The Regulation of Cryptocurrencies: Between a Currency and a Financial Product

ByHadar Jabotinsky.

As cryptocurrencies become better known, the number of the people using them grows. Their attractiveness is due in part to their decentralized, peer-to-peer construction. This makes them an alternative to national currencies controlled by central banks. In times of financial instability, an increase in the use of cryptocurrencies is apparent. Given that these cryptocurrencies are already replacing some of the “regular” national currencies and financial products, the question then arises: Should they be regulated, and if so – how? Some countries, such as China and Russia, forbid Initial Coin Offerings (ICOs) altogether, while others are struggling to gain a full understanding of the currencies in order to formulate coherent regulation.

The question of how to regulate cryptocurrencies is interesting throughout the life of the coin, but is of special interest during the Initial Coin Offering. The reason for this is that the value of the cryptocurrency depends not only on the value of the currency, but also on security issues. Since these coins exist in the virtual world, the sites on which they are traded are sensitive to hackers. Even if hacking the network of the coin itself is difficult, other sites such as stock exchanges of coins are more vulnerable to theft. The ICO process is also vulnerable. An ICO is a process in which people buy virtual tokens from the makers of the cryptocurrency. As the startup grows, these tokens are supposed to increase in value. This is a way of crowdfunding investment in order to cut transaction costs associated with raising capital elsewhere. In some respects, buying some of these tokens is similar to buying stock in an Initial Public Offering of corporations. Currently, unlike regular IPOs, very little information is given to potential investors and these ICOs have until recently largely remained “under the radar” of the securities authorities. Questions of disclosure are particularly interesting with regard to the “safety” of these coins: Should disclosure requirements include cyber security matters? Are investors equipped with the right tools to assess cyber issues with regard to cryptocurrencies?

This paper posits that although the technology underlying most cryptocurrencies is very similar, the logic behinds them differs. Some cryptocurrencies function like regular national currencies and have traditional currency traits. As such, they provide a medium of exchange, unit of account, and/or store of value. Other cryptocurrencies, however, may also represent additional rights. This interesting phenomenon actually causes some cryptocurrencies to be viewed as closer to real national currencies while others seem to be closer to financial products (such as securities or derivatives).

This phenomenon requires regulatory authorities to investigate each new ICO and determine how to classify the token. Some tokens, such as Bitcoin, indeed resemble currency and should therefore only be regulated to insure that fraudulent behavior is prevented. These types of cryptocurrencies should be more carefully regulated in case they increase systemic risks in the general financial system. Other tokens resemble securities and should be regulated accordingly. The main distinction between the two types of cryptocurrencies is whether or not their value is dependent on the efforts of others.

With regards to cryptocurrencies that are actually securities, additional mandatory disclosure should be required with regards to security issues surrounding the ICO. Investors should be informed about what kind of Blockchain technology is being used, who developed the code, and whether it was published openly. In addition, information with regards to what kind of cyber audits were conducted prior to the issuance of the coin is essential.

Hopefully, by implementing the steps suggested by this paper, regulatory authorities will be able to protect financial markets while still allowing room for innovation.

 

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