Regulating the no man’s coin – the rapid rise of cryptocurrencies has regulators scratching their heads

In September 2017, China’s long-rumoured restrictions on cryptocurrencies trade came into effect, sending the global prices of digital tokens reeling. Within weeks, bitcoin—the oldest and largest cryptocurrency—lost close to 40 per cent of its value, equal to around $30 billion.

Supporters of digital coins are hoping that China’s move to ban most cryptocurrency transactions is only a temporary freeze. They argue that the global market, estimated at close to $200 billion today, is too tempting to shrug off and that China, which accounts for a large part of that market, will eventually substitute the ban with comprehensive cryptocurrency legislation.

But China is far from being the only country to zero in on digital coins. With the financial crisis of 2007–2008 still fresh in memory, state regulators and central banks are increasingly wary of the blockchain bonanza. They fear that the digital-only money could turn out to be an overblown bubble, ready to burst and send shockwaves throughout the “real” economy.

Most countries do not go as far as China and instead try to rein in the largely unregulated cryptocurrency market by incorporating it in their financial and banking system and applying the associated rules and laws.

A few years ago, the Fed and the European Union central bank began accepting cryptocurrencies as virtual currencies. More recently, the Islamic Republic of Iran started preparing the use of cryptocurrencies as one of its legal payment methods. Ukraine introduced a legislation that proposes to tax the gains from “mining” and trading of cryptocurrencies. The Russian Federation is expected to regulate its market next year.

This variety of approaches to cryptocurrencies reflects the ongoing debate on the very fundamentals of the phenomenon. Legislators and market watchdogs are struggling to classify cryptocurrencies, which elude classic, pre-Internet definitions. Opposing factions fail to agree on how to regulate cryptocurrencies and even on whether to regulate them at all.

Even if consensus is finally reached, regulating the decentralized cryptocurrencies will be fraught with difficulties. China’s recent ban is a blatant case in point. Faced with the September blockade, online businesses simply registered elsewhere and continued with their trade. Within a month of the collapse, cryptocurrencies made up their losses and continued their spectacular growth as if nothing happened.

Decentralized and autonomous, cryptocurrencies are governed by the users’ consensus over a set of rules. They are independent from political influence and actions of monetary authorities. This also means, that in case of cryptocurrencies’ non-compliance with a country’s laws or regulations, there will be no institution to hold accountable.

Yet, despite these challenges, countries have serious reasons for trying to regulate the cryptocurrency market: shielding the economy from another burst bubble, protecting their citizens from uninformed decisions that could cost them their savings and making it difficult for money launderers to move cash across borders.

The very nature of cryptocurrencies makes them a likely candidate for the next financial bubble. “Traditional” assets, such as stocks, bonds, real estate, commodities or other currencies, are underpinned by real-life factors, such as the economic performance of a company or a country, housing situation or the availability of a natural resource. Although the value of these assets is also occasionally inflated, the risk of becoming a financial bubble becomes much greater without such anchors in reality.

Cryptocurrencies have no physical grounding and their price is determined largely by the demand. This means they are worth only as much as users are prepared to pay for them at any given moment, making them highly susceptible to volatility and sudden price changes. For example, earlier this month, bitcoin posted a sudden dip of 29 per cent, losing $38 billion in a matter of days. Certainly not an investment for the faint of heart.

The critics of cryptocurrencies include some prominent global financiers, such as the JPMorgan Chase Chief Executive Jamie Dimon, who recently suggested that bitcoin was mostly useful for “drug dealers and murderers.” While this is an extreme view, it is true that cryptocurrencies have been used for money laundering, tax evasion and dodging international sanctions. Governments wishing to tighten their banking and tax systems to prevent these practices, will have to carefully monitor the new market of digital coins.

Nobody can accurately predict the development of cryptocurrencies. If their staggering growth continues, cryptocurrencies could eventually become a viable competition for national currencies, affecting the deposits and balance sheets in commercial and central banks. This could ultimately lead to the end of the monetary system as we know it today.

To further explore the topic of cryptocurrencies, download the latest Monthly Briefing on the World Economic Situation and Prospects here.

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