Abstract
The exponential rise and volatility in the price of Bitcoin has heightened investor interest in cryptocurrencies and crypto assets. These assets have attracted a growing number of investors but also have been used to facilitate a wide range of illicit activities. In some cases, legitimate participants in crypto asset markets have incurred substantial losses. In response, the Financial Economists Roundtable discussed the potential benefits and risks associated with crypto asset markets and agreed that financial regulators need to be more proactive in addressing abusive activities.
Viewpoint is an occasional feature of the Financial Analysts Journal. This piece was not subjected to the peer-review process. It reflects the views of the authors and does not represent the official views of the Financial Analysts Journal or CFA Institute.
The exponential rise and volatility in the price of Bitcoin, the most widely used cryptocurrency to date, has heightened investor interest in cryptocurrencies and crypto assets more broadly. These assets have attracted a growing number of investors in many countries but also have been used to facilitate a wide range of illicit activities, even espionage against the United States. In some incidents of fraud, legitimate participants in crypto asset markets have incurred substantial losses, which has raised the issue of whether more effective regulatory oversight of crypto markets is needed, and if so, what kind of regulation and by whom.
In response to this growth of crypto assets, the Financial Economists Roundtable (FER), at its annual meeting on 16 July 2018, discussed the potential benefits and risks associated with crypto asset markets. While the views of individual FER members about specific issues raised by our discussion often differed from one another, the consensus is that financial regulators need to be more proactive in addressing abusive activities in crypto asset markets, such as fraud, money laundering, illicit drug activity, and price manipulation. Many of the abuses associated with crypto asset markets have been exacerbated by the conflicts and gaps that exist in the current regulatory structure and by ad hoc regulatory responses.
A key FER recommendation is that financial regulators must work together to develop a coordinated international regulatory response to abuses in crypto asset markets. We also propose, in the final section of this Statement, several immediate regulatory goals that should be used in developing such a coordinated regulatory response.
Potential Benefits of Crypto Assets
A crypto asset is a digital asset designed to work as a medium of exchange and a store-of-value that typically uses distributed ledger technology (often called a blockchain), which enables all participants to transact with each other without the need of a central, coordinating entity (such as a bank or clearinghouse). The blockchain ledger contains a history of all verified financial transactions and controls the creation of additional units.Footnote1 In contrast, sovereign fiat money is controlled by a central authority (central bank) and transferred through regulated financial institutions (banks).
Proponents of the use of crypto assets suggest that they may reduce transaction costs by eliminating the need for centralized, coordinating entities and they may provide an alternative store-of-value that provides protection from expropriation by governments. Furthermore, blockchain technology has the potential to enable the unbanked and underbanked to create their own financial alternatives in an efficient and scalable manner.Footnote2 Other potential benefits are rapid confirmation of transactions and a reduction in counterparty risk.
Potential Risks and Costs of Crypto Assets
Cryptocurrencies may also aid bad actors when used as a method of payment. Unlike cash whose transfer can be bulky, cryptocurrencies can easily move across borders with the push of a button.
For example, cryptocurrencies have been used as a method of payment for the purchase of illegal drugs, such as on the online black market Silk Road, which the FBI shut down in October 2013.Footnote3 In 2017, the US Department of Justice Drug Enforcement Administration issued a report concluding that “virtual currencies, such as Bitcoin, enable transnational criminal organizations (TCOs) to easily transfer illicit proceeds internationally.”Footnote4 On 12 July 2018, Special Counsel Robert Mueller, in an indictment charging 12 Russians with unlawfully interfering in the 2016 US elections, alleged that more than $95,000 in Bitcoins “facilitate[d] the purchase of infrastructure used in their hacking activity.”
Although one asserted benefit of using cryptocurrencies is their anonymity, they may not be fully anonymous. For example, because Bitcoin is issued and traded on a blockchain that provides a complete public history of transactions, authorities may be able to identify wrongdoers using Bitcoins by tracing their illicit transactions. Such traces may not have been possible had those transactions been carried out with cash.Footnote5 Also, not all cryptocurrencies use a public blockchain.
Additional concerns have been raised about initial coin offerings (ICOs) and the issuance of ICO tokens backed by cryptocurrencies.Footnote6 The offering documents (“white papers”) for ICOs have often included misleading and inadequate disclosures. Investors cannot easily distinguish between legitimate issuers and those who seek to profit by using fraudulent disclosure, which creates what economists call a “lemons problem” and results in risky or “bad” crypto assets poisoning the market for good or legitimate ones.
The trading of some crypto assets also has led to price manipulations (such as “pump and dump” schemes) and cyberattacks against holders or custodians of crypto assets, both of which have resulted in significant investor losses and a loss of investor confidence. On 23 May 2018, the US Commodity Futures Trading Commission (CFTC) and the Department of Justice (DOJ) jointly announced they were investigating allegations of manipulation through “spoofing” and “wash sales” at two minor virtual currency exchanges. On 8 June 2018, the CFTC asked four exchanges whose prices are used as benchmarks for Bitcoin futures—Bitstamp, Coinbase, itBit, and Kraken—for information related to this investigation.Footnote7
Numerous high-profile hacks of trading venues that function as both custodians of and dealers in crypto assets also have cost investors millions of dollars of losses both in the United States and other countries. The Bitcoin Exchange Guide lists all major cryptocurrency hacks from 2011 through 2017, including the infamous hacking in Japan of Mt. Gox in 2014, at one point the world’s leading Bitcoin exchange.Footnote8 Cryptocurrency holders lost nearly $1 billion in 2018.Footnote9 Many of these thefts appear to have occurred through exchanges or custodians, rather than through the cryptocurrencies themselves. Bitcoin’s blockchain has never been hacked or otherwise compromised.
Partially in response to these problems, some crypto asset firms have voluntarily submitted to regulatory oversight. For example, in June 2018, Coinbase bought an SEC-registered broker/dealer, Keystone Capital, that runs an alternative trading system, thus enabling Coinbase to make a market in crypto assets. Coinbase also has licenses in at least 37 states and is authorized by the SEC to trade ICO tokens that are classified as securities.Footnote10
In March 2018, the Praetorian Group filed a registration statement with the SEC to issue crypto tokens (PAX) structured to meet the SEC’s test of a “security” so its tokens would benefit from SEC approval. Unlike a traditional IPO sold through an investment bank, PAX tokens will be sold exclusively on Praetorian’s website (praetoriangroup.io). Investors will be able to purchase the tokens using Bitcoin, Ethereum, and Litecoin. The company anticipates that PAX tokens will be traded on cryptocurrency secondary exchanges, including DEX, Binance, Bittrex, Liqui, Poloniex, and Kraken, as well as some Japanese exchanges.
US Regulatory Responses.
Financial regulators have responded in different ways to these problems.
ICOs.
The SEC has gradually moved toward treating many, if not most, tokens issued by ICOs as securities, subject to SEC disclosure rules applicable to security offerings. More specifically, in July 2017 an SEC report on DAOs (decentralized autonomous organizations using blockchain technology) indicated that the SEC would employ the “Howey Test” to decide whether an ICO token is a security or an “investment contract.” (See SEC v. W.J. Howey.Footnote11) One criterion of this test is that an ICO token (or any other crypto asset) is a security if it carries an expectation of profit rather than just being a useful item or having utility (such as club membership).Footnote12
The SEC also launched HoweyCoins.com to warn investors about the risks of investing in tokens issued through ICOs. The website provides a mock-up of a fictional token and white paper and educates investors on red flags that may signal fraud. The FER supports these regulatory actions and urges financial regulators in other countries to provide similar information to investors in their countries.
In September 2018, the federal district court for the eastern district of New York ruled in United States v. Zaslavskiy that ICOs may be treated as securities, therefore making issuers potentially liable for criminal sanctions if the court finds the offering to constitute securities fraud.Footnote13 On the same day as the Zaslavskiy decision, the SEC settled charges against an “ICO Superstore,” TokenLot, for not registering as a broker/dealer in connection with the sale of its digital tokens.Footnote14 Also in September 2018, the Financial Industry Regulatory Authority (FINRA), which oversees securities broker/dealers, filed a complaint against a cryptocurrency promoter alleging securities fraud and the illegal distribution of an unregistered cryptocurrency.Footnote15
Derivatives on Crypto Assets.
In December 2017, the CFTC, which regulates all futures contracts and futures exchanges in the United States, authorized the Chicago Mercantile Exchange and the Chicago Board Options Exchange (CBOE) to begin trading cash-settled futures contracts on a Bitcoin index. (At this writing, the CFTC is considering whether to authorize trading of futures on an Ethereum index.) The December 2017 decision signals the CFTC’s intention to treat crypto assets like any other commodity or financial contract on which futures can be written.Footnote16 Among other CFTC regulations, exchanges are required to establish daily margin requirements on futures contracts to reduce counterparty risk.
Cryptocurrency Exchanges.
In 2014, the New York Department of Financial Services, which regulates money transmitters operating in New York, proposed rules for granting a BitLicense to entities that enable exchanges between cryptocurrencies and fiat currencies. These rules became effective in 2015.Footnote17 The FER believes that all cryptocurrency exchanges should be subject to regulation wherever they reside, whether in other US states or other countries.
Money Laundering.
The Treasury Department, through its FinCEN arm, now oversees money laundering and other illicit activities, including those facilitated by cryptocurrencies.Footnote18
Taxation.
Recent IRS rulings make clear that crypto asset transactions are taxable just like transactions in any other property.Footnote19 Other countries also are beginning to do this.
Congressional Responses.
In the wake of the disclosure that some Russian persons and entities used Bitcoin to finance the hacking of the 2016 US elections, the House held a Hearing on 18 July 2018 to discuss the role of cryptocurrencies.Footnote20 A blockchain caucus in the House now convenes regularly to discuss policy issues related to blockchain technologies.Footnote21 Two bills, with bipartisan backing, to create a special regulatory structure for cryptocurrencies also have been introduced in the House this year.Footnote22
International Regulatory Responses.
While financial regulators in all major countries (including the United Kingdom and the European Union) are studying crypto asset markets and appear to believe that some regulation is needed, few have settled on a coherent regulatory response to either cryptocurrency or crypto asset markets.Footnote23 Three countries that have are China, Japan, and South Korea, which have taken different regulatory approaches. China prohibits its citizens from owning cryptocurrencies, including Bitcoin, but encourages experimentation with blockchain technology. This approach may be best summarized by the comments of the Deputy Governor of China’s central bank, who said, “The only thing to do is to sit by the riverbank and wait for Bitcoin’s corpse to float past.”Footnote24
At the other extreme is Japan, which takes a more liberal approach. Its “Virtual Currency Act,” enacted in 2017, declares that cryptocurrencies are a legal means of payment. The Japanese financial services authority also has granted licenses to 11 crypto exchanges subjecting them to regulatory oversight, with the objective of reducing fraud and preventing another hacking incident like the infamous Mt. Gox episode.Footnote25
South Korea initially took a liberal approach to the regulation of crypto assets but later proposed banning cryptocurrencies in January 2018. Subsequently, the government rescinded that proposal, declaring that cryptocurrency trading accounts must be registered in the real names of traders and that capital gains taxes must be paid on sales of cryptocurrencies. The government, however, is still considering a ban on the issuance of tokens through ICOs.
In addition to individual country responses, several international regulatory bodies are attempting to develop a coherent framework to regulate the issuance and trading of crypto assets. The Financial Stability Board (FSB), an international group of major countries headquartered in Switzerland, issued a report to the G–20 concluding that, while the volume of crypto assets is still small relative to official government monies (around 1%), the FSB “will identify metrics for enhanced monitoring of the financial stability risks posed by crypto assets and update the G20 as appropriate.”Footnote26 The International Organization of Securities Commissions (IOSCO) has pointed to the growing use of ICOs to raise capital as an area of concern and has issued a statement to members discussing the risks associated with ICOs and the various approaches taken by the regulatory bodies of member states.Footnote27 These international initiatives are a promising step toward developing a global regulatory response to the growth of crypto asset markets.
Recommendations
The FER recommends that financial regulators in all countries should work together to develop a coordinated international regulatory response to the growth of crypto asset markets. A regulatory response that transcends national borders is needed to thwart the use of cryptocurrencies for illegal activities, such as drug dealing and money laundering, and to protect cryptocurrency users from fraudulent and manipulative schemes that threaten the integrity of crypto asset markets.
More immediate regulatory goals should be to:
Ensure that regulation does not impede legitimate and innovative uses of cryptocurrencies and blockchain technology.
Eliminate the current uncertainty about the applicability of securities laws to crypto assets both in the United States and other countries. Regulators should decide which crypto tokens issued through ICOs qualify as securities and are subject to disclosure requirements at the time of offering.
Ensure that institutions that enable exchanges between cryptocurrencies and fiat currencies have cutting-edge security technologies to protect against hacking and the theft of crypto assets. Currency exchanges also should be subject to minimum capital requirements and be required to perform customer background checks.
Ensure that entities that provide both exchange services and customer margin accounts have strong incentives to confirm that customers have the financial resources to meet margin requirements should asset values decline significantly.
Require that crypto asset exchanges provide regular tax reports to tax authorities and to customers that describe all trading activities, like the reports that US brokers and mutual fund companies now provide in their IRS Form 1099-B reports. Such reports would reduce costs for legitimate crypto asset investors and assist worldwide law enforcement in tracking and penalizing money laundering and other illicit activities.
FER Members Signing the Statement, “Crypto Assets Require Better Regulation”
Edward I. Altman
New York University
Marshall E. Blume
University of Pennsylvania
Arnoud Boot
University of Amsterdam
Charles W. Calomiris
Columbia University
Jennifer Conrad
University of North Carolina
Franklin R. Edwards
Columbia University
Robert A. Eisenbeis
Cumberland Advisors
Kathleen Hanley
Lehigh University
Larry Harris, CFA (Executive Director)
University of Southern California
Richard J. Herring
University of Pennsylvania
Takeo Hoshi
Stanford University
Andrew Karolyi
Cornell University
Jan Pieter Krahnen
Goethe University Frankfurt
Ravi Jagannathan
Northwestern University
Kose John
New York University
Jonathan Karpoff
University of Washington
Robert Litan
Brookings Institution
Robert McDonald
Northwestern University
Olivia Mitchell
University of Pennsylvania
Terrance Odean
UC Berkeley
Frank Partnoy
University of San Diego
Stephen Penman
Columbia University
Rafael Repullo
CEMFI
Jay Ritter
University of Florida
Anthony M. Santomero
Citibank
Stephen Schaefer
London Business School
Catherine Schrand Ramaswamy
University of Pennsylvania
Lemma W. Senbet
University of Maryland
Erik Sirri
Babson College
Chester S. Spatt
Carnegie Mellon University
Robert F. Stambaugh
University of Pennsylvania
Laura T. Starks
University of Texas
Siew Hong Teoh
UC Irvine
Ingo Walter
New York University
Roman L. Weil (Drafting Committee)
University of Chicago
James A. Wilcox
UC Berkeley
Notes
1 The remainder of this Statement discusses only cryptocurrencies associated with distributed ledger technology. The blockchain is one type of distributed ledger technology. Blockchains may be “public” or “private.” The Bitcoin cryptocurrency is an example of the use of a public blockchain. Issues associated with public blockchains have raised public policy concerns that are the focus of this Statement. Private blockchains are used by companies in supply chain management and recordkeeping. Because the FER believes (as do many others) that the market should be left to sort out the security and cost effectiveness of private blockchains, we do not discuss them in this Statement.
3 See https://en.wikipedia.org/wiki/Silk Road_(marketplace).
6 Most references to ICOs in the media and in many blogs about crypto assets treat them as assets, when in fact ICO is an acronym for initial coin offering, which is a process. The tokens issued in exchange for cash or crypto currencies are the actual assets.
7 A recent analysis by Bloomberg suggests that the case for manipulation may be weaker than it has appeared in the press. See www.bloomberg.com/view/articles/2018-06-15/bitcoin-manipulation-study-is-less-than-it-seems.
11 328 U.S. 293 (1946).
13 Memorandum & Order, 1:17-cr-00647-RJD-RER (E.D.N.Y.), ECF No. 37 (11 September 2018).
14 See Securities Act Release No. 10543, Exchange Act Release No. 84075, Investment Company Act Release No. 33221, Administrative Proceeding File No. 3-18739, ¶ 2 (11 September 2018).
16 The CFTC has issued a white paper entitled “Backgrounder on Oversight of and Approach to Virtual Currency Futures Markets” that outlines the agency’s regulatory approach. See www.cftc.gov/Bitcoin/index.htm.
18 See www.fincen.gov/news/news-releases/fincen-issues-guidance-virtual-currencies-and-regulatory- responsibilities.
23 See https://bitcoinmagazine.com/articles/cryptocurrency-regulation-2018-where-world-stands-right-now/.
24 Quoted in the Economist (20 January 2018), p. 65.