Cryptocurrency Regulation

A Reflexive Law Approach

Immaculate Dadiso Motsi-Omoijiade

• Publisher: Routledge
• Year: 2022
• ISBN:
  9781000594607
• Edition: 1
• Topic: Economia
• Subtopic: Settore bancario

This work argues that current cryptocurrency regulation, particularly in the areas of enforcement and compliance, is inadequate. It proposes reflexive regulation as an alternative approach. This book provides strategies for a reflexive regulation approach to cryptocurrencies, developed through the identification of the internal self-regulatory mechanisms of the cryptocurrency system. Apportioning blame for current problems to the regulators' failure to take into account the inherent technical features of cryptocurrencies, the work promotes reflexive regulation in which the law acts at a subsystem-specific level to install, correct, and redefine democratic self-regulatory mechanisms. It provides strategies for this approach, developed through the identification of the internal self-regulatory mechanisms of the cryptocurrency system. These are identified as imbedded in the technical functionality of computer code and consensus-based distributive governance mechanisms respectively. In addition to providing a technical, historical and legal overview of cryptocurrencies, the book concludes by providing recommendations aimed at redirecting code and consensus towards achieving regulatory goals. In this way, it draws from the theory of reflexive law, in order to provide both a substantive and jurisprudential perspective on the regulation of cryptocurrencies and to illustrate how Financial Technology (Fintech) regulation can only be effective once regulators consider both the 'Fin' and the 'tech' in their regulatory approaches. The book will be of interest to researchers, academics and policy-makers working in the areas of Financial Regulation and Jurisprudence, Financial Crime, Banking Regulation, Information Systems, and Information Technology.

1 Overview of cryptocurrencies

DOI: 10.4324/9781003254164-1

1.1 Introduction

This chapter provides an introduction to and overview of cryptocurrencies in order to lay the contextual foundation for the thesis, prior to considering their regulation. Taking an evolutionary perspective to the advent of cryptocurrencies, the chapter begins by describing their history and development starting with the emergence of alternative currency and the emergence of blockchain and Distributed Ledger Technology (DLT). The chapter then proceeds to highlight the complexity of cryptocurrencies by describing the multi-player ecosystem in which they operate including miners, developers, and the various cryptocurrency financial intermediaries. This is followed by highlighting the issues of regulatory concern raised by cryptocurrencies in order to gain an understanding of the motivation and rationale for their regulation. The chapter then concludes by discussing the key insights from this consideration of what cryptocurrencies are, how they operate, and why they need to be regulated.

1.2 History and development

1.2.1 Emergence of alternative currency

The first step in the evolution of cryptocurrencies was the introduction of the notion of alternative currency. Alternative currencies, which are unconventional ‘objects of monetary value’, ¹ are the earliest conceptual iterations of what have now evolved into cryptocurrencies. Alternative currency can come in the form of global and local community currencies; examples of local community alternative currencies within the United Kingdom (UK) are Transition Town Pounds, Time Banks, and Local Exchange Trading Systems (LETS). ² These were designed for specific purposes, such as the regeneration of local areas, addressing social exclusion, and the addition of value to unpaid work. Examples of Transition Town Pounds are the Totnes ³ and Brixton Pounds, which are paper notes with legal status equivalent to a retail voucher, with restrictions to a particular geographical community. ⁴ However, the majority of alternative currencies are of a more global and universal nature, and include items such as tokens, loyalty schemes, credits, or points earned in games and virtual or online worlds. The latter are early examples of Virtual Currency (VC), which mainly have been restricted to in-game use as units of value in online or virtual gaming communities. In this way, VC is ‘a type of unregulated, digital money, which is issued and usually controlled by its developers, and used and accepted among the members of a specific virtual community’. ⁵ Often used synonymously, Digital Currency (DC) is ‘a privately issued code or serial number representing value that is circulated online’. ⁶

1 Parliamentary Office of Science and Technology, ‘Alternative Currencies’ (POSTnote Number 475, August 2014) <http://researchbriefings.files.parliament.uk/documents/POST-PN-475/POST-PN-475.pdf> Accessed 7 June 2016. 2 Ibid. 3 The Totnes Transition Town Pounds experiment ended in March 2019, citing a decline of use partly due to an increasingly cashless economy. For further details, see <https://www.transitiontowntotnes.org/2019/03/totnes-pound-celebration/> 4 Parliamentary Office of Science and Technology (no. 1). 5 European Central Bank, ‘Virtual Currency Schemes’ (ECB, 2012) <https://www.ecb.europa.eu/pub/pdf/other/virtualcurrencyschemes201210en.pdf> Accessed 7 June 2016. 6 P Mullan, The Digital Currency Challenge: Shaping Online Payment Systems through US Financial Regulations (Palgrave Macmillan, New York, 2014) 4.

Early VCs and DCs had a central managing authority, usually in the form of a game developer, who ‘directly or through software managed the issuance, storage, and redemption of the in-game currency and who may have validated, tracked, and recorded transactions’. ⁷ Examples of these operating in 2012 are Arena Net’s Guild Wars 2, Iceland’s CCP Games, and Valve Corporation, which aimed to create a shared currency across two virtual environments. ⁸ Second Life and its Linden dollar is another example of a closed virtual community with its own VC. Launched in 2013 by Linden Labs, Second Life is an online world that allows real-life purchases in the game through Linden dollars. Although now in decline, ⁹ Second Life’s Linden-based economy was highly liquid, even ‘producing its own millionaire, Anshe Chung, who made a very real fortune from buying and selling property that existed only on Second Life servers’. ¹⁰ This ability to have bi-directional flows of value between virtual and ‘real’ worlds led to an extension of the use of VCs beyond the gaming world into the everyday economy, mostly as a way to launder the proceeds of criminal activity. An example of this is Liberty Reserve, an online bank that converted local currencies to Liberty Reserve dollars. ¹¹ More recent examples of post-gaming VCs include the now defunct Facebook Credits facility and Amazon Coins, ¹² which sought to use their own platform-specific virtual currency to facilitate transactions on their websites. ¹³ The concept and functionality of digital and virtual currencies was incorporated and augmented by the introduction of cryptocurrencies. Cryptocurrencies are ‘digital currencies that rely on a cryptographic protocol to regulate the manner in which (and the extent to which) currency can be created and/or exchanged’. ¹⁴ The evolutionary leap that distinguishes cryptocurrency from VC and DC is the use of peer-to-peer networking ¹⁵ and cryptography, ¹⁶ to maintain the integrity of a technologically sophisticated system underpinned by blockchain and DLT.

7 M Berta and W Noonan, ‘The Property-Contract Duality of Bitcoin’ (Financier Worldwide Expert Briefing, June 2015) < https://www.financierworldwide.com/the-property-contract-duality-of-bitcoin#.XeUdyNXgqUk> Accessed 7 June 2016. 8 P Gross, ‘A History of Virtual Currency: Why Bitcoins Shouldn’t Surprise You’ (CFA Institute, 2014) <https://annual.cfainstitute.org/2014/01/10/a-history-of-virtual-currency-why-bitcoins-shouldnt-surprise-you/> Accessed 7 June 2016. 9 According to the New World Notes blog, Second Life has about 60,000 premium subscribers in 2019, up by 3000 from 2017 low point, but still below 2012’s peak of 70,000, see <https://nwn.blogs.com/nwn/2019/05/sl-premium-subscriptions-linden-lab-tyche.html > Accessed 2 December 2019. 10 B Collins, ‘Whatever Happened to Second Life?’ (Alphr, 4 January 2010) <http://www.alphr.com/features/354457/whatever-happened-to-second-life> Accessed 7 June 2016. 11 Gross (no. 8). 12 R Satran, ‘6 Virtual Currencies that Went Bust’ (US News, 13 May 2013) <http://money.usnews.com/money/personal-finance/slideshows/6-virtual-currencies-that-went-bust/9> Accessed 7 June 2016. 13 These two initiatives preceded Facebook’s Libra cryptocurrency initiative and Amazon’s blockchain activities. For more details on both projects, see <https://www.ccn.com/facebook-amazon-libra-threat/> Accessed 2 December 2019. 14 P De Filippi, ‘Bitcoin: A Regulatory Nightmare to a Libertarian Dream’ (2014) 3(2) Internet Policy Review 1, 1. 15 As explained by techterms, ‘in a P2P network, the “peers” are computer systems that are connected to each other via the internet. Files can be shared directly between systems on the network without the need of a central server’. <https://techterms.com/definition/p2p> Accessed 2 December 2019. 16 Cryptography is a ‘method of protecting information and communications through the use of codes so that only those for whom the information is intended can read and process it’. <https://searchsecurity.techtarget.com/definition/cryptography> Accessed 2 December 2019.

1.2.2 Emergence of blockchain and DLT

The second significant concept necessary to understand cryptocurrencies, after that of VC and DC, is that of ledgers. Used in bookkeeping and accounting, ledgers have been a part of the earliest banking systems as a means to facilitate payments. For example, when goldsmith banks emerged in the 16th century, ‘they kept ledgers of their customers’ deposits which enabled payments to be made by making changes in the ledgers rather than physically exchanging the assets’. ¹⁷ This ledger-keeping function of banks was made universal by the introduction of central banks to settle interbank obligations and maintain confidence in the convertibility of bank liabilities into cash at par. ^{18 ...}