Banking Law - Essay 2 (Cryptocurrency) PDF

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Summary

John Danahers class this is a sample essay for the second essay title in his class, as there is no written exam these essays are paramount to a good grade. Even if you weren't to use the body of the essay itself the sources used are of utmost relevance as he doesn't cover this topic in class due to ...

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 Name: Ronan Garvey  Student ID: 15319721  Module: Banking Law  Lecturer: Dr John Danaher  Essay Title: “Financial technologies are a major problem for financial regulators.” Critically discuss, focusing on one financial technology. I have chosen to focus on Cryptocurrency.  Word Count: 2487

I.

Introduction

Innovation breeds uncertainty in the minds of financial regulators, with established frameworks constantly playing catch up to emerging financial technologies. With the creation then of a decentralised digital currency, built on the algorithm-based Blockchain, one could imagine the wariness and heed taken in attempting to regulate it.1 Cryptocurrency is a financial panacea for individualists, a mechanism to evade control and bureaucracy, promoting autonomy and self-governance.2 These themes seemingly detach from the established policies of our current financial regulation. Conversely, I argue that the principles underpinning cryptocurrency allow it to be encapsulated within existing regulatory frameworks. That virtual currency intermediary’s act as a nexus between its global application and regulatory control, allowing current financial legislation to be imposed upon it, with minor alterations. Through this essay I wish to show how the conflicting legal status of cryptocurrency in the world’s major financial hubs serves to negate its global application. I will then focus primarily on the United States in establishing its applicability to the existing financial safeguards in place. II.

Underlying Blockchain Technology

To define the legal nature of cryptocurrency it is pivotal to explain the technology that it is built upon, the blockchain. The blockchain is a digital public ledger, an immutable record of all transactions that pass through it and due to the cryptography involved the ‘chain’ between blocks is tamperproof. This immutability also means that exchanges of value over a computer network can be monitored, verified and enforced without the presence of a trusted 3rd party, such as a bank. It is a verification and authorisation technology as well as being programmable, meaning it can enable more efficient ownership verification and title transfers.3 This enables the use of smart contracts, as is the case with Ethereum. The key aspect to the blockchain and the cryptocurrencies that are built upon it is decentralisation. Therefore, there is no apparent need for central institutions, making transfers of value borderless and frictionless. 1 Connor Gamble, ‘The Legality and Regulatory Challenges of Decentralised Crypto-Currency: A Western Perspective’ (2017) 20 International Trade & Business Law Review 346. 2 Satoshi Nakamoto, ‘Bitcoin: A Peer-to-Peer Electronic Cash System’. 3 Trevor Kiviat, ‘Beyond Bitcoin: Issues in Regulating Blockchain Transactions’ (2015) 65 Duke Law Journal 569.

III.

Conflicting Legal Status of Cryptocurrency

A. United States Due to their decentralised nature, cryptocurrencies enjoy no unified global legal status, seen as property, currency and securities in their respective jurisdictions.4 Moreover, unlike other financial instruments, such as stocks and bonds, there is no global consensus as to their application.5 In the United States for example, there lacks a unified federal code on cryptocurrencies, with the IRS and the US Treasury confirming that they are not ‘legal tender’ in any state, rather they are treated as property, and by extension a commodity for the purposes of taxation.6 However, there have been attempts to define virtual currencies by US Courts, such as in Espinoza, where a Florida court controversially stated that “bitcoin is not legal tender for its inability to act as a store of value”, ruling Bitcoin, at least in the State of Florida, as not a currency.7 B. United Kingdom This approach is also taken by the United Kingdom, who like most of the Western world classify cryptocurrency as commodities. As HM Revenue & Customs have stated, the “advent of cryptocurrencies such as Bitcoin is a new and evolving area and determining their legal and regulatory status is ongoing”.8 While this may be the case, the UK Financial Conduct Authority, have stated their intentions to provide a positive developmental environment for virtual currencies. What is especially interesting in this approach is that of their sole intention on regulating exchanges, rather than wallets. Seemingly they understand that imposing stringent rules on wallets would not aid their plight in mitigating money laundering or crossborder terrorism. This could be said to be the most balanced approach taken in the Western World, carefully allowing for innovation while not imposing stringent criteria for regulatory approval, as the technology evolves.9 4 Deidre Liedel, ‘The Taxation of Bitcoin: How the IRS Views Cryptocurrencies’ (2018) 66 Drake Law Review 107. 5 Jerry Brito; Houman Shadab; Andrea Castillo, ‘Bitcoin Financial Regulation: Securities, Derivatives, Prediction Markets, and Gambling’ (2014) 16 Columbia Science & Technology Law Review 2. 6 Internal Revenue Service Notice 2014-21. 7 Florida v Espinoza F14-2923 (11th Cir, 2016) 8 HM Revenue & Customs (UK), Revenue and Customs Brief 9 – Bitcoin and other cryptocurrencies (3 March 2014). 9 HM Treasury and Home Office (UK), Action Plan for anti-money laundering and counter-terrorist finance (21 April 2016).

C. East Asia In contrast to the property/security status cryptocurrency enjoys in the West, in the major financial hubs of East Asia crypto is undergoing a tumultuous regulatory period. For instance, China have issued stringent rulings on the issue, with the Peoples Bank of China outright banning access to domestic and foreign exchanges. Contrasting to the more liberal approach taken by Japans Financial Services Agency, who officially recognised bitcoin as a form of payment method by passing the Virtual Currency Act, effective 1st April 2017.10 Moreover, a laissez-faire approach is taken by South Korean regulators, other than banning the trade of futures contracts and other derivatives tied to bitcoin, no firm framework exists to deal with this growing financial phenomenon. In sum, their consensus in the major financial hubs, at least of the western world is that cryptocurrencies, specifically bitcoin, are classed as a commodity. Its decentralisation and disruptive properties working against it in terms of its global adoption. Essentially it is these properties, in tandem with its volatile nature that will halt its evolvement from a commodity to a currency.11 IV.

Applying Existing Legislation to Virtual Currency

Having established cryptocurrency’s status as a commodity, at least in the context of the United States, it is therefore possible to tailor this new financial technology to existing policies, but under what principles will it be established? In recent years innovative financial technologies have been largely used by financial actors to engage in fraud and regulatory arbitrage. To address this potential shortcoming in cyborg finance, I see the close examination of regulatory objectives underlying existing law as a crucial tool to advance the development and discussion of a comprehensive framework for virtual currency regulation, in a US context.12 While it would be both burdensome and outside the scope of this paper to examine all applicable legislation within the US jurisdiction, the following are said to have the most influential impact on virtual currency regulation (a) state money-transmitter laws (b) anti10 Virtual Currency Act 2017 11 Joshua J. Doguet,’The Nature of the Form: Legal and Regulatory Issues Surrounding the Bitcoin Digital Currency System’ (2013) 73 Louisiana Law Review 1119. 12 Matthew Kien-Meng Ly, ‘Coining Bitcoin's Legal-Bits: Examining the Regulatory Framework for Bitcoin and Virtual Currencies’ (2013) 27Harvard Journal of Law & Technology 587.

money laundering legislation (c) federal securities law and SEC regulation. To address the various challenges that policymakers face I see it as pivotal to understand what brought upon the passage of those laws and how their application would be beneficial in the context of regulating cryptocurrencies.13 A. Exchanges acting as Money Transmitters & Intermediaries State money-transmitter laws serve to protect the consumer from suffering financial loss by regulating money transmitters. A money transmitter is a business that transmits money from one person to another, in this context, these laws are purported to relate to cryptocurrency exchanges, such as Coinbase or Kraken. In applying existing money transmitter laws, it is crucial to outline the underlying aim of this policy; consumer protection.14 The government began this process of establishing cryptocurrency application by applying the US Treasury Departments Financial Crime Enforcement Network (FinCEN) guidance as to which regulations apply to individuals or entities using them.15 The obvious issue with the existing framework is that its application rests solely with brick and mortar institutions, banks and unions, traditional money transmitters. Moreover, an exchange must obtain a license to carry out these activities and these requirements vary from state to state. A time-consuming process given the global application of cryptocurrency. To combat this inefficiency a more novel approach should be considered, specifically the implementation of a cryptocurrency act modelling after the Nationwide Mortgage Licensing System (NMLS).16 The application of a similar framework would ensure cohesion between state regulators in their management of cryptocurrency exchanges licenses. Notably, the issue of requiring separate state licenses is not a new issue, this requirement flagrantly circumvented in the build up to the 2008 financial crisis, where mortgage originators were scantly regulated. In response to this, the Safe and Fair Enforcement of Mortgage Licensing Act (SAFE Act) was introduced.17 The purpose of the act is to require all loan originators to annually obtain or renew their license. The SAFE Act also established the NMLS which maintains a federal registry system for licensing loan originators. This is relevant because certain states have expanded the use of 13 Kevin V. Tu & Michael W. Meredith, Rethinking Virtual Currency Regulation in the Bitcoin Age’ (2015) 90 Washington Law Review 46. 14 Kelsey L. Penrose, “Banking on Bitcoin: Applying Anti-Money Laundering and Money Transmitter Laws” (2014) 18 North Carolina Banking Institute 529. 15 Financial Crimes Enforcement Network Report, Department of the Treasury (18th March 2013). 16 12 U.S.C. § 5101 (2012). 17 Safe and Fair Enforcement for Mortgage Licensing Act of 2008.

NMLS to new industries, including money transmitter licensing. Both cryptocurrencies exchanges as money transmitters and regulators would benefit from this, especially as an exchange could then register at a federal level, lessening the burden upon state regulators and bypassing the need for state by state approval. By adopting an already established framework, this would further lessen the burden that this new financial technology imposes on financial regulators. Essentially, exchanges act as a chokepoint to the anonymity aspect of cryptocurrency, granting regulators a mechanism in which to apply law. With the advent of exchanges comes control, as they are subject to the same rules and regulations that a typical financial institution must comply with.18 In my view, they serve as an anchor to the fantasy of a truly decentralised financial network. B. Money Laundering & Criminality Aspects of Crypto To date, a large focus of financial regulators has been to address the money laundering applications of cryptocurrencies, their anonymous attributes inadvertently serve to promote criminality.19 Money laundering is the process of making ill-gotten monetary gains appear legal and it is accomplished in three steps; placement, layering and extraction. Monetary gains are then divided into three tranches for the purposes of anti-money laundering regulation; decentralised, centralised and physical.20 I will focus on the ‘centralised’ aspect of these monetary gains, in this context cryptocurrency exchanges. The primary piece of legislation to combat money laundering is the Bank Secrecy Act (BSA).21 While initially seen as a failure during its initial implementation as financial institutions scantly conforming to its regulations, the introduction of Title III of the Patriot Act gave the BSA a wider ambit.22 The Patriot Act gave a broader definition to what qualified as a ‘money transmitter’ for the purposes of the act, encompassing any person or business who facilitates an illegal money transfer. It also implemented the “Know Your Customer” provision, requiring each financial institution to employ a customer identification program. Which obliges financial institutions to report any suspicious activity. 18 Yilu Zhang, ‘The Incompatibility of Bitcoin's Strong Decentralization Ideology and Its Growth as a Scalable Currency’ (2017) 11 New York University Journal of Law & Liberty 556. 19 R. Stokes, ‘Virtual money laundering: the case of Bitcoin and the Linden dollar’ (2012) 21(3) Information & Communications Technology Law 228. 20 Danton Bryans, ’Bitcoin and Money Laundering: Mining for an Effective Solution’ (2014) 89 Indiana Law Journal 441. 21 Bank Secrecy Act 1970. 22 International Money Laundering Abatement and Financial Anti-Terrorist Financing Act of 2001

Furthermore, the Money Laundering Control Act (MCLA) made money laundering a federal crime in the United States.23 The act is comprised of two sections, (a) intent to distribute tainted funds and (b) the distribution of already tainted funds for the purposes of money laundering.24 The first aspect of intent would be difficult to prove in an anonymous peer to peer network, while the second, that of the criminalisation of money transactions greater than $10,000 derived from “specified unlawful activities”, would not.25 Moreover, while pinpointing individual virtual currency users would serve to be a time-consuming process for law enforcement, with the advent of 31 C.F.R. § 1010.312, a financial institution must validate and record the verification details of its users.26 In this context, law enforcement would be able to track the buyer and the seller on a bitcoin exchange. Showing that regulators would have an already established avenue in which to impose liability upon criminal cryptocurrency users.27 Briefly, another avenue to pursue possible money laundering would be through 18 U.S.C. § 1960, which prohibits knowingly operating an unlicensed money transmitting business. The application of which is most effective when a business has knowledge and disregard for the state licensing requirements and when the money being transmitted is clearly ‘dirty’. In sum, while I understand that the existing framework does not fit quite squarely with cryptocurrency in a money laundering context, having already established the concept of crypto-exchanges as money transmitters, regulators can apply existing money laundering safeguards to this innovative financial technology. C. Application of Securities Law Having established that the western world universally regards virtual currency’s as commodities and by extension of the definition, investments. I see the tailored application of securities law to cryptocurrency as further lessening the burden imposed on regulators.28 A landmark case in defining virtual currencies as investments is that of Shavers.29 Where the Securities and Exchange Commission filed a complaint against Bitcoin Savings and Trust 23 Money Laundering Control Act (MCLA) of 1986. 24 18 U.S.C. § 1956. 25 18 U.S.C. § 1957. 26 31 C.F.R. § 1010.312. 27 Danton Bryans, ’Bitcoin and Money Laundering: Mining for an Effective Solution’ (2014) 89 Indiana Law Journal 443. 28 C. Baek & M. Elbeck, “Bitcoins as an investment or speculative vehicle? A first look” (2015) 22:1 Applied Economics Letters, 32. 29 Securities and Exchange Commission v. Trendon T. Shavers and Bitcoin Savings and Trust, Civil Action No. Civil Action No. 4:13-CV-416.

(BTCST), a company ran by Shavers, alleging that it was Ponzi scheme. The court applied the Howey Test to establish whether investments in Shavers company, BTCST, qualified as securities, to which the SEC would then have jurisdiction to indict him.30 The test, which finds an instrument as a regulated investment contract under the Securities Act if the (a) the investment of money; (b) in a common enterprise; (c) with the expectation of profits is derived solely from the efforts of others. The Court found that the BTCST investments met the criteria of the Howey test and as such, are securities. This has massive implications for issuers and exchanges, in that they will not be able to escape SEC regulation by merely denominating securities in cryptocurrency. Furthermore, due to this classification, the SEC has an increased responsibility in protecting consumers from the misrepresentation of material information of cryptocurrency exchanges. Cryptocurrency price valuation is incredibly volatile, recent developments showing that rapid adjustments in price are more subject to media speculation than regulatory or governmental intervention. To incorporate virtual currency into the existing Securities Act would prove tedious but worthwhile for regulators, due to the principle that they are built upon, decentralisation.31 In relation to the SEC’s jurisdiction of cryptocurrency’s as investment instruments, in recent years there has been a surge in Initial Coin Offerings (ICO’s). Whose structure is grounded in the offer of tokens utilizing blockchain technology, these ‘tokens’ then represent cryptocurrencies.32 Regulators have broached the issue with warniess. The SEC has issued warnings to investors regarding companies promoting their investments in ICO’s as a wider “pump-and-dump” scheme to inflate share price and manipulate their own share price. As an example, the SEC has imposed trading suspensions on PDX Partners Inc. (PDXP), and Victoria Construction Group Inc. (VICT) for these very reasons, showing their willingness to impose sanctions to company’s who attempt to manipulate the market by spreading false and misleading information to create a buying frenzy.33 V.

Eternal Resource Asymmetry

30 Securities and Exchange Commission v. W. J. Howey Co., 328 U.S. 293. 31 Securities Act 1933. 32 Zetzsche, Dirk A., Ross P. Buckley, Douglas W. Arner, and Linus Föhr, ‘The ICO Gold Rush: It's a Scam, It's a Bubble, It's a Super Challenge for Regulators’ (2018). 33 Hartmann, F., Wang, ‘Evaluation of initial crypto asset offerings: the state of the practice. In Blockchain Oriented Software Engineering’ (2018) International Workshop 34.

This coincides with my final point, that regulatory bodies will eternally be faced with some resource asymmetry. While I do stress that cryptocurrency does not completely disrupt the regulatory status quo, the resource asymmetry between public and private actors will always lead to some regulatory backlog. However, I view this as inherent, the driving forces between regulatory bodies and financial institutions differ too drastically to afford cohesion, the financial industry has continuously pioneered more and more complex financial instruments in a bid to increase profits. Due to this resource disparity between the regulators and the regulated, the governance of the innovative financial technology is becoming an everincreasing challenge to police. VI.

Conclusion

In sum, I am of the view that regulation should never stagnate, it should keep on par with current events and plan for future innovation. The highlighted negative aspects of cryptocurrency represent a minute percentage of the growing population who seek financial independence. Moreover, as shown with the influx of cryptocurrency intermediary’s, regulators have a platform in which to implement and tailor existing legislation. The advent of cryptocurrency to the current financial system has on its face been disruptive, but on closer examination of the current regulatory frameworks in place, it pos...