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UK Treasury Report on Digital Currencies

A call to regulate the 'Wild West' of crypto-assets

28 September 2018

The UK House of Commons Treasury Committee has recently published a unanimously-agreed Report on the outcome of its Digital Currencies inquiry. The Report concludes that regulation of the "Wild West" crypto-asset market is needed and that, at a minimum, the regulatory response should address consumer protection and anti-money laundering (AML) risks.

The Report calls on the UK Government and regulators to evaluate further the risks of crypto-assets and consider whether their growth should be encouraged through a proportionate regulatory response. The Report predicts that if this is done, the UK could become a global centre for crypto-asset markets and activities.

The Report also examines potential impact of blockchain technology on financial institutions and financial infrastructure. It returns a mixed verdict, highlighting the slow, costly and energy-intensive nature of current blockchain verification processes but recognising the potential of blockchain to manage certain types of data in the long run.

Crypto-asset investors at risk

"Crypto-asset investors are currently afforded very little protection from the litany of risks, namely there are no formal mechanisms for consumer redress, nor compensation."

Most crypto-assets and Initial Coin Offerings currently fall outside the scope of Financial Conduct Authority (FCA) regulation. While the Report acknowledges that there are self-regulating bodies in the crypto-asset industry, it emphasises that their codes of conduct and best practices are entirely voluntary. The Report concludes that this is insufficient to protect consumers and therefore identifies a need for regulation.

Examples of risks that consumers face as a consequence of this lack of regulation include one-sided adverts that imply the crypto-asset market will only go up as well as outright theft of their crypto-assets by hackers without any redress mechanisms (there is no statutory compensation scheme to protect investors' crypto-assets, like there is for bank deposits and other regulated asset classes).

Another risk lies in the volatility of crypto-assets' prices, which make them a tool for speculation and could lead to large potential gains if the market does go up – but equally poses a great risk to investors who might lose (almost) all of their money if the market goes down. To illustrate the volatility of crypto-assets: the price of a Bitcoin increased from $6,472 in November 2017 to $17,629 in December 2017 and fell to $7,208 in February 2018.

Even if these risks do not materialise, there is yet another risk that might come as a surprise to consumers; if they lose their password to a crypto-currency platform, the firm that operates the crypto-currency platform will not be able to restore it. In an unregulated world, there is no recourse for customers who have lost their passwords. They will not be able to access their crypto-assets and in effect lose their investment.

Money laundering risk

"Crypto-asset exchanges are not currently included in the AML regulations. Owing to this, and their inherent anonymity, crypto-assets can facilitate the sale and purchase of illicit goods and services and can be used to launder the proceeds of crime."

The Report also identifies the potential for crypto-assets to be misused for the sale and purchase of illicit goods and services and to use them to launder the proceeds of crime. These AML risks emerge from the inherent anonymity of crypto-assets.

The Committee recognises that the EU's Fifth AML Directive, which will bring crypto-asset exchanges within scope of AML regulations, is a step forward. However, the deadline for implementing these requirements is set for the end of 2019, leaving a substantial period of time during which the current levels of money laundering risk would prevail. Therefore, the Committee urges the Government to prioritise and expedite the transposition of these requirements.

A global centre for crypto-assets?

"If the UK develops an appropriate and proportionate regulatory environment for crypto-assets and if future innovations in crypto-assets proved themselves as beneficial to society and industry, the UK could be well placed to become a global centre for this activity"

In deciding upon a regulatory approach, the Government and regulators should evaluate the risks of crypto-assets and consider whether their growth should be encouraged. If growth is to be encouraged, the Report suggests that the introduction of regulation could enable crypto-asset markets to mature and attract institutional investors, which would in turn increase liquidity and reduce some of the current risks, such as volatility. The Report suggests that if the UK develops a proportionate regulatory environment for crypto-assets, the UK could be well placed to become a global centre for this activity.

Blockchain

"A fundamental drawback of decentralised blockchains is the slow, costly and energy-intensive verification process for transactions"

The Report explains that blockchain (or DLT) is an electronic ledger that underpins transactions in crypto-assets. It assesses the advantages and limitations of this technology for storing data and as a payments system. It also considers the potential application of blockchain to financial services and other industries.

The Report points to a fundamental drawback of blockchain, that decentralised blockchains are "slow, costly and energy intensive" in the context of transaction verification. It concludes that this may limit the extent to which crypto-assets and blockchain can replace conventional money and payment systems. The Committee does however recognise that blockchain technology may have the potential to be a more efficient and secure method of managing certain types of data in the long-term.

This article was written by Yana Papst, Trainee, Finance Group