With the innovation in technology, enormous growth has been witnessed over decades. While several other developments have taken place; cryptocurrencies influenced the financial sector. Not only did it introduce an independent means of payment for goods and services but also a decentralised end to end encrypted system. Embedded in a complex technological working, not everyone understood cryptocurrencies. Over time, as awareness increased, people began to invest in the first generation of cryptocurrencies, Bitcoin. As the system prides itself on enabling an anonymous transaction, it led on to stir controversies in the legal sector and in turn, received concerns from regulators.

Thus, this paper will take a legal perspective to examine the issues with regard to cryptocurrencies, some of which are criminal activities, money laundering, and tax evasion. Some possible suggestions will then be made, however, owing to the loopholes in them, the paper will conclude that there is no direct solution to bitcoin problems. In fact, bitcoin in itself is a problem.[1] It must be noted that this no thrashing exercise on the regulatory bodies but simply aims to identify the concerns and issues with cryptocurrencies. Without a doubt, the rise in cryptocurrencies is intimidating and threatening to the world economy and regulators.

 

Cryptocurrencies

Cryptocurrencies are the new product of the monetary innovations. They are referred to as a technology-based currency system that operates ‘peer to peer’ with no observatory eyes of the government or banks.[2] In other words, at the heart of the system is a decentralised public ledger which records the ownership and transfer of such tokens.[3] The working of this decentralised ledger is complex and beyond the scope of this paper. However, the core idea underlying this is rather simple and rests its backbone on the concept of blockchain.

Whenever a cryptocurrency is transferred from the owner to the recipient, ‘mining’ is used to authenticate the transaction. Miners are members of the public who download the relevant software to consult the ledger against previous versions of this digital ledger to confirm the ownership title and record the transfer to the new recipient.[4] This authentication process involves competition wherein the crowd of miners contends to crack the cryptographic problem. The winner is the first miner to find the solution and gets a new set of automatically generated cryptocurrencies as a reward.

 

Bitcoin

A well-known first generation of cryptocurrencies came about in 2009 under the name of Bitcoin. Said to be developed anonymously, the white paper on bitcoin was released under the pseudonym of Satoshi Nakamoto.[5] The paper claimed bitcoin to be a non-fiat currency. Put differently, “it is a virtual currency that claims to be tradable in the same fashion as sovereign currencies, yet without a sovereign.”[6] It is further advocated to have ‘real’ value which is derived from mining. The mining of these coins becomes difficult with the passage of time owing to the concept of scarcity that bitcoin is founded on.[7] The mathematical algorithms that generate new tokens intensify the amount of processing power required to produce each set of new bitcoins, thus making the process more difficult. The increasing difficulty aims to ensure that the maximum number of bitcoins that can be mined is no more than 21 million. The difficulty increased from 1 to 877,227 in 2011 and to over 10 billion in 2014.[8] This increase implied a difficulty in supply but an escalation in demand, hence making bitcoin attractive because of profit prospects. In 2015, the difficult rose to over 47.5 billion with over 14 million coins mined.[9] It is unlikely that the difficulty level will reduce therefore, developers have embarked on introducing various other forms of cryptocurrencies; Ripple, Litecoin, and Ethereum to name a few.

 

Advantages

Further to the rising number of cryptocurrencies, this is owing to the benefits it possesses. From the above discussion, it is evident that transparency is the key advantage as the ownership and transfers of bitcoin are verified publicly by peers. Not only that, these transactions are theoretically anonymous because of an end to end encryption despite being publicly transparent. In other words, the peers have the knowledge of a transaction taking place, but the identity of the traders is hidden therefore transcending the traditional currency system.[10] Further, the technology employed uses 256-bit version of a secure hash algorithm designed by U.S. National Security Agency.[11] Given that, the integrity of blockchain is maintained, signatures are secured and cannot be altered due to the mathematical proofs of authentication.

 

Problems

(1) Volatility

The flip side introduces the nature of bitcoin as tremendously volatile. It has not only crashed numerous times but also has constantly been fluctuating in price.[12] The viability of it being a currency can be questioned. It is highly unstable and unreliable. To explain the volatility, the non-fiat aspect of bitcoin plays an important role. Unlike fiat money which is regulated by fiscal policies, valuation and interest rates by a centralised body, bitcoin is non-fiat and therefore is bound to lose its equilibrium.[13]

(2) Market Manipulation

Further, given the complex technology overshadowing blockchain, it poses physical barriers to entry for general public due to increasing difficulty in mining. Rendering it as a possibility and possession for few, it can be subject to manipulation. Keeping in view that the early adopters were fortunate to lay hands over a large number of bitcoins, it is hard to rule out the possibility of them using it to leverage the market.[14] The creators could influence trade by selling or buying large amounts of bitcoin hence, contributing to the market price fluctuations.

(3) Property, not a currency

Following the instability, bitcoin has been subject to speculation by investors. Instead of spending it on buying commodities, they choose rather to wait until it can be sold at a profit. In other words, the flow of bitcoin in the market has reduced since it is being stored. This flow is capable of forming a hyper-deflationary spiral.[15] Resultantly, it ceases to be a proper currency in the literal sense- it has minimal prospects of being used as a medium for buying and selling commodities. This idea has been supported by the Electronic Money Institutions Directive 2009/110/EC. Even though it is an umbrella regulation to cover virtual currencies, cryptocurrencies are beyond its scope.[16] As they do not qualify as electronic money under the directive, they are not deemed to be a legal tender, at least in the UK. Simply put, cryptocurrency is rather a property itself [17]. The ledger outlines a right in such property.

However, despite the problems pertaining to the classification of cryptocurrencies, the pro-bitcoin population has still accepted it as a medium of exchange. An explanation to this lies in the fact that the little similarity in bitcoin and banking system is resultant of the ideological assumptions that surround the cryptocurrency scheme.[18] It is not accidental. With that in mind and owing to the acknowledgement of innovation, people have overtime invested in bitcoin.

 

Legal landscape

The acceptance of bitcoin by people is not sufficient to say that people have equal trust in private money, i.e. cryptocurrency and legal tender just yet. But, with some acceptance of cryptocurrencies on the part of people comes greater responsibility on the regulators.

Criminal activity

One of the major advantages of bitcoin is the anonymity tied to it. This also implies that cryptocurrency is attractive to those engaging in illegal activities. As the identity of the bitcoin holders is not compromised, it can be used to buy anything ranging from drugs to guns.[19] For instance, a marketplace called Silk Road accepted only bitcoin for the illegal sale of cocaine, weapons, fake passports and so on.[20] Although it was operating in the ‘dark web’, it could still be accessed by following the instructions in variously available manuals. It was eventually closed down however, there will always be a possibility of other similar activities. Not only that, but cryptocurrencies can also be used to finance terrorist activities.

The legislative approach has been to introduce Know Your Customer regulation in order to ensure that institutions are aware of who their customers are.[21] The aim of this regulation is to prevent the sale of unauthorised materials to unauthorised individuals. The European Union has attempted to implement the same and has taken steps to include bitcoin under their current anti-money laundering framework. However, there are limitations to this current approach.[22] Regulating exchanges is absolutely not the same as regulating cryptocurrencies.

Money laundering

Further to criminal activities enabled by bitcoin, money laundering is a major concern as well. Bitcoin is proving to be an effective way of hiding both the source and the destination of money. In specific, layers of dummy transactions are added by act of ‘tumbling’ to further disguise the origin of a transaction.[23] It is likely that as much as £4 billion can be laundered by way of cryptocurrencies.[24] This figure is of great concern. Without centralisation of the ledger, any steps taken to combat this would be futile. As Wainwright correctly acknowledged, even where the criminal could be identified, their assets cannot be frozen like that in a regular banking system.[25]

Tax haven

A further advantage of this anonymity is with regard to taxation laws. The problem of tax evasion has been a major concern for the government. However, cryptocurrencies have the potential to defeat the success of strict taxation laws. Cryptocurrencies have helped entangle the two strands – money and taxation. The earnings are subject to tax but if the money is invested in cryptocurrencies, the identity of the taxpayer is concealed.[26] Further, since they are decentralised, they are independent of any third party including government and financial institutions. This could lead to cryptocurrencies being the new tax haven. It seems that tax evaders no longer have to hunt techniques of off-shore bank accounts in tax friendly jurisdictions but sophistically evade tax by investing in bitcoin. In other words, bitcoin can be the new savings account.[27]

Moreover, ‘fork and merge’ patterns have been noticed by scholars.[28] Under the fork pattern, the significantly large quantity of bitcoins can be divided into multiple small accounts which are owned by the same person. On the other hand, merge pattern refers to using different accounts to buy significant quantities of bitcoin.[29] The regulators have considered the tax evasion implications; however, it has been inevitably difficult to control these owing to the subtraction of financial institutions acting as tax collection agents from the equation. In the UK, HMRC issued a paper regarding the tax position of income received from the sale of cryptocurrencies. This position is similar to that of other foreign exchange currencies.[30] With regard to the unknown categorisation of cryptocurrencies as currency or commodity along with the tracing difficulty, this interim tax position is not viable. It is indeed challenging to devise a regulation that would allow tracing of such hidden funds. Regulators have therefore been restrained whilst attempting to tackle the issues surrounding crypto-currencies in light of tax evasion.

 

Regulator’s view

Regulators around the world have accepted that the current legislation is incapable of encapsulating the crime and fraud that comes with the new cryptocurrency technology. The cryptocurrencies are bound to increase in number despite the warning by the government urging investors not to invest in bitcoin because of the risks involved.[31] Therefore, the future is in the hour of need for regulation. As Greg Madcraft proposed, “for us regulators, [it] is reconfiguring our toolkit around the end users of our markets… Given the speed of change, we need to think about that toolkit now.”[32]

Furthermore, regulators have also acknowledged that the scope of cryptocurrencies is not just national but international.[33] Although they do not intend to supress the benefits of technological development, it is hard to differ from the stand that there still needs to be some monitoring; a world-wide monitoring policy in this case.

 

Further solutions

Nicky Morgan acknowledges that “striking the right balance…while not sifting the innovation, is crucial.”[34] However, how will that right balance be struck? Academia has made several suggestions that might work theoretically but in practice, they are not free of limitations.

As said, this is a worldwide problem, and some jurisdictions have taken steps to combat the negative implications. The UK could derive inspiration from Germany. The German government issued a report wherein they suggested the treatment of cryptocurrencies as that of any other financial investment for tax purposes.[35]

As an alternative, with the help of further research, an innovative regulation can be implemented to target the middlemen in the transaction.[36] For instance, people usually buy cryptocurrencies using website or intermediators who would potentially hold some information about the buyer. As most users of bitcoin are not technology experts, the purchase through a middleman is unavoidable. This approach decouples the two main characteristics of bitcoin i.e. anonymity and decentralisation.[37] Next, it targets the anonymity aspect but protects decentralisation.

However, it must be noted that both the German and middlemen approach will only pierce the veil at the point where a legal tender is exchanged for bitcoin.[38] Neither of these approaches will be free of loopholes. Where transactions will be carried out between bitcoin holders, there will still be difficult to trace the identity of the owner and the recipient. As a result, the assets of the bitcoin holders will continue to remain disguised and hence be indicative of the incapability of solving the problem of crime, money laundering and tax evasion.

Another possible approach is rather radical wherein the legislators could ban the payment for goods and services in Bitcoin. However, more than anything, this would be a coward move and cause extreme political and normative unrest. Moreover, such action does not, in reality, tend to the issue of tax evasion. Also, it must be noted that even if attempts are made to limit the use of bitcoin, there are other similar cryptocurrencies that would still require some form of regulation.

A study-and-wait-and-see approach is rather recommended.[39] Considering that the innovation of cryptocurrencies in a new model, most regulators are still in the process of understanding the underlying principles. A haste and reckless regulatory reform will not only lead to complications in the economy but also hinder further technological developments and innovations.

 

 

 

References:

[1] Martin Walker in Courtney Goldsmith, “The UK’s cryptocurrency trade body is urging MPs to regulate the industry” [2018] < http://www.cityam.com/285013/uks-cryptocurrency-trade-body-urging-mps-regulate-industry> accessed 18 June 2018

[2] Andres Guadamuz and Chris Marsden, “Blockchains and Bitcoin: regulatory responses to cryptocurrencies” [2015] Sussex Research Online 12(20)

[3] ibid

[4] Peter Van Valkenburgh, “Framework for Securities Regulation of Cryptocurrencies” [2016] Coin Centre Report 1

[5] Satoshi Nakamoto, “Bitcoin: A peer to Peer Electronic Cash System” [2008] < https://bitcoin.org/bitcoin.pdf> accessed 18 June 2018.

[6] Ibid.n[2]

[7] Böhme, Christin, Edelman, & Moore, “Bitcoin: Economics, technology, and governance” [2015] Journal of Economic Perspectives, 29(2), 213-238.

[8] Block chain statistics obtained from < https://blockchain.info/stats > accessed 18 June 2018

[9] ibid

[10] ibid.n[2]

[11] Bitcoin Anonymous, “How does bitcoin work?” [2011] < https://bitcoin.org/en/how-it-works> accessed 18 June 2018

[12] Jonathan B Turpin, “Bitcoin: The Economic Case for a Global, Virtual Currency Operating in an Unexplored Legal Framework” [2014] Indiana Journal of Global Legal Studies 21(335)

[13] ibid.n[2]

[14] ibid.n[2]

[15] Joel Hruska, “Bitcoin’s recent volatility risks deflationary spiral, could undermine it as a currency” [2017] < https://www.extremetech.com/internet/260093-bitcoins-recent-volatility-risks-deflationary-spiral> accessed 15 June 2018

[16] Financial Conduct Authority, “The FCA’s role under the Electronic Money Regulations” [2011] < https://www.fca.org.uk/publication/archive/emoney-approach.pdf> accessed 15 June 2018

[17] Ruben Grinberg, “Bitcoin: An Innovative Alternative Digital Currency” [2011] Hastings Science & Technology Law Journal 4, 160

[18] “CFTC Asserts Jurisdiction over Bitcoin Derivatives” [2015] < www.sidley.com/news/10-15-2015-derivatives-update> accessed 10 June 2018

 

[19] Andrew Norry, “Bitcoin and Money Laundering: Complete Guide to Worldwide Regulations” [2018] < https://blockonomi.com/bitcoin-money-laundering/> accessed 15 June 2018.

[20] Hope Reese, “How the founder of the Silk Road made millions on his illegal startup on the Dark Web” [2017] < https://www.techrepublic.com/article/how-online-marketplace-silk-road-became-the-craigslist-for-illegal-drugs/> accessed 11 June 2018.

[21] Vedat Akgiray, “Blockchain Technology and Corporate Governance” [2018] Organisation for Economic Co-operation and Development

[22] ibid.n[20]

[23] Edgar G. Sanches, “Crypto-currencies: The 21st Century Money Laundering and Tax Havens” [2017] U. Fla. J.L. & Pub. 28(167)

[24] Lynsey Barber, “£4bn is being laundered through bitcoin and cryptocurrencies, Europol boss Rob Wainwright tells BBC Panorama” [2018] <http://www.cityam.com/280473/gbp4bn-being-laundered-through-bitcoin-and-cryptocurrencies&gt; accessed 08 June 2018.

[25] ibid

[26] Omri Marian, “Are Cryptocurrencies super tax haven?” [2013] University of Florida Levin College of Law, UF Law Scholarship Repository

[27] ibid

[28] ibid; Dorit Ron & Adi Shamir, “Quantitative Analysis of the Full Bitcoin Transaction Graph” [2013] < https://eprint.iacr.org/2012/584.pdf> accessed 18 June 2018; Eric Wall, “Chain merger- unifying block chains after fork” [2017] < https://medium.com/@ercwl/chainmerger-unifying-blockchains-after-a-fork-4ccc930907c0> accessed 17 June 2018.

[29] Ibid

[30] HMRC, “Bitcoin and other cryptocurrencies” [2014] Revenue and Customs Brief 9.

[31] Anonymous, “Bitcoin risks: Government warns against cryptocurrency, says don’t get trapped” [2017] Business Today < https://www.businesstoday.in/current/economy-politics/bitcoin-cryptocurrency-ponzi-schemes-rbi-warning-virtaul-currency-digital-money/story/266972.html > accessed 10 June 2018.

[32] Greg Medcraft, “The Future of Capital Markets in a Digital Economy” [2015] Keynote speech at Carnegie Mellon University (Australia)

[33] Ousmene Jacques Mandeng, “Cryptocurrencies, monetary stability and regulation” [2018] London School of Economics and Political Science < https://www.researchgate.net/publication/323417307 > accessed 19 June 2018

[34] Commons Select Committee, “Digital Currencies inquiry launched” [2018] < https://www.parliament.uk/business/committees/committees-a-z/commons-select/treasury-committee/news-parliament-2017/digital-currencies-17-19/> accessed 15 June 2018

[35] Ed Howden, “The Crypto-currency conundrum: Regulating an uncertain future” [2015] Emory Int’l L. Rev 741

[36] ibid.n[26]

[37] Omri Marian, “A conceptual framework for the regulation of cryptocurrencies” [2017] University of Chicago Law Review Online 1(82), 53

[38] ibid.n[26]

[39] ibid.n[27]

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