Cryptos: The future or the next bubble?

Posted on 02 Oct 2018, by Christiana Constantinides

Cryptocurrencies have undoubtedly been the centre of attention in the markets since they were introduced. Considering the fact that everything is gradually digitalized, it is not to wonder how the idea of virtual currencies was so well-received by the forward-looking investor and technically-minded people.

The concept of digitalized payments is certainly not new and has existed for a while now, with alternative payment methods, where e-wallets that can be credited and used electronically for transactions being already popular.  Virtual currencies, however, take this concept a step further, as the e-wallet is now filled with a new kind of currency, one which does not exist as a fiat currency.

Up until today, the world knows that currencies are issued by Central Banks, or the Federal Reserve in the case of the US: bodies which are then responsible to regulate, monitor and guide the use of currencies and their interaction with the market. The introduction of cryptocurrencies now gives the power to organizations and start-ups to issue their own currency and offer them to the public in their attempt to raise capital. Along with Initial Public Offerings of shares, companies are now given the option to fund their business through an Initial Coin Offering, where instead of shares, the company issues coins or tokens, which are offered to the investors in a similar manner.

From the companies’ perspective, this means that they now have another funding option, which is positive, while at the same time allowing investors to engage in new fields and diversify. Many Banks and Regulators, however, do not seem to share the same opinion. The idea of a product that is issued and distributed much like a share, but at the same time is intended to be used as a currency has created a strong controversy, which, backed by the fact that the transactions are anonymous, and well protected by the supposedly impenetrable block chain technology has been giving regulators a hard time. Big economies, like the one of China, have already issued warnings against cryptocurrencies, banning them as an unrecognizable product, while others still struggle with coming up with a way to categorize them and include them in the sphere of financial regulation.

This lack of uniformity has sparked the fears of the most conservative, which again started warning against how this excessive hype that Cryptos have been enjoying has strayed the attention away from the real concerns which include the potential security flaws that exist within the underlying technology, regulatory concerns and fear of market manipulation, with the most pessimistic anticipating the bubble to burst as happened back in 2008 in the US housing market.

Despite the above, the efforts to increase recognition of Cryptos, and finding ways of dealing with the shortcomings in an attempt to regulate them, have been observed globally. The US Securities and Exchange Commission has declared that coins offered during Initial Coin Offerings may be categorized as securities under US law, provided that they pass the so-called Howey Test, which states that a financial instrument can be a security if it fulfils four criteria; namely, that it is an investment of money, with an expectation of profit, in a common enterprise, and the profit to be generated by a third party. [1]

In Europe, the applicable framework at this time is the latest Market in Financial Instruments Directive, MiFiD II, which defines “transferable securities” as those securities that are ‘negotiable on the capital market’, except instruments of payment, which apart from shares and bonds can also be any security that is transferable, or giving right to a cash settlement determined by such transferable securities.[2] Considering this definition which, in essence, is not that far apart from the US criteria, reconciling the approach in the US and EU is permissible, and thus the case behind incorporating Cryptos into securities law is further enforced.

Things have started progressing on a country level as well, with Malta having already established the Malta Digital Innovation Authority, or MDIA, which is responsible for overseeing distributed ledger technology, including Blockchain, and a Virtual Currency Act, paving the way for more countries to follow. More individual initiatives are expected to follow, with countries like France already debating changes in their regulatory framework which will make them more favourable to the Blockchain industry.

For the moment, things might be fragmented with regard to cryptocurrencies. There is a chasm in their recognition in different markets, and regulators are still searching for ways of working around the products’ nature in order to impose traditional regulatory requirements. It is, however, highly unlikely, given the popularity it has gained, that this multi-million industry will not find a way to stay, and even in the worst case scenario, it is most certainly not going down without a fight.

[1] For reference see Securities and Exchange Commission v. W. J. Howey Co., 328 U.S. 293 (1946).

[2] For reference see MiFiD II, Article 4(1)(44).

The content of this article is intended to provide a general guide to the subject matter. For further information, please contact Ms. Christiana Constantinides at christiana.constantinides@kyprianou.com