating a harmonised global regulatory space will be quite an arduous journey.
- To this end, most of these mentioned regulatory actions are constantly amended and changed. This confuses businesses and consumers, and exerts additional pressure on those who want to actually comply with the law.
- Finally, and following on the previous point, compliance in general may be burdening and financially costly. This puts small/medium businesses and startups at a disadvantage, and may push them to either not be fully compliant, relocate, or close down.
Will the regulatory ‘trial and error’ phase end any time soon?
On a global scale, it is unlikely, as there are no serious talks on an international level to bring harmonisation and create standardised frameworks. However, on a regional level, the EU’s Markets in CryptoAssets regulation (MiCA), which is regarded as the first comprehensive piece of legislation, has just been adopted by the Council of Europe. This framework, which raises high hopes, aims to bring standardisation to many activities within the field and harmonisation across the EU. However, given the rapid pace of advancements in this space, we, like many others, believe that by the time its provisions come into full effect, they will already be outdated. For instance, some of its provisions relating to stablecoins and cryptocurrency exchanges will enter into force months after its initial publication (the expected date for publication in the Official Gazette is June 2023). MiCA might seem to theoretically attempt to address many issues within the sector, but in the end, the true power lies in enforcement.
On a second note, MiCA only covers the ecosystem within the EU border, which leaves other jurisdictions out. Other major players such as the United States and the United Kingdom are in a different zone in terms of approaches and directions. For instance, the UK intends to integrate certain activities into existing regimes rather than establishing entirely independent frameworks like MiCA. These variations in approaches can create hurdles in practice. We recently responded to the HM Treasury’s Future Financial Services Regulatory Regime for Cryptoassets Consultation Call.
Some blame regulators for lacking technical understanding and being slow; others pin the responsibility on the technology. Nonetheless, it is not a matter of only ‘who’ anymore, but rather ‘what’ can be done to mitigate and halt the adverse effects on consumers, who remain at the forefront of those impacted. To this end, and to avert getting into a ‘regulatory trial and error’ phase with any piece of technology, it is about time that policymakers consider alternative innovative methods and approaches to policymaking, because playing catch-up has become obsolete.
Special thanks are extended to the co-authors of the paper, Dr. Ingolf Becker and Dr. Marie Vasek. Photo by Alesia Kozik from Pexels.