Evidence submitted by Dr Alison Lui (DGC0016)
House of Commons Treasury Select Committee Digital Currency Inquiry
Written evidence submitted by Dr Alison Lui
I am a Senior Lecturer at Liverpool John Moores University where I teach Financial Regulation and other corporate/commercial modules. I am an Academic Fellow of the Inner Temple, Churchill Fellow and Max Planck Fellow. I was a practising solicitor before entering academia.
Executive summary
Main submission
1. The UK government should consider defining ‘digital currency’ in its legislation. To date, Australia is the only country which has defined ‘digital currency’. Japan and Germany have defined ‘virtual currency’ but this is broader than ‘digital currency’ since online gamers can use ‘virtual currencies’ with no real value. The US case of State v Espinoza (2016) highlights the legislative gap in Florida law in dealing with digital currency. The court in this case had to apply the Texas Department of Banking’s position on virtual currency to interpret Florida legislation.
2. Initially, most countries adopted a ‘wait and see’ attitude or issued warning notices. The trigger to a revaluation of the laissez-faire regulation is the Bitcoin bubble in late 2017. Approaches to Bitcoin range from complete bans of cryptocurrency to more liberal attitudes where Bitcoin is accepted as legal payment. Countries which prohibited Bitcoin trading include Israel and South Korea, where it banned anonymous trading of cryptocurrency.
3. China has adopted the strictest regulation towards cryptocurrency. It banned ICOs; banned Bitcoin trading on mobile phones and the internet and ordered the freezing of bank accounts linked to Bitcoin exchanges. It is important though, to remember that each country’s response to regulating Bitcoin is influenced by local politics and country specific issues. In China’s case, the government was keen to reduce corruption and stem capital outflows. Similarly, Iceland has banned Bitcoin because it is worried about capital flight. Another country which has banned Bitcoin is Bolivia.
4. Meanwhile, at the other end of the scale are countries adopting a relatively liberal approach to Bitcoin, balancing financial innovation with consumer protection. The United Kingdom, Canada, Australia and Japan fall within such group.
5. Canada has a ‘regulate and embrace’ policy. It also tries to tackle anti-money laundering risks through legislation. Canadian anti-money laundering legislation has been amended to classify persons “dealing in virtual currencies” as “money services businesses” requiring those businesses to come under Canada’s anti-money laundering and counter-terrorist financing regime (Chapter 20, Statutes of Canada 2014). Further, section 73 of the Proceeds of Crime (Money Laundering) and Terrorist Financing Act allows the Council Governor to make any necessary regulations in relation to virtual currencies.
6. Australia accepts Bitcoin as legal tender and is removed from double taxation policies. The Australian Transactions and Reporting Analysis Centre (ATRAC) has been given extra regulatory powers regarding digital currency. The ATRAC has passed new policy principles obliging digital exchange providers to comply with online registration requirements. During the period of 3rd April – 2nd October 2018, the ATRAC CEO can take enforcement action if any digital exchange provider fails to take ‘reasonable steps’ to comply. This transitional arrangement is commendable since it operates in a similar manner as regulatory sandboxes.
7. In Australia, the Australian Securities and Investments Commission (ASIC) has operated regulatory sandboxes since 2016. The initial uptake has been poor with only one business using the sandbox by June 2017. Therefore a recent Bill has passed, proposing to establish enhanced regulatory sandboxes. The most important change is providing ASIC with the powers to make conditional (rather than unconditional) exemptions from Australian financial services licence (AFSL) or Australian credit licence requirements. These decision-making powers strengthen ASIC’s control in the regulatory sandbox process.
8. In its one year review of the regulatory sandbox scheme, the FCA recognised the regulatory sandbox scheme has been successful in several respects for firms and consumers. Nevertheless, it acknowledges its shortcomings in a number of areas, including the reluctance of some banks to provide banking services to firms using distributed ledger technology (DLT).
9. DLT was the most popular technology used by the first two cohorts in the UK. DLT is the technology underpinning blockchain, which is used in Bitcoin transactions. A number of reasons are offered as to why some banks refuse firms which wishes to use DLT: greater money laundering and terrorist financing risks; credit risks and compliance costs. Refusing banking facilities to such firms could lead to ‘de-risking’, restricting competition in the financial sector. It is clear therefore, that the FCA is keen to promote financial technology to increase innovation and competition in the financial industry.
Lessons for the UK government
10. Lithuania might provide some food for thought because the Bank of Lithuania will launch a blockchain sandbox platform service called LBChain in 2019. The LBChain provides specific advice, research and consultations to firms using blockchain technology. This unique platform has the support of EU funding and will be of interest to other regulators around the world. The EU itself has set up a EU Blockchain Observatory and Forum <http://europa.eu/rapid/press-release_IP-18-521_en.htm which promotes blockchain stakeholders to have dialogues; monitor blockchain developments and address challenges which blockchain brings. This is a great initiative as it is a pan European forum where stakeholders can discuss cross-border issues concerning blockchain.
11. Another useful and helpful suggestion is a global regulatory sandbox which the FCA have made https://www.fca.org.uk/firms/regulatory-sandbox/global-sandbox. Currently, regulatory sandboxes only allows firms to conducts tests in specific jurisdictions. However, many firms are international and/or use technology for cross-border purposes. As such, a global regulatory sandbox can be a useful way for participants as well as regulators in several jurisdictions to discuss and address challenges and best practice. International co-operation is required to minimise regulatory arbitrage. Yet, any attempt to achieve harmonisation and consensus at an international level is very complex. Therefore, a multilateral regulatory sandbox is going to be very difficult to achieve due to different regulatory issues and systems at this point.
12. The author suggests a step by step approach to reaching that goal. Currently, the FCA has signed ten bilateral agreements with other jurisdictions to encourage greater dialogue. The government has also built ‘FinTech bridges’ with Singapore, South Korea, China, Hong Kong and Australia. It has built particularly close links with Australia, where the two countries agreed to provide mutual support on FinTech; harmonise policies and refer FinTech businesses to each other’s regulatory sandbox. It is submitted that these are fantastic steps towards creating a global regulatory sandbox and it is hoped that the government can incorporate more countries to their existing network. These countries rank highly in the 2017 IFZ Global FinTech Rankings and EY FinTech Adoption Index 2017.
13. Closer co-operation with Asian countries may also reduce regulatory arbitrage and maintain London’s status as the global FinTech hub. London is in fact the top global FinTech hub in 2017—it generated £6.6 billion in 2017. Light-touch regulation and supportive government policy have been cited as reasons for London’s dominance as the global FinTech hub. Brexit however, may lead some FinTech companies to set up in competitive FinTech hubs in Europe such as Berlin, Zurich or Paris. Nevertheless, these EU countries are expensive to live in. Strong competition from Asian countries such as Japan, Hong Kong and Singapore might be the real threat. Singapore has signed more bilateral agreements than any regulator. Japan has been very supportive with FinTech start-ups by passing FinTech friendly legislation on blockchain and application programming interfaces (APIs). It has abolished a law that prevented banks to own more than 5% of a technology company. This would encourage more investment and collaboration between banks and FinTech startups. Finally, the Banking Act 2017 encourages Open Banking through APIs. This requires banks to publish their policies with electronic service providers who wish to use APIs.
14. The UK government can consider creating more academic-industry partnerships in FinTech. One key scheme is the knowledge transfer partnership where an industry intern will work at a university on an agreed project. Mitsubishi UFJ Financial Group has set up its own research unit to conduct more research into FinTech. Enthusiasm from industry stakeholders is a good sign of success. Investing funds into such schemes will provide more incentive to stakeholders than waiting for industry players to take the initiative.
15. Secondly, international organisations such as the IMF. Financial Stability Board and the Financial Action Task Force (FATF) can assist and promote the concept. These organisations have already reduced financial instability by setting standards, principles and rules on FinTech, terrorist financing and money-laundering. The G20 countries will discuss crypto-assets in its summit in November 2018, providing an excellent opportunity to develop and enhance international co-operation in regulating digital currency. International co-operation can be expensive.
16. An example is the closure of an illegal website called AlphaBay. In July 2017, the United States led an international operation to close AlphaBay, the largest online criminal marketplace on the internet. Before the site was closed, more than $1 billion had been exchanged through crypto-assets. This successful operation involved Europol as well as enforcement agencies in eight countries. It is of course, down to political will whether governments across the world are willing to spend more money in regulating digital currency. In the author’s opinion, it is hoped that governments will consider injecting proportionate amount of resources in regulating and enforcing digital currency to restore public confidence in the financial sector.
17. The author predicts that the FCA’s workload will increase in the near future due to three aspects: education and advising of FinTech; supervision of FinTech startups and enforcement. It is important that adequate staff are hired, including engineers and IT experts so that the FCA can confidently tackle the challenges of digital currency. This is in light of the FCA’s recent announcement of prioritising Brexit’s impact on banks, earmarking £30 billion for this. Consequently, it will scale down on non-urgent issues. It would be a shame if FinTech regulation is de-prioritised.
18. Regulators will no longer be confined to lawyers and economists. The complexity of FinTech, such as blockchain, requires both industry players, which includes IT experts, to work with regulators to achieve a balanced and effective regulatory approach. Boardrooms will need FinTech expertise to monitor any potential risks arising from machine learning algorithms. Banks and FinTech startups should have experts in artificial intelligence and FinTech to be able to explain to directors and regulators what potential risks there are with their products, services and models. Auditors are also needed to validate the design and controls of the platforms that host the software and to interpret the complex data sets that are created. The future of regulation will look rather different with a cross-section of experts involved.
Conclusion
The UK government is on the right track with regulating digital currency. However, it can definitely learn from other jurisdictions to further enhance its regulatory approach to digital currency. Although the FCA has prioritised Brexit related matters, it should still financially support regulation and enforcement of FinTech, especially when the law always lags behind technology.