Cryptocurrencies have dominated headlines with their soaring value and accelerating use. Their regulation has remained somewhat of an afterthought, however. This blog post looks at some of the pitfalls and the larger implications for financial professionals and the insurance industry that the risks of cryptocurrency present.
November and December of 2017 saw Bitcoin dominate headlines as it surged in value. On December 17, a single Bitcoin became worth roughly 19,800 USD, before crashing again to a still healthy exchange rate of 1 to 13,000.
Many prominent figures in finance have publically advised investors to avoid the cryptocurrency. Jamie Dimon has compared Bitcoin to the tulip bulbs that caused the Dutch financial crisis in the 17th century, while RBS Chairman Sir Howard Davies has described the currency as a "frothy investment bubble".
Despite this Bitcoin and other cryptocurrencies are becoming increasingly popular and accepted. It was recently announced that a Notting Hill mansion was offered in Bitcoin. Another company selling apartments in Dubai is now also accepting the virtual currency.
More importantly, The Chicago Mercantile Exchange has started offering Bitcoin futures. This allows traders to bet indirectly on the rise and fall of the value of the currency much like any other commodity future. Bitcoin is clearly moving from the fringe to something that financial service professionals should (if not be experts on,) be familiar with.
What does this mean for professionals?
Bitcoin's increasing popularity and usefulness will inevitably mean investors will start asking financial advisers and other financial services professionals about it (hopefully before they re-mortgage their house).
This is true of even sophisticated investors, given the increasing number of Initial Coin Offerings (ICO's). This is where companies launch their own cryptocurrencies in exchange for cash (or other cryptocurrencies), allowing them to raise funds while supposedly sidestepping the regulatory problems of an IPO. This means that soon professionals will be expected to give advice about cryptocurrencies, even if it is simply to echo Mr Dimon's warnings.
Financial service professionals are heavily regulated. Yet Bitcoin and cryptocurrencies in general are so new and seemingly different that they risk falling between regulations, posing headaches for those who try to give advice about them.
Example of Regulatory Problems: Financial Services and Markets Act 2000
To illustrate how complicated these regulatory problems can be, the Financial Services and Markets Act 2000 (FSMA) is a good example. This lays out strict rules about who can provide advice to investors, and provides the Financial Conduct Authority (FCA) with broad powers to investigate people it believes are breaking the law. Currently, under s.19 of FSMA there is a general prohibition against anyone carrying out a regulated activity unless they are either exempt or authorised.
Without going into too much detail, the regulated activities are specified in FSMA, and must relate to an "investment of a specified kind", which are listed in the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001, commonly referred to as RAO.
One would think that Bitcoin would easily fall into a category listed in RAO, given that it is a crypto-currency. - Surely it is money, or another form of financial asset. The futures listed on the Chicago Mercantile Exchange are, obviously, futures. These are specified in and neatly covered by Article 84 of RAO. But cryptocurrencies are not easily pigeonholed.
Take for example the definition of "electronic money". This seems like an obvious category for Bitcoin to fall into. Yet under the definition of E-money (as per Regulation 2(1) of the Electronic Money Regulations 2011) it not so clear cut:
Electronic money is Electronically (including magnetically) stored monetary value, as represented by a claim on the electronic money issuer, which is:-
- Issued on receipt of funds for the purpose of making payment transactions; and
- Accepted as a means of payment by a person other than the electronic money issuer
Bitcoin, as an example cyrptocurrency, does not easily fit into this definition. To start, Bitcoin is not "issued" in the traditional sense. It is instead "mined", a system that rewards new Bitcoins to those people who provide computational power to manage and update the public record of all Bitcoin transactions. The "issuer" is therefore an algorithm and an extended group of people who provide the computational power, not a central bank or other financial institution.
Nor does owning it give its owner an automatic right to a claim on said issuer (if an issuer was imputed to exist). As pointed out in a 2014 article by the Bank of England, digital currencies are not a claim on anybody, and should instead be viewed as assets. It is clearly hard to define Bitcoin (and other cryptocurrencies), at least in a legal sense.
The views and positions of UK regulators
UK regulators in general have been silent about properly defining cryptocurrencies. The Bank of England defines Bitcoin (and other cryptocurrencies) as "private digital currencies." Beyond this definition The Bank has done very little to regulate this new supply of so called money, a position replicated by the rest of the UK government.
The only organisation that has taken a stand is HMRC, which has put out guidance about how Bitcoins should be taxed. They state that:-
This again treats them as an asset, not a currency. HMRC, however, has made no further comment about how Bitcoins should be treated legally beyond taxation, and specifically state their tax advice is not a statement about how cryptocurrencies are to be regulated.
Problems for insureds and insurers
This lack of certainty could raise a number of problems for both professionals and those insurers providing PI and D&O cover.
In a recent speech Jay Clayton of the American Securities and Exchange Commission succinctly outlined some of the issues professionals face. Mr Clayton points out that some ICO's, while being advertised as not being regulated, actually have all the hallmarks of regulated products and procedures. He stressed that lawyers (and other professionals involved in these types of procedures) should urge caution to their clients, even if ICO's are not explicitly regulated.
His point is clear – these regulations exist to protect people and ignoring them could result in losses for investors and liability for the professionals who advised against treating ICO's as regulated procedures.
The reverse of this argument, however, is also true. While it is good to be cautious, advising clients that something is regulated when it is not could be seen as negligent, especially when dealing with sophisticated investors. As demonstrated above, it is far from clear what the legal position of cryptocurrencies is, and there are no precedents to put the issue to bed. Professionals who might be negligent for advising clients to proceed as if cryptocurrencies were unregulated might also be accused of negligence if they advised clients to treat them as regulated products, and the client lost money, opportunities or incurred unwarranted costs for no reason.
Potential Effects on the Insurance Market
There are a number of ways these problems could affect the insurance market.
First, insurers might be forced to pick up the tab for these issues unless definitive guidelines are proposed to explain how cryptocurrencies are regulated, especially when it comes to ICO's. This is especially true given how broadly "wrongful act" clauses can be drafted. Advising that they are not regulated might trigger a claim, but so might advising that they are regulated.
Secondly, many insureds who might think they are insured might not be. In the event that cryptocurrencies are covered by FSMA, then the FCA could start fining companies who advise on them. These fines are uninsurable, meaning that professionals advising on cryptocurrencies might be far more exposed than they realise until further guidance is published.
Finally, insurers are going to have to come up with novel ways to exclude cryptocurrency risk if they decide that it is currently too volatile to value. Defining cryptocurrencies is challenging: Providing a definition for an exclusion clause might either result in the definition being broad enough to describe anything that uses block-chain technology (including smart contracts), or not cover cryptocurrencies as they emerge.
These are just a few of the issues cryptocurrencies are causing. Highlighting one specific area demonstrates that as cryptocurrencies (and other new financial instruments) increasingly become mainstream, insurers and professionals should move quickly to understand and try and manage (to the best of their ability) these emerging risks.