Last Friday China put in place its most extreme ban to date on cryptocurrencies. Crypto exchanges
and other services providers were already technically banned by the Chinese government,
but a loophole allowed Chinese people to trade crypto using offshore accounts.
Friday’s notice leaves no area for interpretation and makes it extremely clear that cryptocurrencies
are no longer welcome in China. China has banned crypto transactions regardless of where exchanges
and accounts are based. The Chinese Regulators say that they are ready to enforce the prohibition,
with the full support of nine different government agencies including the Supreme
Court, the police and the central bank. The People’s Bank of China says that the new
rules are necessary to “maintain national security and social stability.” Now, China has made moves
to limit the rise of cryptocurrency since at least 2013, but with the gradual rollout of
China’s state-backed digital yuan, the government is getting more serious about their crackdown.
I’m sure many of you are wondering what it is that the Chinese government has
against the people of El Salvador and their national currency. But, it’s not just China,
U.S. regulators are also training their sights on crypto too. Gary Gensler, the chairman of the SEC
spoke at length about cryptocurrencies in an event hosted by the Washington Post. He stated that he
doesn’t think there’s a “long-term viability” and later said that the SEC is working “overtime”
to create new regulations for cryptocurrency markets that are likely to be quite a bit more
aggressive than what is already on the books. So why is this happening, does it make sense,
and will the rest of the world follow suit? Well, the reasons China has given for its
increasingly severe bans on cryptocurrencies range from their role as a vehicle for money laundering
and smuggling, to environmental pollution and the intensive electricity used in mining for bitcoin.
These are criticisms that have been around for quite some time.
Let’s start with power usage – and why China might care about energy consumption. Goldman
Sachs announced yesterday that they were cutting their growth forecast for China
because of the countries struggles with energy shortages. There have been major industrial output
cuts recently due to power outages in China. Goldman estimates that as much as 44% of China's
industrial activity has been affected by power cuts. China has also been under international
pressure to meet environmental targets for energy consumption and energy intensity.
For this reason alone, it is no surprise that China banned crypto mining earlier this year.
If energy is scarce, the government would rather see it go to factories ports and people’s homes
rather than being used for crypto mining. As the world gets more serious about energy
use and environmental protection, we can probably expect a growing focus
on the more energy intensive cryptocurrencies. It would appear that the crypto community is
very aware of this issue and they have been taking significant steps in the direction of
greater energy efficiency in the overall space. The other big issue brought up by the Chinese
government was money laundering and smuggling. One of the things that crypto enthusiasts love about
crypto is that it can facilitate cross-border payments, which can be surprisingly complicated
and expensive in the world of traditional finance. In China it can be extremely difficult to get your
money out of the country, and this is how the Chinese government wish to keep it, so from a
Chinese government perspective restricting its citizens access to cryptocurrencies makes sense.
The Chinese government’s move to rein-in cryptocurrency has a lot to do with its desire
to exert greater control over economic activity in the country. I covered this idea in my recent
piece on Evergrande and the Chinese Economy. The Chinese Central Bank will be concerned
with the rise of any decentralized currency that makes it easy to transfer funds in and out of the
country as this reduces the central banks ability to tailor domestic monetary policy. The easier it
is to transfer capital across borders, the harder it becomes for monetary authorities to manage both
currency stability and an independent monetary policy. This is an issue for all central banks.
Now, many would argue that this is a strength and not a weakness of crypto. They might argue
that a form of digital gold would impose monetary discipline on central banks,
limiting their ability to manipulate the value of their currencies for political reasons.
While I may have some sympathy for this argument, my point here is not to agree or disagree
but simply to point out that this has to be an important issue for the Central Bank of China,
but also that it will be taken very seriously by central banks around the world.
As I’m sure you know, China is in the process of creating its own government backed digital
currency, but this digital currency has only superficial similarities to what we think of
as a cryptocurrency. It doesn’t use blockchain, the ledger technology
at the heart of all cryptocurrencies. So, let’s step away from China for a moment
and look at the rest of the world, and ask why other countries might want to regulate crypto.
You might begin by once again looking at the business of international transfers and payments.
Why are these so expensive and complex, both in terms of transaction costs
but also in terms of time and paperwork requirements? One answer to that question
is that a small group of financial institutions controls cross-border transfers
and has kept these costs high to maximize their profitability. I think that most
people would agree that breaking up such an oligopoly is a good idea, and long overdue.
Another (more noble) reason that international transfers are slow and expensive is that there
are huge regulatory requirements in place aimed at controlling the flow of ill-gotten gains
both within countries and across borders. Despite what you might think, banks today are high tech
firms that hire huge numbers of programmers to improve the way their business runs.
They seek any advantage they can find to do things faster and cheaper.
But there are a lot of regulations in place to prevent money laundering, tax evasion and the
funding of terrorist groups, and this is a major bottleneck in the world of traditional finance
that both slows down payments and makes moving money around the world much more expensive.
FATCA (or The Foreign Account Tax Compliance Act) – A US law that was passed in 2010, requires
foreign financial institutions to report the accounts of all US citizens or green card holders
to the IRS to ensure that these people are not evading US taxes. Many Americans residing overseas
or doing international business find themselves locked-out by foreign financial institutions that
have chosen to get rid of all US customers rather than be subject to these reporting requirements.
Boris Johnson, the UK prime minister fell foul of these regulations in 2014,
when he received a tax bill from the IRS for capital gains on a home he had sold.
Boris was born in New York, but lived in the UK since the age of five. He allegedly
paid the tax bill but then renounced his US citizenship to avoid further complications.
KYC (or know your customer) requirements are also in place for all financial institutions.
This requires them to know who their customers are, to verify that they are who they claim to be,
to verify the source of their funds and to keep up to date information on them.
Financial institutions are required to ensure that they don’t have any financial dealings with people
who are on certain lists suspected of receiving bribes or being involved in criminal activity.
In certain cases, financial institutions are even expected to know their customers
customers. As you can imagine these requirements are time consuming and expensive to do right. If
an institution is found to be negligent in their analysis they can be hit with large fines and lose
their regulatory authorization to do business. It is probably obvious to you that it makes no
sense for regulators to enforce these requirements on international money transfers in the
traditional financial system and then allow crypto to be exempt. So if crypto today is faster and
cheaper than traditional financial institutions at moving money around the world it is because
the world of crypto simply ignores all of these regulations. Regulators are not happy about that.
Now, the new Chinese regulations will likely mean that the large centralized and regulated exchanges
will stop accepting new Chinese clients (and will quickly off-board their existing Chinese
accounts). Essentially Chinese customers will be treated the way that US customers are treated by
“non-U.S. crypto exchanges” today (many exchanges refuse to deal with US customers in order to avoid
having a run in with US regulators.) A bigger question though is
whether this crypto ban will work at all? Given that cryptocurrencies are decentralized, it
is, in practice, very difficult to completely ban them. In theory, anyone in China who has a crypto
wallet could start trading on permissionless decentralized exchanges where there is no KYC.
Even if certain websites are blocked in China, crypto traders can just use VPNs to get around
these restrictions. On top of that, millions of Chinese nationals live and work abroad. Stopping
these people from buying cryptocurrencies and bringing them back to China could be impossible.
So what about the US and their plans to regulate crypto? Gary Gensler– The Chairman of the SEC’s
recent remarks have made his intention to use the full powers of the SEC
to rein in illegal behavior in the crypto market very clear. He expressed hope that Congress would
step in and fill any cracks in the current legal framework so that crypto can be fully regulated.
It would appear that Gensler’s initial focus is on what is known as Decentralized finance or DeFi.
DeFi platforms aim to replace financial intermediaries such as banks or brokers
with software known as smart contracts. These would automate crypto market activity.
An example would be a contract that could be funded by crypto investors
that then makes a market between two different cryptocurrencies following hard coded rules,
with no human intervention. A smart contract like this could eliminate the need for exchanges
or middlemen. The appeal is that this technology could lower costs and speed up trading. The reason
regulators are so focused on this area is that these DeFi platforms would replace the entities
that governments rely on right now to enforce the laws against money laundering and tax evasion.
In particular they sidestep all KYC regulations. Just to be clear, money launderers don’t need
cryptocurrencies to do what they do. Most could get by with traditional methods — such as mixing
illegal funds into trade flows or ploughing them into assets like property or art. So,
while the extent of money laundering in the crypto markets is difficult to assess, there
is no doubt that regulators are focusing on it. Janet Yellen, The US Treasury secretary, recently
described “the misuse” of cryptocurrencies as a “growing problem”. Christine Lagarde, The ECB
president, linked digital assets to “totally reprehensible money-laundering activity”.
Right now “The ‘on and off ramps’ into cryptocurrencies are still
traditional financial firms. In order to take your illegally sourced funds and move them
into crypto currencies you still mostly have to deal with a financial institution like a bank
which has the traditional anti money laundering requirements in place. Similarly redeeming crypto
into money that can actually be spent involves going through traditional financial channels.
Over time though, if crypto began to be used for day-to-day spending, a criminal would find
it very easy to avoid any checks. The fact that these on and off ramps are regulated
does not do a lot to prevent money laundering. If you were a criminal mastermind and wished to show
a source for your wealth, you could draw a little digital picture, mint it as an NFT, have someone
buy it from you for say $100 million dollars, and not only can you now show the relevant authorities
where your money came from, but you are also a famous artist and you get to go to glamorous
art parties and drink champagne, rather than going to the criminal parties you are used to.
You might even get to hang out with Logan Paul – one of the major artists of your generation…
not my generation… yours… OK, so if the SEC were to crack down on crypto,
or at least try to bring it inside the current regulatory framework, what might they do? It would
appear that they would likely start with crypto exchanges and DeFi and work from there. The US
Justice department has been going after exchanges for a while for violating KYC rules. It’s not
clear at the moment if the SEC has the legal authority to impose anti-money laundering rules
on the software developers behind DeFi protocols. - the automated exchanges I mentioned earlier.
Under the existing legal framework, they would probably try to find a corporate link in the
DeFi platforms to which legal obligations could be attached. Gary Gensler - the SEC chair, hinted
at this in a recent Financial Times interview where he said that DeFi platforms reminded him
of the “peer-to-peer” lending businesses that developed in the earlier part of the century.
Just as there was “a company in the middle” of peer-to-peer lending, he said
DeFi has “a fair amount of centralization”,
including governance mechanisms, fee models and incentive systems. “A lot of the developers want
to suggest that they are not doing anything more than developing software,” he added.
“It’s a misnomer to say that DeFi platforms are just software that is put out on the web.”
The world will definitely be watching what China does in this space.
It might be close to impossible to ban crypto, but almost everything about crypto is contrary to the
direction that regulators have been moving in over time. It is pretty much guaranteed
that there will be a show down. The question is whether the slow process of creating new rules
and passing laws will be able to keep up with the rapidly evolving world of cryptocurrency.
If you found this piece interesting, you will probably really enjoy my piece on John Law, the
man who invented paper money and the Mississippi Company. Have a great day and see you soon. Bye