Constandino (Dino) Papagiannis and Michelle Meyer
The proliferation of cryptocurrencies and their disruption to the banking business have come on fast and furiously. Consider that at the start of 2017, Bitcoin made up an estimated 90 percent of the virtual currency market by value; by the end of the year, it comprised less than half.1
As the market continues to take shape, regulators are tasked with a tall order of implementing regulation that keeps up with its continuous innovation, rapidly evolving virtual intelligence, and risks.
Bitcoin, the first cryptocurrency, was launched in 2009 and has now become a household name. By December 2017, the Coinbase app, which allows users to buy and sell Bitcoin and other cryptocurrencies, had spiked to the top of the list of the most downloaded iPhone apps in the United States. That same month, the Coinbase virtual currency exchange reportedly had more accounts than the second biggest U.S. brokerage. Bitcoin is the most widely known cryptocurrency, but others include Ethereum, IOTA, Komodo, Litecoin, Ripple, and Zcoin.
Cryptocurrencies’ underlying technology, blockchain, sets up distributed digital ledgers to record transactions among peers on a computer network. Blockchains are decentralized, which removes the need for a third, central party. Blockchain technology has created the backbone of a new type of internet, as the data that is held on blockchains is shared and continuously reconciled.
The subject of cryptocurrency evokes responses ranging from one extreme to the other. At one end of the spectrum are ideologues, who believe the disruption in technology will bring a wave of decentralization that will upend banks, governments, and massive internet companies for the greater good. The other end is completely dismissive and doesn’t see any threat to the current financial services market. In between is where a growing variety of applications and business models are taking root.
The rise of cryptocurrency can produce many benefits. For example, for the unbanked population of the world and citizens in areas with unstable governments and hyperinflated currencies, a decentralized currency can offer hope for a better financial foundation. And, at a time of acute data security concerns worldwide, blockchain’s lack of centralized databases is also said to make it harder for hackers to target and manipulate information.
However, the rapid expansion of cryptocurrency merits a discussion of what could go wrong. As alternative currencies operate outside the control of a central bank or sovereign treasury department, their use can create suspicion among the public and anti-money laundering regulators because they have no central authority. This suspicion is exacerbated by early associations with criminal transactions and the “Dark Web,” facilitated by the anonymity of cryptocurrency ownership.
Writing Cryptocurrency Regulation
The rise of cryptocurrency and its supporting blockchain technology has lawmakers, regulators, and law enforcement officers scrambling to keep up. This is, in part, because many of the current players operate outside of the conventional financial system.
Regulators are tasked with thinking about how to mitigate opportunities for money laundering, fraud, terrorist financing, and tax evasion. Some regulatory bodies have taken a stab at establishing cryptocurrency guidance and rules. One unintended consequence in the U.S. has been a conflict regarding regulatory jurisdiction over virtual currency exchanges, specifically between the New York State Department of Financial Services (NYDFS) and the Office of the Comptroller of the Currency (OCC).
Regulatory efforts date back to March 2013. That’s when the Financial Crimes Enforcement Network (FinCEN) issued guidance titled “Application of FinCEN’s Regulations to Persons Administering, Exchanging, or Using Virtual Currencies” to provide clarity and regulatory certainty for businesses and individuals engaged in an expanding field of financial activity. FinCEN’s rules define certain businesses or individuals as money services businesses (MSBs) depending on the nature of their financial activities. MSBs have registration requirements and a range of anti-money laundering, recordkeeping, and reporting responsibilities under FinCEN’s regulations.
The first U.S. agency to attempt defining cryptocurrency was the Internal Revenue Service (IRS), which in March 2014 announced the classification of virtual currency that has an equivalent value in “fiat” (government-backed) money as a “convertible virtual currency.” For tax purposes, convertible virtual currencies are treated as “property” and subject to existing tax principles for property transactions, the IRS said.
Then, in September 2015, the NYDFS released the first regulatory framework with the creation of BitLicenses, which are currently awarded to virtual currency exchanges. The first BitLicense was issued to Circle Internet Financial, and a few more have followed.
In October 2016, the OCC published guidance titled “Exploring Special Purpose National Bank Charters for FinTech Companies,” under which FinTech companies (potentially including virtual currency exchanges) would have the opportunity to obtain such a charter. The OCC guidance indicated FinTech companies would be regulated similarly to conventional financial institutions to ensure uniform enforcement of safety and soundness laws. That said, by not taking cash deposits, some exchanges would not be insured by the Federal Deposit Insurance Corporation (FDIC), and therefore not subject to FDIC examinations.
In April 2017, NYDFS Superintendent Maria Vullo sent a letter to OCC Comptroller Thomas Curry, expressing public opposition to the special purpose national bank charter and stating that the “regulation of non-bank financial institutions is within the jurisdiction of the states, not the OCC.”
As jurisdictional lines are being drawn, financial services companies and FinTechs alike continue to face regulatory uncertainty, in addition to high marketplace uncertainty, in the field of cryptocurrencies. In the current environment, major credit card issuers are “de-risking” by banning the use of their cards for virtual currencies. But these are still the early days of cryptocurrency, and in March 2018, the U.S. Government Accountability Office called on regulators to act more collaboratively in addressing the nascent market.
Meanwhile, whether or not cryptocurrency is currently regulated, it poses a reputational risk to companies involved in the market. These companies should consider implementing appropriate controls to defend against exposure to fraud, market manipulation, financial criminal and terrorist money laundering, and other potential threats—all in addition to considerable business risk.
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1 "Blockchain – Cutting though the current noise of cryptocurrencies," Ryan J. Todd and Ricky Dodds; https://www.dbresearch.com/PROD/RPS_EN-PROD/PROD0000000000459680/13_Tipping_points_in_2018.pdf ↩
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