Blockchain & Bitcoin: The risks attached to cryptocurrencies
Bitcoin broke fresh ground just within a month of 2021, with a skyrocketing price of $40,000 (£29,000) per Bitcoin last week. Having analysed in a previous article the substance behind the buzz when it comes to Bitcoin and blockchain, this article takes a closer look at the risks attached to cryptocurrencies which have attracted the attention of regulators. The analysis follows such a path by first considering cryptocurrency exchanges and their role in crypto transactions, further examining the insolvency risks and proprietary rights in digital assets highlighted by Mt.Gox’s insolvency, and finishes with the continuing links between money laundering and crypto, and the so-called “black e-commerce”.
Although UK financial regulators have warned of the risks relating to crypto-investing, which are accentuated even more by the growing retail popularity of Bitcoin, there is no current blanket prohibition or ban in the UK on such investing. As previously discussed, cryptocurrencies are considered separate from fiat currency, and presently the Bank of England has not made any moves to introduce a central bank digital currency.
With fears growing that the Bitcoin bubble is about to burst any minute, the cryptocurrency has been seen going through volatile price swings left and right. In the meantime, however, and until regulators step in, crypto transactions are still largely facilitated by cryptocurrency exchanges.
A cryptocurrency exchange is generally a third-party platform that takes investor deposits in fiat currency, e.g. US$ or GBP, and exchanges that currency to a cryptocurrency such as Bitcoin (BTC), Ethereum (ETH) or Ripple (XRP).
Cryptocurrency exchanges often act not only as holders or custodians but also market places for cryptocurrencies. The debate is whether such exchanges fall under any of the two broad categories of “banking” or “custody”. Whereas “banking” involves depositing funds, being entitled to withdraw from those funds, and holding a debt claim against the bank, “custody” involves depositing or acquiring securities/interests in securities, with the custodian holding them and later delivering them to the investor in accordance with the custody arrangement.
The difference between “banking”, “custody”, and cryptocurrency exchanges, is that exchange service agreements may not specify the basis on which the cryptocurrency is acquired or held, which is what any other traditional custody agreement would do. The point of contention is that, where a de facto custodian or banking relationship exists, and not a legal one, an investor finds themselves investing in crypto without having access to a private key to the investment. The crypto investment is instead merely held on an offline secure storage, with other investors’, and the custodian’s own, funds or securities commingled together.
Both banking and custody services are under governmental regulation. Banking, for example, is a heavily regulated industry, with protection of retail customers often involving the benefit of government-backed deposit protection schemes, such as the Financial Services Compensation Scheme.
Case study: Revolut
Revolut has been offering crypto services since 2017 by means of buying, selling, receiving or spending crypto through Revolut’s e-money account. Having a closer look at the fintech’s attached terms and conditions, however, one can discover that Revolut explicitly lays out that cryptocurrencies are not regulated in the UK by the FCA, and investors are not protected by the Financial Services Compensation Scheme. In other words, if crypto funds are lost, it is most likely the case that investors will have no legal recourse for compensation.
This is further exacerbated by the fact that Revolut does not support individual cryptocurrency wallets, and instead stores cryptocurrencies in a ‘pooled’ virtual account. The investor’s balance is recorded on Revolut’s internal ledger, while it acts as a ‘nominee’ for the investor, holding the amount of crypto for them. Under the terms, this nominee relationship includes the right for the fintech giant to appoint third parties to hold the investors’ cryptocurrencies "as they see fit", with the terms setting out that there is no contractual relationship between such third party and the investors.
As a result, the uncertainties in proprietary rights in cryptocurrencies raise real insolvency risk issues, which was closely observed in the Mt.Gox bankruptcy analysed below.
The Mt.Gox bankruptcy and ‘property’ considerations
Once dubbed as the largest Bitcoin exchange in the world, Magic the Gathering Online Exchange, or Mt.Gox for short, was one of the first exchanges for digital assets. Mt.Gox also became the subject matter of one of the biggest bankruptcy proceedings since the relevant market imploded in 2014. In early 2014, customers started to complain that they requested withdrawals but never received their funds. Mt.Gox's bankruptcy soon followed after an announcement by the Exchange, that approximately 850,000 Bitcoins held by it had “disappeared” in a hacking incident. Creditors were left asking for their money, with debt claims totalling an approximate $432 million (£316m).
Legal issues of ownership and proprietary interest arose, particularly as to whether Bitcoin investors had a proprietary interest in the Mt.Gox-held Bitcoins, or if they had a right to be partly repaid in Bitcoin. The appointed trustees to the bankruptcy followed by carrying out a mass search for the lost Bitcoins, with only 200,000 Bitcoins found. The Mt.Gox heist highlighted the high risk relative to cryptocurrencies and unsecure networks as a result of their digital nature, coupled with the intricacies of proprietary interests in unregulated digital assets.
Since the declared bankruptcy, it has recently been reported that for each claimed Bitcoin locked up in the bankruptcy, only 0.23 coin is available to be given out, while proceedings are still ongoing. Even more interestingly, since Bitcoin value was at $483 in 2014 when the bankruptcy was declared, the original creditors are entitled to that price, and not the now skyrocketed price of $38,000 (January 2021 average) per Bitcoin. As a result of the skyrocketing price, there are some speculations that there may even be funds leftover to be distributed to shareholders after the debt claims are settled.
Crypto and money laundering
The cryptocurrency industry has been criticised for acting as a tool for money laundering, illegal trade, and avoidance of capital controls. Indeed, one of the main reasons for which Bitcoin has been slow to gain legitimacy and attract institutional investors is largely due to the early association of Bitcoin with the Silk Road; an online dark-net marketplace where users had access to weapons and illegal drugs with the possibility of anonymous purchasing. In fact, in 2018 the FBI seized over $4 million of bitcoin from Silk Road.
Although the blockchain has a public nature, individual identities are masked as a result of the pseudo-anonymity of 26-35 character alpha-numeric addresses. In instances where users take steps to conceal their identities and trading records, tracing the illegal activity back to a physical user is almost impossible. The importance of cryptocurrency exchanges and their anti-money laundering efforts take centre stage in this instance.
Although Bitcoin uses a transparent ledger which facilitates tracing all the way back to the bitcoin mining source, other cryptocurrencies, called ‘privacy coins’, have recently become prevalent in the dark net. The most anonymous digital currency at present is Monero, which has gained popularity in illicit activities due to its strong privacy features, including keeping user addresses hidden.
For some, the link between illicit activity and cryptocurrency use is still seen as a large factor which should cause concern, transforming the way black markets operate by enabling “black e-commerce”. According to Foley et al. , approximately half of bitcoin transactions were associated with potential illegal activity in 2018, amounting to around $72bn of illegal activity per year. According to Foley’s research, however, the illegal share of Bitcoin activity has been declining, as mainstream interest increases.
Former Goldman Sachs chief executive, Lloyd Blankfein, has warned just this week that regulators may soon be making moves against Bitcoin if the cryptocurrency continues to grow exponentially. Such a moment could be expected once Bitcoin is finally declared as a substantial and real medium of exchange.
Even more imminently, in a push towards regulation, the UK Financial Conduct Authority (FCA) has recently consulted on, and published, regulatory guidance relative to cryptoassets. Conjunctive to this is a separate proposed ban on the sale, marketing and distribution of derivatives (i.e. CFDs, options and futures) and exchange-traded notes referencing cryptoassets, to all retail consumers. It remains to be seen how crypto-libertarians will react to an exchange of their 'digital asset liberty' for crypto-regulation.