Major cryptocurrencies like bitcoin and ether represent a class of financial instrument that is here to stay. But, for the time being these digital mediums of exchange also have a “black box” quality that worries institutional investors and appears to hold unfortunate appeal for criminals and fraudsters.
Unsurprisingly, the explosion of cryptocurrency as a means of raising capital for startup businesses and a spate of fraudulent ICOs has attracted the attention of regulators around the world.
Here, we unpack cryptocurrencies and the emerging issues they pose for finance-industry compliance officers.
The term “cryptocurrency” is shorthand for a wide and evolving range of “digital” mediums of exchange.
The two foundational concepts of a cryptocurrency are “decentralization” (there is no sovereign central bank creating it or controlling its supply) and “scarcity” (there is a predefined maximum number of “coins” that may exist for any given currency, thereby giving the coins their “value”).
Most cryptocurrencies rely on blockchain technology, a “distributed ledger” of ownership for every unique coin (to put it simply, blockchain is simply a clever way to have many different people create one version of something on the internet). A copy of the distributed ledger is available to all users of the currency at once and essentially prevents counterfeiting by tracking and confirming the existence, transfer, and ownership of each coin.
New cryptocurrencies are created through a process that has come to be known as an “initial coin offering” or ICO. In an ICO, the issuer creates a new unit of currency (often referred to as a “coin” or “token”) that can be purchased in exchange for an existing, more widely-traded currency like bitcoin or ether.
The purpose of an ICO is to raise capital for the issuer. The token issued in an ICO may have a variety of attributes, from serving as a new medium of exchange for certain goods and services to representing a bundle of rights (to vote, to receive a future benefit, etc.). It may also appreciate or depreciate, and thereby serve as an a means of speculative investment in its own right.
Global Compliance Challenges
Given the description above, any financial compliance officer will immediately wonder whether a cryptocurrency issued in a capital-raising ICO is a security subject to regulation. The answer is, it depends. The global regulatory community remains unsure of how to characterize cryptocurrencies. It does not help that no two digital currencies are identical in their attributes. Some regulators even dispute that cryptocurrencies are currencies or assets at all.
Compliance officers cannot afford to wait for the global regulatory community to reach consensus on how to characterize ICOs. They must familiarize themselves and stay on top of the regulatory climate.
And yet, ICOs offer a potentially attractive means of raising capital. They are becoming easier by the day to launch and, for the time being, involve substantially less upfront expense than the roughly-comparable process of raising capital through an IPO or a private placement. Compliance officers cannot afford to wait for the global regulatory community to reach consensus on how to characterize ICOs. They must familiarize themselves and stay on top of the regulatory climate in their relevant jurisdictions, such as the following:
— United States
In the U.S., the dominant regulatory stance as of early 2019 appears to be a suspicion about the potential for ICOs to be used as a means of money laundering or for funding criminal enterprises and terrorism. For now, the SEC (Securities and Exchange Commission) has contented itself to applying existing U.S. securities laws and anti-money laundering regulations to evaluate the legitimacy of ICO transactions. Regulators have also expressed, but have yet to resolve, concerns about the potential for front-running and manipulation in cryptocurrencies that do not trade on regulated exchanges.
— United Kingdom
Amidst continuing Brexit chaos, U.K. regulators have remained largely aligned with their E.U. counterparts (and the U.S.) in warning of the potential for bad actors to abuse cryptocurriences and ICOs. The FCA had previously signaled its plan to issue guidelines on cryptocurrencies by the end of 2018, but as of this writing has yet to do so. There is little doubt, however, that the U.K. plans to step up regulation in the future.
Down Under, the Australian Securities and Investments Commission (ASIC) has issued guidance alerting the public to the potential for cryptocurrencies to be subject to regulation as financial products under Australia’s existing financial regulatory schemes (although ASIC has stated its view that bitcoin is not a financial product). Regardless of whether a cryptocurrency represents a “financial product” under Australian law, issuers may not engage in misleading or deceptive conduct toward consumers.
According to Bitcoin Magazine, local regulators in Singapore historically took a relatively laissez-faire view of crytocurrency issuance and trading. As reported in the Singapore Business Review in January 2019, however, Singapore regulators have more recently moved to tighten regulation to protect investors from fraud and money-laundering risk.
China exercises strict regulatory oversight of cryptocurrencies. It has banned ICOs, and in August 2018, its central bank likened cryptocurrencies to a ponzi scheme, and in early January 2019 government cyberspace regulators issued sweeping regulations applicable to Chinese blockchain platforms requiring them to censor content, give authorities access to their data, and confirm the identity of users.
Having initially embraced cryptocurrencies, Japanese regulators have also exercised tighter control over the industry of late after a high-profile hack of crypto exchange Coincheck. As reported recently in The Japan Times, the Financial Services Agency (FSA) effectively stopped issuing licenses for exchanges in 2018, and only recently issued new licenses while signaling that new rules are coming that will protect cryptocurrency investors.
Vigilance is Paramount
As the examples above show, cryptocurrency regulation is in a state of increasing flux around the globe. Worries about fraud and money laundering bedevil the industry. Compliance officers confronting the prospect of their firm investing in, facilitating, or even raising capital through ICOs should take extreme care to apprise themselves of the latest regulatory guidance in their relevant jurisdiction(s).
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