Digital currencies pose difficult questions for regulators eager to protect the public but mindful of stifling innovation. While each regulator chooses its own way, most believe the best approach is to look past the technology and focus on how products behave. But this could change as digital currencies proliferate.
Nothing sums up the divergence of regulatory thinking around digital currencies better than regulators’ disagreement on the fundamental question of whether they even constitute currencies at all.
While many regulators, including the Monetary Authority of Singapore (MAS) and the UK’s Financial Conduct Authority (FCA), recognize digital currencies as what their name implies, the US Securities and Exchange Commission (SEC) considers them commodities. Like gold – and unlike fiat currencies – bitcoin, still the world’s best known digital currency, is finite and cannot be created by central banks. Hong Kong and Russia, like the US, do not recognize digital currencies as legal tender.
This matters because this assessment determines the extent to which digital currencies are forced to comply with anti-money laundering (AML) and know your customer (KYC) regulations.
However, differences between the regulators often look less pronounced in practice. While each jurisdiction has its own views about the legal status of digital currencies, most observe what the UK’s FCA has called “technology neutrality,” leading to broadly similar regulatory approaches to products incorporating the likes of Bitcoin and Ethereum.
Technology neutrality means that products that look like loans are regulated as loans, while those that better resemble bonds are considered bonds, regardless of whether they incorporate digital currencies using distributed ledger technology (DLT). Those with the capacity to store digital currencies, such as digital wallets, are treated as depositories.
The rise of digital tokens issued by private institutions is one of the more recent issues regulators have had to grapple with. Both the SEC and MAS have largely tried to address the market within the existing frameworks regulating financial securities.
“Whether or not a particular transaction involves the offer and sale of a security – regardless of the terminology used – will depend on the facts and circumstances, including the economic realities of the transaction,” says the SEC in a study looking at the growing use of digital tokens. It concluded that digital tokens issued by decentralized autonomous organizations constitute securities under the Securities Act.
Digital tokens issued by decentralized autonomous organizations constitute securities under the Securities Act, the SEC concluded.
The MAS has indicated it will take a similarly flexible approach. While the MAS does not regulate currencies directly – be they fiat or digital – the function of digital tokens has evolved beyond just being merely a virtual currency, it says.
“Digital tokens may represent ownership or a security interest over an issuer’s assets or property. Such tokens may therefore be considered an offer of shares or units in a collective investment scheme under the SFA [the Singaporean Securities and Futures Act]. Digital tokens may also represent a debt owed by an issuer and be considered a debenture under the SFA,” says MAS.
For now this “technology neutral” approach serves authorities well, given the difficulty of keeping up with the innovation. Regulators are therefore likely to maintain a focus on customer protection, rather than trying to take a view on the underlying systems, with rules likely to apply on things like minimum disclosure requirements that help investors make informed decisions.
But like digital currencies themselves and the DLT on which they are based, regulatory thinking is evolving.
Evolving regulatory frameworks
Gavin Raftery, chairman of Baker McKenzie’s FinTech Working Group in Tokyo, says: “US regulators will review their approach to digital currencies and may eventually either fundamentally change their position, or adapt it to ensure AML and KYC protections apply. I expect it to be the latter. Commodity exchanges already have robust KYC protections.”
The FCA admits there may be specific areas where DLT challenges its preference for technology neutrality and it could review the policy if that decision would benefit consumers. It will explore how emerging business models could challenge its existing regulatory framework, particularly with regards to market integrity, consumer protection and competition.
Rules are likely to be stricter for publicly traded digital currencies like Bitcoin and Ethereum than where they relate to those issued by banks themselves, such as the Utility Settlement Coin (see an earlier post). Regulators, like speculators, are likely to gravitate to where market values and volatility are higher, and where retail participation is highest.
Like speculators, regulators gravitate to where market values and volatility are higher, and where retail participation is highest.
While it is still very early days for digital tokens or currencies issued by private institutions, the temptation will be to view them more like loyalty programmes. “Airline miles could provide a roadmap for where the rules around captured digital currencies could start and how they could develop,” says Raftery.
“Such digital currencies could get more attention if they get similarly big. But for as long as they are managed internally by banks, with no leakage into the broader markets, they are not going to be a priority for regulators.”
Digital fiat currencies
When fiat currencies start going digital, their scaleability and interoperability will make them a key concern for regulators. At that point, many of the questions raised will need to be answered by politicians, not regulators. Key among these is how to treat inter-jurisdictional transactions completed using DLT, which represent a significant systemic risk.
National financial regulators have long struggled to come to terms with the increasingly borderless nature of the businesses they oversee and the rise of digital currencies will only compound this problem. Effective regulation will require authorities to redouble their efforts to work together.
The FCA has considered how market-wide DLT solutions could contribute to, or exacerbate, a system-wide failure involving multiple participants. A coding error, for example, would quickly affect all participants across an entire network and could not be tackled by a sole regulator dealing with individual institutions.
However, while digital currencies no doubt present challenges to global systemic risk, they also have features that could reduce it. The decentralised nature of DLT means information is always backed up. In-built cryptographic encryption makes systems highly resilient, while attacks that do penetrate should be less effective as its inherent consensus process ensures fraudulent entries are rejected by other nodes, says the FCA. And, of course, DLT always provides an audit trail.
Digital currencies remain a relatively new phenomenon and it is still unclear what role they will play in the economy of the future. As such, the question of how best to regulate them is equally unclear, and it makes sense for regulators to keep an open mind.
Raftery says: “Are digital currencies going to become a mainstream form of currency used to make payments? Are they going to be an asset for speculative investment? Or will they essentially be a tool for making settlement more efficient? We will need to see more products emerge before the answers become clear, and only then will we see how regulators treat them.”