Regulating Digital Currencies

Digital currencies have caught the high-level attention of international financial policymakers.
For the first time, finance ministers and central bank governors of the G-20 have called for coordinated action on digital or cryptocurrencies like bitcoin in their March 2018 communique.
“crypto-assets…raise issues with respect to consumer and investor protection, market integrity, tax evasion, money laundering and terrorist financing.”
They called on the international standard setting bodies to continue their monitoring of crypto-assets and their risks.
Swift regulatory action is required
to impose consistent enforceable regulations on the persons and entities administering, using, and exchanging digital currencies;
to address cooperatively issues of taxation;
to establish a global framework with respect to initial coin offerings (ICOs).
Challenges to Regulating Digital Currencies
Digital currencies are typically not issued by legal entities but by a decentralized software protocol and a dispersed network of software developers. Decision-making and governance rules are written into the protocol; voting among users and developers is a common feature. These rules establish, for instance, how many stakeholders’ votes are required to make changes to the protocol or how the finality of payments is determined. But digital currency schemes typically lack conventional governance mechanisms such as a management structure or board of directors. They are not incorporated anywhere and do not have headquarters or subsidiaries.
This structure of digital currencies makes it challenging for regulators to apply national laws such as payment system requirements or anti–money laundering provisions to digital currency schemes. A workaround, and probably the only feasible approach that regulators can use vis-à-vis these schemes, is to regulate the entities that operate where cryptocurrencies intersect with the conventional, incorporated financial system. These entities are, for instance, exchanges that convert digital into fiat currencies (and vice versa), wallet providers that offer safekeeping services for digital currencies, or banks that provide fiat accounts to issuers of digital currencies.
In 2013, the United States was the first country to apply this approach. The US Treasury’s Financial Crimes Enforcement Network (FinCEN) published guidance on the application of FinCEN’s regulations to persons and entities administrating, using, and exchanging digital currencies. Crypto-currency exchanges located in the United States need to:
register with FinCEN
have a risked-based know-your-customer (KYC) and anti–money laundering (AML) process
report suspicious transactions. The Financial Action Task Force (FATF)—an intergovernmental organization of 35 jurisdictions that develops and promotes policies to combat money laundering and terrorist financing
What about Taxation?
Since holders of digital currencies are only identified by an alphanumeric code on the ledger it is not easy for tax authorities to obtain information on holdings of digital assets. Most jurisdictions have clarified how digital currencies are taxed, but treatment varies. In the United States, the Internal Revenue Service (IRS) declared that digital currencies are taxed as property and not as foreign currency. The largest US digital currency exchange, Coinbase, accepted an IRS ruling in February 2018 and will provide tax data on its larger clients.
In 2014, the Global Forum on Transparency and Exchange of Information for Tax Purposes (the Global Forum) adopted the Standard for Automatic Exchange of Financial Account Information in Tax Matters. One hundred and two jurisdictions have committed to its implementation; about 50 of these have started to exchange tax information.
An important subset of digital currencies are the so-called ICOs.
In an ICO, contributors provide a digital currency in the form of ether or bitcoin to a startup, often a software company. In exchange, contributors receive a digital coin, which is issued by the startup. This coin or token—usually called a utility token—allows the holder to use the service or platform of the startup once it is operational. In 2017 $6 billion and in the first quarter of 2018 $4 billion were raised in ICOs. They are a promising innovation in crowdfunding because they globalize capital formation.
But ICOs also carry a great many risks.
Default or credit risk for the investor, as empirically most startups fail and go bankrupt—independent of whether they use ICOs or conventional funding.
Fraud. The decentralized nature of ICOs makes them attractive to fraudsters, as they know that cross-border law enforcement is weaker than in domestic markets.
Liquidity risk, as the funding raised by many ICOs is too little to allow for efficient trading and price discovery.
The most detailed ICO guidelines were issued in February 2018 by the Swiss Financial Market Supervisory Authority (FINMA). But their treatment of some relevant issues is ambiguous, such as under what circumstances a token is considered a security. Regulating utility tokens is not easy, as they are an entirely new financial instrument. Classifying them as regular securities would create a heavy regulatory burden for most startups. At the same time, concerns regarding investor protection and market functioning are legitimate.
ICO regulation should be inspired by the approach taken for crowdfunding platforms such as Kickstarter or Indiegogo. This approach should include, but not be limited to, registration, disclosure and audit requirements, proper know-your-customer procedures, and a ceiling on the amount of capital that can raised under a light regulatory regime. Here too, the global dimension of ICOs requires that policies be internationally coordinated.

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