Even as the European Commission proposes a new regulatory landscape for cryptocurrencies, they remain a niche product – for now. Polly Botsford explores the concerns and legal questions that remain for digital currencies.

The digital payments company PayPal hit the headlines in late October by announcing that its customers would be able to buy and sell cryptocurrencies such as Bitcoin or Ethereum using their PayPal accounts. PayPal – which has 26 million merchants worldwide – described the development as an ‘acceleration of the migration towards digital representations of value’.

It might appear from such news that cryptocurrencies have finally arrived in the mainstream. In fact, it’s not quite as clear-cut as that. PayPal has not – yet, at least – enabled its customers to make purchases with their bitcoin, only trade them. Trading cryptocurrencies, meanwhile, remains a niche activity.

2020 has also seen Facebook forced to manifestly rethink its plans for its own private digital currency, Libra, in the light of political resistance.

Libra was originally announced in 2019 as a single currency. Instead, it will reportedly now be a mixture of different digital currencies but, crucially, all of these will be underpinned with government-backed currencies. In effect, it won’t be too different from existing digital payments systems.

What is changing, however, is the legal ecosystem in which cryptocurrencies operate. In September, the European Commission (the ‘Commission’) finally published a proposal for new legislation to regulate them.

Lukasz Szegda, Chair of the IBA Financial Innovations Subcomittee and a partner at Wardynski & Partners in Poland, calls the proposal ‘a revolution’.

‘This is the first significant and large jurisdiction to regulate cryptocurrencies,’ he says. ‘It marks a really important moment in the legitimacy of cryptocurrencies.’

Safety first: EU proposals

To date, cryptocurrencies have managed to remain outside of regulators’ remit globally. This has led to significant concerns over what some call a ‘Wild West’ industry, particularly following the cryptocurrency price crash of 2017 and various hacking scandals.

The ability for cryptocurrency to facilitate illicit trades has also caused concern. In October for example, the US Department of Justice seized $1bn in Bitcoin linked to the notorious Silk Road website, an online black market.

There are worries too over investor and consumer protection, privacy and cyber security, as well as the potential destabilising impact on traditional currencies.

But there have been challenges from a legal and regulatory point of view. It hasn’t been clear what cryptocurrencies are, who owns them – or if they are even capable of being owned – in whose jurisdictions they fell, or how to tax them.

Cryptocurrencies have sat outside established definitions and classifications. For example, is Bitcoin a security or a commodity? They have fallen between jurisdictional and legislative cracks, with different countries attempting to fill in the gaps with piecemeal rules.

There was relief from some quarters, therefore, when the Commission published its draft Regulation on the Market in Crypto Assets (‘MiCA’). ‘It’s a radical change in tack,’ argues Adrian Mulryan, Head of Financial Services at LK Shields in Ireland, ‘because before this proposal the only law in this area was about those in the cryptocurrency sphere having to say who they were.’

‘It was an anti-money laundering approach driven by real concerns over the dark web and underground networks,’ he adds. ‘But for cryptocurrencies to get greater acceptance and greater usage, we need greater regulatory oversight.’

One of the stumbling blocks for regulators has been finding a responsible corporate body or individual to pin their rules to. But it hasn’t been clear who or what that would be in the case of cryptocurrencies. Meanwhile, they can’t regulate the asset itself because there isn’t an entity to supervise.

The EU has radically shifted that position by regulating the issuers of crypto-assets, such as Facebook (with Libra) and the service providers, which include exchanges such as Coinbase. ‘By identifying more tangible bodies, the issuers and exchanges that have, historically, been hacked, these new rules will protect investors going forward,’ says Mulryan.

For David Gerard, author of Libra Shrugged: How Facebook Tried to Take Over the Money, more controls are needed. ‘In trading markets, where people buy and sell cryptocurrencies, it’s often nothing less than a shark pool,’ he says. ‘At its worst, this world is still full of scammers. Let’s face it, its most successful use is for ransomware payments!’

In Gerard’s view, these markets are open to manipulation because there is no one to tell anyone not to manipulate. ‘The answer is absolutely to put more controls on the exchanges but, of course, that means that they are less exceptional, then they are like any other exchange,’ he says.

The super regulator

The MiCA framework requires that issuers of crypto-assets must get prior authorisation from a local competent authority before issuing such assets. There are also various governance requirements such as disclosure, complaints handling, capital requirements and conflicts of interest.

Issuers of ‘significant’ assets – in the sense of market significance – will face stricter regulatory requirements and will fall under the supervision of the European Banking Authority (EBA).

A new super regulator will also be created, and will include national and pan-European regulators to support the EBA. This super regulator will be able to make recommendations on whether additional regulatory measures are needed in any particular currency issuance.

‘An issuer will have to demonstrate that the underlying assets are properly accounted,’ explains As Krzysztof Wojdylo, Head of the New Technologies practice at Wardynski & Partners.

Szegda explains that if and when Facebook does launch Libra, ‘there will be a lot of regulatory homework before being allowed to operate or distribute the currency within the EU’.

Regulators have to tread carefully, however. ‘For a long time, they were grappling to even understand cryptocurrency, and they didn’t know how big it would be,’ says Mulryan. ‘But they have to strike this balance between innovating and safety. The regulator doesn’t want to come out too strongly and stifle innovation as this can lead to regulatory arbitrage. On the other hand, there is a need to provide investor protections to give confidence to the product.’

The UK position

Given the end of the UK-EU Withdrawal Agreement on 1 January 2021, the UK will not automatically come under the final MiCA regime. Back in 2018, the UK government set up the country’s Cryptoassets Task Force, which published its own report in October of that year with a view to constructing a regulatory approach.

Consultation on the approach is expected later in 2020 or early in 2021. What is not clear at this stage is whether the UK will diverge from MiCA or broadly follow the same EU path.

The Taskforce report’s conclusions were that the ‘true benefits’ of cryptocurrencies were not yet on the market but that there may be benefits in the future. In terms of associated risks, however, these were ‘substantial’, and ‘the most immediate priorities for the authorities are to mitigate the risks to consumers and market integrity, and prevent the use of crypto-assets for illicit activity.’

The UK’s Financial Conduct Authority has also, separately, consulted on regulating how crypto-assets are advertised.

An examination of the impact of cryptocurrencies on English law is also underway. This work builds on the watershed moment in 2019 when the UK Jurisdiction Taskforce of the LawTech Delivery Panel – an industry-led group focused on assisting with the digital transformation of the UK legal services sector, stated that crypto-assets could be treated in principle as ‘property’.

It is now the turn of the UK’s Law Commission to explore what this means for English law and whether or not it needs reforming in order, for instance, to provide proper protection to ‘owners’ of intangible assets, such as digital currencies.

As it stands, even if digital assets, including cryptocurrencies, can potentially be property as intangible assets, it does not necessarily follow that they are legally protected in the same way as conventional assets. This is because, so far, there is still a legal conundrum of whether or not an intangible asset can be ‘possessed’.

Professor Sarah Green is the Commissioner for Commercial and Common Law at the Law Commission. She gives a common example by explaining that ‘if a business commissions a database from a software expert, its proprietary interests in that database will not be protected in the same way as its interest in, say, its computer hardware, because the database is currently regarded as an intangible asset’.

Similar uncertainties currently also exist for digital currencies. ‘This seems out of kilter with the digital age,’ she adds. ‘We are going to explore whether or not English common law should be updated so that there is appropriate legal protection for digitised assets.’ The Commission will consult on this over the course of 2021.

Payments in a pandemic

2020, of course, has not been a year like any other and cryptocurrencies have been impacted by Covid-19 like everything else. For John Salmon, a partner specialising in FinTech at Hogan Lovells, ‘the pandemic has accelerated change for digital currencies, but not so much because of an increase in online shopping, nor because people have shied away from cash’.

These trends have increased the use of digital payments, and these are not the same as digital currencies. Instead, ‘people have realised what happens if you miss the boat in going digital,’ says Salmon. ‘It’s all those businesses who were not set up to operate online that have learned a hard lesson that if you are slow in taking up digital, you really might lose out. It’s not just talk. That is the accelerator for digital currencies.’ 

Going mainstream or getting overtaken

With greater regulation and improved stability, the question is whether cryptocurrencies are on a trajectory to become part of mainstream financial services and systems. One way to track their future success is to look at how the next generation view them. A survey published in 2020 by The Economist’s Intelligence Unit, Digimentality: Fear and favouring of digital currency, found that ‘support levels for digital currencies appear higher in young and developing-economy populations’.

This is likely to drive greater use and acceptance of cryptocurrencies in the near future. The survey concludes that it was these same populations that pushed mobile devices to become the dominant way the world goes online today.

But Gerard is not so sure. He argues that cryptocurrencies are a form of ‘fake news’. ‘In reality, Bitcoin (and the like) continue to have an image problem,’ he says. ‘If it was originally created as an electronic means of cash, it has proved not very good at that, its value fluctuates so much, and it still has a reputational problem.’

Another development looming on the horizon is what is known as ‘open’ or ‘decentralised’ finance (DeFi), a spin-off from cryptocurrencies. ‘In a way, stablecoins, Libra and so on, this is old news now and DeFi is moving into that unchartered space,’ says Salmon.

DeFi operates through decentralised applications known as ‘dapps’, such as Uniswap, Maker and dYdX. These dapps run on smart contracts and are not managed by any central authority. Indeed many do not even operate within a company or have staff to manage them, but instead are peer-to-peer.

According to DeFi Pulse, a market information site, the value locked into DeFi has increased massively during the pandemic and now stands at $12bn. This rise is driven in part by the lure of decent interest rates at a time when rates in conventional products have been slashed.

DeFi’s recent popularity has been so feverish that experts say there might be a similar boom-and-bust to that witnessed during the crypto crash of 2017 when, following hacking and other events, the value of cryptocurrencies plummeted.

‘Regulators are beginning to take an interest in DeFi,’ notes Salmon. ‘These are similar concerns as are had over cryptocurrencies. Projects arrive on the market with no testing, new tokens appear all the time, and no one knows who exactly should be doing the regulating, what are the systemic risks and how great.’

The story of cryptocurrencies, from Bitcoin – through boom, through bust – to DeFi, is one whose ending is still unknown but which businesses will need to follow closely.

 

The jargon Cryptocurrencies use blockchain technology, a decentralised ledger where transactions are confirmed without a central clearing authority. Instead, it uses encryption to verify the transfer of funds. Stablecoin are digital tokens that are, usually, pegged to traditional currencies such as the US dollar, British pound or Japanese yen (there are other versions of stablecoin that are backed by a mix of cryptocurrencies but they are very niche). The argument is that because they are pegged in this way, it reduces their volatility and increases confidence in the token. Facebook’s Libra is likely to be an example of stablecoin, if and when it launches. Other examples include USDCoin and Gemini Dollar. The investment bank, JP Morgan, also has a US dollar-based stablecoin called a JPM Coin. When the press, regulators and governments talk about crypto-currency they also talk about ‘digital tokens’. But this is a broad term and new tokens are being created all the time. Cryptocurrency is a form of digital token, which is usually called digital currency because it is designed as a form of exchange. A utility token provides a right to use a product or service, an asset token gives its owner a right to assets and security tokens provide voting rights or rights to a share in the profit or loss of something. Decentralised finance, or DeFi for short, and also known as ‘open finance’, is the all-encompassing term for what its evangelists say is a completely new approach to finance that operates over decentralised, permission-less apps built on blockchain, usually Ethereum. It can be used to lend/borrow, for trading on exchanges, and as a way of creating monetary banking services using stablecoins (see above for definition). Proponents of DeFi believe that it could allow individual consumers in countries with poor infrastructure and governance to benefit from financial services. For example, allowing them to be able to save money, earn interest, borrow easily and at low cost.

 

Are central banks going to take back control? Central banks have become increasingly concerned about – but also interested in – cryptocurrencies. Their potential to upset monetary and financial stability is coupled with their power to reduce friction in the system and improve access to financial services, for example by lowering costs. The logic has become: if you can’t beat them you might as well join them. So whilst no single central bank has committed – yet – to creating its own central bank-backed digital currency (CBDC), the majority of banks globally are examining it. China did start piloting a digital yuan, and Sweden did the same with an e-krona. There has been a spur to action recently with what was becoming a very real prospect of private companies such as Facebook potentially having so much control over private digital payments. At the latest G7 meeting, finance ministers and central bank governors issued a joint statement reminding the world why central banks matter (for the ‘safety and efficiency of payment systems, financial stability, and the achievement of macroeconomic objectives’, they said) and why we don’t want private institutions getting too involved. The statement outlined that ‘a number of G7 authorities are exploring … CBDCs’ and predictions are we will see the first CBDC as early as 2021.