It may be no coincidence that the seeds of cryptocurrencies first germinated during the global financial crisis in 2009 in the form of issue of the first Bitcoin. The seeds may lie in the inventions, such as the RSA Algorithm, which provided the first public cryptography. Hash cash, e-cash, b-money and Paypal were various attempts to enable cash to be transferred via the internet with crypto-graphical and other forms of security. Future historical analysis will undoubtedly cite the financial crisis of 2008 as the first time that the reign of fiat currency, which ruled since the collapse of the Bretton Woods agreement in 1971, was seriously challenged. Fiat currencies are allegedly corrupted by heavy handed intervention by central governments and banks- certainly a reasonable allegation of their behaviour in the period 2007-to date. Of course, cryptocurrencies are anonymous to various degrees so that decisions are not centrally dictated by a national governmental institution.

Financial regulators had their hands full in dealing with the fallout of the financial crisis in the years following 2008. They were certainly not active in assessing the impact of technology inventions in the years between 2008 and 2013. A number of cryptocurrencies were released by 2013 and volumes of cryptocurrencies in circulation were approaching $1 billion by 2013. Events as always trigger reaction. The two most notable were the closing of the Silk Road website and the hacking of Mt. Gox. The events required responses from financial regulators:

• The Silk Road was a dark net marketplace where drug dealers bought and sold illicit drugs. Users of Silk Road used the cryptocurrency Bitcoin to conduct transactions.The site was shut in 2013.
• Mt. Gox was the first Bitcoin exchange, which at its peak conducted 80% of Bitcoin global trading volume. Technical issues resulted in a loss of 850,000 Bitcoins. The exchange was insolvent. Customers lost money. Litigation continues to this day.

Concurrently, the number of cryptocurrencies evolved. Aside from addressing the immediate operational issues arising from the close of the two sites, regulators recognised that cryptocurrencies were more than a passing technology fashion, as cryptocurrencies were assuming some of the functions of money:

1. Firstly, cryptocurrencies were increasingly used to hold value through their discreet storage capabilities;
2. Secondly, they were adopted for exchange of value in commercial segments (though they are not being used extensively as a unit of account).

Regulators have reacted in three ways:

Firstly, regulators have analysed the product, service and risk issues of cryptocurrencies and have identified product, service and risk issues:

Product & Service Issues:

• Privacy Protection:
  Privacy and anonymity of the transacting parties were the prime concern of the proponents of cryptocurrencies. These became part of the underlying principles. The use of pseudonyms conceals the identities, information and details of the parties to the transaction, essential for privacy enthusiasts. This is good for individuals, but less good for state bodies charged with monitoring money laundering, tax avoidance, and other criminal activity.
• Cost-Effectiveness:
  Electronic transactions attract fees and charges. The fees and charges are higher for transactions which are transnational and undergo currency conversion. Equally, transactions attract processing fees levied by the banks, third party clearing houses, or gateways. Debit or credit card transactions also attract a processing or transaction fee when used overseas between 1% and 3%. Electronic transfer fees can exceed 10% of the transaction value. Cryptocurrencies address this problem. Transaction fees have a single valuation globally, and the transaction fee is extremely low, being as low as 1% of the transaction amount. Cryptocurrencies eliminate third party clearing houses or gateways, cutting down the costs and time delay. All the transactions over cryptocurrency platforms, whether domestic or international, are of equal processing effort. They are not governed by financial relationships. Inbuilt security and fraud prevention mechanism eliminate the costs of payment processing gateways which comprise as much as 40% of the costs of transaction fees. Whilst this is undoubtedly good for small businesses, it does have significant implications should the use of the blockchain technology which underlies cryptocurrencies become prevalent in the financial services sector.
• Lower Entry Barriers:
  Possessing a bank account or a debit/credit card for international usage requires documented proofs for income, address or identification. Banks or financial institutions have their eligibility criteria for use of these facilities. Cryptocurrencies lower these entry barriers. Customers join at no cost. The services have high usability. The users are not required to make any disclosure or proof for income, address or identity. Whilst this has positive implications with respect to providing services to the world’s billions of unbanked, it drives a coach and horses through KYC regulations.
• Alternative to Banking Systems and Fiat Currencies:
  Governments have increased their control and regulation over banking systems, international money transfers, and their national currencies or monetary policies. Cryptocurrencies offer users a reliable and secure means of exchange of money outside the direct control of national or private banking systems.
• Open Source Methodology and Public Participation:
  A majority of the cryptocurrencies are based on open source technology methodology. Their software source code is publicly available for review, further development, enhancement, and scrutiny. The ecosystem of cryptocurrencies is primarily participation based. Software development, bug reporting and fixing, testing, etc. are driven by the wider user base, rather than a closed set of individuals or an institution. They have their own consensus based decision making, built-in quality control and self-policing mechanisms for building frameworks, practices, protocols, and processes, though governance remains a significant challenge.
• Immunity to government-led jurisdictional financial sanctions:
  Governments have the authority and means to freeze or seize a bank account, but it is infeasible to do so in the case of cryptocurrencies. Cryptocurrencies are immune to any such seizure by the state, both in repressive regimes where governments seek to control their citizens, and in democracies where governments may seek to freeze or seize the bank accounts of criminals such as drug dealers.
• Volatility:
  Cryptocurrencies have their own set of associated volatility risks: volatility in valuation, lack of liquidity, security, and many more risks. Cryptocurrencies are being denounced in many jurisdictions because of their use in grey and black markets, markets which seek oversight from outside the jurisdiction or ban their use within the jurisdiction. There are two sets of interconnected risks. The first is the risks from growth and expansion of these platforms amidst uncertain regulatory policy environments within most jurisdictions. The second is the risks these platforms pose to the users and the security of the state.

Risks Involved in Holding Cryptocurrencies

• Key/Wallet/Exchange Security:
  A virtual wallet stores the keys and transaction records of the user. The secure digital keys access the public address and sign or authenticate the transactions initiated by the user. Virtual wallets exist in the form of desktop wallets software, web-based wallets (a website/cloud) and mobile wallets (an app). Cold storage of cryptocurrencies is claimed to be more secure, which is in the form of storage media, USB flash drive, or on a paper or hardware wallet. Some use biometrics for authentication. Specialised online exchanges facilitate the purchase or sale of cryptocurrencies. Wallets and exchanges are the weakest link. They are subject to the most security attacks.
• Hijacking/Routing Attacks/Distributed Denial of Service (“DDoS”) Attacks on Cryptocurrency Systems:
  Cryptocurrency systems are open source. They pool the resources of the miners, who maintain the systems. Research efforts in the recent past have delivered proofs-of-concept for hijacking or Internet routing attacks to which cryptocurrency systems are vulnerable. Cryptocurrency platforms are prone to DDoS attacks, targeted at the exchanges, which might slow down services or render the platform completely inaccessible.
• Uncertain Regulatory Environment:
  The further success and development of cryptocurrencies depends upon the way regulatory frameworks are devised. Different countries have approached this innovation in different ways, and, therefore, the regulatory environment remains uncertain.
• Lack of Liquidity and Lower Acceptability:
  Cryptocurrencies function outside banking systems, beyond the regulations or controls of the regulatory agencies. Online exchanges facilitate the exchange of cryptocurrencies with fiat currencies, but, generally, this is restricted to the more popular cryptocurrencies, which have high market capitalisation. For the rest of the cryptocurrencies, and for all of them in certain countries, there is an absolute lack of liquidity. The acceptance of cryptocurrencies at merchant sites is also restricted. As cryptocurrencies are gaining popularity and entering into niche markets, exchanges have sprung up dealing in national currencies such as the G20 currencies and beyond.
• Price Volatility:
  Volatility, a measure of the variance of the price of a financial instrument over a certain period of time, is associated with the risk level of the instrument. High volatility is regarded as risky, and cryptocurrencies are known to be extremely prone to price fluctuations.
• Uncertainly over consumer protection and dispute settlement mechanisms:
  Cryptocurrencies are decentralised, that means, there is no single authority for dispute resolution. The miners are not responsible for any arbitration of disputes between the parties. The transactions are also irreversible, which, in the case of banks or payment gateways, is reversible if the dispute is resolved, safeguarding the users from fraud. Cryptocurrencies lack these safeguards, exposing the users to the risks of fraud and bringing a sense of uncertainty over consumer protection and dispute settlement mechanisms.

Risks From Cryptocurrencies:

• Potential Use for Illicit Trade and Criminal Activities:
  Cryptocurrencies are virtual and decentralised, which places them well beyond the control or authority of the state. Their virtualised and decentralised state made their absorption quicker into grey and black markets, ransomwares and a host of other illicit activities of crime and money laundering. The “Silk Road” over the Dark Web relied heavily on Bitcoins for payments in exchange for illicit trade in narcotics, hacking tools, small arms, child pornography, stolen credit cards information and so forth. Unfortunately, between 2011 and 2013, the value of Bitcoins surged. Criminals were purchasing Bitcoins in large volumes. As late as 2015 and early 2016, Dutch police detected groups that indulged in Bitcoin-related money laundering. Regulatory bodies and law enforcement agencies have raised legitimate concerns that cryptocurrency accounts and wallets cannot be frozen, seized or examined.
• Potential Use for Terror Financing:
  In the aftermath of terrorist attacks such as those on the World Trade Centre in 2001, rigorous vigilance and regulatory controls were imposed on global financial systems to eliminate terrorist financing. Terrorists moved towards sophisticated money laundering. Cryptocurrencies are also emerging as a new funding stream for terrorist outfits. The Islamic State of Iraq and Syria (ISIS) had proposed using Bitcoins to raise funds. The proponents and entrepreneurs of crypto-currencies, however, criticised proposals to ban or put controls on cryptocurrencies. They contest that many technologies such as smartphones are also being used by terrorists and criminals. Analyses of the alleged use of cryptocurrencies in criminal activities and terror financing might lead to divergent conclusions. Nevertheless, cryptocurrencies have thrown open a whole new challenge towards which the majority of the intelligence and law enforcement apparatuses are inadequately prepared to tackle.
• Potential for Tax Evasion and Tax Avoidance:
  It should be noted that tax evasion comprises concealing income or profit from relevant fiscal authorities. Tax avoidance is structuring income and profits, such that one pays the minimal amount to the relevant fiscal authorities. Cryptocurrencies are not regulated or controlled by governments. They are a lucrative option for tax evasion and tax avoidance. Sales made or salaries paid in the form of cryptocurrencies could be used to avoid income tax liability. Taxation rules and regulations vary by jurisdiction. Many countries do not yet have policies in place for cryptocurrencies. There is, as yet, no consistent agreement or understanding on whether the income earned through trading, or for that matter, even mining of cryptocurrencies, should be included in gross income or treated as capital gains. The libertarian advocates of cryptocurrencies have gone to the extent of raising doubts over the authority of the state to enforce taxation on an asset they do not issue or have control of. This reflects their total lack of understanding, and in some instances, denial of the basis for taxation. Taxation is imposed on the basis of the citizenship or residency of the person or enterprise, not on the basis of the asset. The Internal Revenue Service (“IRS”) of the U.S. Government had issued a notice in 2014 labelling cryptocurrencies “intangible property”. The IRS deemed trading in cryptocurrency assets is taxable. Digital currencies are capital assets and are, therefore, subject to capital gains taxes. Similar debates over the categorisation of cryptocurrencies as a security, currency, or a commodity derivative are currently are underway in a number of G20 jurisdictions.

Some of the risks I have listed above are technical challenges, for example, dispute settlement and security of platforms. Others are policy issues. Policy issues are much more difficult to resolve, such as regulation, liquidity, price volatility, and consumer protection. Until these risks are mitigated, the future of cryptocurrencies as legal instruments for exchange or goods and services, even payments, will continue to remain uncertain. Moreover, cryptocurrencies are an entirely new payment method, with privacy benefits for users. Cryptocurrencies can pose significant risks to security, counter-terrorism, law enforcement, and taxation.

Secondly, some regulators have attempted to define cryptocurrencies as an asset class:

• Cryptocurrencies do not have legal tender status in any jurisdiction:
  Many jurisdictions have already declared the transactions for the sale of goods or services, corporate profits, capital gains and income as taxable. As taxation authorities are grappling with devising strategies and guidelines for tax compliance, tax evaders might find their tax havens in the form of cryptocurrencies. How virtual currencies should be classified is still unclear. Should virtual currencies be seen as standards and payment tools, or should they be considered securities that are traded for profit?

Finally, jurisdictions have taken a view on the legal status of cryptocurrencies:

• The legal status of cryptocurrencies varies materially from jurisdiction to jurisdiction:
  The status is changing and in many jurisdictions remains undefined. The majority of countries do not make usage of cryptocurrencies illegal. The variations have different regulatory impacts. Some jurisdictions have explicitly permitted cryptocurrency use; some such as India, Ecuador and Vietnam have banned it; others such as Sweden and China have restricted the use of cryptocurrencies. The U.S. Commodity Futures Trading Commission (“CFTC”) classified Bitcoin as a commodity in 2015. The U.S. tax regulation system, which is administered by the IRS, taxes Bitcoin. The UK has stated that cryptocurrencies are unregulated. They are treated as foreign currency for most purposes, including VAT and General Sales Tax. Bitcoin, specifically, and one would assume other cryptocurrencies are treated as Private Money. When Bitcoins are exchanged for sterling or foreign currency no vat is payable on the value, but VAT will be due from suppliers if any goods or services are sold in exchange for any cryptocurrencies. The Singapore Monetary Authority does not intervene in business transactions, where goods or services are exchanged for cryptocurrencies. The Singapore Revenue Authorities have issued guidelines advising that, where goods or services are exchanged for cryptocurrencies, they may be regarded as barter exchange. Businesses using cryptocurrency exchanges will be taxed on their cryptocurrency sales.

So where does regulation stand as we approach the end of 2017?

1. Regulation is at a roundabout. Do regulators wish to regulate or not? The regulators are going round the roundabout. Most have yet to decide whether to take the "regulate turn-off" or take the “content to leave matters to self-regulation or standards setters turn-off.”
2. Selectively, by jurisdiction, regulators have applied existing regulations to cryptocurrencies.
3. Initial Coin Offerings “ICOs” which use cryptocurrency tokens as their launch pad incentives have added to the risks of cryptocurrencies in the eyes of financial regulators.
4. Should regulators be pro-active and prevent the growing risks of hacking fraud and security breaches in order to protect consumers and the fundamentals of the economy, especially the retail economy? That is a dilemma which only events will solve.

What is the future trend of regulation?

• Regulators have lost self-confidence over the past decade, as regulation is increasingly dictated by political motives and aspirations. In the 10 years since the financial crash, financial regulators are under the yoke of their Political Masters, who see popularity votes in close involvement in financial regulation.
• Political events will inhibit moves towards global regulation in cryptocurrencies.
• There will be some regulatory arbitrage where jurisdictions see an economic advantage in their response to cryptocurrency developments.
• Jurisdictions through their regulatory agencies will tread a fine line between encouraging fintech and protection of consumers.
• Clarity on the regulatory status of ICOs – this may happen very soon based on the most recent information about the Tezos ICO litigation.
• Jurisdictional taxation treatment of stakeholder interests in cryptocurrencies and ICOs will have a defining role in the future of both these forms of token.
• Taxation will shape some of the regulatory developments of cryptocurrencies.

Bob McDowall

November 2017

Published in my capacity as an Adviser to the Cardano Foundation (www.cardanofoundation.org), this paper was the backdrop to a presentation I gave to a cryptocurrency and blockchain summit conference in Singapore on 29th November hosted by the Asian Millionaires Club (www.asianmillionaire.com) and sponsored by DasCoin (www.dascoin.ch).