Digital currencies—tradable digital assets stored on distributed ledgers—have finally 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. The communique states that "crypto-assets...raise issues with respect to consumer and investor protection, market integrity, tax evasion, money laundering and terrorist financing." More concretely, the G-20 members committed themselves to implementing the international standards against money laundering and financing of terrorism as they apply to crypto-assets, and they welcomed reviews of these standards. They also called on the international standard setting bodies to continue their monitoring of crypto-assets and their risks.
These commitments are laudable, but the international financial regulatory community needs to do much more to address the risks inherent to digital assets. As pointed out in a recent article, "policymakers are at risk of getting behind the curve." Swift regulatory action is required (1) to impose consistent enforceable regulations on the persons and entities administering, using, and exchanging digital currencies; (2) to address cooperatively issues of taxation; and (3) 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 (1) register with FinCEN, (2) have a risked-based know-your-customer (KYC) and anti–money laundering (AML) process, and (3) 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—by and large adapted the FinCEN rules in 2015 in its international guidance. However, this guidance has been implemented unevenly across jurisdictions, giving rise to regulatory arbitrage. Thus, the G-20's renewed commitment to review the FATF standards is timely, but the FATF must also assess implementation.
What about Taxation?
Taxation is another area where national rules and international cooperation are appropriate. Since holders of digital currencies are only identified by an alphanumeric code on the ledger—similar to numbered accounts offered by some banks in the past—it is not easy for tax authorities to obtain information on holdings of digital assets. By now 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. After an extended legal battle, the largest US digital currency exchange, Coinbase, accepted an IRS ruling in February 2018 and will provide tax data on its larger clients. As digital currencies gain importance and evolve into an asset class, other countries should implement a similar approach.
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 (the AEOI Standard). One hundred and two jurisdictions have committed to its implementation; about 50 of these have started to exchange tax information. Holdings of digital currencies are not subject to the AEOI standard at this point, but they should be included in the future just like other financial assets.
Special Challenges of Regulating ICOs
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. Entrepreneurs from all over the world can obtain funding from a very diverse base of contributors without having to rely on banks or venture capital firms. On the other hand, retail investors from around the globe can invest in a wide spectrum of projects that they find promising.
But ICOs also carry a great many risks. First, there is default or credit risk for the investor, as empirically most startups fail and go bankrupt—independent of whether they use ICOs or conventional funding. The second major risk is 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. And third, there is liquidity risk, as the funding raised by many ICOs is too little to allow for efficient trading and price discovery.
Regulation of ICOs has been mostly absent—and still patchy where it exists. 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. As outlined in an earlier PIIE blog, 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.
The distributed ledger—or blockchain—technology on which digital assets are based has the potential to significantly improve the safety and efficiency of the global financial system if the regulatory regime is smart. We have outlined three areas—operators of digital currencies, taxation, and ICOs—where national financial officials and regulators need to take prompt, cooperative action across borders to promote a common approach to regulating crypto-assets.
The authors thank Martin Chorzempa, Steve Weisman, and Helen Hillebrand for their comments.