For Blockchain Technology to Proliferate, Regulators MUST Up Their Creative Game!

June 4, 2018

 

 

As I’ve mentioned in past posts, my background is in anti-money laundering (AML) investigations and compliance. For a US-based financial institution to comply with the AML regulatory regime, they must maintain an investigative operation to understand how their platform could be used to facilitate illegal activity that will not only harm society, but negatively impact the reputation of the financial entity. I fully appreciate how a well-designed investigative unit will protect the financial institution from their unknowing participation in a money laundering operation. As more and more traditional financial service firms grow cryptocurrency to a phase of mass adoption, it is vital that the regulation is applied appropriately and that tools to support the regulatory mandates are made available. My interest in seeing a fruitful relationship between crypto-economic organizations and mainstream financial institutions stems not only from my desire for regulated entities to avoid the funding (unknowingly) of a terror operation or drug cartel, but also my impatience to speed the application of blockchain technology throughout the developing world.  Not until we in the Global North are truly comfortable with the innovation taking place will the Global South be able to fully exploit blockchain-related tools that will dramatically improve their economic conditions.  

 

Bitcoin grew out of a rebellion against traditional financial models and a desire to disintermediate third party service providers who were seen as exploiting their positions of power before, during, and after the 2008 financial crisis. Cryptographic currencies were originally embraced by Cypherpunks, Occupy Wall Street and Libertarians who, in general, are anti-any form of mainstream regulation, but this view puts a limitation on the widespread adoption of blockchain technology by “traditional” financial service institutions. I’ve written in the past criticizing the disparaging comments made about cryptocurrencies by Larry Fink of Blackrock, Warren Buffett of Berkshire Hathaway, and Jamie Dimon of JPMorgan Chase (McCalmont-Collateral Damage), comments obviously fueled by the perception of bitcoin’s dark past. This perception provides those entrenched within traditional financial establishments with a reason to maintain the status quo of substandard technical legacy systems.  

 

This attitude has the ability to impact the way regulators consider applying rules to blockchain innovation. Such was the case with New York’s BitLicense, a regulatory hurdle which was originally rolled out in 2015 as a framework for companies that were involved in exchanging and storing cryptographic currencies; it became a prime example of reckless application by regulators. New York State Senator David Carlucci considers the regulation to be a failure because it places a regulatory expense on crypto-related startups that is economically unfeasible for these newly created entities; he plans to introduce legislation that would revise the BitLicense. During Consensus 2018 in New York City, ShapeShift CEO Erik Voorhees and Kraken CEO Jesse Powell stated publicly that the reason their two premiere cryptocurrency exchanges decided not to conduct business in New York is because of the regulatory “overreach” of the BitLicense (Kraken-ShapeShift).  

 

Another concern I have with US regulatory regimes is their inability to maintain a consistent front: the US Internal Revenue Service (IRS) classifies cryptographic currencies as property for tax purposes. The Financial Crimes Enforcement Network (FinCEN) has stated that cryptographic currencies are not legal tender in any jurisdiction, even though, cryptocurrency exchanges are required to register as a money services business. Public comments made about the initial coin offering (ICO) market and cryptographic currencies by US Securities Exchange Commission (SEC) Chairman Jay Clayton pointed to their need to be classified as a security (Clayton-SEC), yet at times he seems to treat securities crimes committed with bitcoin and other virtual currencies as crimes committed with money.  

 

There is an additional pressure on regulatory regimes that other significant changes to the financial services sector have not displayed to this degree. The creativity on the part of developers that is found in applications built upon blockchain technology is occurring at a never-before-seen pace. These innovations exploit the inconsistency and lack of urgency on the part of the regulators to the benefit of the developers. California-based company Abra facilitates international money transfers without having to register as a money services business; they don’t retain custody of any of the assets in the process of transfer, but instead, act like a financial version of Uber by turning individuals who own a smartphone into human ATMs. No one involved in the transactions ever hold funds that don’t already belong to them; they don’t go through Abra as a third party but rather peer-to-peer. This system is entirely on the blockchain and never intersects with the traditional financial system. Abra does, however, comply with economic sanctions applied to countries by eliminating any connections via IP addresses based in (for example) Iran.  

 

The advent of decentralized exchanges is another creative development that is rising out of the current state of regulatory confusion. Similar to Abra’s business model, decentralized exchanges that facilitate the trading in virtual currencies and ICOs never hold the actual assets; the user is in control of his/her private keys at all times. A decentralized exchange facilitates peer-to-peer trading with your funds moved to a smart contract on the Ethereum Blockchain to finish the transaction. This structure allows the exchange to avoid know-your-customer requirements. Because these exchanges are decentralized, there is no single point of failure and no sovereign regulator.  

 

The agility of cryptocurrencies and tokens to quickly help solve a humanitarian need is another positive angle to the cryptocurrency economy. In the case of Venezuela, the conversion of Venezuelan bolívars into bitcoin (McCalmont-Venezuela), or in the case of Argentina, the conversion of the Argentine peso into bitcoin, provides citizens of those countries with the ability to hedge their exposure to the wild fluctuation of their own fiat currencies. During the European austerity initiative post-2008 financial crisis, the government of Cyprus threatened to take a certain percentage from Cypriot citizen bank accounts to aid in the country’s economic recovery. The threat of this action fueled a tremendous spike in citizens exchanging their Cypriot pounds held in Cypriot bank accounts into bitcoin in order to shield their assets from the government; the distributed borderless nature of cryptocurrencies allows for this phenomenon. To a lesser degree, that convention is playing out here in the US. The creative development extends beyond the areas of forex and the trading of ICOs.  The rise of cryptographic currencies is an answer to prayers said by state legalized marijuana retailers who are all outlawed at the federal level. Because federal authorities are charged with regulating banks, it’s illegal for a financial institution to bank any business that’s actively involved in the distribution of marijuana, even when the business is legally operating at the state level. Banks are forced to categorize proceeds earned by marijuana dispensaries as laundered funds, and, therefore, if a bank regulated by the federal government holds those proceeds, the bank could be considered running counter to US AML regulations. This also impacts the ability of a marijuana business to hold debit/credit cards and checks. This level of a business cash intensity poses many security concerns as they are an easy wealthy target for thieves. Retailers in states where marijuana is legal are adopting cryptocurrencies as a payment option to reduce their dependence upon cash due to a lack of options offered by federally regulated financial institutions.

 

I bring this up to illustrate examples of the speed in which developers are able to rapidly respond to needs that arise and can be fulfilled outside of regulatory controls. As we continue down the road of comprehensive blockchain applications, I believe this will be more and more of a challenge to traditional regulatory regimes. Keep in mind, the first (Genesis) block on the bitcoin blockchain is just a few months shy of ten years old and the regulators are still struggling to adequately respond. Regulators have unique challenges in this new age: the speed of new application development, the result of what I call “Infrastructure Light” requirements for end users (internet connection and a smartphone); the 24/7/365 borderless global nature of application development; and the speed of product dissemination via social media and other modern channels. We are witnessing firsthand how the speed of blockchain technology is changing society as a whole, but at the same time regulatory regimes are potentially stifling creativity, as in the case of BitLicense, and displaying a complete lack of urgency, as in the case of the SEC failing to approve the trading of bitcoin exchange traded funds in a timely manner. It is imperative more than ever that regulators move in concert with developers of new innovative products. It is only with the “blessing” from regulators that the true potential of this technology will transform the world for the better.  

 

Chainalysis is a company created in response to the need for innovation to answer the regulatory challenges rising through the growth of cryptocurrency transactions. Founded in October 2014, Chainalysis just released a compliance product that actively monitors cryptocurrency suspicious transactions in real time, providing the financial services firm or government agency using their software with an immediate alert. This is possible through the company’s archive of addresses that have displayed signs of suspicious activity in the past and the merging of machine learning and the opensource nature of public blockchain technology. This dramatically limits the number of false positives when compared to “traditional” AML monitoring software. The knowledge and functionality of Chainalysis is adequately responding to the growth of the cryptocurrency space. The company plans to expand their investigative tools to ten additional cryptographic currencies by the end of 2018.

 

After three years of languishing in the bowels of the SEC, in March 2017 the Winklevoss Bitcoin Trust Exchange Traded Fund was denied “approval.” In December 2017 bitcoin futures began to trade on the Chicago Board Options Exchange (CBOE) and on the derivatives marketplace the CME Group after the green light was provided by the Commodity Futures Trading Commission (CFTC). The SEC has agreed to re-examine their prior decision to reject the application submitted by the founders of the Winklevoss Bitcoin Trust, Cameron and Tyler Winklevoss.  Again, the inconsistencies and lack of communication between US-based regulatory bodies are on full display. The approval of the application by the SEC would allow bitcoin exchange traded funds to be traded on major US exchanges. In the meantime, the Winklevoss brothers have created the Virtual Commodity Association (VCA), a cryptocurrency self-regulatory organization. The VCA in conjunction with the work already being done by the cryptographic currency think-tank Coin Center will provide for better understanding and fill the visible gaps between regulatory authorities and the creative development taking place on the part of developers. The sooner this takes place, the sooner the developing economies will truly benefit from this revolutionary technology.  

 

 

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