Virtual currencies have generally existed unregulated since Bitcoin’s creation in 2009. Since then they have increased in popularity and the number of different cryptocurrencies has expanded to over 1,300 different virtual currencies.

This growth in popularity, coupled with price volatility and concerns about criminality, has led to a focus by regulators worldwide on whether, and how, to regulate cryptocurrencies. Recent news stories such as the $500m security hack of Coincheck, the Japanese crypto exchange house, highlight the need for such regulatory attention. This article considers the benefits and uses of virtual currencies, their risks and upcoming regulation.

Uses and benefits

Currently cryptocurrencies are mainly used for private transactions, raising funds via initial coin offerings and making purchases. Certain websites including Overstock, Expedia and Shopify already accept virtual currencies and others are likely to follow as cryptocurrencies become increasingly mainstream. An innovative development in the virtual currency realm is websites offering users, as an alternative to viewing adverts, the option of allowing the website to use their device to mine cryptocurrency whilst the user is using their website.

The principal benefits to using cryptocurrencies include privacy, speed, low transaction costs and security. The pseudonymous quality of virtual currencies gives its users a level of privacy not afforded by ‘real’ currencies. This can be of real benefit in certain circumstances, for example to operate outside the confines of oppressive governments. Cryptocurrencies have lower transaction costs, and are often faster, than electronic payments made via banks. This makes them popular with users, one such group being immigrants sending remittances to their families overseas. The security of cryptocurrency transactions is a further benefit. They cannot be easily counterfeited and transactions cannot be reversed.

Risks

The flipside to the above is that virtual currency use also presents a number of risks. Whilst privacy can be a benefit, it can mask criminal activities such as fraud, money laundering, financing terrorism and tax evasion. There is concern among regulators that cryptocurrencies are increasingly being used for illegal purposes.

The current lack of regulation leaves individual users exposed to price volatility and financial loss resulting from operational and security failures arising at crypto exchanges. Earlier this year Lloyds Bank and Virgin Money responded to this risk by banning their customers from using their credit cards to purchase cryptocurrencies. Facebook has also decided to ban all adverts for digital currencies from its site on the basis they frequently mislead consumers.

There is also concern among some legislators that cryptocurrencies pose a systemic risk; that if the virtual currency economy continues to grow uncontrolled, it may destabilise the traditional financial system.

What regulatory approach is being taken?

The presence of these risks and the growth in popularity of cryptocurrencies has meant governments and central banks are turning their attention to virtual currency regulation. Government responses globally range between all out cryptocurrency bans, issuing warnings only, introducing regulation and creating state-backed cryptocurrencies.

To date, involvement of UK regulators has been limited to issuing cautionary statements. The FCA has warned consumers of the risk of fraud in respect of cryptocurrencies and the dangers of initial coin offerings.

Looking ahead, the UK government is currently working with the EU to bring cryptocurrencies within existing anti-money laundering and counter-terrorism financial legislation. ‘Virtual currency exchange platforms’ (professional exchange houses) and ‘custodian wallet providers’ (the equivalent of a bank or payment institution offering a payment account) will be brought within MLD4, meaning they will need to comply with regulatory obligations including performing customer due diligence and reporting suspicious transactions. These changes are intended to crackdown on the use of cryptocurrencies for illegal activities and tax evasion.

The proposed legislation is due to come into effect at the end of 2019. Its implementation is unlikely to be affected by Brexit as the UK is expected, at least temporarily, to stay within the single market post-Brexit, and will, therefore, need to transpose the regulations into UK law.

In addition to government regulation, there is nascent self-regulation within the UK cryptocurrency industry. Seven large crypto companies have recently set up CryptoUK, the first UK cryptocurrency trade association with the aim of improving industry standards and engaging policymakers. CryptoUK has produced a code of conduct for its members which includes guidelines around better due diligence, and ensuring customer funds can pay out in the event of insolvency and increased account security.

The future

We are currently in a period of regulatory change and it will be interesting to see what approach is taken by other countries. Governments will need to take a balanced approach to ensure technical innovation surrounding cryptocurrencies are not stifled by onerous new regulations. The borderless nature of virtual currencies means that, ultimately, a globally co-ordinated approach will be needed to create effective regulation, and governments will need to work together in the future to achieve this. This sentiment has been echoed by the IMF which has called for global coordination on the regulation of virtual currencies.