Introduction and Rationale
The introduction of cryptocurrencies into the global financial system has led to the growth of a new sector of finance known as FinTech. It is largely characterised by technological innovation, which is redefining the nature and structure of traditional areas of finance. The development of cryptocurrencies has emerged from this trend. It is defined by unique characteristics, such as the decentralisation of financial functions, anonymity of the players involved, and privacy in financial transactions. Stemming from the implications of these characteristics for the financial sector, regulation has been proposed as a tool for streamlining FinTech. This proposal explains why several governments (locally and internationally) are reviewing cryptocurrencies with a special emphasis on finding the appropriate type of legal framework to adopt. This push is partly informed by the fact that cryptocurrencies offer an alternative to conventional banking. Additionally, they significantly change the way vendors and buyers make payments.
FinTech regulation is a relatively unexplored area of research because it offers a new way of financial modelling. The legality of the process is also under review because cryptocurrencies outline a decentralised model that operates outside of the conventional judicial framework. Therefore, the need to explore legal issues pertaining to cryptocurrencies emanated from the failure of different countries to account for the threats that cryptocurrencies introduce to the global financial system. For example, although money laundering is a comprehensively explored area of research and a threat to the conventional financial system, it is not explored in a similar manner in FinTech.
This research argues that attempts to regulate cryptocurrencies are misguided because those advocating for the same do not understand the technology that underpins this area of financial revolution. Key pieces of evidence that support this position are derived from the decentralised nature of cryptocurrencies, the borderless nature of their transactions, the lack of an issuing authority for digital currencies, and the lack of a clear set of actors in the virtual market. Although counterarguments are discussed, this study largely demonstrates that different forms of regulation (as currently proposed) do not take into consideration the above-mentioned factors and fail to recognise the complex technology that underpins FinTech. This research is guided by two research questions highlighted below.
Research Questions
- Which opportunities provided by cryptocurrencies are relevant for regulatory bodies?
- What are the threats and barriers to the regulation of cryptocurrencies based on their inherent characteristics?
Review of the Literature
Research Methodology
This paper is the product of a desk research of secondary research materials investigating the merits and demerits of regulation in FinTech. The secondary research materials reviewed were mainly in the form of scholarly texts and legal documents.
Research Findings
Introduction to Cryptocurrencies and FinTech
Cryptocurrencies and FinTech are new areas of financial innovation. They are distinguished by their unique features, which make them stand out from traditional instruments of finance. The lack of a common authority is one of the main design features of cryptocurrencies, which distinguish it from fiat currencies. Bitcoin is the most popular cryptocurrency. It was invented after the 2007/2008 global financial crisis, which was partly attributed to the activities and unethical business practices of banks. Therefore, by their very design, Bitcoin and other crytpocurrencies do not support a centralised financial model because they eliminate the need for currency issuance and settlement. At the same time, they minimise the lurking moral risks associated with such a financial system. Nonetheless, it should be understood that cryptocurrencies cannot directly substitute the role of central banks because the functions of such financial institutions are broad and include credit expansion, price stability and the control of monetary flow in an economy.
Cryptocurrencies are deemed to be incapable of fulfilling the above roles. Although cryptocurrency enthusiasts have shown their disapproval for a centralised financial monetary system, proponents of regulation still say that price volatility and deflation are inherent risks associated with their use. Particularly, they draw attention to the possibility that cryptocurrencies are vulnerable to external clashes because of the lack of a centralised system. They also point out that such a decentralised system is prone to hacker attacks and incorrect coding which may undermine the credibility of the entire system. In the same breadth of analysis, they have said that changes in transaction sizes will affect the value of Bitcoin if there is no central authority to control the entire system. However, their concerns are still true for the conventional financial system because regulation has not eliminated them yet.
The fact that the quantity of some cryptocurrencies, such as Bitcoin, has been capped is another point of support that critics have used to advocate for regulation because it reflects the quantitative control of currencies as a measure of exchange. Here, since digital and fiat (regular) currencies have a quantitative control of currency value, cryptocurrencies could be significantly devalued when the system fails because of the lack of control by a central authority. In this analysis, the complexity of cryptocurrencies as alternative modes of payment stems from the fact that currencies are essentially deemed as “public goods,” which require protection from the state.
The lack of an issuing body for cryptocurrencies and no central authority in the issuance of the same could lead many people to believe that digital currencies would falter in design and functionality. However, this is not the case because the blockchain technology that underpins the functionality of cryptocurrencies is designed in such a way that accountability is built into its functionality. In other words, the structure and organisation of cryptocurrencies are such that every transaction involving the medium of exchange is recorded on a public ledger, where people can trace transactions that have occurred from and to a cryptocurrency account. The underlying premise of value creation is hinged on collaborative mining. Collaborative mining occurs only when parties within the blockchain validate transactions. This type of transaction makes cryptocurrencies less attractive to fraudsters and money launderers, compared to “hard cash” because it is impossible to track the movement of physical money by merely looking at it. Relative to this view, it is understandable for governments to request cryptocurrency exchange platforms to provide information about their clients, but such a request should not be guaranteed by burdensome regulations.
Many people who advocate for government intervention in the use of cryptocurrencies also do not understand that virtual currencies work in the same manner as fiat currencies do. The only difference is that there is no intermediary present to complete a transaction involving cryptocurrencies. This financial design means that there is no one available to stop or reverse a transaction when it starts. Although this feature may seem problematic to some people, it emerges as one of the strengths of cryptocurrencies. What many people do not understand is that although regulation is meant to protect consumers, digital currencies provide the same protection, but through cryptography. This technology makes cryptocurrencies some of the most reliable forms of value exchange commodities. Security concerns, which have affected some transactions that involve the use of cryptocurrencies, are also disappearing because cryptocurrency platforms are competing for users and only those that have the highest standards of accountability are gaining more customer numbers. In this regard, users act as regulators because they have the power to “punish” platforms that do not employ high ethical standards and fair business practices.
The involvement of users as regulators means that different people could be mining a currency from different locations and at different times. In this regard, the prospect that a single entity would penetrate the network and gain control of it is remote. However, it is important to point out that in 2014; one company was reprimanded for gaining control of almost 51% of Bitcoin mining activities. The concern was that the entity was becoming too powerful because it was centralising mining operations to its users. However, this threat only existed for a few hours. If the activity persisted for long, it would mean that a single entity would have owned a majority of all the cryptocurrencies mined. There is also a possibility that the conglomerate could send false information over the network and alter transaction history. Such a risk caused panic in the cryptocurrency network, thereby prompting users to urge members of the conglomerate to seize their activities and prevent the company, which operated as “GHash.io,” from acquiring a 51% stake of all Bitcoin mining activities. After the incident, the mining company sent out a statement that it would take proactive measures to ensure its activities do not surpass the 51% mark.
The lesson to be learnt from the above example (and that relates to regulation) is the strict public oversight that underpins crytpocurrency activities. Even with its decentralised nature, it is difficult to undertake unethical transactions without people noticing. Therefore, even without a centralised authority like a central bank, the integrity of the system is still safeguarded.
The above example mimics what always happens in the cryptocurrency space because it shows that its users are inherently responsible for the system through the blockchain technology. It is difficult to conceive a situation where a foreign entity such as a government (or any of its proxies) would infiltrate the system and regulate it. The decentralised nature of crytpocurrency operations means that the system is too vast to control. Comparatively, regulation only works when a central authority does not only formulate the rules and policies to be followed, but also enforces them. The decentralisation of cryptocurrency transactions shows the difficulty of achieving this goal because, although it may be possible to formulate a single set of rules to be followed by cryptocurrency users, it is difficult to enforce the same on a system that has millions of anonymous users.
The lack of an issuing authority in cryptocurrency trade highlights some of the challenges that could be witnessed in regulation. This problem emerges from the fact that central banks are important authorities in the regulation of financial services and without their involvement, it would be nearly impossible to achieve any serious regulatory milestones. Therefore, the absence of a central issuing authority has increased scepticism surrounding the feasibility of regulating cryptocurrencies. Such concerns are legitimate in the wake of a deeper understanding of how cryptocurrencies work because many people who have advocated for regulation in this sector are misled to think that it is possible to implement it effectively in a virtual market where there is no central issuing authority.
Therefore, unlike how banks would use fiscal and monetary policies to influence the performance of the financial system and the economy, it is difficult for the same approach to be adopted in a framework that does not recognise any issuing authority. This analysis means that Bitcoin users and vendors are the ultimate authority in the operations of cryptocurrencies and because of the public nature of cryptocurrency transactions; regulation is achieved without the involvement of a government authority or agency. What this means is that without a central issuing authority, the structure for regulation is undermined, thereby making it nearly impossible to achieve significant regulatory gains in this regard.
Legitimacy
The legitimacy of cryptocurrencies as legal tenders has been characterised by the different interpretations of laws regarding the same. Stated differently, many countries assume varied levels of legitimacy for cryptocurrencies. The variation causes differences in cryptocurrency legitimacy across borders. This is one reason why regulation is not necessary. In other words, cryptocurrencies are not linked to one country or legal framework because by gaining access to an internet connection and a cyrptocurrency wallet, one can undertake financial transactions virtually. Furthermore, one institution that has regulatory power does not oversee the blockchain technology, which supports cyrptocurrency transactions. This finding means that although it may be prudent to introduce legislation in countries that can regulate cryptocurrencies, it may be difficult to enforce the same laws in other nations that have lax regulation. Therefore, based on this challenge, it may be difficult to enforce existing regulation on Bitcoin. At the same time, different countries have unique approaches for prosecuting cybercrime. Even when cooperation is sought, it may be difficult to gain international cooperation when prosecuting cyber-related crimes. For example, some countries in Asia, such as China and North Korea have a strict and “no-nonsense” approach to cyber-related crimes because of national security issues.
Relative to the above view, in 2013, China banned the use of Bitcoin – a move that saw the world’s most popular cryptocurrency plummet in value. In 2014, several accounts linked to Bitcoin were closed. Such moves sparked concern among cryptocurrency owners that government regulation would affect the growth of the virtual currency. There have been similar attempts in the US to regulate cryptocurrencies, as was evident in a recent case in New York, where the state won a landmark ruling that guaranteed it access to the identities of 14,000 Bitcoin users. Additionally, the New York state government introduced a new regulation that required Bitcoin traders to have a “BitLicence.”
The lesson to be learnt here is that some countries may have a different approach to prosecuting crimes that are related to cryptocurrencies from western countries, which have a more liberal stance on the same. For example, western nations may not necessarily perceive crimes related to cryptocurrencies as falling within the realm of national security issues, but rather from an economic crimes standpoint. Alternatively, they have a responsibility of balancing national security issues and rights and freedoms, which are enshrined in their constitutions. It may be challenging to reconcile the two approaches of regulation to provide a holistic framework for regulating cryptocurrencies.
Although the above views indicate that cryptocurrencies were developed from complex technology, the premise in which they work is simple – any person, located anywhere on the globe with an internet connection can exchange credits, products and services easily. Unlike traditional forms of payment where merchant accounts and payment gateway accounts are needed, cryptocurrencies provide the freedom from such sort of third-party obligations. This feature explains why Bitcoin has gained a lot of interest in different parts of the world.
Another issue that emerges in crytpocurrency regulation is the capacity to enforce laws across different jurisdictions or to prosecute a case involving a breach of law in the use of cryptocurrencies. This concern emerges from the fact that operating virtual currencies require some technical knowledge from the law enforcers. In most cases, hackers and people who launch attacks on cryptocurrency users are too sophisticated for law enforcers to understand the nature of the crimes they commit. Although the capacity to prosecute cryptocurrency-related crimes may improve, it is difficult for law enforcers, especially in jurisdictions that do not have highly advanced cybercrime units, to secure a conviction associated with cryptocurrency use. This concern partly explains why the cross-border nature of cryptocurrencies is a serious impediment to regulation. Even if one country builds the capacity to prosecute cryptocurrency-related transactions, it would be difficult for them to make other authorities understand their point of view. More importantly, it would be difficult for them to police the entire world. In this regard, it remains a difficult task for authorities to find a practical way of not only introducing regulation, but also enforcing it across a borderless framework.
The institutional model, which governs the operations of many regulatory activities today, cannot be relied upon to spearhead initiatives aimed at regulating cryptocurrencies because they are not designed to work across borders. The institutional model works by giving an opportunity to regulators who have appropriate expertise to apply them in specific fields of financial regulation. However, this model has two main issues. The first one is premised on the fact that varied financial institutions may produce products that are functionally the same, but are governed by different regulatory agencies. Such is the problem that characterises the use of cryptocurrencies in the sense that although they may be similar in function to fiat currencies, they are different in terms of the varied approaches to regulation that may adopt. The cross-border nature of crytpocurrencies is one such difference that explains the limitations of regulation. Furthermore, it provides strong incentives for regulatory arbitrage.
An example that explains the above issue happened in the 1990s, when different actors in the securities market participated in credit intermediation. They used the same method to create deposit-like and short-term credit claims similar in manner to how banks would do. The securities exchange commission (SEC) which is supposed to regulate such activities was supposed to act on this, but did not do so because it lacked the regulatory framework and soundness to perform its duties as a regulator of banking activities.
The institutional model, which is used in the banking industry, and that has been proposed for implementation in the cryptocurrency space, is similarly not equipped to work in the sector because it cannot cope with systemic risks associated with digital currencies. Managing systemic risks would require a proper engagement and understanding of the entire market, but this is not the case for the cryptocurrency space because few regulatory agencies understand how it works and comprehend what areas of its operations need regulation, relative to the implications of the same actions on the market in general. Besides being unable to manage systemic risks that could affect the financial sector, the current institutional model that is proposed for use in the cryptocurrency space is poorly placed to deal with changes that characterise the financial sector and that govern new innovation in the financial sector, such as those witnessed through Bitcoin and other cryptocurrencies. Therefore, if crytpocurrency use spanned across different sectors, they would be subjected to a patchwork of legal provisions, which would be implemented in the pretext of introducing regulation in the cryptocurrency space. The process will ultimately undermine the merits of FinTech. In other words, the appropriate expertise needed for supporting fair play and cryptocurrency development may be lacking if the current proposals to regulate virtual financial transactions are successful.
The challenge of implementing regulatory proposals across different jurisdictions is an old one. It has also proved to be problematic for experts who have tried to address the problem in the past. For example, at the turn of the century, the United Kingdom (UK) tried to streamline the designs of its regulatory proposals under a common regulatory authority by making sure that its officers were not limited by regulatory boundaries. After a few months of implementation, they discovered that the problem was insurmountable. The challenge was attributed to the poor consideration of prudential supervision, which should have been a priority in the regulation of cross-border financial transactions. Poor prudential supervision is also a significant threat in the regulation of cryptocurrency trade today because there is an overzealous group of people who are advocating for consumer protection at the expense of prudential supervision. Similar to the failure of the UK’s Financial Service Authority, such an attempt at providing a single unified regulator is not superior to the borderless design of the cryptocurrency financial system.
The borderless nature of cryptocurrencies also poses a problem in the creation of a regulatory framework for managing FinTech because of problems associated with enforcement. For example, the revocation of licenses is a significant tool used by regulatory authorities to ensure rules are followed. In the cryptocurrency framework, such a tool is useless because, except for New York, many states around the world are not required to provide a license for trading cryptocurrencies. Even users of Bitcoin in New York may still exploit the borderless nature of cryptocurrencies and choose to conduct their businesses from another location to avoid the regulation. In this regard, it becomes increasingly difficult to enforce laws and regulations involving financial transactions of a borderless nature. Furthermore, an attempt to enforce the rules of one country in another one would generate too much political controversy that would make it impractical to enforce regulatory laws or approvals in different countries.
A counter argument that has been proposed to address enforcement problems in a borderless world is the use of other tools of “punishment,” such as reputational damage. In other words, a simple argument that one firm is notorious for flouting regulatory principles is likely to cause a reputational damage on the same company. However, it is difficult to conceive a situation where such a tool may work in the current financial system because cryptocurrency use is not defined by the activities of different companies. In other words, there are no merchants to blame for flouting regulatory policies because cryptocurrencies eliminate the need for third parties in the financial system. Consequently, it is difficult to understand how to introduce regulatory frameworks in cryptocurrency use when the borderless nature of cryptocurrencies poses an insurmountable threat to the enforcement of the same laws.
Investor Protection
Regulatory approaches employed in the financial system are meant to protect consumers above all other actors involved in the same system. Although the theoretical definition of a consumer (in the context of a financial system) is subjective, there is little contention that users of financial models need the utmost protection from risks that could emerge from the implementation of the financial model. This view informs bold suggestions by critics of digital currencies who say that regulation would not only protect the interest of investors, but also promote the acceptance of digital currencies as legal tenders. In other words, they believe that when cryptocurrencies are under regulatory approval, they are more likely to be accepted in the mainstream financial industry.
The above view has been partly supported by critics who believe that regulation would elevate cryptocurrencies to the same level of mainstream financial services, thereby increasing their odds of being received as an acceptable mode of payment. However, accepting regulation in the FinTech space would only bring digital currencies under the control of the mainstream financial system. In other words, it would shift the power of innovation and its control back to banks, which are regarded as some of the most powerful players in the global financial system. Based on this understanding, it is important to understand that consumers of the conventional financial system may not need the same level of protection as those who use cryptocurrencies because of different levels of exposures involved.
The conventional financial system exposes consumers to different types of risks (mostly systemic) that need to be mitigated through regulatory interventions. In other words, government agencies have to ensure that regulation is followed to protect the interests of customers. They often do so to achieve several key objectives, which include the facilitation of improved consumer choice (through information-based strategies), imposing restrictions on poor choices (product regulation), minimizing the predatory behaviours of rent-seeking financial institutions, protecting the system from “nudging” consumers, and providing welfare safety nets. These key objectives, which are focused on the protection of consumer interests in the conventional financial system, explain why regulation has been proposed as a necessary tool in the proper functioning of the financial system. However, a careful review of these objectives show that, although users of cryptocurrencies could also be exposed to some types of systemic risks, they do not stand to benefit from any other advantages above the objectives of regulation, as is currently designed.
Generally, four types of regulatory tools are used to protect investors in the current legislative framework. The first one centres on the imposition of capital requirements on banks to maintain healthy balance sheet reserves. The goal of introducing such a stipulation is to meet any shortfall in the value of the banking assets, relative to the liabilities they have. This provision shows that cryptocurrencies do not need to be subjected to regulation because they do not share the same risks as those experienced by banks. For example, they do not need capital requirements because there is no need for a balance sheet to maintain, as there are no assets or liabilities. Additionally, unlike banks, cryptocurrencies do not have banking assets or a need for “loss absorbency,” which has necessitated regulation in the conventional banking sector. The immunity from such risks emanates from the decentralised nature of cryptocurrency trades. Therefore, it is difficult to understand why regulation is needed in this field because cryptocurrencies do not expose their users to the same type of risks as banks do.
The second reason why regulation was introduced in the financial sector is to require banks to have a significant portion of their assets in liquid form to meet depositors’ withdrawal requests. Again, cryptocurrencies do not have the same problem. Therefore, they need not be subjected to the same regulation. Stated differently, no liquidity problems are associated with the use of cryptocurrencies. The same is true when the risk of losses on deposits is analysed because existing regulation is in place to make sure that depositors do not lose their money. In other words, authorities always ensure that there is adequate regulation as insurance against the loss of deposits. This problem is non-existent in the use of cryptocurrencies because they are not centralised. Therefore, the need for regulation, when analysed within the context of insurance provision, is unnecessary.
The same is true for regulations that are set in place to create a lender of last resort in centralised financial systems. This principle works by introducing the central bank, or the government, as the ultimate authority that is supposed to bail out financial institutions when they are unable to meet their financial obligations. The same principle is unnecessary in cryptocurrency use because there is no central financial structure where the principle of the lender of last resort is applied. In other words, cryptocurrencies do not act as banks where they are supposed to meet the financial obligations of their clients in a centralised financial system. This analysis shows that although cryptocurrency use could pose as a direct threat to the banking system (as it is currently constituted), the need for regulation, as conceived through the operations of banks and other financial institutions in the conventional financial space, is inapplicable in the virtual financial system.
Collectively, the four needs for regulation in the financial sector, which have been highlighted in this paper, highlight the need to protect depositors’ money, the need to maintain balance sheet reserves, the need to hold some assets in liquid form and the need to set up a lender of last resort are inapplicable in the crytpocurrency space. Many critics of digital currencies and advocates of regulation in this sector do not understand that crytpocurrencies work differently from the conventional financial system. Therefore, regulation as currently proposed to mimic the types of structures adopted in the conventional banking system cannot work for the benefit of its users. The decentralised nature of cryptocurrencies makes any arguments for regulation impossible to implement because it is difficult to understand how regulation would work in a decentralised environment where the needs for regulation, as proposed in the financial sector, do not apply.
Disclosure of Information and Transparency
A cardinal principle applied in financial regulation is the identification of culprits and making them accountable for their actions. Cryptocurrencies pose a challenge in this regard because some of the transactions that are completed on the platform are anonymous. Therefore, there is no clear set of actors involved in such a trade. This way, it may be difficult to identify offenders when laws are contravened. Relative to this assertion, law enforcement officers often find it increasingly difficult to trace illicit proceeds, which are obtained through cryptocurrencies. This view emphasises the prosecutorial challenge that authorities may face when regulating cryptocurrencies. Consequently, the development of any meaningful legal control needs to be supported by a global concerted effort, which is typically difficult to achieve. At the same time, the actions of one country in creating regulatory control could easily be negated by the inaction of another using a proxy system that would allow users to transact internationally.
Evidence of the difficulty of regulating cryptocurrency trading is seen through frustrations experienced by governments around the world in shutting down torrent sites. In many western countries that have tried to do so, the issue has proved to be problematic because regulating peer-to-peer technology platforms is a difficult undertaking. A fairer comparison of the difficulty to regulate cryptocurrencies is seen in the “dark web.” Although some people could be arrested for participating in illegal activities on the dark web, it is difficult to conceive a situation where the government can effectively regulate it. This analysis means that it is technically difficult to regulate cryptocurrencies.
In response to cases where governments have successfully managed to obtain the identities of those who engage in transactions involving cryptocurrencies, it is still difficult to link the same identities with real people. In other words, it is possible for users to hide their identities when using cryptocurrencies through VPN, thereby making it difficult to trace them. In the same manner, it is possible to hide a cryptocurrency wallet (offline) making it difficult for authorities to establish the true owner of cryptocurrencies.
Although some researchers have highlighted the above challenges in cryptocurrency regulation, some proponents of regulation have voiced the need to structure regulations in a way that prevents users from cashing out. However, for such a proposal to work there needs to be a concerted effort globally. Nonetheless, it is difficult to achieve such universal cooperation, especially because it is possible for users around the world to trade any major currency online, from anywhere in the world with an internet connection, and cash out. Furthermore, if the government wanted to regulate one type of cryptocurrency, users could simply shift to another. With dozens of cryptocurrencies in circulation and more being made, it would be practically impossible for the government to track and regulate them, unless they stop the use of currencies altogether. At the same time, numerous online financiers who accept cryptocurrencies do not require any form of identification to complete transactions. In this regard, cryptocurrencies upset how retailers, vendors and purchases relate to the marketplace. This disruption makes it difficult to impose a set of regulations that would govern the activities of unknown actors.
Although the consumer is the most important actor in the cryptocurrency market, it is difficult to understand how the same stakeholder would benefit from regulation. The anonymity that surrounds cryptocurrency use is one impediment to realising the benefits of regulation in this sector because it is often difficult to know the identity of those involved in cryptocurrency transactions. Furthermore, it is difficult to know where they are located on the globe. Therefore, if regulation were to be introduced in the cryptocurrency space with the goal of benefitting users, such impracticalities would suffice. Consequently, it would be difficult to understand who the intended beneficiary of regulation should be. In any case, studies have shown that regulation would only stifle the activities of users in the virtual marketplace, thereby acting to their detriment, as opposed to encouraging their innovation, which should be the case.
Consumers are not the only actors involved in the cryptocurrency trade; vendors are other entities that need to benefit from regulation as well. However, existing proposals aimed at introducing regulation in the virtual marketplace make it difficult to understand how vendors would benefit or receive protection from regulation. In fact, current regulatory proposals seem to discourage vendors from accepting Bitcoin and other forms of cryptocurrencies, as an acceptable mode of exchange, because of limitations in the acceptability of cryptocurrencies as a legal tender. Since it is easy to establish the identity of merchants who accept Bitcoins, it would be expected that regulation would benefit them directly and clearly. However, this seems not to be the case. In many jurisdictions, limitations on cryptocurrency use have been proposed as a prohibitive tool for discouraging vendors from destabilising “status quo.” In this regard, regulatory proposals appear to be protecting the current conventional financial system as opposed to creating fair play and practice in the system. In this regard, regulation does not seem to have a tangible value to the ecosystem that supports digital currencies.
Broadly, it is difficult to enforce regulations in FinTech because the innovation is underscored by the principle of collective actions, which make it difficult to hold one party responsible for an infringement of law. At the same time, it is difficult to conceptualise a framework that would guarantee cooperation among all the market entrants involved. Collectively, these considerations reveal a situation where the imposition of regulatory limitations on cryptocurrency use would be ineffective because the regulatory concerns that apply to FinTech are different and more severe than those observed in the conventional financial system are.
Legal Aspects
Current Laws
The regulatory framework proposed for use in FinTech traces its history to the 2007/2008 financial crisis where a raft of recommendations was introduced to control banking activities. As explained by the Harvard Law School, most of the regulations proposed in that era were conceptualised under the Dodd-Frank Act and significantly altered the regulatory landscape. Notably, Wall Street and traditional banks found themselves engulfed in a web of financial regulation that affected different aspects of their operations, including conforming to new restrictions on propriety investing and committing themselves to support new legal frameworks to ensure banks and insurance firms survive in the wake of financial stress. Although current proposals to regulate FinTech have been based on similar recommendations, the innovation underpinning financial technology poses a challenge to this proposal. For example, the Dodd-Frank reforms identified specific financial institutions and termed them as “important entities.” Although such proposals were meant to protect investors, they failed to see a growing undercurrent of decentralization in the financial sector that was started by cryptocurrencies and that is shifting away the focus from Wall Street.
Notably, small technological start-ups were starting to provide services that were traditionally offered by central banks, thereby eliminating the need to have third party financial services. For example, in this paper, the role of merchants in global trade is highlighted as one of the services that is under threat from the growth of cryptocurrencies. Based on this example, alone, it is possible to see how the wave of legal reforms introduced in the post-crisis era are ill equipped to address some of the fundamental changes that cryptocurrencies have introduced to the global financial system. Different countries have reacted to these changes in varied ways. Table 1 below explains the status of cryptocurrency legitimacy across different jurisdictions in the world.
Table 1. Legitimacy of Cryptocurrencies across Different Jurisdictions.
Based on the table above, the growth of FinTech has questioned the assumption that the regulation of systemic risk needs to be focused on centralised financial services and the dominance of large and seemingly important “too big to fail” financial institutions. The conventional view of financial regulation is premised on a few key principles. The first one is that banks have grown to become important financial institutions, which require support; otherwise, if they were allowed to fail, they would affect the performance of other parts of the economy.
Alive to this fact, many governments around the world have gone out of their way to bail out these financial institutions, especially those that are deemed “too big to fail.” The principle of financial bailout is a reasonable one especially because governments have a duty to protect their citizens from the adverse economic effects of financial impropriety. However, it is difficult to ignore the fact that a guaranteed government bailout will not have a significant effect on the decision-making processes of such banks. In other words, the banks may engage in risky financial transactions because they are sure of government guarantee. This way, they know that they will be protected from the adverse effects of their actions if their strategies fail to pay off. Such risky financial behaviours happened and reached a crescendo when banks took unnecessary and risky gambles in the subprime mortgage market using complex derivatives that were meant to cover financial risks in a wider and faulty financial framework that collapsed and caused a global financial crisis. Ever since that time, the precedence in financial regulation has been centred on the need to regulate institutions that are “too big to fail,” or that are important for the economic prosperity of a nation.
Nonetheless, this principle of regulation, under the concept of “too big to fail,” assumes that systemic risks could only come from centralised financial bodies. It is faulty because it undermines other sources of systemic risks that could come from small entities perceived to be unimportant. Indeed, according to the findings of the Harvard University Law School, smaller financial entities may pose significantly worse risks than those predicted under the conventional legal model of regulation. Based on this premise alone, regulations that are designed to control operational issues in a centralised financial system may increase the risk profile in a decentralised one.
Issues with Current Laws
Current regulatory models in cryptocurrency trades have little chance of success because FinTech poses a challenge for three main reasons. For instance, FinTech is more vulnerable to adverse economic shocks compared to conventional currencies. These shocks are more likely to spread to all other parts of the model, which rely on the financial framework, unlike the traditional financial design. Regulation is likely to fail in such a decentralised financial model because it would be difficult to monitor financial activities in cryptocurrency use compared to a centralised financial system where a few large entities hold a lot of power. Furthermore, Fintech offers regulators little information about the structure and operations of its markets. One theme that emerges from these discussions is the opportunities that decentralised monetary systems pose to societies. Cryptocurrencies are designed in a decentralised framework because they do not have a focal point of operation. Since traditional financial systems are centralised, cryptocurrencies (and FinTech in general) provide a new way of thinking in the way the global financial system operates.
Potential Threats and Possible Remedies
Potential threats associated with the use of cryptocurrencies are confined within arguments that highlight money-laundering, fraud, theft, and hacking as possible issues related to its use. However, one of the main arguments against regulation has been based on an attack on the merits of cryptocurrencies. People who have expressed their reservations about this platform believe that cryptocurrencies, such as Bitcoin, are only “passing clouds” in the financial system because they do not offer any intrinsic value to it. For example, their response to the recent rise in the value of Bitcoin is that the currency’s value has risen almost 17 times because of speculative forces. Based on this argument, they believe that cryptocurrencies have caused a “bubble” that will soon burst. With such contempt for cryptocurrencies abound, there have been little prospects for regulation and even a smaller agreement that it is important to regulate a “passing cloud.” Based on this view, the possibility that such arguments would not pose as a barrier to regulation is small. However, critics who overlook the power of cryptocurrencies do so at the expense of failing to understand that cryptocurrencies are powerful tools of trade that are here to stay. More importantly, they fail to understand that these digital currencies are immune from regulatory control because there is no clear set of actors to hold personally responsible for legal breaches.
Another problem associated with cryptocurrencies is the fact that most laws that have been proposed to regulate cryptocurrencies have been borrowed from the banking industry and the centralised conventional financial system, which is mostly maligned with the interests of small start-ups and small technology companies. The operations of cryptocurrencies in the global financial system reflect the business lifecycle stages that small technology start-ups undergo. However, there is an exception because unlike how the government promotes the growth and development of small technology start-ups (such as those based in the Silicon Valley), cryptocurrencies are treated with a lot of suspicion. Additionally, proposed regulations to govern its operations are designed to stifle its growth and undermine the innovative platform that make it work. Using most types of regulation, such actions (as currently being promoted in different jurisdictions around the world) are not helping to promote the technology or the innovation behind it, but rather to “kill” it. In fact, according to two researchers, Brito and Castillo, the application of banking industry standards on Bitcoin and other cyrptocurrencies would almost assuredly lead to negative outcomes.
The decentralised nature of cryptocurrencies means that it is difficult to introduce regulations that would holistically govern them because they cannot be controlled or clamped down easily. In other words, cryptocurrencies are not associated with any arrangement involving a national bank or central oversight authority. Therefore, it works outside the domains of direction. The fact that digital currencies are decentralised means that no government owns them and by this definition alone, authorities do not have the direct control required to enforce laws.
The decentralised nature of cryptocurrencies has been hailed as one of the key selling points of virtual currencies because it gives users unlimited access to their currencies. In this regard, it is termed as a sophisticated type of currency. According to one author called Sean Bennett, in his book aimed at helping people understand how cryptocurrencies work, he said banks are even considering using certain aspects of FinTech in their conventional banking systems to make them more appealing to their customers.
One problem associated with critics of cryptocurrencies who advocate for the growth and development of the conventional banking industry at the expense of cryptocurrencies is the fact that they do not recognise that the banking system also has many risks such as those affecting cyptocurrencies. For example, the banking theory argues that such financial institutions operate on the premise that people are not going to make withdrawals at once; otherwise, the banks will suffer a “bank run,” which occurs when the institutions deplete their financial reserves at once. The principle behind this risk is called fractional reserve, which means that only a specified amount of money is usually set away for withdrawals, while others are issued as loans. This principle explains the “magic” and the “catastrophe” that could be the banking system because on one hand, they could be instruments for economic growth and prosperity, and on the other hand, they could be agents of spectacular financial crises and disasters.
Although there are calls to regulate Fintech, there is a consensus among regulatory bodies worldwide that the financial risks that are to be regulated do not necessarily occur because of the technology of financial products to be regulated, but because of corporate governance weaknesses. This view is partly explained in an article by Europa, which says that the absence of effective checks and balances within financial institutions have contributed to some of the world’s most notable financial crises. The article also explains that imprudent risk-taking is largely to blame for systemic financial issues in many states around the world. In response to such kind of problems, different jurisdictions have introduced legislations that would address them. For example, Europe introduced Directive 2004/39/EC to address weaknesses in corporate governance. However, there are calls to supplement such legal provisions with more detailed principles and minimum standards of financial regulation. More importantly, experts have cautioned that the same provisions should be applied in recognition of the complexity and scale of the operations being regulated.
The above recommendations are not being observed in attempts to regulate cryptocurrency operations around the world because there has been little attention paid to the scale and complexity of virtual transactions. More specifically, critics of cryptocurrencies have paid no attention to the global nature of digital currencies and the borderless nature of payments. By any scope of measurement, most of the regulatory proposals currently under consideration in western countries do not factor in these issues when proposing new regulation and are blind to the limitations of regulatory implementation in a decentralised economic environment.
The observation of European experts in financial regulation, which point out to corporate governance weaknesses as being the root cause of financial and systemic risk, seem to support anti-regulation calls because cryptocurrencies are not governed by corporate rules. In this regard, they are not vulnerable to the same risks as fiat currencies. The support comes from the decentralised nature of cryptocurrency trade and the equal power it gives both buyers and sellers on the trading platform. Although there are arguments that support a contrary position that cryptocurrencies are subject to manipulation, they seem to be confined to the trading of cyrptocurrencies on the securities and commodities market, as opposed to the actual working of the innovation that underpins it. Furthermore, most of the people who have made such claims seem to target Bitcoin and its recent gain in price. However, Bitcoin is only one type of cryptocurrency. Its merits and demerits are not representative of all types of cryptocurrencies and it does it outline the vulnerabilities or weaknesses of all types of all digital currencies. Therefore, such arguments seem to lack the focus, depth, or insight required for regulatory approval. More importantly, they describe the misinformation that surrounds cryptocurrency use.
Based on the above views, regulatory proposals, which are meant to govern cryptocurrency trade, are being made without a proper understanding of how cryptocurrencies work, or the basic nature of the innovation that supports them. Particularly, people who have made proposals to regulate cryptocurrencies are oblivious of the fact that transactions involving digital currencies are decentralised. This fact means that the cryptocurrency structure is unlike the conventional banking model where financial transactions are centralised within a framework that is controlled by central banks (as envisaged in the conventional financial system). Typically, each country has a unique name for its central bank, but the structure is usually the same – the central bank, which controls most financial transactions, sits at the top of the financial model in a controlled financial framework. In the cryptocurrency field, transactions are not designed in such a manner because there is no focal authority that controls the financial system.
The possibility of cryptocurrencies growing into a bigger global phenomenon necessitates policymakers to look at it this issue more seriously. Relative to this concern, criticisms highlighted above concerning cyryptocurrencies stem from their ability to realize a decentralised orderly governance. In other words, it is difficult to accept cryptocurrencies as effective credit management tools if they are not accepted as a legal tender or a national credit endorsement. However, studies have shown that the lack of a central authority in a financial system does not necessarily mean that the system would degenerate into chaos.
Such is the findings of research studies that have used the open source theory and common governance principles to investigate financial regulation in a decentralised framework. In other words, the same findings demonstrate that seemingly “loose” organisations can still thrive on sound financial management so long as there are healthy relationships among the actors involved. Such is the case of cryptocurrencies and the virtual financial system because they are bound by healthy interactions among stakeholders. Here, different actors who are involved in the decentralised financial system, such as vendors, miners and programmers, are able to make changes to the financial system in a manner that a central bank will do. Additionally, they have kept some cryptocurrencies functioning well, as is the case of Bitcoin, which has operated successfully for close to a decade.
Based on the above analysis, it is not easy to understand the need for regulation in a system where communities managing cryptocurrency ecosystems can reach a consensus without a board meeting or a group resolution, as would be needed in a centralised financial system. For example, there was one incident, involving the use of Bitcoin, where some transactions were not recorded on the Bitcoin ledger in a timely manner because the cryptocurrency’s growth was happening too fast. Without a centralised authority, community members agreed to improve the operations of the blockchain technology, which underpins Bitcoin operations, to record transactions much faster than was previously done. This review shows that communities that support cryptcurrencies work in the same way as central banks do and could exhibit the same type of effectiveness in a decentralised organisation structure.
Summary of Findings
Based on the arguments presented in this report, it is important to point out that the decentralisation and migration of financial services from the mainstream financial sector to virtual networks (triggered by the proliferation of cryptocurrencies) will demand that regulators adopt a new look at financial regulation. More importantly, they ought to recognise the need to rely less on entity-based regulation. Stated differently, entity-based regulation in its traditional sense will not work in the future as activity-based regulation takes centre-stage.
Another important issue that has emerged in this investigation is the delicate balance that promoters and regulators have to strike between privacy and transparency concerns. These two elements of the financial system have been integral to this analysis because they affect trust, which is a key ingredient to the future acceptance of digital currencies and which keep the current financial system working. More importantly, the blockchain technology that supports cryptocurrency use and the distribution of information across networks has highlighted the importance of balancing transparency and privacy concerns. However, the sharing of data across an open network without a common regulator makes it increasingly difficult to protect the privacy of users who use cryptocurrencies and still avail data freely to meet transparency stipulations. Therefore, regulators have a difficult role of developing an approach that address both privacy and transparency concerns.
Another challenge that regulators face is the problematic area of regulating algorithms that underpin cryptocurrency use. The challenge exists in providing a regulatory framework that will both improve consumer trust in cryptocurrencies and at the same time provide an oversight to the complex algorithms that underpin the digital currency system. Ideally, the algorithms that underpin the financial system need to be designed in a manner that they do not expose consumers or the financial system to undue risk.
As the financial system exists today, there are few ways of understanding how the regulation of cryptocurrencies is done across different countries. This situation informs why creating a general regulatory framework for managing cryptocurrency trade may be difficult because many regulatory loopholes exist. Therefore, international regulation and harmonisation will be central to manage systemic risks that may be involved in the use of cryptocurrencies. This need is dire today more than ever because blockchain and distributed ledger technologies are becoming more mainstream than in the past.
The point that could be learnt from the above facts is that no financial system is perfect. Therefore, the same cryptocurrency system, which is partly criticised for its lack of stability, has the same chance of success and failure as the conventional banking system (with or without regulation). In any case, the cryptocurrency model itself ensures some of the risks associated with the conventional banking system cannot occur. For example, it is impossible to have a “bank run” in the cryptocurrency model because the framework is not based on a centralised system, such as the conventional one, which is controlled by banks. In other words, the decentralised model ensures such risks will not occur. Therefore, it is inherently safer than the conventional model in this regard and much less in need of regulation to manage such a risk.
Additionally, a comparison of the need for regulation in the banking industry and the cryptocurrency space show that the centralisation of funds in the conventional financial system creates the necessity for regulation, unlike the decentralised financial system, which supports cryptocurrencies. In other words, governments introduce regulation in the conventional banking system to check the power of banks in the centralised model because they could significantly alter key performance indicators in the country’s economy. Here, banks play a central role in safeguarding the economic health of a country because they are key players in the centralised financial model. In fact, the performance a country’s currency could be significantly influenced by the activity of banks because of the centralised nature of financial transactions in the conventional operating model.
Regulation is necessary in such a system because banks cannot be left to operate on their own when they have such immense powers not only to influence the economic performance of a country, but also to affect the performance of its currency. Crytpocurrencies do not have such influence. Based on their decentralised system, it is difficult to understand why regulation may be needed when they do not have the powers that banks do. Furthermore, they are not exposed to the fragility that is associated with the banking system and that necessitates regulation in the first place. For example, regulators understand that the banking system is fragile. Therefore, they have introduced regulation to protect depositors from such risks. For example, in many jurisdictions, central banks act as lenders of last resort, to protect depositors from the excesses of the banking industry.
Suggestion for Future Research
The lack of an issuing authority is at the centre of arguments advanced by proponents of cryptocurrencies who have drawn the world’s attention to the manipulative power of central banks and the monopoly they hold in not only influencing national but global economies as well. For example, movements like “Occupy Wall Street” and the populist “Main Street” movements stem from this idea. Although the reasons for discontentment are varied and wide, the concept of monopoly of power in the financial system is unsettling for some users of cryptocurrencies who have been profoundly attracted to use digital currencies because of the seeming inability of governments to interfere with the structure and working of cryptocurrencies. Their arguments are partly focused on the idea that, in many countries, central banks are interestingly opaque government entities that have the monopoly and the ability to control financial systems, while cyrptocurrencies are transparent entities that work well without the need for government intervention. Their potential to make mistakes is more disturbing for many people who believe that cryptocurrencies provide them the freedom they need to interact with vendors freely. The freedom and transparency that cryptocurrencies provide their users partly explain why the alarm is always raised whenever there is suspicion that one entity in the system is gaining a monopoly.
In a world where technological advancements are creating a narrative that excludes central banks from the monetary system and make people question whether they are necessary in the first place, an argument can be made that regulation is unnecessary in an environment where there is no central issuing authority. From an ethical standpoint, it is even easier to question the authority of central banks who have caused millions of people financial and emotional pain by engaging in corrupt deals that have resulted in global financial crises, such as the Great Recession, where central banks have colluded with banks to abate economic crimes (willingly or unwillingly). With the existence of a central authority, it is wrong to undermine a cryptocurrency system that saves users millions of dollars that have been traditionally pocketed by merchants in the form of (intermediary) transaction fees. In this regard, regulation is unnecessary in the wake of technological innovation that naturally eliminates the need for intermediaries in the first place.
Nonetheless, an existing threat of cryptocurrencies is the fact that governments are closely studying them and even though they pose a direct threat to the existence of central banks, it is difficult to conceive a situation where they would be dethroned as the apex issuing authority without a fight. The current lull that exists between governments and users of cryptocurrencies could be partly explained by the fact that the adoption of cryptocurrencies is still slow and they do not pose a significant threat to the current monetary system. However, it is believed that if the adoption of crytptocurrencies continues to grow, central banks around the world could start to issue their digital currencies thereby undermining the growth and development of existing ones. Based on this possibility, future research should explore the implications of governments issuing their own digital currencies.
Based on the information highlighted in this paper, four recommendations suffice if regulation should be considered a feasible step in the growth of cryptocurrencies. One of them is the need to produce a regulatory framework that can generate more and better information about cryptocurrencies and how they work. Secondly, there needs to be a limitation regarding how contagion may be propagated in cryptocurrency use. Thirdly, regulation should be focused more on promoting self-policing, as opposed to the introduction of a new entity or party in FinTech regulation. Lastly, FinTech regulation cannot work in a borderless environment where there is little international cooperation and communication. These reforms could better reduce the seriousness of the systemic risks that exist in FinTech. Without them, it is difficult to understand why regulation should be introduced in this new and emerging sector of financial innovation in the first place.
Conclusion
This paper has explored supporting and opposing views of regulation in the cryptocurrency space. The main arguments presented in support of regulation centre on four main pillars, which highlight the need to encourage institutions to accept regulation as an accountability tool for managing systemic risk, to protect consumer interests in a market where information is not freely shared, to support competition and prevent oligopolistic behaviour, and to enable flexibility and regulatory arbitrage. Here, support for regulation has premised on the need to make sure that systemic risks are contained and regulation goals are sustained. Analogously, regulatory proposals have been made in the backdrop of a belief that legal controls would bring sustainability to an otherwise disorderly sector of the financial market. Relative to this view, consumer protection has emerged as a core pillar of support. Support for this view has also emerged from the perception of regulation as one way of approving the type of innovation that supports cryptocurrency use. The common wisdom is premised on the view that regulating the financial sector would promote consumer trust in digital currencies because it will be approved as a new type of payment system.
Based on these arguments, supporters of regulation in FinTech seem not to understand the types of changes that have been brought by cryptocurrencies. For example, they fail to understand that the technology is revolutionary and has transformed how the financial management system works. Particularly, it has redefined how banks operate, how capital is raised, and made people question what they believe about the concept of money in the first place. Some of the changes that FinTech has introduced into the mainstream financial system mean that there needs to be a reconceptualization of regulation as it is currently constituted. A key finding that emerges in this analysis is the failure of the current regulatory framework to address distinct systemic risks associated with FinTech because they have been traditionally designed to prevent systemic risks in traditional financial institutions that are “too big to fail.”
It is normal for analysts and observers to be sceptical about cryptocurrencies and the role they play in the world’s global financial system because no other instruments of trade like them have ever existed before. A peer-to-peer financial system such as that being used by most of the world’s major cryptocurrencies were initially inconceivable because the technology that was previously available could not support it. Nevertheless, this technology now exists and it is defined by blockchain innovation. This paper demonstrates that most of the calls to regulate cryptocurrencies stem from people who do not understand this technology and how it works. Here, it should be recognised that cryptocurrencies are tools that can be used to achieve good and bad objectives, just like any other financial tool. However, failing to understand how cryptocurrencies work has made some sections of the society to blow its threats out of proportion because of the anonymous nature of the transactions.
However, based on the findings highlighted in this study, it is important to embrace digital currencies as new modes of payment, as opposed to fighting them through regulation. In other words, digital currencies should be viewed more like gold and not like PayPal because they are not agents of payment, but rather currencies of exchange. However, it is not expected that people will openly embrace the as legal tenders because the conventional financial model, which controls the global market, has been fine-tuned over the century to work in many parts of the world. Furthermore, it is difficult to integrate the cryptocurrency model with it. Consequently, it is important for nations to recognise the warning sign by accepting cryptocurrencies as legal tenders. Indeed, it is difficult to undo the financial innovation that underpins cryptocurrencies. Therefore, it is not going anywhere. The future of cryptocurrencies should be created in an inclusive framework where developers and users interact. It is simply a smart and effective way of undertaking global commerce.
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