Cryptocurrency Regulation Must Both Protect Consumers and Promote Innovation

by Brian Sewell (863 words)

The Dual Priorities Cryptocurrency Regulators and Exchanges Must Address

The cryptocurrency market, financial professionals, and potential investors seem to be clamoring for cryptocurrency regulation. Such protections could unleash a wave of confidence and investment.

Not so fast. Much is at stake in regulating cryptocurrency markets. Regulators and exchanges have a dual challenge: They must combat fraud and market manipulation. But they must also create fertile ground for law-abiding innovators, for cryptocurrency's next Googles and Amazons.

Learning How to Regulate Cryptocurrency Takes Time

To strike this balance, deliberation should take precedence over speed. Protecting investors while nurturing innovators requires that regulators learn a great deal. Investing in staff and R&D could develop the knowledge, monitoring methods, and enforcement tools to protect investors against criminal activity while nurturing innovation. Establishing that learning curve takes time.

Consider the advice of leading cryptocurrency expert Andreas Antonopoulos, who in 2014, addressed Canada’s Banking, Trade, and Commerce Committee. "Wait until the technology is better understood by all of us,” he testified. “There are nuances in this technology that require very careful treatment, because a blanket treatment...would stifle this technology in its early days."1

In other words, cryptocurrency’s complexity requires implementing regulations gradually and thoughtfully. Regulators should test and build interrelated, surgically designed rules and processes, not implement sweeping, blunt measures without fully understanding their total impact.

An Effective Global Approach to Cryptocurrency Regulation

In July, the U.S. Internal Revenue Service and tax authorities from Australia, Canada, the Netherlands, and the UK formed the Joint Chiefs of Global Tax Enforcement (J5). The task force aims to address tax evasion perpetrated through cryptocurrencies and cybercrime, transnational tax crime, and money laundering.2 Establishing a transnational taskforce embodies the deliberative, collaborative approach that regulating cryptocurrency requires.

 

 

New York's Constrictive Approach to Cryptocurrency Regulation

In contrast, New York became the first U.S. state to create cryptocurrency regulation, establishing a BitLicense in 2015.3 In the nearly three years since, authorities issued licenses to only four companies as of this May.4 Though the total number rose to nine by June, approval remains difficult.5 Some key industry players have consequently moved out of New York. Other jurisdictions, including the United States as a whole, risk the same fate if they create such an onerous approval process.

 

 

The SEC's Measured Approached to Cryptocurrency Regulation

I thus applaud the SEC's more meticulous, measured approach. In June, SEC Director of Corporation Finance William Hinman offered thoughtful guidance on what types of technology and business offerings might come under SEC regulation.6 Director Hinman opined that bitcoin and ether currently do not come under SEC disclosure law because their networks are sufficiently decentralized. The SEC would not regulate these tokens because investors can’t count on an individual or team representing these cryptocurrencies “...to carry out essential managerial or entrepreneurial efforts…,” or to possess unique knowledge that would help inform investors.7

The SEC on ICO Regulation

But Hinman added that most Initial Coin Offerings (ICO’s), which seek to raise money for ventures by issuing company-specific cryptocurrency, currently do fall under SEC regulations. That’s because an ICO's success relies on a third party with unique knowledge of the venture. That requires a regulatory framework "promoting disclosure of what the third party alone knows..." to inform investors of the risk.

 

 

The SEC's Condition For a Bitcoin Exchange-Traded Fund

Similarly, if a business markets even a decentralized cryptocurrency, Hinman elaborated, the resulting investment contract might come under SEC regulation. For example, if a promoter were to place “... Bitcoin in a fund or trust and sell interests in such vehicle, it would create a new security....provided the investor is reasonably expecting profits from the promoter’s efforts.”8

In other words, a bitcoin exchange-traded fund (BTC ETF) would clearly come under SEC regulation. The SEC has so far declined to approve a BTC ETF. Such a vehicle would facilitate bitcoin investment, by enabling the purchase of shares in a fund rather than requiring a direct investment in bitcoin. But a major sticking point is the SEC’s reasonable, yet challenging, demand. A listing exchange should demonstrate that it can mitigate the risk of cryptocurrency fraud and market manipulation, presumably in collaboration with other exchanges.9

Some Exchanges Are Uniting Against Cryptocurrency Fraud

Four exchanges are committed to doing just that, through the newly formed Virtual Commodity Association, founded by Cameron and Tyler Winklevoss of Gemini Trust Co. Initial members include Bittrex Inc.; bitFlyer USA, Inc., a unit of Japan’s bitFlyer Inc.; Bitstamp, Inc. and Gemini. This creates positive competitive pressure on all cryptocurrency exchanges to collaborate to detect and deter fraud and market manipulation. It's unclear whether one proposal currently before the SEC, the VanEck-SolidX Bitcoin ETF and its listing exchange, the Cboe, will undertake a similar initiative.

Which Countries Will Host the Next Cryptocurrency World Capitals?

Cryptocurrency regulation necessitates innovative ways to protect both consumers from criminal abuse and entrepreneurs from draconian constraint. This will eventually require information-sharing among exchanges and regulators on a global scale. Whichever countries and exchanges most effectively balance these priorities will likely host the next world capitals of the cryptocurrency revolution, reaping its many potential future benefits.

Brian Sewell is Founder of Rockwell Trades (www.rockwelltrades.com), an OTC cryptocurrency trading service.

 

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Cryptocurrency Market Outlook

by Brian Sewell (1,642 words)

Don't count out the cryptocurrency market. Granted, ether and other tokens have recently taken a beating, and the market is down from its all-time highs. But I believe the fundamentals suggest that cryptocurrencies may outperform other asset classes over the long term. Deciding whether -- and how much -- to allocate to this emerging asset category requires understanding how investor sentiment and fundamentals influence cryptocurrency’s risk/reward profile.

Blockchain Technology and Cryptocurrency

blockchain technology enables peer-to-peer transactions without intermediaries

Blockchain Technology

Blockchain technology enables the secure, peer-to-peer digital exchange of value without need of a trusted third party to authenticate or record the exchange. This new non-intermediated process seeks to offer a cheaper, virtually instantaneous way to engage in transactions, update ledgers, execute contracts, and access databases.

Cryptocurrency

Cryptocurrency represents the first application of blockchain technology. And bitcoin is the first functional blockchain-based cryptocurrency, specializing in financial transactions. 

Currency - A Trusted Agent to Settle Debt Obligations 

Let’s define currency as a trusted agent in a financial system, entrusted to transfer value by settling debt obligations. As Paul Vigna and Michael Casey observe in The Age Of Cryptocurrency, cryptocurrency such as bitcoin proposes to "rearrange the rules of trust," removing banks, brokers, and governments as intermediaries from that financial system. 

A Bright Adoption Outlook

global adoption can boost the cryptocurrency market value

The quality of a token's underlying technology can impact its value, both as a transaction medium and as an asset, influencing the cryptocurrency market. Key criteria include a cryptocurrency’s adoption rate, transaction volume, transaction speed, and the quality of its software code, including encryption.

Cryptocurrency’s global adoption rate is estimated at no more than 3.5%1. But long term, I believe higher transaction speeds, new applications, and need in the Developing World for reliable financial payment methods will boost cryptocurrency adoption. Distrust in traditional currencies and failing financial systems, such as in Venezuela and Argentina, could also fuel adoption and support the overall cryptocurrency market.

Cryptocurrency’s Anti-inflation Feature

A central bank can cause inflation of a fiat currency by printing more money

The anti-inflationary characteristic built into a cryptocurrency’s code may also boost adoption rates. This represents a significant advantage over a fiat currency, which a government may devalue through printing money or excessive borrowing. In contrast, a legitimate cryptocurrency limits production of its units. Bitcoin’s code, for example, limits production to 21 million currency units by 2140.

Growing Pains - ScalabilityCryptocurrencies require scalability to grow into a global transaction technology.

Cryptocurrency’s substantial volatility reflects its status and promise as a developing technology. For example, major credit cards and PayPal have “scalability,” which means they can process hundreds, if not thousands, of transactions per second. Bitcoin can currently process only three to seven transactions per second. This has occasionally made bitcoin a victim of its success, sometimes causing bottlenecks, reducing the speed, and raising the cost of   transactions.

Yet the Lightning Network, a “‘second layer’ payment protocol that operates on top of a blockchain...”2, is now being tested to bring bitcoin to scale. If successful, scalability could allow bitcoin to surpass the transaction capacity of  other cryptocurrencies and any other payment method.3 Scalability projects are also in progress for other cryptocurrencies and platforms, such as for ether and Ethereum, through Plasma.

Rising Adoption of Bitcoin

Rising bitcoin adoption as a transaction medium supports the cryptocurrency market as an asset class.

As a payment medium, bitcoin transaction volume is down from its highs. But during more than two years, the technology has experienced an unabated rise in adoption, of 654%4. Some blockchain applications are also integrating bitcoin into their platforms, which could further boost bitcoin adoption and its market value.

Cryptocurrency Investor Sentiment

Investor Psychology

Many bitcoin investors are inexperienced, driven by fear and greed.

Cryptocurrencies can move sharply based on fear or greed rather than on fundamentals. Take bitcoin, with the largest market capitalization of all cryptocurrencies. Many bitcoin investors are Generation-Xers and Millennials, who distrust banks, Wall Street, and governments, and so embrace cryptocurrency’s independence from intermediaries.

Panic Selling

But judging from market movements, many are also inexperienced investors seeking a way to get rich quick. Instead of holding for the long term, many have resorted to panic selling in downturns. Panic selling has caused some investors to miss out on bitcoin’s relatively small number of dramatic up days, and/or to lose money. Selling on fear has also exacerbated the overall cryptocurrency market downturn.

Long-term Investment Outlook

Bitcoin

Bitcoin, in my opinion, may have the best opportunity to be a reliable long term cryptocurrency market performer. Bitcoin’s significant first-mover advantage has led to four compelling characteristics:

Bitcoin's robust code contributes to its reliability as a technology.

  • Development of a robust, highly functional software code, including the quality of security and encryption;
  • Market dominance and wider adoption as a cryptocurrency transaction medium;
  • The largest market capitalization;
  • Higher trading liquidity;
  • Risk/reward profile that may appeal to institutional investors.

How Institutional Investment Could Benefit Bitcoin and The Cryptocurrency Market

Though few institutions are invested in cryptocurrency, more institutional investment would represent a key milestone for the sector. In the next twelve months, I expect more institutions to allocate a small proportion of assets to cryptocurrency, driven by its historical lack of correlation to traditional asset classes, including stocks and bonds.

Due to fiduciary duties, many institutional investors will want to minimize risk. Minimizing risk will likely require higher exposure to the top ten cryptocurrencies -- over-weighted in the most well-known, stable, and liquid issue, bitcoin. I believe the entrance of a high profile institutional investor in bitcoin, for example, could then attract even more institutional investors and support the overall cryptocurrency market.

Other Cryptocurrencies

I currently favor focusing on the top ten5 cryptocurrencies by market capitalization, over-weighted in bitcoin, which typically is less volatile than other cryptocurrencies. Granted, various tokens outside the top ten have specialized codes aimed at disrupting particular industries, from artificial intelligence to entertainment6, which I think will transform our entire economy. And successfully identifying the few smaller cryptocurrencies that will succeed may significantly enhance returns. But picking those winners, out of over fifteen hundred cryptocurrenciesis easier said than done.

How News Drives Cryptocurrency Volatility

Skeptics

Pundits have proclaimed bitcoin's demise over 300 times.

Various pundits have pronounced bitcoin dead over 300 times since December of 20108. They cite cryptocurrency's high volatility. They doubt the viability of its payment system, based on open source software code instead of a third party intermediary such as a bank or government. They question that a cryptocurrency merits a high asset price. Such pronouncements themselves have sometimes depressed the cryptocurrency market. But although down nearly 50% YTD, bitcoin has generally remained above $6,000 this year.

regulation protecting consumers and nurturing innovators can support the cryptocurrency market.

Regulatory Factors

Friction between global regulators and cryptocurrency exchanges has periodically depressed prices, due to the technology’s unregulated status and concerns that criminals can misuse cryptocurrency’s anonymity for money laundering and other fraudulent activity9.

Benefits of Regulation

I believe over the long term, the U.S., for example, will implement regulations that protect consumers while nurturing innovation. Striking this balance could add integrity to the cryptocurrency market, boost investor confidence, and encourage institutional investment. SEC approval of a cryptocurrency exchange-traded fund (ETF) would represent a key step toward such comprehensive U.S. regulation. Between September and March, the SEC may well approve what I believe to be the best chance so far for an SEC-approved bitcoin ETF 10. But until or unless countries implement comprehensive rules that protect investors without stifling innovation, I think regulatory uncertainty will remain a key driver of cryptocurrency market volatility.

Initial Coin Offerings (ICO’s)

ICO's may experience a shakeout, but by one measure, most funding goes to legitimate, promising ventures.

Initial Coin Offerings (ICO's) typically allow companies to raise money by issuing a new digital token to investors in exchange for fiat currency or cryptocurrency such as bitcoin or ether. Hoping the tokens will rise in value with the fortunes of the company, the investor can trade, spend, and use the new tokens within that company-specific blockchain platform. These token holders do not own any equity in the company that they’ve invested in, so the investors have no leverage to make the company fulfill their promises. Though segments of the ICO market may continue to experience substantial returns, if many of these businesses don’t fulfill their promises, I expect the ICO market to experience a shakeout.

ICO Market Analysis

Aaron Brown, however, a former Wall Street financial research executive, opines that most of the actual funds raised for ICO’s have gone to legitimate, promising ventures. Of the approximately $6 billion in ICO funds raised in 201711, he estimates that most of that capital (over $5 billion) funded thirty to forty promising, reputable deals. For the remaining number of ICO’s -- at least the roughly 500 deals that each raised one $1 million or more -- he estimates that 20% of deals, comprising roughly $500 million in funds raised, went to legitimate ventures. Though roughly 80% of the remainder may have been fraudulent, negligent, or lacking in merit, that comprises roughly $500 million in funds raised, out of the $5 billion total, or scarcely more than 8%12.

Hacking

Hacking risks raise cryptocurrency market volatility

Hot Wallets

As with any digital medium, including credit cards, a cryptocurrency holder may be vulnerable to a hack. The risk of a hack may be especially high if cryptocurrency holdings are stored for an extended period online in a “hot wallet.” A hot wallet is used for transactions, but is vulnerable to hacking since it's connected to the internet.

Exchanges

Cryptocurrency exchanges have been notoriously hacked, such as two in South Korea13. But exchange security is improving, as are fraud reimbursement policies and insurance protection options.

51% Attacks

Thieves can wage a “51% attack” to steal money by gaining majority control of a cryptocurrency’s ledger. The high cost14 of perpetrating such a heist against larger tokens such as bitcoin or ethereum reduces their risk of 51% attacks15. Several smaller cryptocurrencies, however, have endured attacks. This underscores both the relatively higher risks of investing in smaller tokens, and the need for all cryptocurrencies to innovate, one of the hallmarks of open source software.

Cryptocurrency’s Investment Suitability

Overweighting in bitcoin relative to the cryptocurrency market may mitigate investment risk.

For high risk-reward asset allocations, I believe that at current prices, bitcoin represents a worthwhile option relative to other asset categories. Although some smaller cryptocurrencies may perform well, I think bitcoin will continue to dominate as a transaction medium, and may represent the most reliable cryptocurrency at its current price.

Appendix - Four Components of Blockchain Technology

Taken together, four components of blockchain technology can transform how the world does business:

A Digital Peer-to-Peer Network

Enables the transfer of value over the Internet.

 Cryptography

Provides anonymity for each party in a transaction, through encrypted digital signatures.

Blockchain Database

A transparent, immutable chain of transaction records, or ledgers, arranged in sequential blocks.

Proof-of-Work

A transparent system of fraud prevention, which authenticates a transaction by recording it in a time-stamped numerical code, or “hash.” The hash becomes part of a blockchain, the public chain of transaction records. An attempt to fraudulently “double-spend” even a minuscule amount of value, by tampering with even a single transaction record, would corrupt the entire expanding chain of public records, generating a hash code error, which the network of legitimate users would reject.

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Brian SewellBrian Sewell is Founder of Rockwell Trades www.rockwelltrades.com, a concierge OTC cryptocurrency trading service.

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This material is provided only for general educational purposes and is not investment, legal, tax or professional advice or an offer to buy or sell any assets. Opinions provided herein are exclusively those personal opinions of the author and should not be relied upon in making decisions regarding cryptocurrencies. This material may be inaccurate and there is no requirement that the author update this content or correct it at any time.