Balanced regulation of cryptocurrencies necessary to support innovation

Those were the views expressed by members of banks and other businesses from the payments market that attended a workshop on cryptocurrency, distributed ledger technology and their regulation at the recent Future of Money conference hosted by Pinsent Masons, the law firm behind Out-Law.com.

Cryptocurrencies have gained a lot of media attention in recent times. Following the rise in value of bitcoin, thousands of other cryptocurrencies have emerged onto the market. Instead of becoming mainstream methods of payment, however, cryptocurrencies have more commonly developed as investment assets and, in the case of the growing market for 'initial coin offerings', tools for raising capital.

At the workshop, conference delegates debated whether cryptocurrencies should be categorised as money, commodities or securities – their categorisation being central to how such assets are regulated.

Mark Carney, governor of the Bank of England, recently made a speech about the future of money, including how the regulatory landscape is taking shape for cryptocurrency. In it he referred to economist Adam Smith's definition of money – how it serves as a store of value with which to transfer purchasing power from today to some future time; a medium of exchange with which to make payments for goods and services; and a unit of account with which to measure the value of a particular good, service, saving or loan.

According to Carney, cryptocurrencies do not fulfil the roles of money. He said: "The long, charitable answer is that cryptocurrencies act as money, at best, only for some people and to a limited extent, and even then only in parallel with the traditional currencies of the users. The short answer is they are failing."

He referenced the volatility of bitcoin as an example of cryptocurrencies "proving poor short-term stores of value", and said cryptocurrencies are an "inefficient medium of exchange" because it generally takes longer for payments by cryptocurrencies to be processed than fiat currencies and cost more. He also highlighted that no major high street or online retailer in the UK currently accepts bitcoin as a means of payment. Because cryptocurrencies are not proving to be great stores of value or mediums of exchange, Carney said "there is little evidence of cryptocurrencies being used as units of account".

Despite this, 34% of conference delegates said they believe the use of cryptocurrency will become more prevalent as a method of payment rather than as an investment asset in 2019. The more prominent view expressed in the workshop was that we are more likely to see cryptocurrencies emerge as a more prevalent method of payment over the next five years.

With the growth we have seen in cryptocurrencies, it has not been surprising to hear the likes of Mark Carney and other financial market regulators and policy makers around the world directly address how they should be regulated.

According to the workshop attendees, the biggest concerns that cryptocurrencies raise are around their potential to be exploited as tools for money laundering and in relation to consumer protection. The rise in prominence of cryptocurrencies has given birth to a new fund raising platform: the initial coin offering (ICO), however, there have been reports of ICO scams and highly speculative, unverified white papers. Last year, UK financial regulator, the Financial Conduct Authority (FCA) issued a warning to consumers about the risks involved in investing in ICOs.

Globally, regulators have chosen to address the question of crypto-market regulation very differently. Guidance on whether crypto-assets constitute securities, and fall subject to securities regulation, has been offered by the FCA and regulators in the US, Hong Kong, Singapore, Switzerland and New Zealand, among others, while China and South Korea have taken a harder line and banned ICOs altogether. In the EU, the amended Fourth Money Laundering Directive subjects cryptocurrency exchanges to anti-money laundering and customer due diligence rules – earlier this month the new rules were adopted by EU law makers.

The feeling among workshop attendees was that tighter regulation of crypto-markets is inevitable. They warned, however, that too much regulation could stifle innovation and growth, but some also cautioned against loose regulation too.

In this respect, the FCA's 'technology neutral' approach to regulation came in for scrutiny. Some attendees at the workshop accused the FCA of 'sitting on the fence' and failing to give sufficient clarity on the way regulation applies to crypto-assets as a result. Comparisons were made to the State of New York's, albeit not uniformly positive, and Japan's highly proactive approach, concerning regulation in this area.

The potential for a central bank to issue its own cryptocurrency has also been raised in recent times. The topic was directly addressed by both Carney and Jens Weidmann, president of Germany's central bank, earlier this year.

At the workshop, the overall view expressed by attendees was that there is no use case for a central bank developed cryptocurrency (CBDC) in the UK at this moment in time. In addition, their view was that for countries where the central banks and governments cannot be trusted, the idea of a central bank cryptocurrency is also flawed.

The Bank of England is on record as having "an open mind about the eventual development of a CBDC" and has a specific research programme dedicated to exploring its potential.

Distributed ledger technology (DLT) is the underlying technology on top of which applications such as bitcoin and other cryptocurrencies are built. However, DLT has shown potential in a much broader range of contexts across sectors such as energy, pharmaceuticals and humanitarian aid. In financial services, inter-bank 'know your customer' (KYC) blockchain-based registries is one of the potential use cases being explored.

Despite certain scepticism, the Bank of England has a positive outlook with regard to DLT. It is clear that the Bank is keen to investigate the use of DLT for innovation, and Carney is on record as highlighting the potential of DLT for underpinning the Bank of England's current real-time gross settlement system.

The question of whether DLT can improve banking services, and what the most valid potential use cases are for it, was put to workshop attendees. An interesting discussion around non-cryptocurrency-based DLT use cases was held, with debating centring on the potential for DLT to serve settlement and clearing processes in banking. The attendees concluded that in order for the technology to be widely adopted, there is a responsibility on financial institutions to experiment with it on a small scale in order to build the trust necessary for widespread adoption. DLT is an enabler and will help speed up processes and instil trust in the digital world. It was recognised that DLT will be widely used in the correct use cases across industries. 

The evolution of cryptocurrencies, DLT, ICOs and the way they are all regulated is likely to be followed keenly by the banking industry over the coming months. The FCA recently reported that they would be issuing new guidelines on all of these areas later on in 2018.

Charlie Clarence-Smith is a specialist in blockchain technology, cryptocurrencies and regulation at Pinsent Masons, the law firm behind Out-Law.com.