Cryptocurrency Regulation

By Noah Carr and Grace C Zhou

The Future of Cryptocurrency

Regulations Varying by Locality and Nation

Because cryptocurrency remains a nascent field, the regulation for the market also remains relatively undeveloped. Depending on both the nation and even sometimes the smaller localities, cryptocurrencies can receive extremely varying treatment.

Texan Regulation

In Texas (a must mention for the University of Texas at Austin), cryptocurrency has seen some recent regulatory debate. 4 recent bills (HB 4474, HB 1576, HB 2199, and SB 334) came before the Texas Legislature with varying outcomes.

1. HB4474 laid out guidelines for deciding what constitutes a cryptocurrency and how they may be used.
2. HB 1576 seeks to create public-private work groups to guide blockchain legislation
3. HB 2199 sought to create a digital identity working group and optimize state digital identity regulation.
4. SB 334 would have made it so that Texas Government Agencies would be required to accept signatures that used blockchain technology.

HB 4474 was passed and approved, going into law in Sept . HB 1576… HB 2199 and SB 334 did not actually end up being passed.

Regulation of Other States

Wyoming, Colorado, Ohio, Texas, California are all noteworthy for their support for cryptocurrency business or services, consumer protections for cryptocurrency users, etc.

Wyoming, perhaps, is at the forefront of legislating toward the development of the cryptocurrency industry. Wyoming has established special purpose depository institutions that can have custody of cryptocurrencies. They also have allowed DAOs, or Decentralized Autonomous Organization, to be bundled within LLC to act as operating agreement or charters for companies.

National American Regulation

American financial securities regulators are governed by what is known as the Howey Test. The Howey Test is a test to determine what is an “investment contract” or security. 

The test has 4 stipulations.

An investment contract is: 

1. An investment of money
2. In a common enterprise
3. With the expectation of profit
4. To be derived from the efforts of others

Therefore, when evaluating a cryptocurrency like Bitcoin. While it is an investment of money with the expectation of profit, and while it may be a common enterprise, it’s hard to evaluate it as driven by the efforts of others. Efforts of others are measured by whether or not the cryptocurrency is decentralized enough that no one party has the influence to enact changes on it. Therefore, Ethereum or Bitcoin do not pass the Howey Test while Ripple and Uniswap are not.

The CFTC meanwhile regulates the derivatives like futures, options and swaps.

Because it is not an investment contract, BTC is not regulated by the SEC nor are they regulated by CFTC as it is not a derivative. Both regulators have looked into including such assets into their mandates though, and this may change in the future.

El Salvador

Famously, El Salvador recently legalized BTC as payment after buying $26M of BTC. El Salvador’s government claims that because 70% of Salvadorans don’t have bank accounts it will expand the access to wallets for Salvadorians.

THe motivation for El Salvador to make the switch is actually related to the dollar. El Salvador is dollarized, meaning they adopted the dollar and lost control of the currency that is used. Because of this, it made it easier for them to adopt bitcoin in hopes that maybe they can rely less on USD. 

There are two ways to de-dollarize? The first is to create a new currency but if citizens don’t trust the government to control inflation the new currency will not work. The second is to create an inflation hedge that you have some control over, which is the route El Salvador chose. The third would be to find another international currency to swap to.

However, this legalization has received criticism and left many not believing the de-dollarization rationale. For one,  only 33% of people use the internet regularly (mostly tourists, or citizens in urban areas). Moreover, 25% of El Salvadorians are below the poverty line, and the confusion created by this switch makes it unclear if the swap was worthwhile. 

China

Non-government based cryptocurrencies are actually frowned on by China. Most recently, China announced a ban against Bitcoin. Business crypto transactions are deemed illegal in the country, individuals can still hold, but businesses cannot use it in exchanges.

Central Bank Digital Currency

Many nations are also racing to develop a Central Bank Digital Currency or CBDC. Other nations are also researching CBDCs. The Bank of International Settlements says 80% of Central banks are implementing CBDCs. The typical process consists of working on policies for CBDCs and then researching into implementing them.

Of the larger nations, leading the race is likely China, which has worked to build CBDCs for several years now. The European Central Bank and Bank of Japan have followed suit in researching CBDCs. The Federal Reserve Bank of Boston is also working with MIT to develop CBDC, but remains behind its peers in the process of implementation. Smaller nations like Denmark and Norway have also researched CBDCs as nations that are part of the EU but do not use the EU.

International Capital Weightings

Capital Weights

A bank’s balance sheet is based on the balancing of assets (loans) with liabilities (deposits) and equity. Banks make the spread on loans and deposits. The FDIC insures a depositor’s bank account so we don’t care about what the bank does with our money. Therefore, banks want to load up on risk because they know the government insures the bank. Government then regulates what kind of loans the bank lends out to ensure that the bank does not take undue risk because of the insurance. 

The question is, if you are a regulator, what is the ratio between the deposits and equity you want the bank to have?

According to the Basel accords: there isn’t really a fixed number, it depends on what loans you have. If you have risky loans, you need to have more equity. Specifically, you hold % of capital depending on the type of loan. Ex. 65% for an IG corporate loan, etc. For cryptos, you have to have 1250% or 12.5x the loan amount. 

Recent Crypto Decisions

The Bank of international Settlements defines a token as a distributed ledger, non-custodial, cryptographic asset.

Bank of International Settlements, existed since the 1930s

• Basel Committee on Banking Supervision (BIS) June 2021
  • Group 1: 
    • 1a: Tokenized: bonds, loans, equities, cash
    • 1b: stabilized: 10bps cap on volatility, only allowed to exceed that 3 times a year. IS redeemable for assets, 1a cannot
  • Group 2: BTC, ETH
    • A risk weight of 1250%, BIS want cryptos to be 1250% collateralized
      • If this exceed max loss possible on crypto asset derivative, max loss is used instead
    • Counterparty risk for derivative exposure
• Why 1250%
  • Basel 1:
    • Pillar 1: enhanced minimum capital (8%) and liquidity requirements 
    • Issue: loans to SK and Switzerland viewed as the same loan, so crude view of relative risk
  • Basel 2: 1988
    • Pillar 2: supervision
    • Pillar 3: transparency, market disclosure of what you’re investing in. 
  • Basel 3: added 2.5% to minimum capital requirements
  • So BIS wants you to have 8% of 1250% of the loan. 
    • So if you borrow $100 crypto, 1250% is $1250. So you need to hold 8% of it in equity, therefore, the bank needs $100 worth of crypto.  
    • Only applies to Group 2 Assets
• Bank Response
  • Banks gave pushed back
  • Condition unlikely to be met in practice and therefore should be removed
  • Put together numbers on how often tokens have had threshold breaches
    • Want more focus on what goes int safer category 1
    • Want to increase threshold to 25 times
  • Split Group 2: 
    • 2a: liquid two-way market (holding requirement: 90-95%)
    • 2b: nascent or illiquid crypoassets (1250%)