Legal framework and risks of virtual currencies

May 2018 | SPOTLIGHT | BANKING & FINANCE

Financier Worldwide Magazine

May 2018 Issue

In 2009, and against the backdrop of the financial crisis of 2007-2008, an anonymous person or group called ‘Satoshi Nakamura’ created the first decentralised virtual currency, or cryptocurrency, the Bitcoin. Much more revolutionary than the cryptocurrency Bitcoin itself, however, was the technology behind it: the blockchain. The idea of a network of users that validates transactions through its user collective instead of a middle man (a bank) was groundbreaking. Transactions can take place much quicker, easier and cheaper. The technology is not limited to virtual currencies but can work for almost every type of transaction between parties.

Essentially, with blockchain, the information of a transaction is stored in a data block (block). In this block, users have solved the arithmetical problem underlying the transaction (mining) and distributed it to the network. If the majority of the network approves this solution (proof-of-work), the new block is connected to the previous block via a cryptographic step, a unique thumbprint (hash). This creates a chain of transaction blocks that is further supplemented, the blockchain. All blocks are publicly accessible in a decentralised register (ledger) and distributed to all members of the network (peer-to-peer structure). Due to the uniqueness of each hash and the publicity of the ledger, the blockchain is extremely secure against manipulation.

Regulatory standard regarding virtual currencies

Since this new technology has emerged and grown stronger, so too has the need for regulation. With an estimated 1400 different virtual currencies based – for the most part – on the blockchain, regulators are having a hard time. Currently, there are barely any clear laws or regulations in place and even those that do exist differ from country to country and even from state to state, not least because the virtual currency market is in constant flux. Attitudes toward virtual currencies could not be more diverse, seeing as their handling ranges from outright bans to complete regulation. Meanwhile, a worldwide trend is beginning to emerge which will further regulate virtual currencies and potentially introduce the same state of regulatory density as ordinary currencies, including the same risks and opportunities.

A closer look at the EU – including the UK – reveals that so far, there is no common take on cryptocurrencies. Its overall approach toward the blockchain technology is rather positive and welcoming, though, seemingly following the path of an innovation-driven business philosophy, supporting the development of virtual currencies. This is particularly evident as the Council of the EU is currently introducing a 5th Anti-Money Laundering (AML) Directive which will be adopted sometime in 2018 and which, among other changes, will introduce a world-first definition of ‘virtual currencies’ and will oblige exchange platforms, as well as wallet providers, to comply with its AML stipulations.

The EU also planned to discuss a regulatory framework for cryptocurrencies at the G20 summit in March 2018. Ultimately, however, the international consensus consisted only in setting up a committee to submit proposals for a possible regulation of virtual currencies by July 2018. This was due, in particular, to the assessment of the Financial Stability Board (FSB), which does not attach sufficient importance to virtual currencies at the present time. Moreover, it was agreed to classify virtual currencies as property which, however, contradicts the decision of the European Court of Justice in 2015, in which it characterised cryptocurrency as akin to ‘real money’ to which no value added tax (VAT) would apply. It remains to be seen how this contradiction will be resolved. For the time being, and until consensus is found, the European Banking Authority indicated that it will apply AML and anti-terrorist financing rules to virtual currencies.

With a view to the US, things are no better. There is no federal regulation of virtual currencies. The only regulation to date has been a smattering of state level rules and fragmentary rulings or recommendations by some federal agencies. So far, the SEC has denied approval for any exchange-traded products comprising cryptocurrencies for listing or trading and requires licences for trade while lately having enforced their actions against fraudulent Initial Coin Offerings (ICO). The CFTC classified Bitcoin as a commodity and allowed the launch of Bitcoin futures and trading platforms. The IRS added that Bitcoins were to be seen as property for tax purposes, with profits made on virtual currency to be declared while the Department of Treasury announced that it planned to review the Financial Crimes Enforcement Network’s (FinCEN’s) cryptocurrency practices relating to AML and terrorism financing risks.

While Russia cannot seem to decide on its approach to virtual currencies and is already criticising its newly proposed law as too strict, other countries have taken a stand. The most notable ‘disrupter’, in this context, is Japan, which passed a law accepting Bitcoin as legal tender in late 2017. The Marshal Islands followed suit by introducing its own cryptocurrency, the ‘Sovereign’, as legal tender which will be issued later in 2018, just like Venezuela which issued its ‘Petro’ in February 2018. At the other end of the spectrum, Bangladesh passed a law in 2014 imposing stiff fines on anyone using virtual currencies – just like Ecuador and lately Vietnam. China has labelled virtual currencies a ‘disruption to the financial order’, outlawed ICOs and banned token sales. Similarly, South Korea is on its way to banning virtual accounts currently used for cryptocurrency trading and will only allow authenticated bank accounts for new trades, seemingly trying to bring trading with virtual currencies under state control.

Legal and other risks relating to virtual currencies

Due to their novelty and technical peculiarities, their lack of national and international regulation and unpredictable developments, virtual currencies carry a variety of risks.

The immutability of the blockchain, for one, is diametrically opposed to the European data protection principles such as the rights to rectification, to erasure and to be forgotten. There are several ways to force alterations on a blockchain despite its immutability – such as forking, the 51 percent attack or a chameleon hash. However, these extreme measures are not really suitable to regularly change or remove the personal data from the blockchain once they have been entered; this is simply not intended. Practice will show how future generations of blockchain will deal with this problem and whether the blockchain might not even have potential with regard to data protection and the principle of privacy by design.

In view of the varying regulations of virtual currencies another problem is that it may vary from country to country whether the possession or trade in virtual currencies is legal.

In addition, there is the issue of unwanted, non-transaction-related content – so-called non-financial arbitrary data – in the blockchain. This content is inserted via the commentary function of the blockchain for transaction-related information. By abusing this mechanism illegal or at least controversial content (e.g., child pornography, politically sensitive content, copyright infringements) is entered into the blockchain. Due to the immutability of the blockchain, it cannot be removed retrospectively and thus can illegalise an entire blockchain system. Already, the possession of the blockchain would then be sanctionable by law. Newer generations of the blockchain will implement appropriate security mechanisms by default as a precaution; older versions can only, but hardly, fall back on the chameleon hash or forking.

In terms of money laundering or terrorist financing, there is, contrary to public opinion, no greater risk than with conventional currencies, even though misuse admittedly was a big problem in the early days of Bitcoin & Co. It is still a common misconception that Bitcoins are anonymous when, at best, they are pseudonymous. But other virtual currencies featuring even more secure ‘anonymity protocols’, such as Monero, are traceable by way of back and probability calculation and by cross-referencing additional transaction data. Besides, the IP address of a computer can be logged and even mixing services used to conceal the origin of virtual currencies have their limitations. In fact, a study by the National University of Singapore established that law enforcement is usually successful in tracing back virtual currency transactions in 88 to 98 percent of cases – a higher percentage than with paper money.

From a tax law perspective, allowing virtual currencies as means of payment poses a risk insofar as the wrong classification of taxes might constitute tax evasion if processes are not adapted accordingly.

Yet, the risks arising are very similar, if not the same, as with foreign currencies. Corporate tax (and trade tax, if applicable) is to be considered when cashing in exchange rate gains, whereas withholding tax should not be of importance and VAT is, at least in the EU, not applicable.

Another problem of the immutability of the blockchain is that it cannot do justice to constructs where contracts are rescinded or nullified in retrospect, which can be of particular significance in connection with so-called smart contracts. Such considerations and contingencies cannot be integrated into the blockchain by default and would thus leave the blockchain representing an incorrect legal status under civil law. A legally-compliant status could then only be brought about by fictitious transactions that are fed into the blockchain until the original error has been corrected.

Besides, those most vulnerable to the mishaps of virtual currencies are, as usual, consumers. This is particularly relevant given that, in general, no consumer protection rules apply to virtual currencies, meaning that deposits of virtual currencies are not protected by bank deposit insurance. Likewise, there are no systems or mechanisms required by law to protect those assets from theft or hacking.

Still, the risk of being hacked is not confined solely to virtual currencies and their platforms. Banks have been targets for some time, and most recently in Taiwan, Ecuador, Ukraine and the Bangladesh central bank in 2017.

Similarly problematic for consumers and the market is that virtual currencies – due to their limited reproduction capacity and their being an object of speculation – are significantly more volatile than conventional currencies, thus bearing a high risk of loss of value.

In order to counter this risk, as with most other volatile currencies or commodities, there are really only two options: either resell the virtual currency as quickly as possible or keep it for speculation purposes.

These points and the corresponding media coverage also have an impact on the credibility and trust in virtual currencies, which they urgently need in order to establish themselves sustainably.

Yet, young and technically-sophisticated people often welcome the possibilities offered by the blockchain and decentralised virtual currencies. As usual though, inventions – especially of this potential magnitude – are met with scepticism and even fear. It remains to be seen how long it will take for the blockchain and the technologies it underpins to ultimately convince people of its inherent potential and future sustainability.

Julia Wirth is an in-house lawyer at Siemens AG. She can be contacted on +49 172 948 5915 or by email: julia-wirth@siemens.com.

Julia Wirth

Siemens AG