30 Oct 2017

Regulators in China and Japan have recently rolled out significant changes as they come to terms with rapidly growing virtual currencies such as bitcoin. Despite policymakers still facing major obstacles to oversight of this digital marketplace, their moves could offer some lessons for other countries.

China until recently the largest market for bitcoin trading in the world rattled the world with cryptocurrency restrictions in September, including a ban on initial coin offerings (ICOs). Japan, conversely, has taken a more permissive approach by approving 11 cryptocurrency exchanges as part of a new regulatory scheme that some experts believe positions Japan as one of the most cryptocurrency-friendly countries in the world.

China had previously been the largest market for bitcoin trading, while Japan and the US jostled for second place. However, China's trading volume plummeted in the wake of the country's crackdown and announcements that major exchanges such as BTCChina would cease local trading.

Due to China's significance to the global cryptocurrency market, the regulators' moves contributed to a plunge in the price of bitcoin and other cryptocurrencies. One industry watcher observed that the value of bitcoin declined as much as 30 per cent from record highs earlier in September. The currency has since recovered, however, with the value of one bitcoin hitting a new high of US$6,060 on 20th October signifying a total market capitalisation exceeding US$100 billion.

Regulators therefore need to find the right balance between two competing priorities. On the one hand, they wish to prevent money laundering, protect consumers and reduce financial stability risks. On the other hand, advocates of digital currencies warn against stifling an innovative sector with regulations that may cast a wide net over legitimate activities.


Obstacles affecting cryptocurrency oversight

Bitcoin, the world's first decentralised digital currency, was launched at the beginning of 2009. The developer, a mysterious individual or group known as Satoshi Nakamoto, envisaged a purely peer-to-peer electronic cash system that bypassed financial institutions.

Ramkishen S Rajan, a Professor at the Lee Kuan Yew School of Public Policy, part of the National University of Singapore, explained that a desire by some parties for decentralised monetary and financial arrangements was one of the motivating factors behind the rise of cryptocurrency.

There has been a long and established field of thought on free banking' in which its advocates have argued that money should be competitively issued rather than be centralised and issued by a single entity in a country (i.e. the central bank), Rajan said.

This decentralised arrangement creates obvious difficulties for regulators. Traditional financial regulations were not designed for trading based on blockchain technology a kind of shared, public database of transactions that is updated and visible to the vast network of market participants. The Bitcoin Foundation has described the cryptocurrency as the ultimate tool of economic empowerment while suggesting that it can't be controlled.

Further, the activity in question can change quickly, as seen by the bitcoin split in August. In that case, technical disagreements about the blockchain prompted the currency to fork into two branches: bitcoin and the new offshoot known as bitcoin cash. Experts have indicated that another split is expected in the near future. Therefore, regulatory schemes must be nimble to be effective.

Risks if the market is left unregulated

Concerns have been expressed around the world about the dangers of cryptocurrency misuse, such as for money laundering and terrorism financing.

Furthermore, investors could be at risk if cryptocurrency exchanges which allow people to convert bitcoins and other cryptocurrency into standard currencies and vice versa are not properly managed.

The collapse of Tokyo-based Mt. Gox, once the world's biggest bitcoin exchange, is a case in point. The exchange had been subject to a number of hacking attacks over the years. When Mt. Gox filed for bankruptcy protection in 2014, it announced that about US$473 million worth of bitcoins had gone missing.

Meanwhile, UK regulators have described ICOs, a fundraising method by which virtual tokens are given out rather than shares in conventional initial public offerings, as very high risk. Investors could be vulnerable to significant financial losses if the sector is not subject to appropriate consumer protections.

Rajan said that, with some exceptions, policymakers worldwide have recognised the need to understand cryptocurrencies and the underlying distributed ledger technology.

In some senses they have little choice, as failure to embrace these new innovations may lead to erosion of their control over payments system and ability to manage the macroeconomy over time (in terms of monetary policy and role as the lender of last resort).

While bitcoin was the first mover and remains the most popular cryptocurrency, many other versions have been launched. Ethereum, the biggest alternative as measured by market capitalisation, went live in 2015 with the promise of extra features such as smart contracts. Ethereum is estimated to have about 57 per cent of the market share for ICO projects.

An added worry is the fact that some of these rival currencies, known as altcoins, also offer their users greater anonymity than the bitcoin architecture provides, which could increase the risk of illicit transactions.

Naoyuki Iwashita, a special adviser at PricewaterhouseCoopers Aarata and former head of the Bank of Japan's FinTech Center, said the cryptocurrency market was growing rapidly and should be subject to a balanced level of regulation.

As bitcoin and other cryptocurrencies are transferable globally, they are good tools for money laundering, he explained. We need to pursue a balance between healthy market growth and consumer and social security.

Lessons from Japan and China
's experiences

Japan has taken quite a calculated liberal approach to cryptocurrencies and positioned itself as one of the most cryptocurrency-friendly countries in the world, noted Rajan.

Following the collapse of the Mt. Gox exchange, there were calls for regulatory reform in Japan. Some of those plans are now coming to fruition.

Earlier this year, Japan passed a law to regulate virtual currencies, which was seen as giving a confidence boost to the sector. Days after the new law came into effect in April, Japanese electronics retailer Bic Camera announced it would trial accepting bitcoin payments in several of its brick-and-mortar stores.

Japan's Financial Services Agency (FSA) also asked cryptocurrency exchanges to register with the body by the end of September. The exchanges must maintain a minimum capital stock of 10 million yen, among other conditions. It was recently announced that the registration of 11 exchanges had been approved while another 17 applications were still being considered.

Iwashita, who is providing expert advice to the FSA, said the agency had begun full surveillance of cryptocurrency exchanges, meaning that it continually monitored business practices and compliance.

Significantly, the resulting exchange of information could help inform policymakers elsewhere. Dialogue between industry and supervisory authorities will also be useful for overseas regulatory authorities, said Iwashita.

China's recent moves have not been as accommodating for the sector though. The People's Bank of China and other regulatory bodies said in a joint statement that ICOs were believed to be linked to criminal activities such as illegal securities issuance, financial fraud and pyramid schemes.

Rajan interpreted the measures as a temporary setback for cryptocurrencies and ICOs, noting that China is still a fintech hotbed.

It is likely that the ban will not be permanent it is probably being done to allow the authorities some breathing room to put in place regulatory safeguards, he said. This is especially so since the country while still growing rapidly has been faced with concerns about financial instability and capital outflows. There is some speculation that China has been developing a national digital currency.

Regulators elsewhere will be watching closely to see where China finally lands.

Recommendations for governments grappling with virtual currencies

It is clear that regulators should constantly review their approach given the fast-changing nature of this space. They should also work closely with industry players to understand the practicalities and maintain dialogue with regulators in other countries. Sharing of insights across borders is important because of the global scope of the issue.

Even if countries do not roll out their own digital currencies, the blockchains underpinning them are likely to become very widely used in the future, Rajan suggested. Therefore, experimentation in the field of distributed ledger technology is critical.

It is only with such experimentation that policymakers can fully understand how to best harness their benefits (in terms of smart contracts, reduced costs of fund transfers especially cross-border payments, etc), while putting in place appropriate regulations and disclosure requirements to minimise various risks posed by virtual currencies, Rajan said.

Policymakers and regulators should also develop clear communication strategies to inform the general public about potential dangers and how to protect themselves.

Regular people have little information on cryptocurrency, Iwashita said. To that end, Japan's FSA has already issued a brochure explaining the risks and alerting people to be on alert for fraud and Ponzi schemes, he said.

The debate could also gain from forward-looking research projects. Despite the explosion in cryptocurrencies, there has been limited academic work in the area, Rajan observed. He opined that there might be scope in Singapore to launch a large-scale research policy project on issues related to blockchain technology, implications for central banking policies, and the potentially transformative impact on how government services could be delivered.

Fuelled by the excitement over the potential to bypass the banking middleman, bitcoin and other cryptocurrencies have grown rapidly, but their popularity has been punctuated by warnings over their risks. Policymakers must keep pace with the developments to ensure regulatory schemes are appropriate. In the process, they just might find that the underlying technology can open up new and more efficient avenues for payment systems and service provision.

This piece was written by Daniel Hurst featuring an interview with Ramkishen Rajan of the LKYSPP. It was republished at Business Times on 3 November 2017.