Cryptocurrency has been a buzzword in the financial world, with some coins reaching unprecedented levels of value in recent years. However, with the lack of regulation in the cryptocurrency market, concerns have arisen about the security of crypto exchanges. Instances of crypto exchanges being hacked have resulted in the theft of millions of dollars’ worth of digital currencies, while some have been accused of engaging in fraudulent activities, such as manipulating trading volumes.
Ensuring Security and Building Trust in the Cryptocurrency Market
Regulations for crypto exchanges aim to prevent these types of incidents from occurring. By implementing regulations, crypto exchanges are required to adhere to certain standards and protocols, which can help to improve their security and prevent fraudulent activities. Regulations can also provide users with greater confidence in the safety and legitimacy of crypto exchanges, which can help to increase adoption of cryptocurrencies.
The Securities Exchange Act of 1934 is one applicable law in the US that regulates the trading of securities and prohibits fraudulent activities in the securities markets. Failure to comply with regulations can result in legal liability for the crypto exchange owner, including fines, penalties, and even the revocation of the exchange's operating license. Failure to comply with regulations can also damage the reputation of the exchange, which can lead to decreased user confidence and adoption of cryptocurrencies. Regulation is necessary to ensure the security and legitimacy of crypto exchanges. With greater regulation and liability, users can have more confidence in the safety of their digital currencies, leading to increased adoption and growth in the cryptocurrency market.
The Securities Exchange Act of 1934 is one applicable law in the US that regulates the trading of securities and prohibits fraudulent activities in the securities markets. Failure to comply with regulations can result in legal liability for the crypto exchange owner, including fines, penalties, and even the revocation of the exchange's operating license. Failure to comply with regulations can also damage the reputation of the exchange, which can lead to decreased user confidence and adoption of cryptocurrencies. Regulation is necessary to ensure the security and legitimacy of crypto exchanges. With greater regulation and liability, users can have more confidence in the safety of their digital currencies, leading to increased adoption and growth in the cryptocurrency market.
The Debate Over Whether Crypto Assets are Securities
Regulating cryptocurrencies has been a major concern for governments and central banks since they were first exchanged over ten years ago. However, the issue is still ongoing and poses a significant challenge. In the United States, several federal agencies monitor the crypto market, including the SEC, the Commodity Futures Trading Commission (CFTC), the Federal Trade Commission (FTC), and the Department of Treasury through the Internal Revenue Service (IRS), the Office of the Comptroller of the Currency (OCC), and the Financial Crimes Enforcement Network (FinCEN). Despite the multitude of agencies overseeing cryptocurrencies, there is little rule-making, and jurisdictions often overlap. At the state level, some governments have passed laws that either support or restrict blockchain technology. Wyoming, for example, has legalized the creation of crypto-focused banks and decentralized autonomous organizations (DAOs), making it the first state to acknowledge DAOs as a form of LLC. Nebraska, Virginia, Utah and Arizona all followed in the same fashion (in particular Nebraska and Virginia promoted the formation of crypto-banks, instead Utah and Arizona, while still supporting cryptocurrencies, did not). On the other hand, Iowa prohibited public entities from accepting payments in the form of cryptocurrencies and at least ten other states issued warnings relating to investments in these financial instruments. New York, instead, has eased its previous restrictions to attract back companies that had exited its market.
In 2014, the sponsors of Ethereum gathered millions of dollars by selling 60 million tokens to fund further expansion of the network. Since this maneuver had many similarities with a traditional IPO, this “initial coin offering” (ICO) opened Pandora’s box and a new, big problem emerged: are crypto assets securities and should they be regulated under the already existing
US federal securities laws? The Securities Act of 1933 and the Securities Exchange Act of 1934 describe in detail what constitutes a security, and the Howey Test is used to determine whether an investment contract represents a security. The Howey test has four elements, all of which must be met for a transaction to be considered an investment contract: [1] There is an investment of money, [2] The investment is made in a common enterprise, [3] There is an expectation of profits from the investment, [4] The profits are derived from the efforts of a promoter or third party. The SEC considers the first two points of the Howey Test to be true, but the third and fourth points are problematic because profits are not always the goal, and decentralization is a key feature of many blockchain projects.
In 2014, the sponsors of Ethereum gathered millions of dollars by selling 60 million tokens to fund further expansion of the network. Since this maneuver had many similarities with a traditional IPO, this “initial coin offering” (ICO) opened Pandora’s box and a new, big problem emerged: are crypto assets securities and should they be regulated under the already existing
US federal securities laws? The Securities Act of 1933 and the Securities Exchange Act of 1934 describe in detail what constitutes a security, and the Howey Test is used to determine whether an investment contract represents a security. The Howey test has four elements, all of which must be met for a transaction to be considered an investment contract: [1] There is an investment of money, [2] The investment is made in a common enterprise, [3] There is an expectation of profits from the investment, [4] The profits are derived from the efforts of a promoter or third party. The SEC considers the first two points of the Howey Test to be true, but the third and fourth points are problematic because profits are not always the goal, and decentralization is a key feature of many blockchain projects.
Howley Test
In a speech held in June 2018, William Hinman, the SEC’s director of Corporate Finance, seems to admit the problem, stating the idea that if a blockchain project is sufficiently decentralized, the crypto asset doesn’t represent an investment contract under the Howey Test and consequently it does not represent a security. In 2019 the SEC released a guide of about fifty factors to determine the decentralization level of a project. Critics argue that these points are vague and difficult to evaluate, but most importantly the result of the analysis can change over time. Thus, a project could start its life as a security and convert into a non-security later on. This is what happened to Ethereum, according to what Mr. Hinman said during his 2018 speech.
Apart from Bitcoin, Ethereum and few others, though, it has been impossible to apply the SEC’s guidance in a consistent and shared way (often because some information is not disclosed to the public). This alternative theory views ICO and capital-raising transactions to be different from crypto assets. The first being securities, because they involve an investment contract (sponsors put effort into the expansion of the network and there’s the aim of a profit, just like regular IPOs). The second being not. This clearly doesn’t imply that trading cryptocurrencies on exchanges or in peer-to-peer transfers should not be regulated: FTX’s failure is yet another proof of why it should be. It only means it should not be regulated by existing securities law and the government should fill the regulatory gaps by creating new law.
Apart from Bitcoin, Ethereum and few others, though, it has been impossible to apply the SEC’s guidance in a consistent and shared way (often because some information is not disclosed to the public). This alternative theory views ICO and capital-raising transactions to be different from crypto assets. The first being securities, because they involve an investment contract (sponsors put effort into the expansion of the network and there’s the aim of a profit, just like regular IPOs). The second being not. This clearly doesn’t imply that trading cryptocurrencies on exchanges or in peer-to-peer transfers should not be regulated: FTX’s failure is yet another proof of why it should be. It only means it should not be regulated by existing securities law and the government should fill the regulatory gaps by creating new law.
Uncovering the Dark Side of Cryptocurrency: The ICO Boom and the Need for Regulatio
Cryptocurrency has been in the news for the past few years and has gotten a lot of attention. One of the key events that brought hype to the crypto markets was the 2017/2018 Initial Coin Offering boom. It was a time of incredible growth and innovation in the cryptocurrency space, but it was also marked by a significant number of fraudulent projects and scams.
A study conducted by EY showed that 86% of coins were trading below their listing price, and 30% had lost all value only one year after the ICOs. Moreover, only 29% of projects had working products. In a dataset of ICO whitepapers in a Harvard International Law Journal article, it was found that more than two-thirds of them did not provide information on the issuing entity, initiators, or backers, or contact details of these parties. Additionally, a significant number of whitepapers lack details on important aspects such as applicable law, segregation or pooling of client funds, and the presence of an external auditor.
As a result, regulatory bodies such as the US Securities and Exchange Commission (SEC) began to pay closer attention to the cryptocurrency industry and issued guidelines and regulations aimed at protecting investors from fraudulent ICOs. This increased attention and regulation helped to weed out many of the fraudulent projects that were prevalent during the ICO boom and paved the way for a more mature and legitimate cryptocurrency industry. However, recent events such as the Terra and FTX cases have shown that although the ICO market's regulation was helpful, the crypto industry still has a long way to go in limiting the number of scams. There is little control over the funds of crypto companies, leading to a large number of "Ponzi Schemes" and other fraudulent cases in the sector.
A study conducted by EY showed that 86% of coins were trading below their listing price, and 30% had lost all value only one year after the ICOs. Moreover, only 29% of projects had working products. In a dataset of ICO whitepapers in a Harvard International Law Journal article, it was found that more than two-thirds of them did not provide information on the issuing entity, initiators, or backers, or contact details of these parties. Additionally, a significant number of whitepapers lack details on important aspects such as applicable law, segregation or pooling of client funds, and the presence of an external auditor.
As a result, regulatory bodies such as the US Securities and Exchange Commission (SEC) began to pay closer attention to the cryptocurrency industry and issued guidelines and regulations aimed at protecting investors from fraudulent ICOs. This increased attention and regulation helped to weed out many of the fraudulent projects that were prevalent during the ICO boom and paved the way for a more mature and legitimate cryptocurrency industry. However, recent events such as the Terra and FTX cases have shown that although the ICO market's regulation was helpful, the crypto industry still has a long way to go in limiting the number of scams. There is little control over the funds of crypto companies, leading to a large number of "Ponzi Schemes" and other fraudulent cases in the sector.
Balancing Innovation with Stability and Safet
Experts predict that the development of cryptocurrencies will be accompanied by tighter and global regulation. The World Economic Forum has identified four main pillars for future regulation: financial stability, equity and safety, innovation, and sustainability. The goal is to promote net positive macroeconomic outcomes, which are expected to have a stronger impact on future regulation agreements. To combat growing risks and uncertainty while preserving innovation, the International Monetary Fund suggests several key measures which include licensing, registering, and authorizing crypto asset service providers. Furthermore, corporations that perform several functions should be subject to more requirements. Additionally, stable coin issuers and financial institutions should be exposed to stricter conditions. Finally, there is a need for global regulation that can effectively overcome uncoordinated national methods.
PricewaterhouseCoopers estimates that as crypto assets become more integrated into the traditional financial ecosystem, they need to be brought under the existing financial services framework. While the original idea behind cryptocurrencies was to operate without control, it has been shown to be ineffective and harmful to the financial sector. Therefore, it is crucial to develop a robust global regulatory framework for digital assets similar to traditional financial assets. All of these studies highlight the trend towards more binding and universal regulation requirements in the near future.
PricewaterhouseCoopers estimates that as crypto assets become more integrated into the traditional financial ecosystem, they need to be brought under the existing financial services framework. While the original idea behind cryptocurrencies was to operate without control, it has been shown to be ineffective and harmful to the financial sector. Therefore, it is crucial to develop a robust global regulatory framework for digital assets similar to traditional financial assets. All of these studies highlight the trend towards more binding and universal regulation requirements in the near future.
Written by: Emanuele Tartaglini, Lilit Kalantar, Maxim Shkolnikov, Vittorio Granuzzo
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