This September will mark the tenth anniversary of the last financial crash. In October, another equally longstanding development will celebrate its first decade: Bitcoin, the original cryptocurrency network.
In just 10 years, cryptocurrencies have become much more than a payments system, the original aim of Bitcoin’s founders, and spawned hundreds of peer-to-peer networks for the exchange of assets, goods and services. They have also grown as a fundraising device.
Below we discuss how leading jurisdictions have designed regulatory frameworks to accommodate this promising new technology, and how other financial hubs, such as the Cayman Islands and the United States, can benefit from the growth of cryptocurrencies.
Much more than tulips
When an author or group of authors, writing under the pseudonym Satoshi Nakamoto, published a paper outlining the features of a “Bitcoin: a peer-to-peer electronic cash system,” they were laying the foundations for a broad swath of decentralized applications that promise to enable viable transactions at scale without intermediaries. As of late June 2018, the total market capitalization of cryptocurrencies stood at $250 billion. Bitcoin remains the largest of more than 1,600 coins listed, but its market share of 40 percent is much smaller than the 87 percent it commanded as recently as 2014.
What explains the rapid rise of cryptocurrencies? Skeptics are wont to dismiss it as a modern-day bout of tulipmania, an irrational speculative craze for something that has no use or value.
But a number of events help to explain the enthusiasm of people around the world for a technology whose potential remains largely untapped. First, the idea of a stateless currency – serving as medium of exchange, store of value and unit of account – when sovereign monies have failed to preserve their purchasing power over long periods, attracts many people.
Second, startups’ ability to raise capital by issuing a cryptocurrency – a so-called initial coin offering, or ICO – rather than through more traditional and costlier initial public offerings (IPOs), and without having to restrict their share offerings to wealthy investors, makes capital formation easier. It also democratizes investment.
Finally, even those who doubt the market potential of individual cryptocurrencies share an excitement about the underlying distributed ledger technology. Indeed, the use of blockchains to record transactions appears to have countless applications, from land titles and insurance to shipping contracts and securities trading. What these potential use cases share is the prevalence of high transaction costs among incumbent intermediaries. Proponents of blockchain applications believe that peer-to-peer technology can vastly reduce costs and break up the market dominance of a few large players.
When innovation clashes with regulation
The extent to which the promise of cryptocurrencies and blockchains can be realized depends in large measure on policymakers’ willingness to let them flourish.
Jurisdictions around the world are taking very different approaches. Some are positively draconian, such as the Chinese ban on ICOs and cryptocurrency exchanges. South Korea has also prohibited ICOs since September of last year. Auspiciously, both countries have since made informal statements suggesting that the bans may be relaxed in the near future.
Other countries have sought to accommodate cryptocurrencies within their existing regulatory frameworks. Germany, Japan, the United Kingdom and the USA all fall under this category, although differences in national regulatory regimes mean that the impact of bringing cryptocurrencies under existing rules is not the same in each country.
In the United States, which is the world’s most important cryptocurrency market by trading volume and number of ICOs, regulatory uncertainty has arguably chilled innovation in recent months. From a peak of $2.4 billion in February, monthly funding for new ICOs in May dropped to just over $1 billion, having fallen to as low as $700 million in April.
To be sure, an uncertain policy environment was not the sole driver of this decline. The excitement that drove cryptocurrency prices ever higher at the end of 2017 has all but evaporated, with one bitcoin fetching less than $6,000 at the end of June, compared to $19,300 at its mid-December peak and $9,800 as recently as May. It is not unreasonable to suggest that subdued prices have curbed issuers’ eagerness to offer new coins.
However, cryptocurrency volatility is itself magnified by regulatory instability. When rumors about the Chinese exchange ban started to circulate in September, the bitcoin price took a 10 percent hit. Another drop of similar magnitude followed the official enactment of the ban in February.
Policy uncertainty and expectations clearly play an important role in cryptocurrency markets, which is why equivocal statements by key U.S. financial watchdogs in recent months have kept the industry on tenterhooks.
Jay Clayton, chairman of the Securities and Exchange Commission, has repeatedly claimed that most ICOs to date were securities offerings, according to the definition established by legal precedent. Commissioner Brian Quintenz from the Commodity Futures Trading Commission, America’s other main capital markets regulator, has replied that, even if some ICOs were securities at the time of issue, they could become commodities once the associated network – Bitcoin for payments, Ethereum for computer power, and so on – went live.
The need for regulatory clarity – and openness
The distinction matters. Classifying all or most cryptocurrencies as securities, as some have proposed, would subject their issuers to onerous registration requirements. It would restrict who can buy and hold, and who can act as custodians and exchangers, of cryptocurrencies.
A securities designation would also make it very difficult for ordinary households to buy cryptocurrencies, since issuers would be reluctant to bear the costs – upwards of $1 million – of a public listing and would therefore raise money privately. Yet, such private offerings are open only to accredited investors, typically those with an income greater than $200,000 or net worth in excess of $1 million. Plainly, most households fall below these thresholds, which means they are excluded from private offerings.
The potential negative consequences of overzealous regulation should not deter policymakers from clarifying which rules apply to cryptocurrencies. Despite ebbs and flows in cryptocurrency prices, that Bitcoin has been around for a decade shows that this technology is here to stay. Furthermore, as more cryptocurrencies launch and elicit interest from retail buyers, the need for clear rules becomes greater, both to avoid stunting the growth of cryptocurrencies and to minimize the scope for fraud.
One way for U.S. regulators to provide clarity would be to enshrine into policy the distinction between functional cryptocurrencies – those that can be exchanged and used right now – and promises of future cryptocurrencies financed through ICOs.
The first category are decentralized networks that give users access to goods and services, such as payments, computer power, and electronic storage space. They do not seem to meet the legal definition of a security, which involves an investment of money in a common enterprise with the expectation of profits from the efforts of others. Instead, functional cryptocurrencies resemble traditional commodities, since they serve as inputs into transactions.
Regulators are finally coming round to recognize this. Chairman Clayton has declared that bitcoin is not a security, and recently William Hinman, who directs the SEC’s Division of Corporation Finance, stated that ether, the cryptocurrency of the Ethereum platform, also fails to meet the criteria for a security. Bitcoin and ether represent 60 percent of total cryptocurrency market cap, so this change in stance is a momentous development. It is time to extend it to the remaining 40 percent.
A balanced approach toward ICOs
For cryptocurrencies that are not yet functional, regulators must balance the need to protect against fraud with the desire to promote innovation and capital formation. ICOs cannot become the exclusive province of scammers, but they also must not be regulated out of existence.
The way to achieve both objectives is to accept that some ICOs, in specific circumstances, may qualify as securities offerings. This is likely to be the case where the contracts offered can be traded in secondary markets before the associated application goes live. Because the value of the contracts in the interim depends on the success of those developing the app, they may constitute a money investment in a common enterprise where the work of others leads to expected profits – that is, a security.
In other cases, however, an ICO can look more like Kickstarter. A group of developers want to build an application that delivers a service, say, bike rental. To raise funds to cover the costs of developing the app, they offer tokens that will entitle the buyer to a set number of bike rentals when the app goes live. But until then, the tokens may not be traded.
In that case, the contract is not a security but the advance purchase – presumably at a discount – of a service. The exchange is similar to a coffee farmer who promises coffee beans tomorrow in exchange for money today. Such agreements are known as forward contracts and have for decades been recognized by regulators as distinct from securities and other investments.
This two-tier approach makes possible the supervision by securities authorities of those cryptocurrency projects which are most subject to volatility and asymmetric information: early-stage ICOs. But it gives greater flexibility to those ICOs that give token buyers stability and transparency between the time of issue and the time that the platform goes live.
Learning from the leading jurisdictions
To corroborate why a flexible approach can best secure the benefits of cryptocurrencies while adequately dealing with any associated risks, it helps to examine how other leading financial centers are proposing to regulate them. Switzerland and Singapore stand out for having attracted a disproportionate amount of ICOs, especially among larger offerings. Together, the funding raised in ICOs in these two jurisdictions matches the $830 million raised in the United States so far.
Both the Swiss and the Singaporeans have moved quickly to clarify which regulations apply to cryptocurrencies. They have distinguished between tokens, such as bitcoin, that are used for payments; tokens that entitle the holder to goods and services, like in our bike rental example above; and tokens that are akin to ownership shares in businesses. The first two are not securities, whereas the latter involve rights similar to ordinary stocks and are therefore regulated as securities.
The Cayman Islands have also been fertile territory for ICOs. In an analysis of 100 recent token issues that had raised more than $10 million, Cayman was the home jurisdiction for seven, surpassed only by Singapore and Switzerland. The largest ICO so far in 2018, for blockchain investment platform EOS, was domiciled in Cayman and raised $4.1 billion. The Caribbean jurisdiction will be the site of at least another 16 ICOs this year, according to PwC.
While the Cayman Islands Monetary Authority has warned ICO investors about the risks associated with these offerings, its financial services sector has embraced cryptocurrencies.
As an investment management hub and the home jurisdiction to 85 percent of the world’s hedge funds, the Cayman Islands is in a privileged position to play host to ICOs and cryptocurrency investors. Like Switzerland and Singapore, the comparable clarity of Cayman’s securities rules helps to make it especially attractive.
What about all the fraud?
The rise and popularity of ICOs, admittedly, has attracted scammers aplenty. A recent market study found 80 percent of token issues to be fraudulent. It is important to note that this represents a crude share of the total number of ICOs, rather than of total funds raised. The bigger the ICO, the less likely it is to be a scam – or, indeed, to fail.
Nevertheless, it is reasonable to worry about fraud, not only because of the direct costs to those whose money is stolen, but also because widespread investor deception can undermine the growth of cryptocurrencies and blockchain-based platforms. The two-tier system for ICO regulation outlined above would minimize the chances of successful scams by subjecting those token contracts that were tradable before the platform was developed to securities regulations.
Any booming technology and geography – from railroads to tech stocks, from the South Sea to 1920s Florida – is bound to attract a disproportionate number of opportunists with evil intentions, looking to profit from the greed and gullibility of others. But it would be a mistake to conclude, because some fraudsters are peddling cryptocurrencies, that most cryptocurrencies are fraudulent.
On the contrary, the most popular cryptocurrencies have stood the test of time and trade at prices higher than they did a year ago. Furthermore, by most expert estimations, blockchain technology has only scratched the surface of potential applications across the economy. The willingness of policymakers to allow beneficial innovation to flourish will determine the extent to which the promise of cryptocurrencies can be realized.
Diego Zuluaga is a policy analyst at the Cato Institute’s Center for Monetary and Financial Alternatives.