The Regulation of Cryptocurrencies - Between a Currency and a Financial Product

As knowledge of cryptocurrencies becomes more widespread, the number of the people using them grows. Their attractiveness is due in part to their decentralized, peer-to-peer structure. This makes them an alternative to national currencies which are controlled by central banks. So much so that in times of financial instability, an increase in the use of cryptocurrencies is already apparent. Given that these cryptocurrencies are starting to replace some of the traditional national currencies and financial products, the question then arises: should they be regulated? And if so, how? Some countries, such as China and Russia, prohibit Initial Coin Offerings (ICOs) altogether, while others strive to reach an understanding of the currencies in order to come up with coherent regulation.

The question of how to regulate cryptocurrencies is interesting throughout the life of the coin but is of special interest during the Initial Coin Offering, the reason being that the value of the cryptocurrency depends not only on the value of the currency, but also on issues of security. As these coins exist in the virtual world, the sites on which they are traded are vulnerable to hackers. Thus, even if hacking the network of the coin itself is difficult, other sites such as cryptocurrency exchanges are more susceptible to theft. Questions of disclosure are specifically interesting with regard to the 'safety' of these coins - should disclosure requirements include cyber security matters: Are investors equipped with the right tools to assess cyber issues with regard to cryptocurrencies?

Although the technology underlying most cryptocurrencies is very similar, the logic behind them differs. Some cryptocurrencies function like regular national currencies and have traditional currency traits. As such, they provide a medium of exchange, unit of account, and/or store of value. Other cryptocurrencies, however, may represent other rights as well. This interesting phenomenon actually causes some cryptocurrencies to be viewed as closer to real national currencies, while others are regarded as closer to financial products (such as securities or derivatives). This leads to the main question of the paper: How should cryptocurrencies be regulated?

The paper draws a legal distinction between cryptocurrencies which are in fact currency and those which are securities disguised as currency. The cryptocurrency phenomenon requires regulatory authorities to investigate each new ICO and determine how to classify the token. Some tokens really do resemble currency and should therefore only be regulated to ensure that fraudulent behavior is prevented. These types of cryptocurrencies should be more carefully regulated in case they increase systemic risk in the general financial system. If financial institutions such as banks and insurance companies start getting involved with cryptocurrencies such as Bitcoin, then the fluctuation in the price of the token might affect the stability of the financial institutions and in turn, cause an increase in systemic risk in the 'real-world' financial system. Here, regulators should find a way to regulate the token or if they do not, it would be advised to prohibit financial institutions from joining and engaging in activities that may expose them to fluctuations in cryptocurrency prices, thus increasing systemic risk in the financial system. Other tokens resemble securities and should be regulated accordingly. For cryptocurrencies that are in fact securities, additional mandatory disclosure should be required with respect to security issues surrounding an ICO. Investors should be informed about what kind of blockchain technology is being used, who developed the code and whether it was publicly published. In addition, information about what kind of cyber audits were conducted prior to the issuance of the coin is essential. 

Hopefully, by implementing the steps suggested by this paper, regulatory authorities will be able to protect financial markets while still allowing room for innovation. 

The paper can be found here.

Hadar Jabotinsky is a Postdoctoral Fellow at the Cyber Security Research Center at the Hebrew University of Jerusalem Law School, Israel.