As cryptocurrencies gain interest from investors around the globe, Wei-Shen Wong examines the splintered Asian marketplace to see how regulators are adopting different strategies when it comes to overseeing these complex instruments.
It could be said that 2017 has been the year of digital currencies. Distributed ledgers like blockchain have received a lot of hype, but it’s been the digital currencies that have hit the markets, posing new opportunities and challenges to both investors and regulators.
Much like the currencies themselves, the focus on these instruments in Asia, specifically, has been volatile. Some regulators in the region have issued warnings to investors, particularly regarding the speculative nature of digital currencies and initial coin offerings (ICOs). Some countries, including China, have taken extreme measures and have banned ICOs altogether.
Despite China’s stance, some regulators in the region have been seemingly more open and proactive than their Western counterparts when it comes to digital currencies. Japan, for example, whose central bank, the Japan Financial Services Agency (JFSA), approved 11 digital currency exchanges on September 29 this year. This came after the regulator legalized digital currencies earlier in the year. The decision called for all companies trading fiat for digital currencies to register as a “virtual currency exchange” business.
Digital currency exchanges have had six months to complete their registration and have also had to go through rigorous vetting processes, with a focus on cybersecurity, anti-money-laundering/know-your-customer (AML/KYC), user protection, and data security.
According to Bitcoincharts, a data provider focused on bitcoin, about 50 percent of all trading volume of bitcoin is in Japanese yen, while slightly more than 30 percent of volume is in US dollars. David Case, Tokyo-based partner of international law firm, Orrick, Herrington & Sutcliffe, adds that the dollar is widely used around the world so not all US dollar-denominated trades can be attributed to the US market.
For ‘Adults’ Only
Case says the JFSA requires market entrants to implement the same internal controls that banks and other financial institutions have for more traditional instruments.
“Regulators do not want the Wild West; it’s a financial market—adults only need apply,” he says.
According to Case, 11 applicants were recently granted licenses. “I understand that another 17 applications are under review and 12 other firms had to shut down their operations after being denied licenses, but there are no firm details,” he adds.
For those that “shut down,” this may just be temporary while waiting for approval after working on their offering. Case adds that Orrick knows of companies in this position, and is working with several on their application processes.
By putting it all down in the rulebook, the JFSA is being proactive in order to prevent possible currency manipulation or fraud. What the regulators do not want is a repeat of the collapse of the Mt. Gox exchange in 2014, which at one point handled 70 percent of all bitcoin transactions globally. Mt. Gox filed for bankruptcy in 2014 after losing its customers’ bitcoins as well as some of its own, racking up losses close to $500 million.
Jon Matonis, vice president of corporate strategy at bitcoin and blockchain research firm nChain, classifies the JFSA’s move as methodical and says this is its way of being cautious. “While it’s encouraging, those exchanges have to now adhere to capital requirements, operating security standards, annual audits, employee training programs, all in addition to KYC/AML requirements,” he says.
He adds that the development of bitcoin in Asia is more prevalent where fintech activity is strong—for example, in Japan, Hong Kong, Singapore and South Korea.
Japan is now the only major advanced economy to regulate crypto-token exchanges, which also makes it the largest domestic market globally for crypto-token trading activity, he says.
Thomas Glucksmann, head of marketing at Gatecoin, a bitcoin and ethereum token exchange based in Hong Kong, says the JFSA’s move has encouraged major Japanese financial institutions such as GMO Group, which made a $3 million investment to build out its bitcoin mining operations, and SBI Group—which has invested in bitcoin companies Kraken, bitFlyer and Wirex, among others—to enter the crypto space.
“Eventually, these firms may offer their new crypto exchange services in conjunction with their existing financial service product portfolios,” he says. “The big three—Mitsubishi UFJ Financial Group (MUFG), Sumitomo Mitsui Financial Group (SMFG) and Mizuho—are also experimenting heavily with cryptocurrencies by creating their own tokens, working with crypto-token exchanges and even investing in some of them.”
As part of its research into blockchain and distributed-ledger technology, MUFG developed its own digital currency—MUFG coin, which was distributed as a reward to employees. Other Japanese banks, such as Mizuho Financial Group and Japan Post Bank, have teamed up to introduce J-Coin—a new digital currency—ahead of the 2020 Tokyo Olympics. “Regulators from other advanced economies would be foolish to ignore the positive developments in Japan,” Glucksmann says.
Japan’s actions in this case might push other jurisdictions in the region to re-evaluate their own policies on digital currencies, adds Orrick’s Case. “It is rare that Japan leads in a new financial industry or technology. The Japanese financial markets are large and mature and it could provide a highly stable platform for virtual currencies worldwide. Japan has made a conscious decision to lead in fintech. Virtual currencies are one part of that strategy. I think you will see many other fintech-based industries getting a green light in Japan,” he adds.
On the Mainland
Benjamin Quinlan, CEO and managing partner at Quinlan & Associates, says that given the volatile nature of bitcoin and digital currencies in general, cryptocurrency is mainly used as an investment or speculative tool. This is one of the reasons why, in September, China’s central bank, the People’s Bank of China (PBoC), banned all ICOs and digital currency platforms. “In China, regulators do not support speculation—for example, regulators opened up the derivatives market gradually in order to limit speculation from retail investors—and with little control or regulatory supervision, the Chinese government seems to be unsupportive of cryptocurrencies,” he says.
China is adopting a much more conservative stance, as its market is so heavily retail-driven. Given the speculative tendencies of retail investors there, the regulator needs to ensure that it is in control of the situation, Quinlan adds.
Gatecoin’s Glucksmann believes the ban was in response to a surge in illegal financing schemes in mainland China that were targeting vulnerable investors through grassroots marketing in fourth- and fifth-tier cities. “The organizers of those illegal schemes exploited the ICO trend and the government decided to put the lid on things while they worked to understand what was going on,” Glucksmann says. “It is likely that this ban will be lifted soon, and legitimate token sales will be permitted to take place in China under specific guidelines.”
However, there is another school of thought. Some, including nChain’s Matonis, say China’s move to ban ICOs is its way of shutting down those who are evading capital controls and taking their money out of China. “Officially they say it’s for consumer protection or they don’t encourage the use of high leverage, but their main concern is people evading capital controls,” he says. “They are protective of the currency value of the yuan. They get upset when people in China who operate bitcoin exchanges say that bitcoin will hold its value while the Chinese currency will not. Not all governments will think about that the way China does.”
But Dominic Cho, managing consultant at GreySpark Partners, Asia, in Hong Kong, says the PBoC does not understand the purpose of ICOs. “I think the Chinese regulator is extremely sensitive to anything that has a market impact that they do not have a full grasp on. The PBoC didn’t mention they would ban bitcoin mining or trading, so for miners, it’s business as usual for now,” he says.
Glucksmann adds that while bitcoin mining is not affected by the ICO ban, it is likely to be severely impacted by the shutdown of exchanges on the Mainland as miners still need a way to cash out their bitcoin for renminbi to pay their staff and electricity bills.
“Some of these mining firms will shut down in China and will set up in new jurisdictions or declare bankruptcy altogether,” he says. “The result would be a more geographically distributed mining industry where the hashing power is not concentrated among a handful of Chinese firms.”
Although Singapore has been touted as the fintech hub of Asia, it is taking a more cautious approach to digital currencies. The Monetary Authority of Singapore (MAS) recently said that while it does not recognize bitcoin as legal tender, it is looking to regulate companies providing bitcoin payment services.
A spokesperson from MAS says that similar to most other jurisdictions, the central bank does not regulate virtual currencies, but rather the activities surrounding them, especially if those activities are within its general ambit as a financial regulator.
“First, virtual currencies, due to the anonymous nature of the transactions, can be exploited for money laundering and terrorism financing. MAS is working on a new payment services regulatory framework that will address these risks. We intend to initiate industry consultations on the proposed regulations for virtual-currency intermediaries soon,” the spokesperson says.
The second activity the Singaporean regulator is keeping a close watch on is ICOs. To the startup community, ICOs can be seen as an alternative to venture capital and could represent ownership in assets, like a share or bond certificate. In June, Singapore-based TenX, which built a protocol that enables quick and secure transactions across different blockchains, raised $80 million within seven minutes.
MAS has been paying close attention to activities relating to the offer or issuance of such “second-generation” tokens, given the observed increase in ICOs in Singapore. Then, in August, MAS clarified that the existing securities regulatory regime will apply to offers of digital tokens where the tokens constitute securities, which would mean that issuers or intermediaries of such tokens would be subject to licensing requirements under the Securities and Futures Act and Financial Advisers Act. If subject to licensing requirements, the issuer or intermediary of such tokens would have to adhere to anti-money laundering and countering the financing of terrorism (AML/CFT) regulations, according to the regulator.
“MAS sees the risk that even legitimate ICO activities could potentially be abused for money laundering, terrorist financing, and fraud,” says the spokesperson. “Companies that provide such services should have effective AML/CFT controls, including robust customer due diligence and transaction-monitoring processes that serve as preventative measures against illicit activities, to protect the integrity of our financial system.”
That said, MAS has not introduced any new regulations specific to offers of digital tokens. The regulator believes that regulation must not front-run innovation, as introducing rules prematurely may stifle innovation and potentially derail the adoption of useful technology. “We must also remain technology-neutral, allowing for innovation to choose the best path to success,” adds the spokesperson. “At the same time, MAS is closely monitoring the development and implications of digital tokens offerings in Singapore and other parts of the world, as well as taking note of the evolving regulatory approaches taken toward such offers across different jurisdictions.”
Adrian Przelozny, CEO at digital currency marketplace Independent Reserve, based in Australia, says that traditionally, jurisdictions such as Korea, Japan, and Singapore tend to be a bit more welcoming to innovation and helping nascent industries grow. Australia, on the other hand, tends to be more conservative and more risk-averse. Still, Australia recently closed its first ICO, issued by Perth-based energy trading startup Power Ledger, which uses a blockchain for households to trade surplus solar power, and which raised AUD34 million ($26.7 million) for its POWR token.
According to media reports, a number of banks in Singapore closed the accounts of several startups dealing with and in digital currencies. The Cryptocurrency and Blockchain Industry Association says more than 10 companies reported having issues with Singapore banks and that there were no reasons for the closing of accounts. One of the companies, Coinhako, a digital currency exchange and wallet service, announced that it had to stop processing Singapore dollar trades because its banking partner, DBS Group Holdings, closed the company’s account. This issue presents a significant risk to digital currency businesses, says nChain’s Matonis. “If you’re an exchange and you are converting to fiat money, they will struggle,” he says. “They need more than one banking account as well. If there’s a change in political atmosphere that is negative, no banks will even open an account for a bitcoin exchange.”
Independent Reserve’s Przelozny says the exchange works closely with the banks it uses. “We use strict policies that go over and above the policies used by our own banks,” he says. “We try to work with the compliance and risk departments to make sure they are comfortable with what we’re doing.”
The exchange behaves as if it were a regulated entity, he adds. “This is definitely a challenge for the industry, but with more regulations coming in, and once they are in, banks will see it as a smaller risk,” he says.
James Kyd, general manager of strategy and operations, architecture, and CTO, technology, innovation and strategy at Telstra, whose views are his own, says he is aware of one exchange in Australia that is caught up in a similar problem to the one in Singapore, and is having to change bank accounts because its existing ones keep getting closed. “I don’t know if it’s because the startup is not close enough to the bank for it to know and be comfortable with it. The activities on the account just throw up red flags due to the nature of the business, and when banks see those red flags, they will shut it down. I suspect there’s a path forward there, to understand what the company is doing and what needs to be put in place,” says Kyd, but that still needs to be worked out by the industry as a whole.
Another challenge that exists is for authorized and properly licensed market players to rise above the market noise of unlicensed players. Orrick’s Case says that at this point, consumers are having a difficult time distinguishing which ICOs are legal and which aren’t. While he says he believes this will change over time, there is a lot of market noise for authorized players to overcome. “They need to prosecute the truly bad players,” Case says, referring to how regulators can ensure investor protection. “That will dissuade poorly designed products and services being offered,” he says. “Some of the people offering virtual currencies have good intentions, but are woefully ill-informed about financial markets and compliance. Prosecuting bad players will force new entrants to engage with legal counsel to make sure the ICOs offered are legally compliant.”
GreySpark’s Cho says he expects regulators to take an even greater interest in cryptocurrencies in the future, but right now the timing is tough because firms across the globe are grappling with an even greater regulatory regime—the revised Markets in Financial Instruments Directive, or Mifid II. “Overall motivation for regulators around the world to regulate trading in digital currencies is clear, but it is more of a timing issue. Given Mifid II’s go-live on January 3, 2018, is imminent, regulators do not have a compelling reason to consider regulating digital currencies just yet,” he says.
Operators, exchanges, traders, and investors are waiting to see what actions regulators will take and how that will impact the digital currency market in the future. As more and more regulations are introduced, will they help secure and protect the true players, or will they stifle innovation? Perhaps 2018 will be the year that these questions are answered.
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