The New York Attorney General’s office is looking into the practices and policies of cryptocurrency exchanges; experts say any ensuing regulation will likely protect investors while allowing the marketplace to continue growing.
States and the federal government are increasing their scrutiny of cryptocurrencies in an attempt to bring more transparency to a market where buyers and sellers are anonymous and regulatory oversight is light.
Cryptocurrencies such as Bitcoin, Ether, LiteCoin, and Ripple skyrocketed in value last year as investors sought to get in on what many see as the future of global currency – one that for trade and commerce knows no borders. Bitcoin generated massive hype among investors as its value surged more than 1,900% to nearly $20,000 last year, before tumbling back down below $11,000.
Today, it’s valued around $8,500.
Earlier this week, New York Attorney General Eric T. Schneiderman launched a fact-finding inquiry into the practices and policies of cryptocurrency exchanges – the online platforms where cryptocurrencies are bought and sold.
Cryptocurrencies are created on blockchain distributed ledgers, peer-to-peer (P2P) electronic networks that are also used to dispense payments for all kinds of ecommerce. Those open P2P networks operate with no central authority, such as banks or governments. And the marketplace can be highly speculative and volatile.
“Currently, as it stands, cryptocurrencies are not really regulated and I am not seeing that change any time soon,” said Marco Peereboom, new systems development lead at Decred, an open-source, blockchain-based cryptocurrency similar to Bitcoin.
“The real fear is that government will try to turn cryptocurrencies into what cryptocurrencies were designed to resist, but crypto is a global technology and no amount of regulation can stomp it out,” Peereboom added.
Paul Brody, global innovation leader for blockchain technology at Ernst & Young, said thoughtful regulation could create more trustworthy ways of doing business through cryptocurrencies and P2P blockchain networks.
“Setting aside who wants what, the underlying blockchain technology is amazing and will have a huge positive impact. But it won’t get there unless individual investors and companies have confidence in the system,” Brody said. “No corporate CFO or sensible investor wants to park their money or do transactions in a system that isn’t audited and where they could unwittingly find themselves facilitating illegal activity.”
The technology that underpins cryptocurrencies, blockchain, can be open or run as permissioned networks where transcations can take place between pre-approved parties, such as companies in a supply chain.
Bitcoin and other cryptocurrency exchanges operate on open blockchain ledgers or networks, where anyone can transact anonymously with no central authority.
As part of a broader effort to protect cryptocurrency investors and consumers, Schneiderman’s office launched the Virtual Markets Integrity Initiative and sent letters to 13 major virtual currency trading platforms requesting key information on their operations, internal controls and safeguards to protect customer assets.
The move, Schneiderman’s office explained in a statement, hopes to increase transparency and accountability for the exchanges retail investors use to trade virtual currency, and seeks to better inform enforcement agencies, investors and consumers.
“With cryptocurrency on the rise, consumers in New York and across the country have a right to transparency and accountability when they invest their money. Yet too often, consumers don’t have the basic facts they need to assess the fairness, integrity, and security of these trading platforms,” Schneiderman said.
Initial coin offerings (ICO), a crowdfunding mechanism for companies similar to initial public offerings, raise vast amounts of capital from the sale of crypto tokens that in some cases offer no returns. The U.S. Securities and Exchange Commission (SEC) has increased its oversight of ICOs, arresting those involved in alleged money-raising scams.
Unlike stocks, which represent shares of a company, cryptocurrencies can have no intrinsic value in that there is no equity attached to them; they can also be repositories for sensitive personal information about investors and are tied to vast sums of real or government-issued fiat currency paid out for them, Schneiderman’s office said.
Since 2014, hackers and thieves have stolen about $1.4 billion from cryptocurrency investors, according to a Wall Street Journal report. This year alone, hacks of two cryptocurrency exchange cost investors $700 million.
“ICOs in the USA are in deep trouble and something is going to give. At some point, companies or groups that performed ICOs are going to have a reckoning and have to deal with federal law,” Peereboom said. “The real tragedy is the conflation of cryptocurrencies with ICOs. These things are not the same and inherently cannot and should not be regulated the same way.”
Unlike cryptocurrencies, which are treated as assets by the IRS, and are virtually unregulated, ICOs are by definition securities because they pass the Howey test – precedence set by a Supreme Court Case that’s used by the SEC to determine whether a financial transaction qualifies as an investment contract and thus is a security.
In response to government pressure, some companies have switched to calling their ICOs, initial security offerings (ISO), Peereboom said. That indicates they understand the regulatory implications and have registered their crowdfunding efforts with the proper government agencies.
Conversely, Peereboom said, cryptocurrencies are treated as assets by the IRS. “These are well-trodden paths and there really is no value in additional regulations,” he argued.
The A.G.’s questionnaires ask the platforms for information in six major areas, including (1) Ownership and Control, (2) Basic Operation and Fees, (3) Trading Policies and Procedures, (4) Outages and Other Suspensions of Trading, (5) Internal Controls, and (6) Privacy and Money Laundering. The questionnaires also ask that platforms describe their approach to combating suspicious trading and market manipulation; their policies on the operation of bots; their limitations on the use of and access to non-public trading information; and the safeguards they have in place to protect customer funds from theft, fraud and other risks.
“The Attorney General’s office will analyze the responses, compare them across platforms, and at the conclusion of this process, present what it learned to the public,” the A.G.’s office stated.
Some countries have come down hard on ICOs and cryptocurrency exchanges. Last year, China banned ICOs and more generally has been cracking down on cryptocurrency exchanges and bitcoin mining, the process by which computers solve complex mathematical equations in order to generate bitcoin; it’s an intensely energy-consuming process, especially when whole datacenters are dedicated to the process.
Regulations can have a “chilling effect” on business and individual investors who play by the rules, Peereboom said, which can push exchanges to a friendlier locale to continue business.
China’s clampdown, however, led many of the exchanges to find new methods to operate using open-source blockchain to create exchanges hosted through cloud services such as Amazon Web Services.
Also on the horizon are so called DEXs, or Decentralized EXchanges, that will work much as Blockchain does, Peereboom said, thus making it impossible to shut down.
“These DEXs are going to enable two individuals to pseudo anonymously exchange crypto tokens without risk and without middlemen,” he said. “The USA is a business friendly place and I don’t believe heavy handed regulations will happen. Ultimately, the USA wants the jobs and tax revenues it can extract from this new technology.”
“Reasonable regulations that protect investors, for example by ensuring accountability and effective disclosure requirements, can actually grow the market size by increasing investor confidence,” he said.