Cryptocurrency is a hot topic at the moment, so we decided to write a blog on what it is and what regulations in crypto apply. Bear with us, this next section is a bit on the technical side but we will ensure we are all on the same page before we dive in.
What is cryptocurrency?
A cryptocurrency is a secure asset stored on a type of distributed ledger called a blockchain1. To break this down; distributed ledger technology (DLT) is simply a record of transactions that is available publicly, and distributed to a number of locations so that the record can be accessed by anyone. The ledger is secured by a complex algorithm which is solved by supercomputers... Think of it as a puzzle, and whoever solves that puzzle is rewarded. Simple, right? Because the ledger is stored across multiple devices and locations, it makes it impossible to hack the data, which, as a core function of blockchain, gives it significant appeal.
A push for revolutionary technology
Imagine a world where the super-wealthy could no longer mask their income to avoid paying taxes... too good to be true, right?
The current banking framework doesn’t always do a reliable job of preventing this. As such, technology that is immutable by nature offers a unique proposition for financial services. With DLT such as blockchain as a standard for asset transfer, Financial Institutions (FIs) and lawmakers alike would have access to a revolutionary crime-fighting tool. Auditing scandals such as those orchestrated by Satyam Computer Services and Bernie Madoff would be impossible to execute with a blockchain standard, saving taxpayers and governments billions of dollars. It is clear to see just how valuable this technology could be for banking institutions, if they get it right. It is not a stretch to predict that in a few years' time current banking frameworks may be seen as dated and unnecessarily vulnerable to criminal activity.
There is no central authority for blockchain technology, so even though transactions are recorded and are available publicly, it can be hard to discern the owner of assets that are stored on the blockchain. All assets that exist within the crypto space have a cash value, depending on the utility of that asset. If I want to access a network that decreases the cost of data storage for my business, it makes sense for me to own a part of that network. To buy and sell assets, one must find a way to deposit fiat currency (government-issued currency, such as GBP or USD2) to purchase crypto. A centralised exchange (CEX) is typically used for this purpose, and is therefore the obvious target for regulation.
Now the technical bit is over, it’s time to focus on the financial aspect, and what specifically has regulators scratching their heads.
Due to the decentralised nature of crypto, anyone with programming knowledge can ‘create’ their own cryptocurrency with any characteristics or utility that they choose. Crypto allows anyone on the planet to own a part of a business and to access those services without the need for a middle-man taking a slice of the profits. While this creates significant opportunities for innovation, it also opens up a myriad of opportunities for criminals to accumulate funds from investors and disappear without trace due to a lack of effective regulation. The more inexperienced actors within the crypto space can find themselves vulnerable to scams and money is placed in the hands of criminals hand over fist as each day passes without regulations in place. In 2021, Action Fraud reported that over £146,000,000 has been lost by UK users alone, a figure which is up 30% from 20203.
A global state of affairs
September 2021 was a huge month for regulatory crackdown in China, as the people’s republic banned all crypto-related activities4. The official statement cited the “disruption of economic and financial order, breeding illegal and criminal activities”. It is a fascinating viewpoint considering that traditional currencies have never been used for such activity. China was previously positioned to gain significant economic advantage due to the volume of Bitcoin miners that operate within the country, who have been forced to uproot and move to more crypto-friendly jurisdictions. We really didn’t see this one coming.
Currently there is no regulation in India regarding cryptocurrencies, with speculation rife as to how the government will approach the subject. However, there is room for optimism as in December 2021 at the virtual Summit for Democracy Indian Prime Minister Narendra Modi said “we must jointly shape global norms for emerging technologies like cryptocurrencies so that they are used to empower democracy, not to undermine it”5.
Most eyes are firmly fixed on the Securities and Exchange Commission (SEC) of the United States, which holds the most power over financial regulation in the country. In 2020, the SEC filed a lawsuit against Ripple ($XRP) for an unregistered services offering6. The case has raged on since then, with plenty of support for XRP amid an expectation they will triumph in court. Although the SEC has threatened to clamp down on crypto, individual states in the US take their own approaches when it comes to crypto. Wyoming passed legislation allowing for crypto-banks to operate in their jurisdiction, whilst Ohio became the first state to allow taxes to be paid in crypto7. We think it could be more telling to pay attention to what is happening on a federal level, which indicates the US are eager to take advantage of technological advancements. For instance, the United States Department of Defense recently partnered with Constellation network, a DLT company based in Silicon Valley, California to secure military data transfer for the US Air Force8.
Central American country El Salvador made global headlines earlier this year by announcing Bitcoin as legal tender. This means merchants have to accept Bitcoin as payment for goods and services. Imagine buying a 6 pint of milk with 0.000028 BTC! On top of this, the government purchased 1120 $BTC, worth approximately £339m at the time of purchase in October 2021, (£336.5m as of March 11 2022!). Whilst this is a relatively small country, it certainly shows crypto can be integrated into an economy. Perhaps other countries are keeping tabs on the economy of El Salvador to see how crypto integration can benefit9.
What are the regulations in cryptocurrency?
This year the Financial Conduct Authority (FCA) banned popular CEX Binance from operating in the UK due to an inability to meet AML requirements10. In September 2021, the FCA chair urged the UK Treasury to provide regulators with greater powers when it comes to cracking down on crypto. Particularly, social media influencers promoting ‘scam’ coins as part of coordinated ‘pump and dump’ schemes11.
Recently, UK Chancellor of the Exchequer Rishi Sunak gave the strongest indication yet that the UK has a hugely positive part to play in the adoption of cryptoassets: ”It’s my ambition to make the UK a global hub for cryptoasset technology.
We want to see the businesses of tomorrow – and the jobs they create - here in the UK, and by regulating effectively we can give them the confidence they need to think and invest long-term"
This is part of our plan to ensure the UK financial services industry is always at the forefront of technology and innovation.”
The dreaded pump-and-dump
Scams within crypto are often subject to very little scrutiny despite the complexity required to pull them off. A pump-and-dump refers to an asset that is artificially pumped (mass-purchase of tokens at a low price – driving a price increase), then dumped by holders at a preset value (resulting in massive profits for the 1% and massive losses for the 99%). Pump-and-dump schemes are especially heinous in the way they take advantage of retail investors. Influencers (yes, they are a thing) shamelessly promote ‘promising’ ‘1000x’ ‘make you rich’ projects with zero utility or real-world use case, wait until their followers inevitably take the bait, then sell everything they have, leaving naïve investors with, you guessed it, nothing. A recent pump-and-dump scam named ‘Save The Kids’ ripped off much of its branding from the registered charity ‘Save the Children’. This scam was on a larger scale than most, with a co-ordinated effort from several ‘influencers’ to spike the price by claiming charitable benefit from token purchases before dumping their assets, ultimately making the tokens worthless12. As illegal and obviously immoral as this sounds, those responsible are yet to face any charges due to a lack of regulation.
Social media influencers promoted scams aimed at children
How do we stop this from happening in the future?
Crypto assets are often (but not always) grouped by governments under the umbrella of ‘digital assets’ and regulatory bodies aim to target Virtual Asset Service Providers (VASPs) when clamping down on potential illicit activity. As crypto is decentralized, it is nigh on impossible for regulators to successfully target individual wallets and distributors of assets in the form of select currencies because these actors can be anonymous. Instead, regulators target VASPs as they are the principal gateway for fiat on and off-ramping into banks. As CEXs jostle for the lion’s share of the market, some aim for maximum trading volume by providing easy access to cryptocurrencies, whilst others aim to future-proof their business by employing vigorous KYC processes for all customers. The most important takeaway from this is regulators and governments striking a delicate balance between incorporating industry-changing technology, and avoiding criminal activity.
What comes next?
Regulatory bodies across the world are stepping up their efforts to ensure that the new world of cryptocurrency has effective regulation and oversight. They are also making efforts to clamp down on cryptocurrency trading, with the CEO of the FCA hinting that the scheme responsible for compensating £717m this year may remove crypto-related incidents from liability for compensation. Speaking at the House of Commons to the Treasury Committee, FCA CEO Nikhil Rathi offered his assessment of scam currencies “some of these crypto-assets, we don’t believe have intrinsic value. They have been a part of a series of organised crimes and money laundering, and anyone who invests in them must be ready to lose all their money”13. Reading between the lines of this statement may offer further insight in to the FCA’s stance when it comes to investing in cryptoassets; as those assets with intrinsic value may be favoured by regulators in 2022.
As the legal definition applied to cryptoassets is subjective, some countries will settle for more relaxed rules regarding crypto-based activities, depending of course on regulatory guidance. Subsequently, it is highly likely that there will be jurisdictions subject to higher scrutiny when it comes to their adoption of regulations.
Those with a keen interest in blockchain assets will be keeping a watchful eye over the regulatory changes that are looming over the industry. The expectation is that once the first jurisdictions apply more stringent regulations others will swiftly follow.
With regulatory scrutiny accelerating, it’s never been more important to maintain the robustness of your KYC processes. Find your financial crime solution by consulting with our experts.