How Blockchain Needs Regulation to Mature

May 29, 2018

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Blockchains and their cryptocurrencies are energetically following a path similar to other major leaps in technology that have come before it. Like automobiles, electricity, or the world wide web, the technology and communities behind blockchain tech are growing and innovating far ahead of existing regulations or social safety nets.

On one hand, regulation and consumer safety in the space of blockchain technology and cryptocurrencies are becoming increasingly important and desired by those involved.

However, the community seems to be holding their breath on what good regulation can bring and how organizations like governments or SRO’s (Self Regulating Organization) will be able to affect change without stymying progress. It will be important for regulating bodies to try and clarify the competing ideas around topics like taxation, crypto exchanges, and how ICO’s should be handled.

Oversight and safety inside these avenues will help avoid past calamities like Mt Gox or Bitconnect, but even if this industry is in dire need of accountable oversight it’s of critical importance that the regulations don’t do more harm to progress than good to the people.

“We’re at that time now where we need more clarity and rules and we need more certainty. It’s a good time to start revisiting that ‘wait and see’ approach taken by regulators”

– Ryan Zagone, Director of Regulatory Relations, Ripple

What regulation can bring to the crypto economy

The majority of the need for regulation is surrounding the cryptocurrency trading and monetization, and that should come as no surprise.

Legal definitions and regulatory frameworks would go a long way to clear up the current level of uncertainty that is involved in the crypto markets. The uncertainty and volatility are presently doing well for speculators and day traders but doesn’t do too much for the large institutions that are sitting on the sidelines.

Taxation guidelines, ICO (Initial Coin Offering) regulation, crypto-exchange oversight and legal scaffolding for onboarding institutional investors into the crypto markets are a few of the ways regulation can help clean up this industry and make it an even more fertile area for innovation and safe investment.

Taxation

Investments in cryptocurrencies are causing some serious headaches for anyone looking to stay in the good books of their tax collectors. Issues like which jurisdiction collects the taxes, which coins and tokens are taxed, and what activities are taxable events all currently surround investors big and small.

Taxation might seem like an odd positive to highlight from the coming benefits of regulation since it typically means less money in our pockets; however, taxes are a vital part of the economy and in order for large players to be able to confidently join in, the details surround taxes will need to be tightened.

On the surface, it seems that most crypto investments, whether for short-term use or for longer holds, will be taxed under the framework of capital gains and losses. Since crypto assets and currencies in their current form are mostly being used as stores of value rather than active liquid currencies, the capital gains, and losses perspective is fitting.

But as crypto finds new use cases and the velocity of coins increases around the market government departments like the CRA, IRS, and HMRC will need to smooth out their definitions to meet how the new asset class is being used in the real world.

ICO oversight

The ICO (Initial Coin Offering) as an investment technology has been used to collect billions of dollars of value in a very short amount of time. The peak of the craze to participate in the ICO market meant a lot of overreaching projects became quickly funded and often by investors and people that had too little information and too much optimism.

Recently, however, the ICO industry seems to be moving towards a stronger emphasis on investor protection and regulatory compliance. Even without firm rules surrounding how ICO’s and blockchain funding will be handled, the more forward-thinking projects are taking a proactive perspective.

For example, there has been a notable difference in onboarding of investors for early adoption projects. KYC (Know Your Client) and other standards are increasingly being used as the market matures and attempts to separate itself from the past scams and market manipulations.

Initial Coin Offerings have potential to be a great vehicle in which investors can show their confidence in a project’s early stages. However, more protections need to be instituted so that legitimate projects can be better accessed and participants are able to more safely invest.

Exchanges and Custodianship

A major issue facing crypto exchanges is the security of their customers’ coins and more accurately their customers’ private keys. With the exception of decentralized exchanges, crypto exchanges hold their customers’ private keys for a handful of benefits both on the client side and the exchange side. Having the private keys of an account held by the exchange helps by increasing liquidity for coins, improving wallet operations and also enables exchanges to create faster trading by using strategies like keeping the majority of trades off a coins main blockchain or ledger until needed.

Regardless if there are benefits to the way private keys are handled, it doesn’t take too long to find compelling examples of why crypto exchanges holding private keys is a serious risk. Regulations in the case of exchanges could help set forward measurements in both prevention and reaction to the vulnerability of exchange help private keys.

For example, baseline security measurements and third-party auditing could be utilized to create standards of safety. In addition to preventive measures, there is a need for increased accountability over hacks and breaches that affect the holdings of clients on these exchanges.

Recently there has been a shift to fill this gap in regulation where exchanges, big and small, affected by thefts have made attempts to cover their clients’ losses. For now, the pressures of the free market are creating a stop-gap to this issue, but the need for more institutionalized solutions isn’t going away quickly.

Next to insecurities in crypto exchanges, cryptocurrency custodianship to major investors is continuing to undermine their confidence and restricting them from entering the cryptomarkets. In the case of cryptocurrency custodianship, the market isn’t waiting for regulatory help rather the regulation is waiting for a market.

A significant hurdle to the sizable institutional investors, including hedge funds, unions, endowments to name a few, is the lack of accredited and reputable custodians.

Managers of these massive funds have no interest in holding their assets themselves, in fact, the most current regulation requires them to have a third party hold their portfolio’s assets and account for them.

This is most simply a check and balance to protect the fund and funds benefactors. Institutional investment moving into crypto markets would be no different, and in fact likely even more necessary given the technical barrier involved with the safe and secure storage of massive cryptographic value.

There are a few projects and companies coming onto the scene for crypto custodianship, like Coinbase with their recent announcement of their custody solution, so it will be interesting to see how this movement can possibly invigorate the marketplace, however for the majority of investors, custodianship of massive funds will likely be something little talked about once the solutions are put in place.

Oversight and guidance of the crypto exchanges and crypto custodians are going to play a vital role in 2018 and further as this asset continues to mature and begins to attract large players.

Institutional investors are ready to begin to make allocations, but the market needs to be more accountable and provide the necessary tools, like custodianship, to be able to move these large investments into this asset class.

The SEC (Securities) and CFTC (Commodities)

Parallel to the relative popularity of Bitcoin and cryptocurrencies, regulatory bodies have been struggling to parse out their jurisdiction and the majority of the issue can be reduced down to how crypto assets are classified.

There has been particular attention spent on how the major regulatory departments will define and then treat crypto assets within the United States, as the decisions of the SEC or CFTC can often have international influence and set a precedent for future cross-border legislation.

An early appearance of regulatory guidelines within the United States came in 2013 from FinCEN (The Financial Crimes Enforcement Network), a branch of the U.S. Treasury Department, who released early regulation that broadly labeled activities with virtual currencies as money transmissions.

More recently the SEC (Securities and Exchange Commission) and CFTC (U.S. Commodities Futures Trading Commission) have both weighed in with their guidelines and opinions, both in favor of their respective jurisdictions.

The relationship between the SEC and CFTC and their overlapping oversight is making the blockchain environment tough to navigate, especially in regards to the innovators and pioneers creating and imagining in this space.

The slow down and increased thoughtfulness by teams launching a new blockchain project has already been evident as new organizations make stretches to keep themselves outside the SEC’s definition of a security. The concern being that if a teams coin or token ends up being labeled a security then they will have a pretty tough time getting volume as exchanges will be heavily restricted from listing them.

In addition to the SEC, the CFTC is also beginning to apply pressure within their jurisdiction and has recently reinforced their claim to cryptocurrencies as falling “well within the common definition of ‘commodity’.” The CFTC outlining that cryptocurrencies like Bitcoin are commodities allows for them to have the legal precedence to pursue bad actors within the space.

Overall this seems to be a good move for the blockchain community, as it is a step towards greater regulatory clarity. Having the CFTC being able to operate and oversee the cryptocurrency markets helps create more safety and accountability for investors and innovators alike.

Both the SEC and CFTC have a role to play in this space to protect all involved, however, it is obvious they need to move cautiously as neither side wants to be the one to shut down the innovation.

The head of the CFTC, J. Christopher Giancarlo, has echoed this sentiment of sensitivity and was quoted saying “‘Do no harm’ was unquestionably the right approach to the development of the internet. Similarly, I believe that ‘do no harm’ is the right overarching approach for distributed ledger technology.”

Final Thoughts

Moving forward it will be paramount for leaders of regulatory bodies like Christopher Giancarlo to find an appropriate balance where they can provide important consumer safety measures without compromising industry growth and innovation.

However, from what is evident so far, the slow approach of ’doing no harm’ many nation-states have taken seems to be paying dividends relative to the opposite approach of heavy-handed prohibition.

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