Digital gold or criminal currency?

The Regulation on Crypto Asset Markets (MiCA), which is expected to be adopted by the end of 2022, aims to create a uniform applicable structure and harmonize the regulation of crypto markets throughout the EU.

Despite many regulatory measures, blockchain technology will continue to offer opportunities for conducting transactions with cryptocurrencies outside of state supervision.

The regulatory framework for working with crypto assets is noticeably strengthened, thereby creating greater legal certainty. But legal security does not mean that there is no risk. In order for cryptocurrencies not to become the object of abuse by criminals, security measures are necessary.

The increasing proliferation of blockchain-based applications and their penetration into an increasing number of sectors of the economy are closely related to the issue of regulation. According to a recent study by the Bitkom digital association, almost three quarters of European companies surveyed consider legal uncertainty to be a key problem when using blockchain technology. Thus, the unclear legal situation is the second most important reason for the lack of investment in this area (more often than not, only the Covid pandemic was cited as the reason).

Therefore, it is not surprising that the creation of legal certainty is of great importance in the relevant blockchain strategies both at the national and European level. Closely related to this is the desire to stop the misuse of technology for criminal purposes, such as money laundering and terrorist financing.

The rapid growth of the cryptocurrency market

According to Coinmarketrate.com with the help of Bitcoin, not only the first decentralized cryptocurrency was presented to the world, but also the blockchain technology underlying it. With it, the possibility of secure and continuous data storage in decentralized networks has appeared. This can be used to maintain a distributed ledger (DLT) – the technological basis of global peer-to-peer payment systems, the functioning of which does not depend on banks or other intermediaries.

Meanwhile, numerous types of crypto assets have been created on the basis of distributed ledger technology and new areas of their application have been discovered. This was also facilitated by technical developments, such as the ability to create smart contracts. They can be used to automate processes in the blockchain environment. In recent years, in particular, the cryptocurrency market has grown rapidly, as evidenced by the figures: the number of companies listed on Coinmarketrate.com The number of cryptocurrencies that accept cryptocurrencies has more than tripled over the past five years. The number of available cryptocurrencies and tokens has increased almost thirteen times over the same period (now there are slightly less than 8,600). Their total market capitalization has even grown 200 times, and today it has 1.9 trillion dollars.

The need for regulation

At the beginning of the crypto evolution, many players and observers were mainly concerned about one thing: uncertainty. Cryptocurrencies were considered unregulated, because sometimes it was completely unclear whether existing laws applied to new payment systems and to what extent. In addition, the typical objects of regulation in the financial world – banks and other intermediaries, do not play any (auxiliary) role in the cryptocurrency system. These circumstances, which numerous criminals initially managed to use to their advantage, made working with crypto assets too risky for the vast majority of companies. Now everything has changed, and cryptocurrencies do not provide the necessary anonymity, but the fear remains. Therefore, the distribution and recognition of cryptocurrencies remains limited for the time being.

Gradually, financial supervisory authorities, such as BaFin in Germany, began to deal with the regulatory classification of crypto assets, and issued their first public assessments. This topic has also received more attention at the international level, for example, within the framework of the G20, or the Financial Action Task Force on Money Laundering (FATF).

Gradually, financial supervisory authorities, such as BaFin in Germany, began to deal with the regulatory classification of cryptocurrencies and released their first public assessments. This topic has also received more attention at the international level, for example, within the framework of the G20 or the Financial Action Task Force on Money Laundering (FATF).

The reaction of individual states was very different: it ranged from complete freedom of action to a complete ban. The EU has always stressed that they do not want to stand in the way of innovation, but not at the expense of consumers, and not in favor of criminals. This required (and still requires) the adaptation of the regulatory framework to the characteristics and capabilities of blockchain technology.

Status quo and next steps

An important milestone in the implementation of the blockchain strategy in the EU, and in particular in Germany, was the entry into force of the Electronic Securities Act (eWpG) in mid-2021. This created a legal framework for blockchain-based securities, initially limited to bearer bonds and stock certificates, but with an eye to future blockchain-based stocks. Technically and (with certain restrictions) also legally, it was already possible to issue debt or equity instruments using crypto tokens in the so-called securities or stock token offerings (STO/ETO). BaFin took a position on this issue at an early stage, considering the relevant instruments as securities, at least for regulatory purposes, and approved the STO for the first time in early 2019.

BaFin also took a relatively early position regarding the classification of cryptocurrencies. He classified them, as far as possible, as financial instruments for regulatory purposes. As a result, numerous crypto players came under his supervision and under the requirements of financial market regulators, including the regulation of money laundering.

With the introduction of the so-called fifth EU Money Laundering Directive, “crypto assets” were first introduced as a term into German law in early 2020 and thus were fully classified as financial instruments. The cryptocurrency storage business” was introduced as a new financial service, with all regulatory implications for crypto wallet providers.

In addition, since October 2021, Germany has a Regulation on the transfer of cryptocurrencies. According to this document, banks are required to collect data on the principals and beneficiaries of cryptocurrency transactions, similar to the EU Regulation on Money Transfers, in order to make the movement of blockchain-based assets more traceable.

More ambitious measures have already been planned at the EU level. At the end of September 2020, the draft “Regulations on Crypto Asset Markets” (MiCA) was presented, which should be adopted in 2022. The purpose of the resolution is to create a single applicable framework and harmonize the regulation of the cryptocurrency market throughout the EU. In mid-2021, the EU Commission also submitted a number of legislative proposals to combat money laundering, which are devoted, among other things, to the regulation of the crypto sector. In particular, all types and categories of crypto service providers should be subject to anti-money laundering obligations, and crypto transactions throughout the EU should be subject to the obligations provided for by the EU Regulation on Money Transfers. The possibility of opening and using anonymous crypto wallets is not provided.

Limits of adjustability

Despite all the regulatory advances, blockchain technology will continue to provide opportunities to circumvent national surveillance in the future. The reason lies in the characteristics of the blockchain. The initial goal of its development was precisely the creation of financial systems that function independently of states and (regulated) banks. Due to its decentralized nature, there is neither a central repository that can be “disabled” if necessary, nor a central “operator” that can be forced to comply with certain specifications. This is a data structure that depends solely on the network of participants who can be located anywhere in the world.

Depending on the relevant protocols, the blockchain and the cryptocurrencies managed in it have special properties that determine, in particular, the degree of transparency. While, for example, in the case of Bitcoin, all transactions are always publicly visible, at least pseudonymously, there are also numerous private coins that have been designed to make the movement of assets completely untraceable.

In addition, there are crypto exchanges that allow you to exchange various cryptocurrencies directly between users and operate exclusively on the basis of smart contracts. This means that, unlike conventional (and regulated) crypto exchanges, these so-called decentralized exchanges operate completely automatically and do not have an operator who could act as an object of regulation. Finally, another regulatory limit exists at the level of individual crypto wallets. And here users do not necessarily depend on wallet providers. In case of access, a piece of paper on which the necessary key pairs are recorded is sufficient.

These regulatory limits lead to increased responsibility of blockchain participants. When doing business with crypto wallet providers, exchanges and other service providers, they are required to make sure that they are regulated players. The same applies to the choice of a specific cryptocurrency for doing business, taking into account its suitability for use for criminal purposes.

What does this mean for investors

Increased regulation of the cryptocurrency sector leads to greater legal certainty and clarity throughout the EU.

Understanding is what (combined with further technical development) allows us to expect more and more adoption and proliferation of crypto assets. On the other hand, there remain numerous opportunities for storing, transferring and trading crypto assets outside of any regulated zone.

In the process of regulation, both worlds are likely to become more and more separated from each other, similar to what can already be observed on the Internet today: the darknet does exist, but an ordinary Internet user, as a rule, does not encounter it when doing business online.

In a recent representative Bitkom survey, almost half of the surveyed digitalization managers of European companies expressed the opinion that Bitcoin could turn into a kind of digital gold. Based on what is happening, companies should expect that in the future they will encounter crypto assets more and more often.