Meeting the crypto regulatory challenge

This article is brought to you thanks to the collaboration of The European Sting with the World Economic Forum.

Author: Alpen Sheth, Senior Technologist, Mercy Corps Ventures

• Cryptocurrency adoption has soared during the COVID-19 pandemic, as everyone from private investors and public companies to underbanked individuals realised the benefits of digital currencies.
• Regulators have struggled to keep up with this growth and may limit financial inclusion by applying rules to crypto markets that are not fit for purpose.
• By looking to past eras of innovation, regulators can work collaboratively to adapt rules and policies to support open competition and rapid innovation in the cryptocurrency sector.

Global adoption of cryptocurrencies has soared across low-, middle- and high-income countries in recent years. Regulators worldwide are still evaluating how to address the novel issues posed by digital currencies, however. The Global Future Council on Cryptocurrencies‘ recently published paper on navigating cryptocurrency regulation shows how past eras of innovation, such as the early days of the internet, could help meet this challenge.

Here are three lessons that could support the development of crypto regulation that is fit for purpose:

1) Follow the actual drivers of cryptocurrency adoption

For years, most central banks and treasury departments have focused on risk-based reporting and containment policies for virtual assets. Meanwhile, these markets have grown exponentially, with global adoption increasing by more than 2300% since 2019 and 881% in the last year alone. During this time, Bitcoin, for example, has evolved from a small niche internet community into a well-known asset for investors, private firms and even nation-states.

Actual trends vary widely between geographies and are telling. Centralised and decentralised forms of finance (DeFi) are accelerating in the developed world, while peer-to-peer (P2P) platforms are driving adoption in emerging markets, like Vietnam, Kenya, Togo and Tanzania.

Many of these new users have turned to cryptocurrency to preserve their savings in the face of currency devaluation, to send and receive remittances, and for business transactions. Such transactions have grown even as central banks have banned access between banks and crypto exchanges in countries like Nigeria, while threatening the same in countries like India.

Several key factors are driving interest in cryptocurrencies:

● Central bank policies, hyperinflation, and macroeconomic instability have driven volatility and devaluation of local fiat currencies relative to other global currencies before and particularly during the COVID-19 pandemic. This has caused individuals and corporations such as Microstrategy, Tesla and Square to hold bitcoin and other digital monies. It has also inspired increased advocacy by users and awareness among policymakers from the US to El Salvador who are crafting new policies around cryptocurrencies.

● Remittance costs remain exorbitant for traditional payment systems at 6.8% globally and almost 9% in Sub-Saharan Africa, potentially explaining increasing P2P cryptocurrency transactions.

● The invention and rapid scaling of stablecoins as frictionless mediums of exchange between cryptocurrencies and fiat currencies. The market cap of USD Coin, for instance, has passed $25 billion with a compound annual growth rate of more than 6100%. Such traction has even inspired Sweden to pivot its planned e-krona in order to compete with such cryptocurrencies and central bank digital currencies (CBDCs).

● New cryptocurrency networks such as Stellar, Algorand and Solana are gaining users by promising less energy consumption and faster transaction speeds. Layer 2 solutions, such as Lightning Network and India-based Polygon, are being added to public blockchain to extend scalability and efficiency. Such improvements are also propelling DeFi application usage. The rapid proliferation and maturation of these innovations is in large part due to the open-source architecture and global developer communities that undergird crypto networks.

Much like the development of early internet protocols, the vast potential for cryptocurrency applications makes it challenging to automatically apply existing legal frameworks and definitions.—Alpen Sheth, Mercy Corps Ventures

2) Work to understand the technological significance and the many use cases for crypto

Much like the development of early internet protocols, the vast potential for cryptocurrency applications makes it challenging to automatically apply existing legal frameworks and definitions ex-ante. In this context, hasty regulation will likely lead – wittingly or unwittingly – to picking winners and favouring incumbents. Even worse, it could further exacerbate a yawning digital divide within and across countries.

Cryptocurrency networks provide a new paradigm for secure data and value transmission, storage and access over the internet. They offer secure, immutable storage that is resilient to single points of failure and censorship, as was recently evidenced by the use of Arweave by Hong Kong residents. Innovative new NFT gaming platforms like Axie Infinity (now worth over $1 billion) are providing stable income for the un- and underemployed in the Philippines, which makes up 40% of the user base. New software applications across sectors including DeFi, digital art and gaming (non-fungible tokens or NFTs), and non-legal entity formation (decentralised autonomous organisations or DAOs) use cryptocurrencies to embed digital rights and capabilities within tokens in a transformational way.

What is the World Economic Forum doing about blockchain?

Blockchain is an early-stage technology that enables the decentralized and secure storage and transfer of information and value. Though the most well-known use case is cryptocurrencies such as bitcoin, which enable the electronic transfer of funds without banking networks, blockchain can be applied to a wider range of purposes. It has potential to be a powerful tool for tracking goods, data, documentation and transactions. The applications are seemingly limitless; it could cut out intermediaries, potentially reduce corruption, increase trust and empower users. In this way, blockchain could be relevant to numerous industries.

That said, blockchain also entails significant trade-offs with respect to efficiency and scalability, and numerous risks that are increasingly coming to the attention of policy-makers. These include the use of cryptocurrency in ransomware attacks, fraud and illicit activity, and the energy consumption and environmental footprint of some blockchain networks. Consumer protection is also an important and often overlooked issue, with cryptocurrency, so-called “stablecoins” and decentralized applications operating on blockchain technology posing risks to end-users of lost funds and also risks to broader financial stability depending on adoption levels.

Read more about the work we have launched on blockchain and distributed ledger technologies – to ensure the technology is deployed responsibly and for the benefit of all. We’re working on accelerating the most impactful blockchain use cases, ranging from making supply chains more inclusive to making governments more transparent, as well as supporting central banks in exploring digital currencies.

To fully support the development of this new paradigm, regulators need to distinguish between the risks of centralised versus decentralised activities. For centralised exchanges and custodial financial services, cryptocurrencies pose risks congruent with financial risks that are familiar to financial authorities, capital markets regulators, consumer protection, privacy bureaus and tax authorities around the world.

Regulators have highlighted the pseudonymous and borderless nature of cryptocurrency systemsas potential money laundering and terrorist financing risks. Yet, illicit activity is significantly less than in the traditional financial system, comprising just 0.34% of all cryptocurrency transactions.

Cryptocurrencies can enable transparency and provide an opportunity for regulators actively seeking to shift more transactions from the informal to the formal economy.—Alpen Sheth, Mercy Corps Ventures

The auditability of cryptocurrencies also enhances real-time transaction monitoring, record-keeping and mitigation. Instances of money laundering can be detected and deterred, creating the evidence needed to prosecute offences. Examined from this perspective, cryptocurrencies can enable transparency and provide an opportunity for regulators actively seeking to shift more transactions from the informal to the formal economy.

3) Create more inclusive global governance

Today, the differences between jurisdictions create new regulatory arbitrage opportunities as well as market uncertainty. One missing lever for global harmonisation is the lack of genuinely inclusive policy platforms. For example, global standards formulated to mitigate illicit activity have resulted in blunt derisking policies (similar to redlining) that contribute to financial exclusion, especially in Latin America, the Caribbean and Sub-Saharan Africa.

Unfortunately, many developing countries in these regions are not members of some of these standard-setting bodies such as the Bank for International Settlements (BIS) and Financial Action Taskforce (FATF) but are disproportionately affected by such financial rule-making. This disparity and its impact on un- and underbanked individuals living in these countries has contributed to the appeal of cryptocurrencies.

Banning cryptocurrencies will not prevent adoption, it will only limit regulators’ abilities to guide market activity around these networks and address their unique potential risks.
—Alpen Sheth, Mercy Corps Ventures

The big challenge for regulators is that open-source cryptocurrency networks such as Bitcoin and Ethereum are computer protocols available to the public directly via the internet. They are permissionless interfaces for the issuance of tokens, self-hosted wallets and other DeFi services without the need for an intermediary.

Banning cryptocurrencies will not prevent adoption, however, it will only limit regulators’ abilities to guide market activity around these networks and address their unique potential risks. Regulations informed by actual use cases and consultations with technology innovators will prove more robust in the long run and will reinforce important policy objectives driving economic inclusion, competition and growth.