Cryptocurrencies and Regulation

All currency and commodity exchanges around the world are closely regulated, especially the ones that involve trades across borders. Any exchange that circumvented this governmental setup was termed as illegal trades and marked as the ‘Black market’, until now. Enter Cryptocurrency. Cryptocurrencies have evolved from being simply a fiat currency of sorts to instruments that can float complex financial contracts. Cryptocurrency exchanges are currently unregulated and with more complex instruments being devised on them, it is only a matter of time before a government body steps in. Why do we need regulation, you ask? Well, let’s start with the current issues in such exchanges.

Blockchain, the bedrock on which all cryptocurrencies are built is a very versatile piece of tech. Currently, the most successful and widespread implementation of blockchain technology is in the form of cryptocurrency, the largest of them by market cap being Bitcoin, followed by Ethereum. Bitcoin is purely a cryptocurrency and is in some ways a store of value as the number of bitcoins is limited and will eventually be used as or be exchanged for fiat currency. Ethereum on the other hand, is a much broader implementation of blockchain. It uses blockchain to implement ‘smart’ contracts apart from cryptocurrencies. Most of the smart contracts implemented currently are Initial Coin Offerings which are analogous to Initial Public Offering with the coins being traded representing shares and the network being the exchange. This sector is essentially an ungoverned Stock exchange with rampant insider trading by the developers and promoters of the platform. Asymmetric information has always been a problem in all markets and financial market regulators such as SEBI take steps to curb information asymmetry and the power to do so comes from the authority vested in them by the government. Since most (almost all) cryptocurrency networks are decentralized and distributed, it begs the question, which country’s laws are applicable to trades that occur across borders? Who dictates these laws? How would these laws be enforced if anonymity is central to cryptocurrency ? And there is the principal agent problem, where a person making decisions (agent) for another (principal) has incentives to deviate from the best interests of the principal. This is true for ICOs where oversight is almost negligible, where ICOs get sold out just because one of the promoters is rather well known and next to naught can be discerned about the company issuing the coins.

At this point of time, all blockchain based exchanges are unregulated. Is it sustainable? Without regulation, probably not. During April last year, a completely automated investment fund by name DAO – Decentralized Autonomous Organization with no managers, no product and no human employees was created on the ethereum network. Its vision was that it would be a fund run entirely by code which is completely unbiased and ran to cater only to the investors interests. Since there are no preexisting laws on floating companies on the network or a regulatory body to approve/disapprove such an entity, an ICO was successfully issued and $150 million was raised in a month. In June last year, an unidentified person hacked the company and stole $50 million worth of Ether. On the day following the hack, the attacker released a statement saying that he’d read DAO’s code and had discovered a completely legal loophole which allowed him to fork the company and claim the $50 million as reward. The entire community was outraged and devastated because he was right, the fork had been legally allowed by the contract. This is just one instance where regulatory oversight might have helped. History shows that only post a crisis will steps be taken to avert the next event. James Dimon, CEO of JP Morgan Chase is of the same opinion and took a shot at bitcoin recently calling it a fraud because currencies have legal backing while bitcoin doesn’t. He compared it to the Tulip mania and said “somebody is going to get killed” post which he feels regulators would step in. China seems to have taken a step towards such regulation by issuing a ban on fundraising through ICOs over fear of fraud and as an extension seem to have made trading in cryptocurrencies illegal too.

Financial markets world over are regulated in a fashion more stringent than that meted out to other industries because financial market failures can have devastating consequences on the real economy. But one can argue that financial markets currently are huge and varied while cryptocurrency and smart contracts are only in the budding stage, so should we be regulating it now? If we do, would it slowdown the rate of innovation ?  In my opinion, we should start regulation sooner than later. Although it is true that regulation may affect innovation, its effects may be both positive and negative as examined and concluded in a report by the Organization for Economic Co-operation and Development. The regulation itself might change the nature of innovations due to limitations  imposed by the pre-existing, warranting newer reforms. This needn’t necessarily be a hindrance as the regulations grow along with the tech enabling a safe and trustworthy market. The negatives are that any regulation would require precisely identifying who the target body is and might require the veil of anonymity offered by cryptocurrencies as its primary feature to be compromised partially if not entirely. So can this be implemented? Would this be implemented , after all the underlying tech can improve banking, data storage and many other facets of web-based services by leaps and bounds, remains to be seen.

-Sai Kumar M