Crypto Regulation – Where Are We Now?

With appropriate regulation, virtual assets offer significant advantages as a payment method and an inclusive fund raising means for SMEs...

So where are we now on virtual asset (or crypto) regulation almost two years on from when Bitcoin's stratospheric price rise first propelled it into the public consciousness and mainstream media? Beyond the Financial Action Task Force's (FATF) latest requirements for "virtual asset service providers", including trading platforms, to be licensed and supervised in implementing FATF antimoney laundering recommendations, a multinational

approach to virtual asset regulation has yet to emerge. Instead, a patchwork of differing regulatory regimes has

evolved adopting regulation ranging from complete bans as in China, to Japan's mainstream regulated virtual asset

sector. In between, lie a handful of smaller, newly-minted crypto-friendly regimes such as Malta and Bermuda, and a

large number of jurisdictions, including the United States (US), the European Union and Hong Kong, currently sitting on the fence. Keen to avoid stifling financial innovation and losing out to more progressive economies, these jurisdictions have warned investors of potential risks and regulated virtual assets within the existing regulatory framework, but are generally adopting a welcome wait-andsee approach.

China's crackdown on virtual assets, banning initial coin offerings (ICOs) and virtual asset trading platforms, dealt a blow to its once dominant position – China previously accounted for 80% of the world's virtual asset transactions and ICO financing.¹ Yet, China clearly did not drop the ball, announcing on 11 August 2019 that its digital national currency is ready.² Regulation must be looked at in context. When China banned ICOs in September 2017, some 90% of Chinese ICOs were scams, providing an incentive for tightened regulation not seen elsewhere. In the US, unofficial statements by SEC officials, such as Jay Clayton's February 2018 statement, "Every ICO I've seen is a security",³ led to ICOs shunning the US, or being offered there only within restricted securities law exemptions, e.g. only to "accredited investors" or under Regulation A+.

The scale of virtual assets' pros and cons are beyond the scope of this article. Suffice to say that with virtual assets still in their infancy, the associated benefits and risks are significant and constantly evolving as they undergo rapid technological evolution and new use cases develop. Among the positives, virtual assets offer cheaper, more efficient payment methods and innovative and inclusive financing solutions for small and medium-sized enterprises (SMEs) via ICOs. On the downside, their positioning outside the regulatory perimeter in many jurisdictions, leaves them vulnerable to criminal activity (money laundering, theft, insider dealing and price manipulation) and susceptible to fraud and misleading advertising.

One argument for greater regulatory collaboration between jurisdictions is reducing regulatory arbitrage. The position is however complicated by countries' differing regulatory frameworks and economic objectives and the lack of clear definitions or even consistent terminology. Further complexity exists at the national level where several regulators often claim jurisdiction over the same virtual assets. In 2015, Ripple (XRP) was classified as a virtual currency by the US Financial Crimes Enforcement Network (FINCEN), but is now the subject of several lawsuits alleging breach of US securities laws. In the US, virtual assets are potentially regulated by the SEC as securities, by the Commodity Futures Trading Commission as commodities, by FINCEN as currency, and by the Inland Revenue Service as property. They are additionally regulated at state level under widely differing regimes ranging from New York State's rigorous regulation via its Bitlicense regime to cryptofriendly states such as Wyoming which offers tax exemptions and securities law carve-outs for some virtual assets. Australia too has four separate regulators with regulatory remit over virtual assets.⁴ Multiple regulators with differing statutory objectives and overlapping regulatory powers does not make for regulatory clarity and arguably impedes rather than encourages innovation.

Regulators have focused primarily on whether virtual assets are "securities" under local laws. Virtual assets that are tokenized securities – whether shares, debentures or interests in a fund – are regulated as such in most jurisdictions including Hong Kong, Singapore, the UK and US. The regulatory grey area exists where virtual assets do not fall squarely within definitions crafted years ago for very different products. The US Decentralised Autonomous Organisation's DAO token, the first virtual asset alleged to have violated US securities laws, was clearly a tokenized fund. Likewise, Black Cell Technology Limited's ICO, halted by Hong Kong's Securities and Futures Commission and in other jurisdictions, offered virtual assets that were redeemable for equity shares and thus were undoubtedly securities. Yet, these black and white cases are not the norm. The US functional approach to regulation led the SEC to allege that certain ICOs breached US securities laws because the issuers⁵ had primed purchasers' reasonable expectations of profits, rendering the virtual assets "securities" under the 1946 Howey Test. Fortunately, the application of US securities laws to virtual assets should become clearer with Toronto-based Kik Interactive Inc. contesting⁶ the SEC's charge that its Kin token offering breached securities laws.

Under the final Guidance on Cryptoassets⁷ published recently by the UK Financial Conduct Authority (FCA), utility tokens giving holders access to current or future products or services are not regulated as securities, provided they do not carry rights similar to traditional securities (e.g. profit share or right to repayment). Their tradability on secondary markets and potential use for speculative investment purposes are explicitly stated not to bring utility tokens within the regulatory perimeter. Hence, holders' potential realisation of a gain in secondary market trading appears not to bring utility tokens with the definition of a "collective investment scheme" which is regulated. This is of interest to Hong Kong where the SFC has said only that virtual assets constituting traditional forms of securities including collective investment schemes are regulated. The Hong Kong and UK statutory definitions of "collective investment scheme" are virtually identical giving some limited comfort on the regulatory status of ICO tokens. Indeed, Hong Kong has adopted a welcome, wait-and-see approach to virtual asset regulation. The SFC stepped in to regulate Hong Kong managers and distributors of funds investing in virtual assets and opened its regulatory sandbox to virtual asset exchanges.⁸ Otherwise, it has avoided a heavy-handed approach to ICOs which is welcome given the significant benefits for SMEs of appropriately regulated ICOs identified by the OECD.⁹ With the advantages of low cost and speed, ICOs overcome many difficulties facing early stage SMEs in raising capital while fostering an inclusive network of investors and potential users of the company's products or services.

In terms of "appropriate regulation", the OECD recommends clear regulation, standardized disclosure requirements, enhanced retail investor protection measures, and applying anti-money laundering and counter-terrorist financing obligations to ICO issues.

Disclaimer – The regulatory position in jurisdictions outside Hong Kong stated in this article represents the author's understanding of the regulatory status of virtual assets in those jurisdictions, but should not be relied on. Legal advise should be sought from lawyers in relevant jurisdictions in relation to any specific situation.