In a previous article, we explained what blockchain actually is. But what of its most famous iteration: cryptocurrency?
What is a cryptocurrency?
Cryptocurrencies are, simply put, digital assets represented in the form of tokens which are designed to work as a medium of exchange and which employ sophisticated cryptography to secure and validate the transfer of value. Cryptocurrencies are designed to strictly control the creation of further units, thereby ensuring digital scarcity in respect of such token (i.e. there will always be a finite number of tokens able to be created). Continuing the theme of disintermediation discussed in our previous blockchain article, cryptocurrencies are also capable of operating independently of any central governmental or financial institution.
The 'crypto' in 'cryptocurrency' refers to cryptography – the practice and study of techniques for secure communication in the presence of third party 'adversaries'. Traditionally, cryptography has been thought of as synonymous with encryption, which brings to mind the famous Enigma machine used by the German government and military from around 1930 through World War II, during which Allied intelligence officers led by Alan Turing famously 'cracked the code'. In modern times, cryptography is based on mathematical and computer science theory, including computational hardness assumptions (i.e. the hypothesis that a problem or encryption cannot be solved or 'cracked' efficiently). Accordingly, cryptocurrencies are cryptographically secure in that, while they are theoretically able to be broken, it in infeasible to do so by any known practical means.
Are cryptocurrencies regulated?
This article only seeks to provide a high-level view of cryptocurrency regulation in the United Kingdom – a more detailed article is to follow, as part of this mini-series. It is important to note, however, that in addition to the laws of the jurisdiction in which the issuing entity is incorporated or established, the laws of each jurisdiction into which the cryptocurrency is offered or sold (or any other regulated activity which may be treated by local regulators as taking place or having effect in such jurisdictions) will be relevant and must be considered.
In the United Kingdom carrying on a regulated activity is generally prohibited, subject to the relevant person being authorised, exempt, or an exclusion being available. Additionally, and importantly for undertakings involved in the cryptocurrency space, the communication of an invitation or inducement to engage in an 'investment activity' is also generally prohibited, again subject to the communication being approved by an authorised person or an exemption being available. For the purpose of these two distinct but overlapping regimes, the concept of a regulated activity or an investment activity is broadly similar and must, for the most part, involve a specified type of activity being untaken in respect of a particular type of investment. In the case of cryptocurrencies it is therefore necessary to consider whether that token falls within the scope of the UK regulatory regime as a specified type of investment.
Shares, bonds, units in collective investment schemes (i.e. funds, broadly speaking) and derivative instruments, amongst others, are generally considered 'specified investments' and packaging such instruments as cryptocurrency tokens will not serve to escape the regulatory framework. Accordingly, some cryptocurrencies will be regulated as 'specified investments' and we commonly refer to these as 'security tokens'. Security tokens will be treated in the same way as the underlying security for the purposes of the UK regime, both in terms of the activities undertaken by those issuing and promoting those security tokens and the rules that apply to the marketing of those security tokens. Different regimes apply within the marketing rules themselves and the extent to which a security token will require a formal offering document, such as a prospectus approved by the FCA, will vary on a case-by-case basis. Accordingly, we strongly advise that such a document is given the benefit of legal and regulatory advice and review.
Cryptocurrencies which are not currently caught within the scope of the UK regulatory regime are referred to as 'utility tokens'. The regulatory landscape for such utility tokens is markedly easier to navigate, though legal and regulatory advice is still strongly recommended, as a number of other potentially serious issues can still arise.
What are the benefits of utilising cryptocurrencies?
There are numerous benefits to the use and proliferation of cryptocurrency but, in my view, the three most prominent are:
- the elimination of fraud – the use of cryptographic encryption ensures that cryptocurrencies cannot be counterfeited, transfers cannot be arbitrarily sent or reversed, and the risk of double-spend can be eliminated;
- globalisation – there are approximately 2.5 billion individuals with access to the internet around the world and, as cryptocurrencies know no borders, they can be used internationally without incurring expensive transfer and currency exchange fees; and
- disintermediation – by utilising blockchain technology, cryptocurrencies are capable of being managed by their network and not by any one central authority which might unilaterally decide to seize tokens from their holders. We might think this is a remote risk, but in March 2013, the Central Bank of Cyprus planned to seize uninsured deposits larger than $100,000 to help it to recapitalise. Given the increasing levels of global economic uncertainty, the introduction of a disintermediated store of value is extremely timely…
Cryptocurrency sounds scary. It's not. Whether it proves to be the 'new internet' remains to be seen but, one thing is for certain, it's not going away and it will continue to disrupt the traditional means of value transfer for years to come.