Financial Stability and Regulation of Cryptocurrencies

In the recent past, we have witnessed a rapid increase in the rate of adoption of cryptocurrencies and other associated financial products globally. According to analysts, mass adoption of cryptocurrencies is a matter of when and not if. This growth can be attributed to the growing number of projects and innovations, as well as the amount of capital being poured into the sector. This rapid growth has led to various governments and central banks encouraging the idea of having Central Bank Digital Currencies (CBDCs).

However, this impressive rate of adoption brings with it a myriad of new challenges. This is because the use of cryptocurrencies overlaps at some point with the traditional financial systems which tend to be heavily regulated. Regulation by various policymakers such as banks and governments work to protect consumers from fraud, and monitor financial markets for money laundering and terrorist financing in extreme cases. Left unregulated, the illegal use of cryptocurrencies could be detrimental and could pose certain systemic risks to various economies.

The decentralized nature and efficiency of cryptocurrencies such as Bitcoin to transfer significant to large amounts of money makes them susceptible to illegal uses. Additionally, policymakers face challenges such as valuation of the crypto assets, monitoring and management of risks, and identification. These challenges make it almost impossible to understand where exactly cryptocurrencies fall in the traditional financial systems or even how to come up with regulatory frameworks.

Additionally, cryptocurrencies and various associated financial products are continually becoming interoperable, thus raising the question; Are the existing regulatory frameworks sustainable, if any?

Are there any working cryptocurrency regulation frameworks?

The issue of regulation continues to be an absolute headache especially since the sector gradually comes up with more innovative use cases and financial products. This has led to various smaller bodies incorporating some form of a regulatory framework to at least protect their consumers. While this may work for a short period, it is not sustainable in the long run. A good example would be the various regulations put together by some states and federal agencies in the US alone. While these smaller existing frameworks might enable the exchange and transactions across these states, there is still a need for a massive (probably global) regulatory framework for cryptocurrencies and associated products such as NFTs.

Policymakers and regulators continue to be divided on the basis on which to come up with regulatory frameworks and laws. In the US alone, the disconnect is so wide that we have states such as Wyoming, Colorado, and Ohio pass laws that favor and promote the growth of cryptocurrencies. However, other states such as Iowa have passed laws that completely discourage their residents to invest, use or interact with cryptocurrencies in any way, thereby restricting their growth. This culture of a disconnect among various policymakers on regulating cryptocurrencies spreads out to different countries and their stand on cryptocurrencies.

To answer the initial question, I firmly believe that there is a lot of work and collaboration to be done across the board to try and regulate cryptocurrencies. The current lack of a proper framework or basis to regulate cryptocurrencies might just be among the reasons why, while crypto is a great innovation, is not yet adopted globally. The disconnect among various key players such as governments and various financial institutions such as the International Monetary Fund (IMF) limits the innovation, growth, and adoption of cryptocurrencies. In a world where these key players come together to create a working regulatory and compliance framework, the growth of cryptocurrencies would be unprecedented.

However, cryptocurrency maximalists strongly argue that the adoption of cryptocurrencies, due to their nature and convenience is inevitable regardless of the availability or lack thereof of regulations and compliance requirements.

Mitigating Risks Caused By Lack of Regulation

Lack of regulation across the cryptocurrency’s ecosystem poses a significant risk, especially to the consumers who are vulnerable to operational and financial integrity risks. Some of the biggest risks caused by the lack of a proper regulatory structure include; Determining valuation, verifying identity, and monitoring and management of cryptocurrencies. In emerging markets and developing economies, the risks are more severe since they might lead to debasing of the national currencies.

Mitigating or managing these risks is paramount for all parties involved from the cryptocurrency developers and innovators to governments and final consumers. All key players across the ecosystem, have a crucial part to play in the management of the risks posed by cryptocurrency innovations. The prevailing concerns across the board, are consumer protection, anti-money laundering, and terror financing.

Governments and other key financial intermediaries such as banks and cryptocurrency exchanges should come up with a task force to try and come up with a regulatory framework or at least a basis for compliance to protect their consumers. Additionally, these bodies should come up with certain structural mitigants such as reserve requirements and insurance products to mitigate the risk of loss.

Education and raising awareness of cryptocurrencies is also a key element in managing risks posed by the cryptocurrency evolution. To avoid the loss or improper use of the technology, consumers should be well educated on the advantages and convenience of using this newer innovation. A comprehensive approach is almost inevitable in the long run as cryptocurrency continues to steadily creep into the mainstream.

Key players such as crypto exchanges and projects have a responsibility to their users to continually review and improve their business practices. In the long run, this will create trust between these key players and their consumers. In turn, this will promote the growth of the larger cryptocurrency ecosystem.

Existing Regulatory Approaches and their Implications

Even with the divided opinions on cryptocurrencies, their use cases, and regulatory structures, some countries and crypto-based institutions, have come up with innovative solutions and structures to regulate various aspects of cryptocurrency and their exchange.

El Salvador Case Study

In September 2021, we witnessed El Salvador become the first country to adopt Bitcoin as its legal tender. For El Salvador to adopt Bitcoin as a legal tender, they came up with an inclusive and well thought out regulatory structure with the following key highlights:

· A Cyber Security and Anti-Money Laundering program to safeguard their Bitcoin. The programs were implemented based on both local and international legislation.

· A ledger of assets, liabilities, and equity of the service provider inclusive of customer accounts and transactions to curb fraud.

· A resolution plan to account for orderly liquidation in the case of insolvency.

· A limit for transactions according to the comprehensive risk analysis model.

These key principles help safeguard the country’s interests in case of any eventuality, therefore guaranteeing the efficiency of the currency as a legal tender. Most recently, in April 2022 the Central African Republic became the second country to recognize Bitcoin as legal tender. The decision by these two countries to adopt Bitcoin forms a foundation and a benchmark that might lead to further adoption or otherwise.

UK Case Study

In the UK, the government has taken an almost similar approach in a bid to regulate and mitigate the risks involved in the adoption of cryptocurrencies and stable coins. Their approach was designed to ensure that they protect the financial stability and market integrity of their economy, and allow for consumer protection while simultaneously promoting innovation in the sector.

Their approach stood out mainly because they introduced a policy for minimum requirements for ‘stable coin’ projects before beginning operations in the UK. This ensured that any stable coin project would have to meet certain legal, legal, oversight, and risk analysis requirements before launch. Additionally, they clearly defined a regulatory perimeter for tokens before classifying them as financial instruments. This goes a long way in ensuring that the consumers do not fall prey to the infamous “crypto rug pulls” at least for stablecoin and token projects.

Crypto Mining Ban as a Regulatory Measure

While countries like China, India, and Iran among others banned crypto mining for energy consumption concerns, critics believe that discouraging the use of cryptocurrencies across some of these countries was also a motivation. While this may be accurate to some extent, I firmly believe that this was the wrong approach to regulating cryptocurrencies.

The decentralized nature of cryptocurrencies makes them unique in that once users invest in the idea, it is challenging to ban or limit the use of crypto. This creates a situation where citizens continue interacting with cryptocurrencies in a much less conducive environment, therefore, leaving them vulnerable to fraud. This could bring up the question of whether there are any actual limiting regulatory approaches.

Regulation in any field will almost always be a hindrance to innovation. That being said, some approaches to cryptocurrency regulation severely affect and limit the ability of innovators to come up with modern and more convenient solutions. Therefore, as policymakers come up with regulatory and compliance structures, they should ensure that their approach allows or leaves room for innovation and does not completely hinder innovation. A good example of well-thought-out regulatory structures are structures employed by cryptocurrency exchanges.

Cryptocurrency Exchanges and Regulatory Structures

Crypto Exchanges are a key component in the cryptocurrencies ecosystem as they allow for the exchange of value between and across different cryptocurrencies. These exchanges, therefore, have to come up with regulatory frameworks that protect both the consumer and the exchange. Most cryptocurrency exchanges fall under a similar regulatory framework as traditional banks or currency brokerages as they offer similar services to some extent.

A common regulation across some popular crypto exchanges such as Coinbase, Lbank, and Binance is the ‘Know-Your-Customer’ (KYC). KYC has proven to be a reliable way of combating the anonymity question posed by regulators for consumers when using various blockchains. This model, which is widely adopted in the sector allows for traceability, and monitoring of crypto-assets. Additionally, banks, governments, and other jurisdictional bodies have demanded that exchanges collect customer data and they are obligated to share with the relevant authorities any suspicious transactions.

In the US, the Securities and Exchange Commission (SEC) recently revised rules and regulations to fill a regulatory gap by making platforms sitting outside the SEC’s supervision comply with existing standards intended to protect investors and promote fair and orderly markets.

These are only a few highlights of the common regulatory structures taken up by various institutions and exchanges to try and regulate the sector. In the abstract, there have been repeated calls, especially on exchanges to come up with a basis for regulation that cuts across the board. However, like with any new sector, a lack of cooperation across various jurisdictions is a huge challenge in coming up with a regulatory framework.

Global Co-operation Among Regulators

At this point, I could argue that global cooperation among various key players is imperative to come up with a regulatory framework. This is motivated by the fact that cryptocurrencies, especially due to their cross-border remittance capabilities, cannot be solely regulated by one specific jurisdiction. In other words, there seems to be no ‘one-fits-all’ solution for the regulation of cryptocurrencies. However, I recently had a conversation with a crypto maximalist and his argument was; Wasn’t the sole purpose for creating decentralized currencies to avoid limiting regulations? I admit that his point does hold weight. However, only to some extent as the lack of regulation is causing significant losses across the cryptocurrency ecosystem.

The stability of our financial systems also lies in the balance each growing day as the interaction between cryptocurrencies and our traditional financial system continues to interconnect. The implications that would follow if this new form of transfer of value is not properly handled could be catastrophic to our existing financial system. Additionally, given that the underlying technology (Blockchain) that is behind cryptocurrency challenges traditional value systems and models, it is paramount that we prioritize regulatory discussions and decisions, especially at a global level.

Are CBDCs the answer?

Governments play a key role in the control of a country’s economy. For this reason, the lack of regulatory structures for cryptocurrencies creates a threat to a country’s economy in that a government can no longer control capital inflows and outflows from the economy. To paint a clear picture, the government places capital controls to prevent currency outflows as this might debase their currency’s value. Therefore, cryptocurrencies weaken the ability of governments to control and maintain capital controls.

For this reason, governments are looking into exploring the use of Central Bank Digital Currencies as this can be regulated and monitored. CBDCs allow for the convenience and security of cryptocurrencies and the regulated, reserve-backed money circulation of the traditional banking system. They act as a digital form of fiat money and hence benefit from both the traditional financial systems and modern financial systems such as cryptocurrencies. This alone makes CBDCs more attractive especially to governments and central banks as opposed to cryptocurrencies.

While CBDCs solve some of the regulatory questions regarding cryptocurrencies, they bring about certain downsides as well. Data privacy and cyber security are some of the major concerns that various governments and central banks are looking into to facilitate the adoption of CBDCs. The centralized system that allows for monitoring and management of a CBDC also serves as a point of weakness in the CBDC system. Cyber Security or lack thereof is another potential challenge with a Central Bank Digital Currency. Due to the expected large number of users across a CBDC ecosystem, the system is vulnerable to malicious attacks, hence a CBDC must account for a resilient and robust security structure.

So, are CBDCs the future of digital currency? I think not, but they do have a better shot at adoption and better use cases. Because CBDCs are backed by either the government or a Central Bank, they have the advantage of attracting larger user bases as compared to cryptocurrencies. However, in the long run, cryptocurrencies solve and offer a more practical use case while guaranteeing privacy and security, hence CBDCs will eventually be phased out, or might not catch on.

Looking Forward; The Future of Cryptocurrencies

While cryptocurrencies pose a significant threat to financial stability globally, the future of cryptocurrencies is almost guaranteed. Additionally, key players such as banks, governments, and other financial institutions, seem to have realized this and are now working in one way or another to tap into the cryptocurrency ecosystem and provide specific solutions to their consumers.

Use cases like cross-border remittances, digital governance, Decentralized Finance, and Tokenization, will be at the forefront of the adoption of crypto, especially in emerging markets where these solutions are critically needed. Already, the few projects in the above-mentioned areas are doing great, and are continuing to provide ‘real-world value’ to their consumers. This serves as a clear illustration of the expected innovation and consequently an improved rate of adoption once core challenges of the ecosystem are addressed.

However, the future of cryptocurrencies depends heavily on the cooperation of various involved bodies, especially on a global scale to come together and create an innovative and accommodative regulatory framework that seeks to protect consumer interests while simultaneously creating a conducive environment for growth of cryptocurrencies.