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COMMENT: The key investment and regulatory issues for cryptocurrencies

Photo of cryptocurrency apps: Yahoo Finance
Photo of cryptocurrency apps: Yahoo Finance

By Lena Ng and Rocky Mui

Cryptocurrencies has attracted considerable attention globally due to their skyrocketing prices, with Bitcoin reaching an all-time high of above US$20,000 in December 2017.

At the same time, regulators have been warning investors about the potential pitfalls of investing in cryptocurrencies amid the buying frenzy.

So what are the pros and cons of cryptocurrency investments and what is the right regulatory approach to manage this relatively new asset class?

Pros:

1. New asset class for investment

Are cryptocurrencies money, securities, futures, derivatives or something else? Depending on the rights and entitlements built into them and local laws and regulations, they could be any of the above but in their simplest form they are more likely to be classified as ‘something else’. They represent a new asset class which some claim as having low price correlation with other traditional assets and therefore increase the interest of investors for portfolio diversification.

Total market capitalisation of cryptocurrencies increased from around US$17.7 billion in the first quarter of 2017 to over US$620 billion in December 2017. The price of Bitcoin alone increased from below US$1,000 to over US$20,000 over the same period.

2. Low cost, fast transfer

Cryptocurrencies may be transferred within minutes or seconds at very low cost. Ripple, for example, is reported to have an average transaction fee of around US$0.03 and payment settlement within four seconds.

As for conventional cross-border bank transfers, settlement may take three to five business days on average.

3. Fostering Innovation

Ever thought of the possibility of making money ‘renting’ out your home computing power? Deploying mobile financial infrastructure for people without banking accounts in developing countries? Monetising digital contents? Or simply accessing services such as shared office rental or cloud storage? The advent of cryptocurrencies has led to numerous innovative services.

4. New capital market

Initial coin offerings (ICOs) represent a new fund-raising method to connect start-ups and a wider stakeholder base at a much earlier stage. ICO funding for the first 11 months in 2017 was reported to be over US$3.4 billion.

Cons:

1. Volatility

The prices of some cryptocurrencies have been on a roller-coaster ride in recent weeks. Take for instance Bitcoin’s prices in December 2017. It was up 86 per cent in the first eight days, down 26 per cent in the next two days, up 50 per cent in the next seven days, down 40 per cent in the next five days, up 41 per cent in the next five days, and down 22 per cent for the last four days of the month.

2. Fraud and money laundering risks

Due to their discreet nature, cryptocurrencies are vulnerable to fraud, money laundering and terrorist financing risks. Regulators in the U.S., U.K., Hong Kong, Singapore and Australia have warned of the heightened risks around cryptocurrencies, in particular for ICOs.

3. Security breaches

Service disruption due to a denial of services attack? Client money missing due to hacking? Struggling to find an established custodian for cryptocurrencies?

There have been many security breaches and hacking involving cryptocurrencies. There could be very limited or no recourse for victims.

4. Regulatory risks

It is often difficult to assess the regulatory risks involved given the reach of cryptocurrencies across multiple jurisdictions and the lack of clarity under the relevant local regulatory regime. For example, cryptocurrency exchange platforms may be shut down by law enforcement authorities due to criminal misuse of funds, breach of securities exchange rules, or a jurisdiction-wide ban.

The right regulatory approach

Will cryptocurrencies foster innovation, capital investment and talent development? Looking at where the cryptocurrency industry is moving, the signs are positive. It would be a surprise if any international financial centers, such as Singapore and Hong Kong, would overlook the opportunities.

But with opportunity comes risk. One of the key legal challenges for cryptocurrencies is for authorities to strike the right balance between encouraging innovation and ensuring consumer protection.

Various jurisdictions have developed contrasting regulatory responses and initiatives to cryptocurrencies.

Regulators in China, Russia and South Korea have taken a more conservative stance including imposing complete or partial bans on cryptocurrency operations.

Their counterparts in the U.S., U.K., Hong Kong and Singapore have adopted a technology-neutral approach to regulating cryptocurrencies under existing frameworks. In these jurisdictions, we have seen enforcement or legal actions being brought against cryptocurrency operators under their existing regulatory frameworks.

What is the right regulatory approach? It may be too early to say. Imminent harmonisation among different jurisdictions is unlikely, and jurisdictions will continue to diverge in their stance on cryptocurrencies. The following would be essential features of an ideal regulatory approach:

Proactive and ‘understanding’ regulator

Regulators should remain proactive in regulatory developments. It is essential for them to learn and understand the objectives and challenges of industry stakeholders. Launching industry consultations and public statements on a regulator’s stance would help, but ultimately, implementation and execution of rules by regulators is key to the success of cryptocurrency trading.

Permissive regulatory regime with clear rules

As cryptocurrency operations often do not fit in well within existing regulatory frameworks, there may be uncertainty over how existing regulatory regimes apply to industry players and investors. Regulatory uncertainty will discourage new start-ups and capital commitment.

Having a permissive and non-restrictive regulatory approach with a more specific regulatory regime to cover cryptocurrency operations could fill in the gaps and help provide certainty.

Prudential supervision

A ‘light’ regulatory framework, which is open and flexible for cryptocurrencies and start-ups, would be welcomed by cryptocurrency operators.

But prudential supervision is important as well to accord consumer protection. Licensing and registration regimes (for example, a new cryptocurrency exchange licensing regime in Japan) and imposing user protection measures (for example, a proposed Payment Services Bill in Singapore providing both licensing and user protection measures) could give confidence to industry stakeholders, and further enhance the integrity of the cryptocurrency industry.

Lena Ng is a Partner at Clifford Chance who leads the financial regulatory practice in the international legal firm’s Singapore office. She regularly speaks and advises on fintech, cybersecurity and the regulatory reform agenda. Rocky Mui, a Senior Associate in Clifford Chance’s Hong Kong office, regularly advises on fintech and other related issues.