REGULATION OF CRYPTOCURRENCIES AND BLOCKCHAIN TECHNOLOGIES ROSARIO ROY
REGULATION OF CRYPTOCURRENCIES AND BLOCKCHAIN TECHNOLOGIES © ROSARIO (ROY) GIRASA, J. D. , PH. D. DISTINGUISHED PROFESSOR, LUBIN SCHOOL OF BUSINESS, PACE U. , PLEASANTVILLE, NEW YORK
CHAPTER ONE THE DIGITAL TRANSFORMATION BASICS 2 • The digital transformation • New business models due to internet • Rise almost overnight of multi-billion dollar companies • What is money? • Historical evolution as substitute for barter • Barter in modern times • Trust as basis – Reserve Bank of Zimbabwe banknote • IMF - SDRs
3 REASONS FOR RISE OF VIRTUAL CURRENCIES • Costs of third-party servicing and modernization of payments • Lack of security • Lack of convertibility or unavailability in 3 d world • Anonymity or Pseudonymity • Universality of cryptocurrencies • Profit motivation • Trust factor
TYPES OF CURRENCIES 4 • Fiat currencies • Digital currencies • Virtual currencies • Convertible • Centralized • Decentralized • Non-convertible • Cryptocurrencies as subset of virtual currencies
5 KEY ACTORS IN DIGITAL TECHNOLOGY • Inventors • Issuers or administrators • Miners • Process service providers • Users or customers • Wallet provider • Exchanges
6 BENEFITS AND RISKS OF VIRTUAL CURRENCIES • Benefits of virtual currencies: • Verification of identity • Significant reduction in costs • Speed of money transfers • Facilitation of micro-payments • Reduction of exposure risks • Use by persons unable to use banking facilities • Recording of transactions such as deeds
7 BENEFITS AND RISKS OF VIRTUAL CURRENCIES (CONT. ) • Risks of virtual currencies: • Lack of acceptance by banks and protections afforded by them • Loss of interest on deposits • Security concerns – use by criminal elements and tax evaders • Volatility • Payment beneficiary identification • Limited user base • Uncertainty of future regulation • Cyberthreats by hacking, theft, loss of private key
8 BENEFITS AND RISKS OF VIRTUAL CURRENCIES (CONT. ) • Governmental agencies risks assessment • Operational risks – lack of government supervision • Cybersecurity risks – commingling of customer assets and vulnerability of platforms • Speculative risks – volatility and price swings • Fraud and manipulation risks • Bitcoin kiosks lack of safeguards and high fees • Failure to register currency transactions as securities • Tax considerations and how to treat cryptocurrencies as property or currencies
9 CHAPTER TWO TECHNOLOGY UNDERLYING CRYPTOCURRENCIES AND TYPES • Blockchain technology – underlies cryptocurrencies and is an electronic distributed ledger technology • Combination of components including peer-to-peer networking, distributed data storage, and cryptography • It is a type of database shared across nodes in a network • It is decentralized, adding changes to the database in the form of completed blocks of transactional data connected to each other in a chain in which transaction data is stored in a chronological order
10 UNDERLYING TECHNOLOGY OF BLOCKCHAIN (CONT. ) • Users of the block receive copies of transactions automatically • Each block contains a hash which is a one-way digital fingerprint that cannot be reversed • Open system without government supervision or third parties unless use exchanges • Cryptography is branch of mathematics based on the transformation of data and can be used to provide security services such as confidentiality, data integrity, authentication, authorizations, and non-repudiation • Creators open to question –first described by Stuart Haber and W. Scott Stornetta in 1991 in an article but primary later creator is a fictitious named person, Satoshi Nakamoto in a white paper that is basis for Bitcoin
11 UNDERLYING TECHNOLOGY OF BLOCKCHAIN (CONT. ) • Blockchain developments • Initiation of Bitcoin • Blockchain • “Smart contracts” • “Proof of stake” and “proof of security” • “Blockchain scaling” – acceleration of processing of transactions
USES OF BLOCKCHAIN TECHNOLOGY 12 • Identity and access management • Health care • Legal • Financial services • Manufacturing • Tourism • Government
13 TYPES OF CRYPTOCURRENCIES BITCOIN • Bitcoin – most widely used cryptocurrency • Use of internet based on cryptography • Each Bitcoin and user is encrypted with a unique identity • Time and amount of each transaction is permanently recorded on a decentralized blockchain ledger visible to all computers using the network but without identity of parties • Transaction is irrevocable preventing intrusion • Receiver provides his/her Bitcoin address to sender who authorizes transaction using a private key (64 letters and numbers which unlocks digital wallet)
14 TYPES OF CRYPTOCURRENCIES BITCOIN (CONT. ) • Mining – One of three ways to obtain bitcoins (others – use of exchanges or exchange for goods and services) – limit of 21 million bitcoins (12 million issued to date) • Accomplished by solving computational problems for which a “block reward” of bitcoins is awarded but reduced as more bitcoins and are mined – initially was 50 bitcoins now 25 • Problems become much more difficult the more bitcoins are mined and require exorbitant amount of energy to mine causing sharing of energy resources • “Proof-of-work” – miners who find random number (Nonce) which when inserted into the current block releases the bitcoins after verification by other miners
15 VARIATIONS OF CRYPTOCURRENCIES ETHEREUM • Differs from Bitcoin – does also use blockchain but enables many more uses – transaction - based state machine encompassing broad spectrum of account balances, reputations, trust arrangements, and almost any other computer generated action • Block time is 14 seconds vs. Bitcoin 10 minutes • Rewards are 5 Ether (fuel operating Ethereum platform) • Different computer coding, use of ICOs rather than mining • Allows many other decentralized applications to be erected on it such as smart contracts • Created by Vialik Buterin of Canada using crowdfunding moneys • The Enterprise Ethereum Alliance connects fortune’s 500 enterprises, academics, and technology instructors
16 VARIATIONS OF CRYPTOCURRENCIES (CONT. ) • Litecoin – lighter type of Bitcoin, open-sources, cheaper and more everydaypurposed, 84 million coin limit, much greater number of mined blocks for halving the reward, and much less energy-use • IOTA – Scalable, decentralized, modular, and without fees, allowing companies to explore new business-to-business models, without cost • Its “Autonomous Machine Economy” can settle transactions without fees or use of blocks • Has partnered with Microsoft and Pricewaterhouse. Coopers and heavily invested in by companies
17 VARIATIONS OF CRYPTOCURRENCIES (CONT. ) • Golem – scalable, decentralized, secure, open to development, P-to-P, allowing developers to deploy own integration and implement an appropriate monetization mechanism with laptops computers • Uses Ethereum-based transaction systems that clears payments between providers, requestors, and software developers • Request Network – claims lower cost alternative to Pay. Pal and other such payment mechanisms • Decentralized network permitting anyone to ask for a payment that is accomplished in a secure way – layered on Ethereum 2– is DLT that is universal supporting any type of currency, legislation , or language – seeking to become the backbone of world trade • Uses include automation of accounting processes, VAT refunds, auditing
18 VARIATIONS OF CRYPTOCURRENCIES (CONT. ) • Ripple – payment network being used by many banks (Bank of America, Santander, American Express, UBS) • Not open-sourced and is owned by Ripple which alone may issue units • Scalable, secure, interoperates with different networks; can settle cross-border payments with end-to-end tracking • Monero – secure, private, open-sourced, untraceable, cannot be blacklisted by vendors or exchanges – problem of darknet use • Dash – open-sourced, P-to-P, digital cash easy to use and accessible to all users - can add contacts, set up account on blockchain
19 DIGITAL TOKENS • Represent an asset as property or utility or act as securities • Fungible and may offer income or rewards • Ethereum is best known offering tokes instead of coins • Mainly purchased by ordinary investors – many ICO s limit tokens to encourage investors who will contribute more than money to development of the products • May limit to non-U. S. persons due to U. S. regulations
DIGITAL TOKENS (CONT. ) 20 • Types of tokens • Utility tokens • Equity and debt security tokens • Miscellaneous types of benefits • Unlike equity sales in IPOs, these tokens have no know initial market valuation – buyers rely on expectations projections, and possibilities • They may be capped offerings (maximum or minimum number); uncapped offerings with potentially unlimited sales; can have hidden caps and reverse Dutch auctions (initial high offering sum lowered until reach sufficient number of buyers)
21 DIGITAL TOKENS (CONT. ) • Forks – alternate creations of the particular cryptocurrencies • Hark fork – two different versions of the cryptocurrency usually due to inability of the non-upgraded nodes to validate newly created blocks by newly created nodes • Soft fork – divergence in updated version of blockchain modifying earlier version but remains compatible • Altcoins – alternative cryptocurrencies not compatible with Bitcoin but emulates it by using the same hashing algorithm as Bitcoin • May be considered as a hard fork to Bitcoin and claim improvement over it • Hundreds of altcoins, e. g. , Ethereum, Dogecoin, Peercoin, and others
22 DIGITAL TOKENS (CONT. ) • Meta coins – protocol built on cryptocurrency (e. g. , Bitcoin) platform permits users in an inexpensive way to share the same features and is user-friendly, open, safe, and secure – can make bets, smart contracts, create and sell concert tickets, and many other functions • Sidecoin – fork of Bitcoin allowing a snapshot to be taken of the Bitcoin blockchain – makes available public addresses in the Bitcoin network • Sidechain – use of a separate blockchain wherein the user may revert back to the original; blockchain
23 CHAPTER THREE LEGAL ISSUES OF DIGITAL TECHNOLOGY • Jurisdiction • Like cyberlaw, issue of jurisdiction is complex because users can be anywhere and unknown • U. S. – 51 jurisdictions (federal and 50 states) • Federal based on Art 3, Sec. 2 of Constitution – extends to state vs. state, citizens of different states, between a state and citizens of another state, and with foreign states • Exclusive federal – bankruptcy, federal crimes etc. and • Concurrent with states – securities laws, antitrust, certain crimes • Problem of blockchain
24 LEGAL ISSUES (CONT. ) • Digital technology cases • Sec v. Shavers – TX. Resident Ponzi scheme diverting bitcoins for personal use • Gordon v. Dailey – civil case NJ federal ct. involving NJ resident • Virtual currencies as money • IRS – they are moneys • But customers use as money • Smart contracts – virtual contracts atop Ethereum, verifiable, self-executing, elimination of many third parties such as in banking, legal, and other uses
LEGAL ISSUES (CONT. ) 25 • Intellectual property • Types • Patents – inventions or process, 20 -year protection • Trademarks – protection to names, symbol, 10 -year renewable • Copyrights – original works of authorship, life plus 70 -years • Trade secrets – information not in public domain, known by few • Issues – affect of blockchain technology
26 CHAPTER FOUR FEDERAL REGULATION OF VIRTUAL CURRENCIES • Problems affecting virtual currencies • Use by drug dealers, tax avoiders, displacement of national currencies, use by banned countries, terrorists (ISIS) • Government agencies regulating aspects of virtual currencies • Securities and Exchange Commission • Commodity Futures Trading Commission • Financial Crimes Enforcement Network • Other agencies – Federal Reserve Board, Consumer Financial Protection Bureau, Comptroller of the Currency, Federal Trade Commission
27 SECURITIES AND EXCHANGE COMMISSION • SEC – authority over issuance and transfer of securities under Securities Act of 1933 and Securities Exchange Act of 1934 as amended • Definition of securities is very broad based on USSC case, SEC v. Howey that defined a security: • Investment in a common enterprise • Through the efforts of others • With the expectation of earning a profit • Issue is whether exchange of virtual currencies or other purposes comes within the Acts
SECURITIES AND EXCHANGE COMMISSION 28 (CONT. ) • Enforcement cases • REcoin – first enforcement action – against Zaslavskiy as head of REcoin which raised $300, 000 in ICOs – misrepresentations – SEC said needed to register ass securities • DAO – German organization raised funds through JOBS Act sold 1. 5 B DAO tokens in exchange for 12 M Ether, promise of rewards – held to be securities • Munched, Inc. – Ca. firm that created app to review restaurant meals – raised $15 M - promise of deemed to be securities • Crypto Co. – trading briefly suspended due to possible manipulation of offering
29 SECURITIES AND EXCHANGE COMMISSION (CONT. ) • SEC Chairman warning of 12/12/17 re risks of virtual currencies • SEC warnings to social media – major concern that celebrities are touting the purchase of cryptocurrencies without the required necessity to advise potential purchasers of compensation received • FTC also gave comparable warnings • SEC disapproval of NYSE proposed rule change to permit listing by a firm that held bitcoins as its primary asset • Concern about lack of oversight to prevent fraud and manipulation
30 COMMODITY FUTURES TRADE COMMISSION • CFTC oversees and regulates all commodities and futures trading under Commodity Exchange Act • Held that Bitcoin came within definition of commodity “all services, rights, and interests…in which contracts for future delivery are present or in the future dealt in” • Prohibited activities • Price manipulation of virtual currency • Pre-arranged or wash trading • Futures or option contracts or swap traded on domestic platform or facility without registration • Certain schemes involving virtual currencies marketed to retail customers without registration
31 COMMODITY FUTURES TRADING COMMISSION (CONT. ) • Enforcement cases: • Coinflip – First CFTC case re Bitcoin trades; Co. and owner charged with commodity options activity and operating a facility for trading or processing swaps without registration • Co. offered to connect buyers and sellers of Bitcoin option contracts • Bitfinex – Hong Kong Co. Fined for operating online platform for exchange and trading of cryptocurrencies, allowing trades of bitcoins on a leveraged, margined, or financed basis – failed to register with the CFTC
32 COMMODITY FUTURES TRADING COMMISSION (CONT. ) • CFTC recognition of exchange facilities • Ledger X, LLC and Tera. Exchange • Tera. Exchange given recognition in May, 2016 as first facility to offer nondeliverable forward with underlying Bitcoin • 7/6/17 order recognizing them as derivative clearing organizations and authorized clearing services for collateralized digital currency swaps • CME, CBOE, and Cantor Exchanges • 12/1/17 recognition of the 3 exchanges after self-certified new contracts for Bitcoin binary options
33 COMMODITY FUTURES TRADING COMMISSION (CONT. ) • CFTC Chairman Giancarlo commentary of future treatment of virtual currencies – 5 -step process: • Putting Our Best Foot Forward – designate teams to coordinate with Fin. Tech companies • Allow Breathing Room – Allow Fin. Tech businesses to develop and test innovative solutions with fear of enforcement and regulatory fines • Getting Involved – Regulators involvement with Fin. Tech companies to advance regulatory understanding of tech innovation to assist regulators to operate efficiently and effectively • Listening and Learning – Coordination to adapt regs to 21 st C. technologies, and • Collaborating Globally – Assist regulators everywhere to help Fin. Tech companies
34 COMMODITY FUTURES TRADING COMMISSION (CONT. ) • CFTC authority over Bitcoin interpretation • 12/15/17 announcement of exception of jurisdiction for “actual delivery” within 28 days of retail commodity transactions where: (1) customer has ability to take possession and control of entire quantity of the commodity; (2) use it freely in commerce, and (3) the sellers not retain any control or interest in the commodity • CFTC self-certification announcement of 1/4/18 – 5 -prong approach for oversight • (1) consumer protection; (2) assertion of legal authority over virtual currency derivatives to prevent fraud and manipulation; (3) market intelligence by gathering ability to monitor virtual currency derivatives; (4) robust enforcement; and (5) government-wide coordination
35 FINANCIAL CRIMES ENFORCEMENT NETWORK • Treasury Dept. application of Bank Secrecy Act (BSA) to virtual currencies • Fin. CEN’s authority to detect money laundering, terrorist financing, and other criminal acts • Money services businesses are subject to BSA • No distinction between real and virtual currency in its definition of “money transmission services” which come within its jurisdiction • Includes administrator or exchanger that accepts and transmits a convertible virtual currency, or buys and sells convertible virtual currency unless exempted • Deemed a money transmitter if it allows persons to transfer value to another or between one location to another; includes allowance of payment to a third party for virtual goods and services
36 FINANCIAL CRIMES ENFORCEMENT NETWORK (CONT. ) • Persons transmitting decentralized convertible currency (Bitcoin et al) – they are not transmitters but rather are “users” and thus exempt from BSA • If user who creates units of convertible virtual currency and sells them to another person for real money or equivalent and accepts the said currency as part of acceptance and transfer of funds, then such constitutes them as money transmitters • Money services businesses have requirements of registration, maintenance of transaction records and if $3, 000 or more, information about the transmitter, the recipient and the particular transactions undertaken
37 FINANCIAL CRIMES ENFORCEMENT NETWORK (CONT. ) • Fin. CEN’s Rulings • Company that intended to produce virtual currency software to facilitate the Company’s purchase of a virtual currency from sellers by automating its collection and payment of equivalent in legal tender (fiat currency) – ruled not to be a MSB unless it accepts and transmits a convertible virtual currency or buys and sells as an intermediator • Company’s convertible virtual currency trading and booking platform is a MSB – platform consists of a trading system to match offers to buy and sell it for legal tender • Company that mined bitcoins not yet used or transferred but would be used in the future to purchase goods or services by converting them into legal tender deemed not to be MSB
38 FINANCIAL CRIMES ENFORCEMENT NETWORK (CONT. ) • Requirements for “money services businesses” • Develop and maintain effective anti-money laundering program • Incorporate policies and procedures and internal controls to verify customer IDs; filing reports; creating and retaining records; and responding to law enforcement requests • U. S. v. Lord – Court refused to disallow guilty pleas of chiropractor and son who operated a business called localbitcoins. com whereby they provided exchange services by exchanging cash, credit card payments, and other forms for bitcoins without required registration son also had drug dealings using the said services
39 FEDERAL RESERVE BOARD • Virtual currencies determined not to pose major concerns to the financial stability of the U. S. but will monitor if they attain wide-scale coverage • Concern is that if they become a central asset of the U. S. payment system that cannot be predictably redeemed for the U. S. dollar at a stable exchange rate when the economy is faced with a financial crisis, then fundamental concerns would arise • Treasury's Department’s Financial Stability Oversight Council created under Dodd -Frank Act may monitor to see whether they become systemically important financial institutions; also issue of whether the FED has authority to regulate them
40 CONSUMER FINANCIAL PROTECTION BUREAU • Created under Dodd-Frank but currently may be becoming powerless under current administration • Mission to make financial markets work for the consumer by affording protection from unfair, deceptive, or abusive tactics, and initiate enforcement against violators • Provides consumer alerts; advise consultation of Fin. CEN website to ascertain whether exchanges are registered; and other warnings
41 OFFICE OF COMPTROLLER OF THE CURRENCY • Created Office of Innovation to Implement the Framework to address new and different consumer preferences for financial products and services concerning the new technologies, • Office serves as a central point of contact and facilitate responses to inquiries and requests; conduct outreach; provide technical assistance; leverage OCC’s expertise; and other services • Commenced studies focused on the innovations recommending “responsible innovation” to meet the needs of consumers, businesses, and communities with sound risk management aligned with banks’ business strategy
42 FEDERAL TRADE COMMISSION • Created under FTC Act of 1914 – prevent unfair methods of competition by businesses and amended to prevent unfair or deceptive acts or practices mainly to protect consumers • BF Labs, Inc. d/b/a Butterfly Labs – FTC alleged that Butterfly sold mining machines from a $149 - $29, 899 to enable customers to mine bitcoins, – problems of inability to use machines, and services, great delays in deliveries, and other problems • Resulted in compromise settlements to prohibit misrepresentations; ensure prompt and effective delivery of undamaged machines, and provisions for prompt refunds
43 NORTH AMERICAN SECURITIES ADMINSTRATORS ASSOCIATION • Non-governmental entity composed of regulators concerned with virtual currencies hype, extraordinary volatility, lack of safety net or control by central banks, and inability to exchange for other commodities • Engaged in extensive research activities to illustrate the issues and problems affecting virtual currencies including comparing ICOs with IPOs
44 POWERPOINTS COPYRIGHT INFORMATION • Powerpoints are based on text: “Regulation of Cryptocurrencies and Blockchain Technologies: National and International Perspectives” by Rosario J. Girasa who holds initial copyright to the text but copyright is to be transferred to Palgrave Macmillan, the publisher of the text, which publication as a text in the Palgrave Studies in Financial Services Technology is anticipated in June, 2018.
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