INTRODUCTION
Cryptocurrency or crypto is a digital currency traded on a blockchain, which can be used for online transactions. They are made using encryption algorithms and are decentralised in nature. Famous cryptocurrencies like Bitcoin and Ethereum have revolutionised finance, but have created a big headache for regulators worldwide. Without enough regulations, the cryptocurrency market has become susceptible to fraud, money laundering and tax evasion. In this blog, we will explore the key legal challenges faced by countries and regulators when trying to control this large evolving cryptocurrency space.
JURISDICTIONAL ISSUES: A GLOBAL CHALLENGE
One of the most important legal challenges in cryptocurrency regulation is jurisdictional issues. Crypto is global while the laws and regulations made for it are national, for which it becomes quite difficult for the regulators to keep in check the transfers happening across borders as they have no power to enforce their regulations on foreign soil. This creates a regulatory arbitrage, where companies avoid countries with stricter laws and trade off-shore. For example, many cryptocurrency exchanges are set up in countries with loose regulations relating to crypto such as Malta or the Cayman Islands, which allows them to serve customers from countries with stricter regulations such as the UK or US. This makes the job of regulating cryptocurrency quite difficult for governments without any international cooperation.
To address issues like this, countries like the US and China have banned certain crypto activities and allowed exchanges to happen with those that match the local laws. Such as the US has various agencies present that regulate the crypto scene there such as the Financial Crimes Enforcement Network (FinCEN) which treats these crypto exchanges as Money Services Businesses under the Bank Secrecy Act, thus these crypto administrators have to adhere to the regulations of this and register with FinCEN to prevent illegal activities. The SEC uses the Howey method to determine whether it comes under the category of securities, commodities or property and according to that is dealt with by different agencies. If it is determined as a commodity then the Commodity Futures Trading Commission has authority over it under the Commodity Exchange Act. If it is classified as property then the IRS has authority over it where the traders have to report on their income tax returns from gains or losses from trading to selling. On the other hand, China prefers a more stringent approach to this topic of cryptocurrency which all started in 2013 when the People’s Bank of China (PBC) introduced its first set of restrictions regarding where financial institutions were prohibited from handling this currency as they feared financial stability. In 2017 China took its efforts to restrict up a notch by banning the Initial Coin Offerings (ICOs) and shutting down any other cryptocurrency exchanges across the country stating that this currency was being used for illegal activities and banning it as a whole thus restricting the already restricted currency. These restrictions can be understood by China’s nature of having a desire to have strict capital control. The State Administration of Foreign Exchange (SAFE) imposed strict restrictions on foreign exchange making it difficult to move money overseas thus the government saw cryptocurrency as a tool that could bypass the system which makes sense for the blanket ban on most crypto-currency related activities.
However, this global nature of cryptocurrency needs an international approach to collaboration. Global initiatives like the Financial Action Task Force (FATF) have developed guidelines to combat the challenges of money laundering and terrorist financing which offers a framework to establish robust regulatory measures for countries.
CLASSIFICATION DILEMMA: ARE CRYPTOCURRENCIES COMMODITIES, SECURITIES OR CURRENCIES?
Even though it has been a long time since the presence of cryptocurrency, they still do not neatly fit into any existing legal category. Are they currencies, commodities or securities? It is tough to classify them. In the U.S. the Securities and Exchange Commission (SEC) classifies many tokens as securities, whereas on the other hand, Commodity Futures Trading Commission (CFTC) oversees Bitcoins and Ethereum as commodities.
In contrast to this, China bans most crypto transactions entirely. This classification of cryptocurrencies influences how they are meant to be taxed, traded and regulated. Thus, not being able to classify them under a single head creates a lot of confusion for both companies and investors. To address these challenges, countries like the EU have started moving towards clearer regulation with the Markets in Crypto Assets (MiCA) framework. This framework provides comprehensive regulatory guidelines for the cryptocurrencies, classifying them and setting out rules for their issuance, trading and custody.
CONSUMER PROTECTION: SAFEGUARDING INVESTORS IN A VOLATILE MARKET
Even though cryptocurrencies offer great benefits like anonymity and decentralisation, these are the same features that act as obstacles for the government to protect the people from scams, fraud, and hacking. The case of the collapse of Mt. Gox Exchange where the users lost over 450 million US dollars worth of Bitcoin is one of the well-known cases of a crypto exchange hack. Without well-planned robust consumer protection laws, users are left vulnerable. To address this issue, regulators are starting to make cryptocurrency exchanges adhere to similar standards as other financial institutions. This makes sure that the user’s assets are protected and the exchanges are subjected to oversight. One such example of a regulator is the UK’s Financial Conduct Authority (FCA) which has imposed stringent rules on exchanges operating within the country.
TAXATION AND COMPLIANCE: THE CHALLENGE OF TRACKING CRYPTO TRANSACTIONS
Cryptocurrency leads to various opportunities for tax evasion due to its decentralised nature, which makes it quite difficult for regulators to impose tax laws. The Internal Revenue Service (IRS) of the US has started treating cryptocurrency transactions as taxable events, but compliance is low. Many people do not report their crypto gains leading to a considerable amount of tax revenue losses.
To counter this governments are developing better systems to track cryptocurrency transactions and enforce tax laws. However, the anonymous nature of crypto makes the task quite a challenge. Countries like Australia have introduced systems that link the crypto exchanges with tax authorities to make sure the transactions are properly reported. Others like the EU, are pushing for transparency with crypto transactions under the DAC7 Directive.
MONEY LAUNDERING AND KNOW YOUR CUSTOMER (KYC): COMBATING ILLICIT ACTIVITIES
Cryptocurrency breeds money laundering and illicit activities due to its anonymity and untraceable nature. One classic example is the Silk Road case, where billions of dollars worth of Bitcoin were used to buy and sell illegal goods on the dark web. Even today the existence of privacy coins like Monero makes the process of tracking transactions even more difficult.
To combat this issue governments are pressurising for more stronger Anti-Money Laundering (AML) and KYC regulations. However, it is quite a hassle to enforce these regulations on the decentralised exchanges or privacy-focused coins. Many countries are taking steps by passing laws to make sure that the crypto exchanges are required to follow the AML/KYC regulations like the 5th Anti-Money Laundering Directive (5AMLD) launched by the European Union requiring exchanges to register with authority and verify their users identities.
FUTURE OF CRYPTO REGULATION: A GLOBAL COLLABORATION
The regulation of Cryptocurrency faces numerous challenges due to its decentralised nature which makes it so that there is no global approach on the matter. This lack of a global approach is a serious issue which is why we see different countries using different methods to deal with it the US and China have taken a stance against this from imposing regulatory framework to outright bans which are not enough to deal with something which does not take borders into account while functioning. While efforts from the EU in introducing the MiCA framework act as a good starting point more widespread international adoption is needed. Consumer protection is also a major problem in this area where many times people encounter scams and exchange failures for there not being strong legal safeguards. Tax compliance is another major issue where the decentralised nature of the currency makes it difficult to track transactions which leads to evasion of taxes and losses suffered by the government. Finally, the anonymous nature of certain coins makes it challenging to enforce measures like the EU’s 5AMLD.
The key suggestion to improving crypto regulation is having a global regulatory framework as cryptocurrency does not bear in mind borders it is quite difficult for just national laws to manage it. Nations should come together for a cooperative approach with organisations like FATF which could prevent regulatory arbitrage. Furthermore, consumer protection should be strengthened so that incidents of fraud, hacks and loss of user funds do not happen like in the Mt. Gox incident. Tracking crypto transactions can be difficult but governments can introduce systems to link exchanges with tax authorities like Australia did. Finally enforcing AML and KYC regulations to prevent the use of cryptocurrency for illicit activities to have a grip on the complex issues of cryptocurrency.
Author(s) Name: Surya Sekhar Ganguly (Calcutta University)
