In 2019, we witnessed crypto regulations leave the domain of stuffy legal pontification and enter the realm of geopolitics (as a stuffy legal pontificator, I have mixed feelings about this). We saw President Trump tweet about crypto regulations, as well as powerful international organizations express their agenda on how crypto should be regulated. We saw bold, forward-looking moves from smaller nations play out, and crypto-schizophrenic China plant its flag somewhere on the cryptomoon, though we still don’t know on which side.
These actions illustrate the global regulatory landscape evolving along the contours of the legacy international financial order inherited from the 20th century. The “Insiders” — the U.S. and nations of Western Europe and the Pacific Rim — remain at the center of financial and trade systems, and are visibly curious about the developments surrounding crypto. However, it is also noticeable that they sense a longer-term threat in its disruptive nature.
The “Outsiders” — China, Russia and the developing world — represent an ever-growing piece of the global economic pie while relying on a global financial system run by and centered in the Insider countries. The Outsiders face different threats; they are threatened by crypto’s near-term effect on their capital controls and currencies, yet are visibly intrigued by its longer-term disruptive capabilities (as evidenced by epic pronouncements and constant reposturing).
Lastly, we have the “Experimenters” — clever countries like Singapore and Switzerland that have found niches and hacks playing the rulebook set by the Insiders to their own national advantages, and perhaps to the advancement of technology and decentralized systems writ large. These nations tend to be the most pragmatic of the lot.
This piece is the first in a three-part series that looks at the Insiders: the United States, the European Union and Japan. We will look at these groups in turn and see how they are responding to the growing relevance of cryptocurrencies and digital assets.
The Insiders guard their dominance
The U.S., Japan and nations in Western European remain at the center of the global financial system formed at the end of the Second World War. The Organization for Economic Co-operation and Development was formed in 1948 and immediately handed over $1 trillion from the U.S. and Canadian governments to rebuild war-ravaged Europe so it may compete in a newly free-trade-oriented and U.S. dollar-dominated world. By 1960, the OECD declared Europe “rebuilt” and pivoted to guiding the rest of the world in useful directions, forming the Financial Action Task Force. The FATF immediately went to work deciding which countries and industries posed a “high risk” for money laundering, sanctions and other maladies, and thus would be subject to higher interest rates, bank transfer costs and ultimately less economic development.
As the guardians of this system, these developed nations tend to receive net capital inflows for business and technology investments, and cryptocurrency projects, including ICOs and exchanges, are no exception. The Insiders have thus far been net beneficiaries of the rise of cryptocurrencies, at least financially speaking. However, since the 1970s, the Insiders’ system has been balanced on a non-gold-backed U.S. dollar, which is threatened to be “displaced” by cryptocurrencies, at least according to U.S. Rep. Brad Sherman.
More importantly, decentralization around crypto threatens to disrupt the inherent banking hierarchy (with U.S. dollar-clearing, New York Department of Financial Services-regulated banks at the top and the larger European and Japanese banks right below). This hierarchy is maintained by FATF risk rankings and global compliance with Anti-Money Laundering rules set by U.S. federal agencies and their European counterparts. This remains a minor threat, and until 2019, a largely ignored one.
Thus, Insiders face two related threats from crypto: 1) competing institutions and networks acting outside of the existing international banking system, and 2) cryptocurrencies undermining the value of the fiat-currency (i.e., U.S. dollar) undergirding the entire system. These threats are heightened in the developing world, where they maintain no direct political control. Both of these threats may have influenced the NYDFS’s focus on Tether (USDT) this year, as the New York Attorney General’s Office announced it was investigating the project for fraud. It is worth noting — despite numerous disclosures and revelations about it being backed by “cash equivalents” — that USDT is still going strong.
If USDT drew mere ire for representing private-dollar clearing, Facebook’s Libra announcement in June, which mirrors and magnifies the USDT threat, drew panic. Libra seeks to create what is effectively a banking system, and has what is effectively its own stable currency, targeting the developing world considered to be too high-risk for most banks to penetrate.
The blowback has been severe, with the U.S. and EU announcing that they will effectively prevent it from operating in their jurisdictions, and Congress and President Trump acting in seldom-found unanimity. Although this has placed Libra in jeopardy, we have not seen the same kind of backlash from the developing world.
Moreover, the Insiders have also put exchanges in a pickle. In July, FATF announced the need for every country to pass the “Travel Rule.” This rule would require exchanges to know the identities of senders and recipients of every transaction, which exchanges have pointed out is impossible with a technology where anyone can simply create a wallet at will.
Suffice it to say, however, exchanges are not waiting. 2019 saw Binance and Poloniex spin off their U.S. users, and others make moves toward Experimenter nations. With the EU’s 5AMLD regulations coming into effect next month, the major exchanges may need to follow a similar path there. It will be interesting to see how Binance, still offering two BTC per day, virtually Know Your Customer-free accounts, will respond to these EU rules that appear to outlaw these practices.
The sheer quantity of transactions shifting from the established players to the smaller, recently founded exchanges — wash trades notwithstanding — also speaks volumes (no pun intended) about how crypto traders might react to the increased user friction that comes with mandatory heightened KYC requirements. This is not to mention the prospect of increased usage of decentralized exchanges that could be structured to evade any jurisdictional coverage whatsoever. It will be very interesting to see how all of this shakes out in 2020.
This leaves us with Japan. If you haven’t been following crypto regulations and like to go off vague national stereotypes, you will not be surprised to find that Japan is years ahead of the others. Japan has been licensing and regulating cryptocurrency businesses since April 2017. It has used its leading position in the adoption curve to learn how to use a scalpel, rather than a butcher’s cleaver, on its burgeoning crypto industry. 2019 was the year Japan subjected margin trading and ICO solicitation to reasonable regulatory oversight and passed rules for licensing custodial services. Perhaps the biggest question for Japan is how it will deal with the Travel Rule. My guess is that it will simply require exchanges to have mandatory KYC and call it a day.