[This piece has been authored by Rahul Kanna R.N., a student at the Jindal Global Law School, Sonipat.]
Introduction
Cryptocurrency and distributed ledger technology (“DLT“) have brought a revolution to financial markets and capital financing, given their disruptiveness. These technologies have become a catalyst in revolutionising banking and the overall global financial system and are expected to overhaul interbank transfers, cross-border retail payments, traditional stock markets, and more. In statistical terms, there are currently more than 14,000 virtual currencies and billions of dollars raised through initial coin offerings. Further, around 200 million individuals are expected to hold cryptocurrencies by 2025.[1]
However, this unprecedented growth is countered with increasing implications on global tax authorities, consumer protection, terror financing, and money laundering; and presents a great challenge to the financial system and regulatory authorities, calling for an overhaul of the existing financial framework and regulatory mechanism globally. Thus, the approach to dealing with the challenges requires an understanding of the structure of these technologies, as regulation of the individual use of ‘coins’ and ‘tokens’ would be redundant. Therefore, the regulatory framework needs to bring forth changes in cryptocurrency exchanges (decentralised and centralised). Perhaps, lessons can be drawn from the management of American stock markets after the crash in the 1980s. However, this regulatory approach is unique to the particular jurisdiction that is the United States and the securities traded therein at the time; and may be futile given the decentralised nature of cryptocurrencies, and their operation not limited by jurisdiction but rather connectivity to the internet poses challenges which need to be visualised through uniformity in the global regulatory framework of cryptocurrency
Secondary Markets – Cryptocurrencies
There are broadly two markets in the financial system with regard to stocks, i.e., primary and secondary markets. Whilst the scenario is similar in crypto markets, there is a distinction in terms of the secondary market namely (i) Decentralised Exchanges (“DEX”) and (ii) Centralised Exchanges (“CENEX”). The arterial distinction between the two is concerning the system of centralisation, custodial platform akin to traditional stock exchanges, ‘off-chain’ versus ‘on-chain’ settlements and so on. Despite their differences, both offer their own potential advantages and implications.
Centralised Exchanges (CENEX)
Centralised exchanges are similar in nature to conventional stock exchanges and operate using the ‘Hub and Spokes’ model, wherein traders establish themselves as spokes via methods of electronic communication, while a central operator provides the data information that links the supply and demand mechanisms established by it. The CENEX maintains and stores customers’ funds and assets in a custodial position, and similarly, uses and maintains ‘hot’ wallets connected to the network of the platform for trading virtual currencies. The CENEX system, irrespective of facilitation of trading, is not mandated to interact and register the transaction on the blockchain governing the cryptocurrencies as several platforms use ‘off-chain’ systems and the exchange is also devoid of any intermediaries akin to conventional trading platforms[2]. The centralised exchanges have been known to have more weightage with regard to compliance and regulatory framework due to the custodial nature of funds and operating in similarity to the stock markets. An important distinction is that CENEXs are established corporations or entities and are completely independent from the members of thecommunity protocols. CENEX platforms are less transparent in operation compared to the DEXs due to the ‘Fractional Reserve’ phenomenon showcased by some CENEXs, where the customers’ assets and funds are used by the entity to engage in trades and, therefore, such CENEXs might not in reality hold the customer assets of all the members of the platform as was found in the Mt. Gox Bitcoin Exchange leading to the loss of said assets. However, CENEX only charges a transaction fee, withdrawal fee and deposit charges and unlike DEX there is no charge of gas fees for transactions taking place in the blockchain network. Some popular CENEX are Coinbase, Kraken, Binance, etc.
Decentralised Exchanges (DEX)
The DEX establishes a P2P (peer-to-peer) model on the blockchain platforms and the buyers and sellers directly trade with each other while the transaction is recorded on the network by its community. This mechanism forbids the involvement of any intermediary except for the entity placing the order and the buyer of the same, thereby, ensuring anonymity. This system is one of the catalysts of the crypto and DLT technology as it ensures security and transparency of transactions, eliminating the use of any third party intermediatory. The trading is facilitated using the trader’s ‘cold/hot’ wallet and the custody of the assets is held by the trader. Unlike CENEX, the transactions mostly take place ‘On-Chain’, i.e., directly on the blockchain platform; therefore, the traders might have to pay the gas/ transaction fee for the blockchain to register the transaction. The placement of orders can also be affected through the use of smart contracts which identify the price and duration of the offer from the seller and on successful completion of the seller’s requirements, by the buyer, the contract is automatically executed and registered on the blockchain. Therefore, DEXs are more secure than CENEXs as they are mostly transacted ‘On-Chain’ and, further, the issues of intermediatory, custody of funds, Fractional Reserve failure, hacks and disruptions are less likely to occur. DEX systems are in their nascent developmental stage due to the technical implications of the P2P system. Some popular DEX include Uniswap, Ox Protocol and Pancake Swap.
Challenges and Regulatory Concerns
The challenges and regulatory concerns arising with the growing use of the novel cryptocurrency and crypto exchanges need to be addressed, and jurisdictions across the globe are in pursuit of doing so by various frameworks. The arterial focus of regulation stems from the intertwining of both macro and micro policies of nations, specially the impact the technology would have on its sovereign-backed monetary system and the national currencies as fear of maintaining financial stability of nations is increasingly forcing policy makers to work towards a policy and regulatory framework for adoption of crypto and its allied blockchain technology which carry several use-cases.
The concerns relating to crypto exchanges include market integrity, price volatility, consumer protection, finance of terrorism, money laundering and financial instability. Several jurisdictions have applied a regulatory framework to secondary crypto markets similar to that applicable to traditional stock exchanges; however, this approach would not be viable due to the distinct functioning of crypto markets and ‘decentralisation’ in the case of DEX. In practical terms, Hong Kong, through its Securities and Futures Commission (SFC), provides a license for crypto trading platforms[3] whereby it mandates that among all the tokens and coins listed, one of them needs to be registered as a security. This was done for the purpose of ensuring the SFC’s jurisdiction over the secondary market and this excludes DEX. This shows that there is no clear guidance with regard to the regulatory framework and merely provides a temporary solution. Further, this approach was not mandatory but voluntary, thus, placing no compliance requirements or penal provisions for obtaining the license.
Market integrity and manipulation practice avoidance are some of the core functions of regulations in secondary markets. However, the regulation of the same is practically impossible in crypto exchanges due to the nature of the cryptocurrencies that can be traded on different platforms unlike traditional securities bound mostly by a single listing platform which is not the case for both DEX and CENEX. DEX provides a unique situation for the application of regulatory framework where existing regulatory authorities can enforce rules on CENEX platforms due to the similarity to traditional exchanges. The same rules would not be viable for the former. Similarly, another issue with CENEX is the fractional reserve failure which, in the case of Mt. Gox Bitcoin Exchange, showcased the implications of such failure and due to the lack of regulatory clarity, there is scepticism despite modern CENEX like Kraken incorporating a ‘Proof of Reserves’ to ensure funds are not utilised for the entities gains.
Solution
Several approaches have been undertaken globally to overcome these challenges including thorough incorporations of Self-Regulatory Organizations (“SRO“)[4] as a private solution through a non-governmental regulatory framework ensuring transparency, accountability and fairness.[5] The ‘wait and see’ approach is followed by certain jurisdictions including Brazil under which secondary market platforms function under existing regulatory framework. Balanced and Risk proportionate approach is undertaken to foster Public-Private Partnership in developing a landscape for regulating crypto exchanges, Singapore and EU have taken this direction.[6] Some jurisdictions have subscribed to a ‘Specific Regulatory’ approach where a regulatory framework is created to ensure compliance and prevent money laundering and terror financing activities, this approach is promoted by Switzerland and Japan. Finally, certain jurisdictions have engaged in a complete ‘restrictive approach’ this refers to countries that have taken a direction towards banning and restriction of crypto, like China, Turkey and India. The most viable and optimal approach is the balanced risk-based approach instead of an outright ban or leaving the markets completely out of the regulatory sphere. There is also a need for the international community to come up with a uniform draft model using the multilateral forums to ensure uniformity in regulatory compliance and rules due to the decentralised nature of cryptocurrencies.
[1] Hileman, G. and Rauchs, M., 2017. GLOBAL CRYPTOCURRENCY BENCHMARKING STUDY.
[2] Licensed/ Registered intermediaries are involved in stock market operations.
[3] Hong Kong securities and futures commission, statement on regulatory framework for virtual asset portfolios managers, fund distributors and trading platform operators, at appendix 2, (Nov. 2018); Hong Kong securities and futures commission, regulation of virtual asset trading platforms.
[4] Emily Hammond, Double Deference in Administrative Law, 116 Colum. L. Rev. 1705, (2016).
[5] FINRA (Financial Industry Regulatory Authority), USA SRO and members include stock exchanges and Brokerage Firms.
[6]International Finance Corporation, Blockchain Governance and Regulation as an Enabler for Market Creation in Emerging Market, EMcompass, Note 57.