The world is seeing an unparalleled explosion in cryptocurrencies (or cryptos). Cryptos have emerged as a new asset class where hedge funds and investment firms globally are launching new vehicles devoted to these digital assets. Needless to mention that individuals everywhere, on their own, are hooked and long on cryptos, using their hand-held devices. Cryptos were born with an aspiration to democratize finance and it appears the time has come when it’s about to.
Cryptos offer multiple advantages over fiat currencies such as a decentralized structure with no central authority or governing body, no printing involved, enhanced security, privacy and anonymity, ease of use and accessibility, fast transaction speed, reduced or no KYC (know-your-customer), low transaction costs, etc. This uptrend brings with it emerging opportunities and potential pitfalls. While interest in crypto has exploded, the most significant challenge governments and policymakers around the world face today is how to regulate this asset class.
International Adoption
Governments and regulators within are taking varied positions on the subject. While El Salvador has become the first country to declare Bitcoin as legal tender, crypto markets expect Paraguay and Venezuela to follow suit. Russia, post imposition of sanctions by the west due to its recent invasion of Ukraine, is reported to be considering accepting cryptocurrency as payment for its oil and gas exports. Ukraine, on the other hand has also turned to cryptocurrencies to fund its military fight against Russia, which is attracting donors who are looking to support the cause.
Abu Dhabi Global Market has recently licensed Kraken, one of the world’s largest and oldest crypto exchanges, to operate a regulated virtual asset exchange platform, a Virtual Asset Multilateral Trading Facility (MTF) and Custodian in Abu Dhabi and the wider UAE. This will give the local investors the ability to invest, trade, withdraw and deposit virtual assets directly in local currency. Dubai also, is attracting crypto firms as it issued its first law governing digital assets and constituted a regulatory body, the Virtual Asset Regulatory Authority (VARA), to oversee the sector.
Pakistan’s Dilemma
At the other end of the spectrum, the State Bank of Pakistan has, through a circular in 2018, refrained all banks, DFIs, payment system operators and payment service providers from processing, using, trading, holding, transferring value, promoting, and investing in virtual currencies and tokens. The restriction applies to facilitating customers in this respect also and warnings have been issued cautioning the general public not to indulge in crypto-related activities.
Securities and Exchange Commission of Pakistan, following the footsteps of the central bank, through a notification in 2020, extended the aforementioned restrictions for all the companies and limited liability partnerships in Pakistan. Despite this, crypto business is thriving in Pakistan. Such is the nature of Decentralized Finance (DeFi). Apps like Binance, which track and trade cryptocurrencies, are reported to have more downloads than some of the country’s largest banks’ apps.
US as an Example
The financial markets of the United States are the envy of the world; and are known for being the broadest, highly active and most importantly fairest anywhere. The U.S. was quick to understand that the question underlying crypto regulation debate is determining the legal status and substance of crypto assets. The U.S. Securities and Exchange Commission (SEC) typically views cryptocurrency as a security, while the U.S. Commodity Futures Trading Commission (CFTC) calls Bitcoin (BTCUSD) a commodity, and the U.S Treasury calls it a currency. Meanwhile, the U.S. Internal Revenue Service (IRS) classifies cryptocurrencies as property for federal income tax purposes.
In the U.S., Howey Test, based on the U.S. Supreme Court case SEC v. W.J.Howey Co. 328 U.S. 293 (1946), is applied to determine if any contract, scheme or transaction is an investment contract and would be considered a security and subjected to securities law. Four-step criteria to identify a security, laid down by the U.S. Supreme Court, is ‘Investment of money in a common enterprise with the expectation of profit to be derived from the efforts of others’.
It was on this pretext that the U.S. SEC brought an enforcement action against Ripple’s XRP token (one of the world’s largest crypto in market cap terms); that the XRP offering constituted a common enterprise because the fortunes of the participants were tied together and that the purchasers of XRP reasonably expected their profits to be derived from efforts of the defendants of developing XRP use cases and to work with banks and financial intermediaries to implement those.
Hence, SEC concluded that the Ripple offering was a security while Bitcoin and Ether are not. In the same vein, U.S. SEC announced to sue Coinbase, a crypto exchange, over its lending program, which Coinbase subsequently decided to shut down. U.S. SEC’s Chair, Gary Gensler, in a recent speech, has termed crypto asset class as ‘rife with fraud, scams, and abuse in certain applications’. American press has reported only last week that the U.S. SEC is on a hiring spree to double the size of its Cyber Unit to fight crypto fraud and the unit is being renamed as Crypto Assets and Cyber Unit.
The International Organization of Securities Commission (IOSCO), an international body that brings together the world’s securities regulators and is recognized as the global standard-setter for the securities sector, has issued a public report on DeFi and cryptocurrency in March 2022. IOSCO has concluded that while this is a continuously evolving area and that IOSCO will continue to examine this area and its implications for market regulators, it has also noted that many of the crypto products, arrangements and activities in the DeFi mirror, and in some cases overlap with more traditional securities products, services, arrangements and activities.
IMF’s Report
International Monetary Fund’s (IMF) Global Financial Stability Report of April 2022 has one out of its three chapters dedicated to the vulnerabilities and challenges, the rapid growth of fintech poses to the financial stability. The report has emphasized on the necessity for enhanced regulatory surveillance and globally consistent regulatory frameworks for DeFi and crypto. IMF’s report recommends a three-step model for crypto regulation i.e. focusing on crypto ecosystem enablers including issuers, crypto exchanges, hosted wallet service providers, and market makers, public-private partnership on code regulation either through ex-ante guidelines or ex-post code reviews and establishment of self-regulatory organizations.
IMF concedes that enforcing regulations and restrictions in crypto markets is challenging and that one potential approach could be to restrict the exposure of regulated banks and financial institutions to DeFi and crypto markets (especially those not subject to proper regulation or self-regulation), This is thought to slow the pace of growth while addressing the spillover risks onto the regulated markets.
In these times, decision-makers may choose to be technology-neutral and can be anything but public policy-neutral. It is about protecting investors and consumers, guarding against the illicit activity, and ensuring financial stability. Technology must be allowed to take its path for expanded access to finance and contribute to economic growth but in a coordinated and regulated fashion. As new technologies come along, we need to be sure we’re achieving our core public policy goals. Otherwise, we will prove IMF’s Managing Director, Kristalina Georgieva, right when she in a recent panel discussion explained our global response to economic challenges as “acting like an 8-year-old, playing soccer chasing the ball”.
About the Author
Haris Mohsin, a Milken scholar and a Chartered Accountant, serves as Deputy Director at the Securities & Exchange Commission of Pakistan (SECP) and can be reached at [email protected] . The views and opinions expressed are the author’s own. He tweets at @HarisBMohsin
Pakistani idiot bureaucrats of different departments thinks they are smart… And consider common people their slaves