What are the main legal issues arising from cryptocurrency, and what reform is required?
Introduction
The cryptocurrency ecosystem has rapidly expanded, allowing cryptocurrency to be named as one of the best technological inventions in the modern world. But this has also created one of the largest unregulated markets in the modern world. There is no consensus on how to control these digital currencies both internationally and nationally, yet there is a worldwide acceptance that the growth of cryptocurrency will not be halting. It remains very unlikely that the government will allow the continued use (or perhaps better put: misuse) of cryptocurrencies and their current operations. Several risk warnings have been issued by the United Kingdom’s (UK) Financial Conduct Authority (FCA), namely because the system is extremely volatile, and becoming a haven for criminal activity.
This article will explore the legal issues arising from cryptocurrency, due to the lack of regulation and its unique characteristics. Firstly, the article will detail concerns about money laundering, fraud, and wealth concealment. The article will then display how there is a pressing need for regulation to combat these invading issues before cryptocurrency gains the characteristic “criminal-currency”.[1]
However, it will be acknowledged that navigating such regulation is difficult as the whole aim of the system is decentralisation.
Current Legislative Framework
The UK transposed the cryptocurrency regulation requirements set out in the fifth Anti-Money Laundering Directive of the European Union into domestic law in 2020.
Cryptocurrency exchanges must also register with the FCA, which means that all entities engaging in cryptocurrency activities must comply with the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017.
However, there are no other specific provisions currently in force for cryptocurrency platforms, and as recognised by HM Treasury, a broader regulatory approach is required. It is recognised that there is further regulation coming in October 2023 on cryptocurrency advertisement, but this article is intended to provoke discussion on the current framework.
Legal Issues
Money Laundering
Numerous cryptocurrency platforms allow users to pursue anonymous financial transactions without the need to disclose any personal information as users receive a pseudonym. It becomes extremely difficult to link such pseudonym to the real identities, and any user can create an infinite number of anonymous addresses.
One major difficulty is discovering users with multiple addresses, which are not used simultaneously. A stimulation experiment concluded that 60% of Bitcoin users utilising the privacy measures could not be uncovered.[2] Monero, for example, does not provide identification of the sender, recipient, or value of the transaction, and creates a ring signature which prevents any identity attribution. Such a high level of privacy is allowing transactions to be predominantly untraceable and is significantly detrimental to AML processes.
As it is a decentralised universal system there is no central intermediary who can be held accountable to deal with any suspicions. The system is dependent on cryptocurrency platforms themselves to implement measures and although the UK does have AML rules in existence for UK specific platforms, they are being exploited. The UK’s AML scheme focuses on a regulatory approach when registering platforms, but this is only regulating a small aspect of the cryptocurrency chain.
For example, this does not address issues with criminals when they are converting their cryptocurrency to fiat with an exchanger. Even if there is suspicious activity identified, due to the anonymity it is a huge challenge to enforce, freeze, or hold the cryptocurrency assets. Thus, despite efforts of regulation, such regulation is proving ineffective.
Fraud
Individuals who invest into cryptocurrency do so at their own risk as there is no remedial path available in the event of loss, and this stems down to there being no formal legal entity to act as a guarantor in the event of bankruptcy. Therefore, if an investment is made to a platform which subsequently closes, then the money may never be seen again. Moreover, if an individual is scammed by a fake currency or a target of investment fraud then there are no consumer protections.
Scammers took $14 billion worth of cryptocurrency in 2021 and $7.8 billion in 2020.[3] Even exchanges who operate with basic levels of responsibility have not been immune, for example, a Japan-based exchange: Mt Gox, which was the dominant hub of Bitcoin collapsed due to a series of security breaches, stemming from insiders which saw $450 million worth of Bitcoin stolen.[4]
Unlike, regulated firms who benefit from the Financial Services Compensation Scheme who protect up to £85,000 of your money if investments collapse, there are no equivalent protections for cryptocurrency platforms.There is also no means to complain to the Financial Ombudsman Service about service or believed mis-sale.
The FCA did ban one of the world’s largest cryptocurrency platforms: Binance, from operating in the UK in 2021 amid growing concerns about its business structure, legal owner and purchasing methods. This does demonstrate a step in the correct direction, but unless there are extreme worries many fraudulent platforms are falling under the radar.
From the very beginning of cryptocurrency there has been a precedent that it is easy to pursue criminal activity, and this started with Silk Road, where $1 billion worth of illegal goods and services were sold before the cryptocurrency token was shut down. Ultimately, having only a single regulatory check whilst registering, the high risk of hacking, and no institutional backup is providing cryptocurrency platforms with a large opportunity to abuse the system.
Wealth Concealment
Cryptocurrency has created a new platform to hide assets, and this is being increasingly exploited within divorce cases. Unlike schemes such as offshore trusts, cryptocurrency can be quickly set up with no significant investment needed. The virtual untraceable aspect of the system means that cryptocurrencies are more challenging to track and prove than more tangible assets, and they cannot be confiscated in the same manner.[5] Tracking it requires specific experts, a range of tools, and it is a very time consuming and difficult task. Further, conducting a search does not equate to results, and needs careful consideration and often legal advice about whether it is worth the risk.
Secondly, an issue arises when attempting to value and divide any cryptocurrency found due to the extreme volatility in the system. In May 2022 investors carried losses of more than 30% in a single day due to the ban in China.[6] So, this method of hiding wealth is extremely unfair on the party with no involvement and is placing a large amount of power into the unscrupulous persons hands to fluctuate and hide assets quickly and anonymously.
Locating concealed assets can only be completed by a few routes: requesting bank statements to find transactions with a digital coin or wallet reference; looking at tax returns; and locating texts or emails which mention cryptocurrency. However, many individuals feel the need to obtain the information quickly for themselves, but as occurred in Arbili v Arbili [2015] EWCA Civ 542 courts are likely to refuse to accept such information gathered through hacking into their spouse’s accounts.[7] Most innocent parties have to sit back and are essentially left powerless.
Summary
There are clear legal issues stemming from cryptocurrency and these are spreading over new areas of law. The anonymous nature of the system is being misused, the lack of a central controller means that there are no strong mechanisms to hold individuals to account, and the lack of regulation results in frequent scams. Overall, the current regulation is minimal and falling short.
Is Reform Required?
The unique feature of cryptocurrency is decentralisation. Decentralisation empowers individuals to monitor their finances without anyone watching and prevents the system from collapsing at a single point of failure. Therefore, any regulation goes against the whole ethos of cryptocurrency.
However, from a long-term perspective if regulation were implemented, overall risks and legal issues would be reduced, which in turn would result in increased consumer interaction. Studies have found that the upsurge in regulation worldwide has not dampened market activity,[8] and it was just the complete ban in China that had short-term effects on the market. Many participants simply will process the changes and adjust their trading behaviour accordingly.[9] Ultimately, through recognising cryptocurrencies full potential and implementing regulation to reduce the current legal issues there will be more financial stability and reliability.
To balance both perspectives all regulation must be carefully thought outand retaining as many features as possible should be the aim. If severe regulation is implemented it could result in reduced investor reactions, supressing the value of cryptocurrencies. It would be unfair to dismiss the legitimate users and bundle them together with the criminals through removing key features such as anonymity.
Despite there being no precedent and consequently it being a hard task, if the risks are reduced individuals will be more likely to enter into transactions,and cryptocurrency will be able to reach its full potential. Although the government wishes to be careful to not overburden this financial innovation with excessive regulation and therefore hinder the growth, there is an overwhelming need to ensure cryptocurrency is not circumventing the law.[10]
What reform is required?
Below is an analysis of different reform strategies with a conclusion on their effectiveness.
1. Handbook
A downfall in the current system is the freedom provided to exchanges once they are functioning. Consumer confidence could be boosted through all exchanges having set standards to abide by. This could be possible through creating a handbook of rules that all exchanges have to abide by before they are allowed to register. One example being that the platform must have a stable management system before and when operating, which would reduce the possibility of scams. This could be enforced by the FCA when they originally conduct their registration checks. In this way, there does not have to be a whole new process set up, yet there will be an increase in self-responsibility.
However, without continuous checks by the FCA there is no way to ensure that exchanges will continue to abide by the handbook rules. It is unrealistic to expect monitoring agencies and financial regulatory committees to be set up to monitor how platforms are interacting and running. Vast amounts of resources would required. It would be more appropriate to have exchanges operate on a similar basis to Barristers. By holding themselves accountable to the handbook rules, reporting self-breaches and other platform’s breaches, it would hopefully create a system of accountability. It would only require a small committee to be set up within the FCA to process complaints and breaches, and then hand out appropriate sanctions such as a part-time ban, but it would ensure greater transparency and responsibility within the cryptocurrency system.
2. Compulsory Wallet Services
Currently, theft is extremely rife within the system. Making all platforms provide wallet services automatically would ensure that all cryptocurrency is stored in a secure place, and in turn reducec theft in the system.[11] This could be another requirement that the FCA must check for before registering a platform. Although, this is adding another duty to the FCA it is minimal and only requires a brief check, so it is a realistic reform.
3. Regulating Cryptocurrency Advertisements
Ensuring all advertisements within the UK are regulated and properly assessed before promotion would help to reduce customers being misled.
The UK government have this on their agenda as a regulatory priority and wish to ensure all advertisement is “fair and clear”.[12] This should be being introduced from October 2023. The intention is for the FCA to be provided with the appropriate powers to effectively regulate this area of the market. It would be most effective to create a committee within the FCA. Although this does require money, training, and staff, there already exists rules for all other forms of financial advertising so it would just be the case of bringing cryptocurrency in line with already existing rules.
4. An international consensus
Due to the worldwide use of cryptocurrency, the aim of regulation should be to provide a co-ordinated approach that can be applied consistently throughout jurisdictions. The UK can implement as many reforms as it wants, but without an international consensus cryptocurrency criminals will make use of less regulated nations.
However, all countries agreeing on regulation is a very unrealistic reform proposal as the UK has no authority to compel other countries to introduce and adopt the same regulation. It would be more effective to follow suit of other countries regulations. For example, the EU has issued the green light to implementing a ‘travel rule’ introducing an obligation for platforms operating within the EU to collect and produce logs containing information about the originator and beneficiary of the transfers that take place.[13] This would ensure quicker and clearer traceability of cryptocurrency transfers and it is set to be a requirement no matter the number of assets being transferred. Implementing this within the UK would deter individuals from pursuing crime due to the increased traceability of transactions. Having this more unified global approach through following the EU’s stance would also ensure a more accountable system worldwide with less deception.
5. Constantly monitoring transactions
A policing system could be introduced where the ledger is constantly monitored for suspicious transactions, accounts, and platforms.This could be followed by account banning which would help to frustrate the suspicious activity. There would be no need to investigate unless there are suspicions, and this way anonymity can predominantly remain.
However, this is a very drastic and intruding reform to the system; heavily impeding on decentralisation, with extreme funding requirements. The question of what is suspicious is not clear, and although it could become easier to spot overtime, criminals are likely to become more aware of the rules and change their behaviour accordingly.
For a policing system to work, and be worth the amount of funding and resources, the anonymous nature of cryptocurrency needs to be removed. Although it could deter criminals from embarking in illicit activity and make the marketplace more sustainable overall, this reform is too intrusive.
A compromise could be having smaller committees who spot check platforms on the ledger, as occurs with tax audits and HMRC. This would reduce the funding required but also act as a warning to platforms.
6. Regulating Fiat Exchangers
There are more components to the criminal chain than simply looking at platforms, as people must convert their cryptocurrency into fiat. Ensuring that fiat exchangers are proactively investigating suspicious transactions will enable criminal transactions to be identified and help to start to rebuild the money trail.
However, fiat exchangers will not simply agree to implement these measures and there will have to be legislation and funding introduced. Fiat exchangers will not only have to create committees themselves, but committees will need to be set up within the FCA to monitor that fiat exchangers are fulfilling their obligations. Overall, when considering that no cryptocurrency platforms have any regulation features themselves, tackling the system from within first is more important.
Summary
Overall, the most realistic reforms are the compulsory wallet service and regulation of advertisements, as they require the least intrusion. Considering all other financial adverts are regulated there is no reason for cryptocurrency not to be. Committee structures and current processes can be quickly adopted. Moreover, a wallet service is a quick add on for the FCA to check when platforms are initially registering.
If the UK were to invest a larger amount of money into cryptocurrency regulation, a handbook is the most reasonable reform to introduce. Although a committee is needed, it does not need to be large, and it will increase the accountability of platforms. Following the EU’s stance does seem reasonable, but it would be better to see the effectiveness of it first within the EU. Regulating fiat exchangers is unrealistic, as ultimately the cryptocurrency system itself needs regulation first. Finally, the constant policing system intrudes too much on the very nature of cryptocurrency. The compromise of random spot checks is however more realistic, but it does restrict decentralisation and anonymity, so it remains a questionable proposal.
Conclusion
There is a clear problem with the current cryptocurrency system and an even clearer need for reform.
The lack of a central regulator means that there is nobody to monitor the system for suspicious transactions and then hold the criminals to account. Similarly, platforms having no regulation apart from the initial registration check by the FCA are providing a large amount of freedom to conduct scams and even aid criminals. The anonymous features provided by systems are being exploited by large numbers of users, from criminals to money launder, to spouses who are looking to conceal assets or very quickly reduce the value of assets. Overall, cryptocurrency is creeping into new areas of law and becoming a burden for practitioners.
Despite the advantages in the current system, such as the absence of third-party influence, quick processes, and anonymous features ensuring equality, if no regulation is implemented problems will continue to grow. Regulation will not only reduce legal issues, but it will also increase consumer confidence and cryptocurrency investment.
Navigating regulation is not simple, most reform strategies infringe upon the very nature of cryptocurrency: decentralisation. Implementing small reforms such as advertisement regulation or compulsory wallet services would slowly reduce some legal issues. If the government wishes to invest more funding and create committees within the FCA then introducing a platform handbook and spot checks for platforms will be of more benefit.
Overall, all the proposed reforms would help to create more responsibility within the system and will ensure quicker and more effective traceability of criminals.
Ellie Twist
Pupil Barrister
JSC Chambers
[1]Sesha Kethineni and Ying Cao, ‘The Rise in Popularity of Cryptocurrency and Associated Criminal Activity’ (2020) 30(3) Int Crim Law Rev 325, 325 [2] Hao Hua Sun Yin, Klaus Langenheldt, Mikkel Harley, Raghava Mukkamala and Ravi Vatrapu, ‘Regulating Cryptocurrencies: A Supervised Machine Learning Approach to De-Anonymizing the Bitcoin Blockchain’ (2019) 36(1) J Manag Inf Syst 37,43 [3]Alex Gailey, ‘Why Cryptocurrency Regulation Is Actually ‘A Good Thing’ for Investors, According to These Experts’ (Next Advisor, 2022) <https://time.com/nextadvisor/investing/cryptocurrency/why- crypto-regulation-is-good-for-investors/> accessed 6 July 2022 [4] Ludwig Christian Schaupp and Mackenzie Festa, ‘Cryptocurrency Adoption and the Road to Regulation’ (2018) 78 ACM 1, 2 [5]Sean Cleary, ‘Finding and Dividing Hidden Crypto Assets in a Divorce’ (Wealth Management, 2022) <https://www.wealthmanagement.com/high-net-worth/finding-and-dividing-hidden-crypto-assets- divorce> accessed 23 July 2022 [6] Anon, ‘How cryptocurrency can fuel asset concealment in divorce’ (Bannerjones) < https://www.bannerjones.co.uk/resources/how-cryptocurrency-can-fuel-asset-concealment-in-divorce> accessed 23 July 2022 [7]Arbili v Arbili [2015] EWCA Civ 542, [2015] 5 WLUK 643 [8]Brian Feinstein and Kevin Werbach, ‘The Impact of Cryptocurrency Regulation on Trading Markets’ (2021) 7(1) J Financ Regul 48, 89 [9] ibid 90 [10]Ludwig Christian Schaupp and Mackenzie Festa, ‘Cryptocurrency Adoption and the Road to Regulation’ (2018) 78 ACM 1, 4 [11]Anon, ‘What is cryptocurrency and how does it work’ (Kasper Sky) < https://www.kaspersky.com/resource-center/definitions/what-is-cryptocurrency> accessed 6 July 2022 [12]HM Treasury, ‘Government to strengthen rules on misleading cryptocurrency adverts’ (Gov.uk, 2022) <https://www.gov.uk/government/news/government-to-strengthen-rules-on-misleading- cryptocurrency-adverts> accessed 29 July 2022 [13] European Parliament Press Release, ‘Crypto-assets: green light to new rules for tracing transfers in the EU’ (European Parliament News, 2023)< https://www.europarl.europa.eu/news/en/press-room/20230414IPR80133/crypto-assets-green-light-to-new-rules-for-tracing-transfers-in-the-eu > last accessed 10 July 2023
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