Crypto Assets Risks and Regulation

17th October 2018 3062 - Blog Posts

Crypto Assets Risks and Regulation – Latest Report Summary

The Treasury Select Committee has issued a detailed report on crypto assets (19 September 2018), following an inquiry into the risks of cryptocurrencies, which includes recommendations for regulatory measures. Cryptocurrencies reached a peak market capitalisation in January 2018 of $830 bn, and this along with growing concern about financial risk and the use of cryptocurrencies to fuel the dark web has prompted this Committee inquiry.

Evidence was submitted from a wide range of organisations, including The Bank of England, Financial Conduct Authority, SEC, Crypto UK and Everledger.

Cryptocurrencies and the Treasury Committee definition

Cryptocurrencies are digital currencies that are encrypted using cryptography, which is the use of encryption techniques to secure and verify transactions. Blockchain is the underlying decentralized ledger that records and validates transactions chronologically.

The Committee heard that there are no cryptocurrencies that perform all the functions that are generally understood to define the term currency. Martin Etheridge, Head of Note Operations at the Bank of England, told the Committee that:

“They [so-called cryptocurrencies] are not acting as a medium of exchange; they are not particularly good as a store of value, given the volatility; and they are certainly not being used as a unit of account.”

It was agreed that for the purposes of the Committee report that cryptocurrencies would be referred to as ‘crypto assets’ in the text.

The Crypto Asset Landscape

The enthusiasm for crypto assets and blockchain began to emerge in 2008, with Bitcoin as the initial incarnation. Initially Bitcoin faced considerable challenges, including the cost in conventional currency of creating and using Bitcoin in a commercial venture and the emergence of the ‘dark web’ where Bitcoin became the currency of choice used to orchestrate illicit activities. After Bitcoin, other altcoins and tokens were created and can be included in the term crypto assets.

Gradually, market capitalisation of crypto assets increased and in January 2017, it reached $17 billion. Crypto asset market capitalisation reached its peak in January 2018, at $830 billion. By the end of August 2018, it had fallen to $191 billion. Despite the rise in value of crypto assets, their overall market capitalisation remains small. According to the Bank of England, even at their recent peak, the combined global market capitalisation of crypto assets was less than 0.3 per cent of global financial assets.

The Advantages and Limitations of Blockchain and Crypto Assets

Blockchain

Resilience, security and a reduction in processing time were all noted as advantages of blockchain. The Bank of England said that blockchain could: “increase the efficiency of managing data, by reducing data replication and associated reconciliation processes.”

The FCA also noted “cost and time reductions arising from the removal of intermediaries required for processing a transaction.”

Chris Taylor, Chief Operating Officer of Everledger argued that one of the major advantages of storing data in blockchain form is that it becomes immutable and cannot be changed retroactively except by consensus among users.

Some limitations to blockchain were noted though, particularly in its scalability and reliability, with the Bank of England surmising that: “consideration will be needed around how a distributed system is controlled and governed.”

Jorge Stolfi, Professor of Computer Science at the State University of Campinas in Brazil also noted that the relative anonymity of blockchain made it useful to facilitate illegal activity.

Crypto assets as a medium of exchange

One of the advantages of crypto assets is that their peer-to-peer nature allows individuals to transact without a financial intermediary. There is also an argument that crypto assets could be more efficient because of this lack of intermediaries.

The volatility of crypto assets and higher costs for transactions are noted as limitations on its capacity of a means of payment though. The Bank of England states that measured against the US dollar, Bitcoin is ten times more volatile than sterling, and other crypto assets are even more volatile than Bitcoin.

The Bank of England also stated that crypto assets and blockchain face capacity constraints – while more than 30 million transactions are made through BACS, and Faster Payments every day in the UK, Bitcoin has a global peak capacity of around 0.6 million transactions per day. This capability capacity will, in turn, lead to higher costs per transaction, and blockchain’s fundamental need for participant verification also causes delays in transaction processing.

Risks and regulation

Current regulatory remit

Currently, the FCA states that crypto assets themselves are not within the scope of its regulation. This is because crypto assets “generally do not meet the criteria to be considered a specified investment under the Regulated Activities Order, nor would they typically qualify as ‘funds’ or ‘e-money’ in the Payments Services Directive 2 and E-Money Regulation 2009.”

Initial Coin Offerings (ICOs) – where a company issues a token or coin, which can be used to provide access to, or purchase a product or service, or provide voting rights or a share in revenue – sometimes do fall within the FCA’s regulatory remit, depending on their structure.

In the EU, steps are underway to ensure crypto asset exchanges are covered by Anti-Money Laundering regulations. From July, entities that hold, store or transfer virtual currencies will have to identify customers and report suspicious activity.

Crypto-asset risk

The Committee received a range of evidence outlining specific risks to investors. One of the greatest risks was price volatility, with the inquiry concluding that as crypto assets have no inherent value, their price fluctuates according to sentiment.

Theft and loss were also cited as risks to investors. As crypto asset exchanges are vulnerable to hacking, there is potential for investors to incur loss. The report cites an example, where South Korean exchange, Coinrail, lost approximately 37 per cent of its assets after a cyber-attack. Mitigating the risk of cyber-attacks is not a straight forward task, although solutions such as keeping customers’ details offline, also known as cold storage, have been put forward.

The inquiry concluded that there is no mechanism for compensation or collective deposit scheme in the case of losses incurred through theft or lost passwords which may make crypto assets particularly ill-suited to investors. Concerns were also raised about the repercussions when investors lock themselves out of their accounts accidentally by losing or forgetting their details. It has been noted that in some cases investors have lost permanent access to their crypto assets which represents a real risk.

Recommendation – Currently ICOs fall outside the regulatory perimeter because they offer future access to a service or utility. The inquiry surmised that this regulatory loophole should be closed, and ICOs should be regulated by the FCA as a matter of urgency.

Anti-money Laundering and the Financing of Terrorism

The use of crypto assets for money laundering and the financing of terrorism is of serious concern, and the previously mentioned EU directive to bring crypto assets under AML regulation is a step forward in combating this problem.

Recommendation – The Committee urged the Government to expedite the consultation period on the Directive which is not planned to finish until the end of 2019. If the UK leaves the EU without a transition period next March, the Committee wants to see the EU directive replicated in UK law.

Price manipulation

The inquiry also heard that crypto assets are particularly vulnerable to price manipulation and at present they fall outside of the scope of market abuse rules.

Recommendation – The Committee recommended that the FCA should outline its approach to countering market manipulation if the sector were to fall within its remit.

Implementing a regulatory regime

The overwhelming theme from the inquiry is that crypto assets needed to be better regulated to prevent investor losses and financial crime. The Committee also found that there are potential opportunities in regulation for the sector. A robust regulatory framework for the crypto asset market could help the business model to mature, and the UK to become a global centre for the sector.

After considering the best way to establish a regulatory remit, the Committee stated that extending the Regulated Activities Order (RAO) would be quicker than setting up a new framework. It also suggested that the Government should consider the activity to be included in the RAO but at a minimum should cover the issuance of ICOs and the provision of crypto exchange services.

Although international regulation on crypto assets is still in its infancy, the Committee encouraged UK regulators to engage with international bodies to share best practice.