Cryptonomy’s Response to the Treasury Select Committee Inquiry April 2018
Cryptonomy Ltd is pleased to respond to the Treasury Select Committee Inquiry. Submitted 10.04.18.
Cryptonomy Ltd is pleased to respond to the Treasury Select Committee Inquiry. Submitted 10.04.18.
Submitted 10.04.18 – PDF version
Cryptonomy is pleased to respond to the Treasury Committee’s digital currencies inquiry.
Established in 2012, Cryptonomy is a consultancy specialising in cryptocurrency, blockchain and DLT. We provide expert consultation and support in emerging technology design, development, security, marketing and law. Our clients include: The Royal Mint, Ethereum, Cardano Foundation, and IOHK, as well as a breadth of prominent clients in San Francisco, Chicago, New York, Hong Kong, London, Zug and Paris.
We are also the chosen partner to the popular Ledger Wallet, delivering development and support for cryptocurrencies on Ledger’s devices and BOLOS platform.
Are digital currencies ultimately capable of replacing traditional means of payment?
Digital currencies and the market they represent are still very much in their infancy.
Consider the example of the largest digital currency by market cap: Bitcoin. Its approach to establishing itself as a digital currency is cautious and experimental. The bitcoins themselves will not finish distributing for around another 120 years. Arguably Bitcoin is still in its “boot-up” phase and just getting itself established as a financial vehicle.
With this view Bitcoin can be considered analogous to a boat bobbing on ocean waves. It is currently about the size of a rubber dingy but slowly growing in size to an aircraft carrier. As it matures the experience of peaks and troughs should reduce.
Therefore, one could argue that certain digital currencies, particularly those with distributed governance and a considered growth strategy, are likely to remain and become a complementary form of payment alongside traditional channels.
Taking this view, it’s clear that its designer’s main goal was not to get rich quick, but to create a viable currency system. Other “me-too” digital currencies have been too quick to release coins into their ecosystem and are clearly catering for the “get rich quick” mindset. Users need to be very cautions of such digital currencies as they often have a rapid valuation peak and then die off entirely.
Despite its early stage volatility, Bitcoin is still being used for trade today. Many of those we work with use Bitcoin for day to day activities such as payments and to settle debts particularly in the business to business sector.
To what extent could digital currencies disrupt the economy and the workings of the public sector?
The most obvious area for digital currency disruption is the removal of middle men and the automation of systems and processes. Many of these are areas which are automatable but for one reason or another remain intensively manual even today.
Shopping carts on websites which accept digital currencies automatically generate payment details from the distributed ledger such as a bitcoin payment from the blockchain. Fiat price (EUR, GBP, USD) value is also automatically calculated against the current spot price for user convenience.
It seems a natural next step to allow fully automated tax and earnings assessments to be generated from these transactions via an interface to a tax authority such as HMRC. For example, a business would submit its public key seed to HMRC, from this HMRC would be able to generate all the payment addresses a business will use and thus spot all payments relating to that business on the blockchain and automatically generate a tax bill or statement for the business to check and sign at year end. Other processes such as VAT cash accounting can be similarly automated and reconciled with minimal manual intervention at the end of each quarter.
What risks and benefits could digital currencies generate for consumers, businesses and governments?
We can see two prominent areas of risk.
Firstly, blockchain based digital currencies are “pushed” i.e. funds can only be sent by a user who controls them, they cannot be “pulled” in the way a direct debit is pulled each month by from the payer’s account to the payee’s account.
This means that if the money is sent to a malicious seller or to the wrong address it can never be recalled.
This has benefits to business, as they can be certain they will not suffer from chargebacks; a common problem with internet retail. But it can be a disadvantage to the customer as they are not covered by the Consumer Credit Act (where using a credit card) for such transactions in the UK.
At Cryptonomy we have developed a variation of blockchain which allows our clients, who will run the network, to have more control over users’ funds and to freeze or seize funds if ordered to do so by a legal authority. This makes these digital currencies compliant with Anti-Money Laundering (AML) and Know Your Customer (KYC) regulation.
Secondly, banks are refusing to touch businesses and individuals who deal in digital currencies or withdraw from exchanges. This is bad in two ways, it’s a short-term way to protect the business interests of banking institutions, and a failure to engage with a new market sector. It also means that users are forced to hold and use digital currencies directly, further damaging banks’ abilities to operate in the long run, as people and business trade directly, instead of via their bank. So, it has been our observation that, inadvertently, the banks are hindering the processes required to improve regulation.
How is distributed ledger technology being applied in the financial services sector, and how might it be applied in future?
One key area we are aware of is resolving end of day totals for the derivatives markets. This is currently a problematic area because the current process of valuing derivatives at end of day is onerous, manual and to some degree opaque as different parties can reach different valuations for the same derivative at the end of a given day.
Migrating derivatives to a distributed ledger technology removes any requirement for manual intervention and any ambiguity in how the end of day valuation is derived.
What work has the Government (and its associated bodies) done to understand, prepare for and, where relevant, encourage changes that may be brought about by increased adoption of digital currencies?
Where a third party has custodianship of another user’s funds there needs to be clear regulation because the opportunity for that third party to: act incorrectly; lose funds due to poor digital security and procedure; or simply abscond with the funds is high.
Other regulation in this space should be nuanced and considered; in Cryptonomy’s opinion that this space is still young so we should not be making any final regulatory decisions as they could significantly hinder innovation and growth in this space.
How might the Government’s processes adapt should digital currencies be adopted more widely (e.g. tax implications, anti-money laundering measures)?
Digital currencies are more convenient and accurate at tallying than traditional monetary systems which can be onerous, manual and expensive to monitor and reconcile. Although at a glance digital currencies seem like they could increase undesirable behaviours such as tax avoidance, we at Cryptonomy think they can reduce the overheads and increase the simplicity of orchestrating tax collection and filing for both government and citizen.
Because most blockchains and DLTs publicly list the movement of funds, should tax avoidance be a concern, they can easily have searches applied to them to infer, with a level of certainty, where tax avoidance is likely to have taken place.
Tax avoidance monitoring can be achieved by a government agency scanning the data on the blockchain or DLT in real-time.
Flagging of any unaccounted or suspicious movements of funds is achieved by referencing known addresses, either those provided by tax applicants or harvested from online searches and identifying payment patterns. Statistical certainty can be given using a number of measure such as the number of layers a suspicious payment is removed from a known recipient, i.e. a 1st, 2nd or 3rd tier connect etc.
This percentage likelihood of certain transactions being tax avoidance or fraud can then be algorithmically applied to each movement and at a certain threshold of certainty and/or GBP value human officials can be notified to investigate and recover losses as necessary.
This methodology would allow for real time identification of possible tax avoidance, not in arrears, as per the current system.
Is the government striking the right balance between regulating digital currencies to provide adequate protection for consumers and businesses whilst not stifling innovation?
Digital currencies are not covered by Financial Conduct Authority (FCA) regulation. Rights accorded by the Consumer Rights Act (e.g. digital content) and the Consumer Credit Act (primarily the unauthorised transaction element) do not extend to digital currencies. The extension of both legislation and regulation would bring digital currencies in line with those which are more familiar, to consumer and business alike.
The balance that needs to be struck relates to income tax. For consistency, it would be advantageous to treat virtual currencies as currencies, and be clear about the application of capital gains tax.
In the US, capital gains taxation is already too onerous to allow digital currencies to be used viably by the majority of its citizens. Take the example of a small purchase, such as a book or cup of coffee with bitcoin. If a user were to buy some bitcoin, then later make a purchase, they need to report any capital gains adjustments to account for the value change of bitcoin over the intervening period, even if the amount was a few cents.
The overhead of conducting such reporting would cause a net loss to both citizen and state, as filing paperwork to account for a few cents significantly outweighs the benefits of using a digital currency to make payments. An amendment has been proposed (US HR3708), to permit citizens to not file for capital gains if these are below $600.
Could regulation benefit digital currency start-ups by improving consumer trust?
There are two types of start-up: those who issue tokens to build a product, system or solutions (commonly creating an ERC20 token within the Ethereum network), and complete payment/store of value systems (e.g. Bitcoin, Litecoin, Ethereum). Arguably, the latter have already built consumer trust.
We invite the committee to consider whether the FCA’s approach to unregulated collective investment schemes (UCIS) has worked. If the committee concludes that UCIS (which have placed a heavy burden on the Financial Services Compensation Scheme in the past two years), have been successful, then it seems reasonable for the FCA to designate all initial coin offerings as UCIS.
If the committee concludes that the UK public requires more protection, then some of the heavier duty FCA Handbook investment chapters must apply. The committee should also consider whether the UK’s listing regime ought to apply to virtual currency exchanges in some form (currently initial coin offerings are available direct to the public, with secondary market liquidity provided by such exchanges).
How are governments and regulators in other countries approaching digital currencies and what lessons can the UK learn from overseas?
To answer this question, it is important to make the distinction between coins and tokens, and between the regulation of securities, and money transmission in general.
Coins (Ethereum, Bitcoin, and Litecoin) are defined as commodities by the United States. However, the Commodity Futures Trading Commission (CFTC) exercises no oversight over the spot market in them, or the virtual currency exchanges which exchange them. Notwithstanding, in order to operate legally, even those virtual currency exchanges trading only in the above named coins, must register as money transmission businesses (MTB) with the Financial Crimes Enforcement Network (FinCEN, part of the US Treasury Department), and those US States in which their customers reside. Failure to do so (and to comply with local anti-money laundering and counter terrorism financing requirements) has led to prosecution by individual State Attorneys General, and also FinCEN.
Tokens, such as those issued during an Initial Coin Offering (ICO), may be based on Ethereum (ERC20 being a common standard), or any other blockchain facilitating simple smart contracts, but are treated as securities by the Securities and Exchanges Commission (SEC). This is based on the Howey test, the traditional context for this is a legal entity raising money by issuing shares in order to invest in plant, or Research and Development, which may ultimately increase the value of the shares held, or the dividends to be derived from them. Those who invest in initial coin offerings often do so in order to benefit from the sudden increase in the value in the event that those tokens are listed on an exchange with significant liquidity. The SEC treats any promises relating to exchange listings during an ICO as evidence that a management team is seeking to increase the value of the asset.
The following US enforcement notices include applicable United States Code references.
Mt.GOX, accounts seized for failing to register as a MTB
US MTBs are equivalent to UK authorised payment institutions (APIs). The Financial Conduct Authority (FCA) could extend its perimeter to include virtual currency exchanges within its definition of APIs, or even fully-fledged e-money institutions, depending on the business model of the exchange at hand, and the way in which it holds assets.
With regards to the protection of ICO investors, their situation is analogous to those who invest in unregulated collective investment schemes (UCIS). The existing FCA requirements are that these may only be marketed to qualified investors. We would urge the FCA to exercise more oversight in this area than it has over the distribution of UCIS.
ICOs and cryptocurrencies are subject to laws and regulations. Do you know what they are and how to comply to them? If you need advice, please get in touch and we will connect you with one of our experts.Talk to us