Bitcoin and the Race to Regulate Cryptocurrency Series, Part 2

October 2018 Bitcoin and the Race to Regulate Cryptocurrency Series, Part 2

A new form of asset called “cryptocurrency” is experiencing a surge in interest from mainstream investors and corporations worldwide. However, the rising popularity of the digital coins has not gone unnoticed by global regulators. In the second paper of our series on cryptocurrency, we focus on the role of virtual currencies in the global markets and the impact on the regulatory environment. Bitcoin (BTC) and the topic of cryptocurrency as trading momentum drove the price of BTC from $8,002 an investment continues to attract the market’s on November 23 to an all-time high of $20,000 on attention, largely due to the rise in investment from December 18, 2017. In contrast, in March 2018 the institutional-sized investors, corporations, and other market shed more than $60 billion after Google’s parent major players in the financial markets. The most company, Alphabet Inc., announced it was banning all active cryptocurrency exchanges have traditionally crypto-related advertisements.2 been in the more developed countries of Japan, China, Adding to market uncertainty, some major banks South Korea, and the United States. But growth is have limited the purchase of cryptocurrency directly strengthening in the emerging economies of Russia, with bank and credit cards until the risks are better Brazil, Colombia, and Venezuela, where the coins known. To temper crypto-related activity, online are viewed as a potentially more stable medium of payment companies such as Visa and MasterCard exchange than government-backed currencies. have increased their charges for a cryptocurrency However, with the digital coins increasing their transaction by redefining it as a cash advance rather presence in the global economy, regulators have been than as a standard purchase. compelled to take action to provide better oversight U.S. cryptocurrency exchanges, as well as the sale, in an effort to limit downside risk to the markets. offer, or trading of digital coins and initial coin offerings The degree to which government regulators have been (ICOs), are subject to federal regulations governing open to legalizing BTC and other cryptocurrencies other financial entities, including compliance with anti- has varied by country. While the United States and money laundering rules, know-your-client standards, international countries such as China and Japan have and the Bank Secrecy Act. In April 2018, the New York researched the potential economic and social benefits Attorney General’s Office launched the Virtual Markets of the digital coins, other countries such as Russia Integrity Initiative to increase accountability and have outright banned cryptocurrency-related activity. transparency at the major exchanges in New York and across the country. The U.S. Department of Justice United States opened a criminal probe in May 2018 regarding whether While initially conceived to act as a medium of BTC and Ether altcoin traders are manipulating the exchange, recent trade activity would suggest investors view BTC as a vehicle for speculative trading, which is reflected in its historical price movements. After In an initial coin offering, a crypto-related start-up starting 2017 with a combined market cap of roughly company issues a tradable utility or equity token in $17.7 billion, cryptocurrencies reached a record exchange for funds from investors. An equity token $830 billion in January 2018, an increase of more than represents ownership of a security. 3,300% in one year.1 Similar to the dot-com bubble,

1 Mybudget360, “Cryptocurrency Bubble or New Paradigm? When $100 Billion in Market Cap Evaporates Overnight and the Rise of New Currencies [Web Blog Post], January 11, 2018, http://www.mybudget360.com. 2 L. Laurent, “Google’s Ad Ban Leaves Twitter with a Crypto-Challenge,” March 14, 2018, https://www.bloomberg.com/gadfly/articles/2018-03-14/google-ad-ban-leaves-twitter-jack-dorsey-with-a-crypto-challenge.

pnc.com Bitcoin and the Race to Regulate

one SEC staff member has publicly suggested that both Chart 1 Bitcoin Price Index (in Dollars) BTC and ETH should not be considered a security since they are decentralized and they do not seek to fund a 15,000 13,860.14 project in exchange for a return; rather, the digital coins 12,500 are used for facilitating transactions.5 10,309.64 9,916.54 10,000 9,244.32 With regulation becoming more of a reality in the 7,726.89 United States, it is our view asset managers, trading 7,500 6,926.02 7,013.97 6.387.31 firms, and institutional and retail investors appear 4,764.87 5,000 to be growing more comfortable operating in these 2,328.91 2,500 exchanges. But executing large trades can be difficult 967.67 1,079.75 Bitcoin price index in U.S. dollars 608.44 742.01 and time consuming to complete with the market 0 fragmented across many exchanges, and connecting

Sep 16 Nov 16 Jan 17 Mar 17 May 17 Jul 17 Sep 17 Nov 17 Jan 18 Mar 18 May 18 Jul 18 Sep 18 to each exchange requires setting up separate accounts. Exchanges also tend to impose limits on Note: The graph presents the evolution of BTC price index from September 2016 to September 2018. The BTC price index is an average daily activity, and prices can move dramatically before of bitcoin prices across leading global exchanges. The bitcoin index an order is completed. value for the end of September 2018 amounted to $6,604.97. Source: https://www.statista.com/statistics/326707/ In December 2017, CBOE Global Markets became bitcoin-price-index/ the first major exchange to launch a futures product linked to the price of BTC, with the well-known price of the coins, with federal prosecutors working with Chicago Mercantile Exchange (CME) following suit. the Commodity Futures Trading Commission (CFTC) to These products are regulated under the laws of the 3 investigate incidences of spoofingand wash trading. CFTC, and the CBOE also applied with the SEC to list In an ICO, a tradable utility or equity token is issued by six BTC exchange-traded funds (ETFs).6 the company in exchange for funds from investors. An Intercontinental Exchange (ICE), the parent company of equity token represents ownership of a security and the New York Stock Exchange, is working on a trading must be registered with the Securities and Exchange operation to buy and sell BTC more directly in the form Commission (SEC) and taxed by the Internal Revenue of swap contracts. In this case, clients would receive Service. An asset’s likelihood of being defined as a the digital coins at trade settlement, and the trading security depends mostly on whether the buyer expects would be regulated under CFTC laws.7 While hedge to profit from the work of a centralized third party. funds trade BTC directly for sophisticated clients, Purchasers of a utility token expect their investment will appreciate as demand for the company’s product or service grows, and the investment traditionally has Spoofing is the act of entering visible nonlegitimate not been subject to regulation. The SEC has concluded orders with the intent to mislead other traders the definition of a utility is quite similar to the about the true level of supply or demand in the characterization of a security, thus most tokens should market. Wash trading refers to entering into, or be regulated as a security and start-ups must follow purporting to enter into, transactions to give the private placement rules and file all the necessary appearance that purchases and sales have been 4 financial statements and disclosures. made, without incurring market risk or changing There have been no instances of ICOs registering with the the trader’s market position. It is an illegal stock SEC so far. The SEC publicly confirmed in June 2018 that trading practice. it believes most ICOs are securities. However, at least

3 M. Robinson and T. Schoenberg, “U.S. Launches Criminal Probe into Bitcoin Price Manipulation,” May 24, 2018, https://www.bloomberg.com/news/articles/2018-05-24/bitcoin-manipulation-is-said-to-be-focus-of-u-s-criminal-probe. 4 W. Hinman, “Remarks at the Yahoo Finance All Markets Summit: Crypto,” https://www.sec.gov/news/speech/speech-hinman-061418. 5 Ibid. 6 Robinson and Schoenberg, “U.S. Launches Criminal Probe into Bitcoin Price Manipulation.” 7 “Why NYSE’s Parent Company Is Building a Bitcoin Exchange,” Fortune, http://fortune.com/2018/05/08/nyse-bitcoin-exchange/.

2 Bitcoin and the Race to Regulate institutions such as mutual funds and pensions have seven exchanges were ordered to suspend business avoided it largely because of the absence of regulation. for a specific period of time until they were more up to In a January 2018 statement, the SEC said it was code. Despite the uptick in regulation and incidences willing to consider such investment products, but of hacks, two of Japan’s foremost trading brokers, the noted it will need to weigh various investor protection Monex Group Inc. and SBI Holdings Inc., have shown issues such as trade manipulation, valuation, custody, interest in branching out to cryptocurrencies. and liquidity. No BTC ETFs have been approved as of September 2018, and it is worth noting that in August China and the Emerging Markets nine more applications were rejected by the SEC, with While traditionally a supporter of cryptocurrency, in the regulator pointing to a lack of transparency and January 2018 China announced it was ramping up its continuing concerns over trade manipulation.8 efforts to prevent the trading of the digital coins, causing the price of BTC to drop more than 67%.10 Until 2017, Japan China held 70% of all global BTC mining operations, but The yen is currently one of the most active this changed when the Chinese government, alarmed currencies trading BTC. Japan’s government has about the rise in unlawful behavior, chose to ban mining been one of BTC’s biggest proponents, viewing and ICOs, and shut down all domestic exchanges. it as a potential source of economic growth. Several operations have moved to countries such as Japan’s Financial Services Agency (FSA) was one Switzerland, where there is both cheap electricity and of the first government agencies to implement an a more favorable regulatory climate. Chinese citizens effective regulatory structure, and the industry have been able to circumvent the restrictions via has flourished as a result. Since April 2017, the nondomestic trading options, forcing the government country’s cryptocurrency exchange businesses have to block all international cryptocurrency websites and 11 been regulated by the Payment Services Act, which to curb bank loans to crypto-related businesses. requires the exchanges to register with the FSA, South Korea, like China a previously booming region maintain detailed records of all transactions, and for cryptocurrencies, has also reined in the market follow specific security measures to reduce risk. amid an escalation in thefts from the exchanges, Japan was driven to enhance its regulatory oversight underage trading, and the emergence of multi-million- following a hacking attempt at the Coincheck exchange dollar Ponzi schemes. The country now accounts for a in January 2018. Coincheck, one of Japan’s most small percentage of global BTC trading. In April 2018, popular cryptocurrency exchanges, lost about prosecutors targeted Coinnest, the country’s largest $400 million of its customers’ NEM crypto tokens.9 trading operation, for allegedly stealing customer As a result, the FSA ordered all domestic exchanges to assets. The Bithumb, Coinone, and Korbit crypto submit a risk management report, and all unregistered exchanges have voiced their support for stricter laws 12 exchanges are now subject to FSA inspections. as a means to legitimize and reinforce the industry. In March, the FSA conducted an inspections of The Reserve Bank of India outlawed banks from Coincheck and other exchanges, leading to the local making loans to cryptocurrency exchanges beginning finance bureaus issuing business-improvement orders in July 2018. Rupee-based BTC prices fell and to seven exchanges, including Coincheck. Two of the trading volumes plunged.13 While the intent of global

8 D. Scheer, “SEC Quashes More Bitcoin ETF Pitches in Another Blow to Crypto,” The Wall Street Journal (August 22, 2018), https://www.bloomberg.com/news/articles/2018-08-23/sec-quashes-more-bitcoin-etf-pitches-in-another-blow-to-crypto. 9 “Regulation of Cryptocurrency Around the World,” The Law Library of Congress, Global Legal Research Center, June 2018, http://www.law.gov. 10 R. Derousseau, “Bitcoin’s Price Is Plunging and Here’s Who to Blame,” January 17, 2018, http://time.com/money/5105008/bitcoin-plummets-as-more-governments-crack-down-on-cryptocurrencies/. 11 A. Lielacher, “Bitcoin, China, Regulation” [Web Blog Post], April 2, 2018, https://bravenewcoin.com/news/chinas-waning-influence-on-the-global-bitcoin-economy/. 12 J. Young, “South Korea’s Largest Bitcoin Exchanges Ready for Strict Regulations,” December 14, 2017, https://cointelegraph.com. 13 A. Nupur, “Despite India’s Crackdown, New Cryptocurrency Exchanges Are Still Coming,” May 17, 2018, https://qz.com/india/1279288/despite-indias-crackdown-on-bitcoin-new-cryptocurrency-exchanges-are-still-coming/.

3 Bitcoin and the Race to Regulate regulators is to promote a safe and secure market the popular, new asset class is largely unregulated. environment, their actions have spurred some Financial institutions are grappling with their own cryptocurrency investors to trim their positions due to ambiguities, specifically whether banks will accept the an uptick in government oversight and more stringent digital coins as deposits and collateral and whether trading conditions. investment firms will partake in trading for their clients, provided it is within the boundaries of existing laws. In some less stable emerging economies, many There are numerous unknowns related to the regulatory citizens may have access to modern-day amenities, and legal hurdles, including the custodial prerequisites such as the internet and cellphones, but lack basic if assets are held on a blockchain network, fulfilling the government services and a reliable central bank. anti-money laundering obligations, protecting against Consider Russia, where a deteriorating infrastructure, cyber threats, and appropriately evaluating counterparty shrinking populations, and inadequate government risk. As the regulatory environment becomes more services in the country’s more impoverished areas concrete across the globe and opportunities to invest prompted a Russian farmer, Mikhail Shlyapnikov, become more abundant, we think it will become clearer to invent a local digital coin called the Kolion in for financial organizations and other mainstream 2017. The coin’s intention was to help address the investors to determine if cryptocurrency is an attractive problem of income disparity between the urban and feasible option for their portfolios. At the moment centers of Moscow and Russia’s poorer agricultural though, the investment landscape is apt to transform communities like the town of Kolionovo. It has been considerably over the coming years, yielding far too integrated into the local economy as a way to pay for many ambiguities and risks, in our opinion, for an 14 municipal services such as trash and snow removal. investor today.

Jeffrey D. Mills What’s Next for the Markets Co-Chief Investment Strategist The establishment of firmer regulations is gathering international momentum, with governments Julia C. Wirts, CFA® articulating a goal of addressing the perception that Investment Advisor

In our next paper, Crime in the World of Virtual Currency, we explore Bitcoin and how it has become a factor in international money laundering and other criminal enterprises—and what law enforcement is doing to address this issue.

14 T. Grove, “Russian Farmer Alters Rural Economy with Virtual Currency, as Moscow Watches Warily,” April 22, 2018, https://www.wsj.com/articles/russian-farmer-alters-rural-economy-with-virtual-currency-as-moscow-watches-warily-1524398400.

The PNC Financial Services Group, Inc. (“PNC”) provides investment and wealth management, fiduciary services, FDIC-insured banking products and services, and lending of funds through its subsidiary, PNC Bank, National Association (“PNC Bank”), which is a Member FDIC, and provides specific fiduciary and agency services through PNC Delaware Trust Company or PNC Ohio Trust Company. This report is furnished for the use of PNC and its clients and does not constitute the provision of investment advice to any person. It is not prepared with respect to the specific investment objectives, financial situation, or particular needs of any specific person. Use of this report is dependent upon the judgment and analysis applied by duly authorized investment personnel who consider a client’s individual account circumstances. Persons reading this report should consult with their PNC account representative regarding the appropriateness of investing in any securities or adopting any investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. The information contained in this report was obtained from sources deemed reliable. Such information is not guaranteed as to its accuracy, timeliness, or completeness by PNC. The information contained in this report and the opinions expressed herein are subject to change without notice. Past performance is no guarantee of future results. Neither the information in this report nor any opinion expressed herein constitutes an offer to buy or sell, nor a recommendation to buy or sell, any security or financial instrument. Accounts managed by PNC and its affiliates may take positions from time to time in securities recommended and followed by PNC affiliates. PNC does not provide legal, tax, or accounting advice unless, with respect to tax advice, PNC Bank has entered into a written tax services agreement. PNC does not provide services in any jurisdiction in which it is not authorized to conduct business. PNC Bank is not registered as a municipal advisor under the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Act”). Investment management and related products and services provided to a “municipal entity” or “obligated person” regarding “proceeds of municipal securities” (as such terms are defined in the Act) will be provided by PNC Capital Advisors, LLC, a wholly-owned subsidiary of PNC Bank and SEC registered investment adviser. Securities are not bank deposits, nor are they backed or guaranteed by PNC or any of its affiliates, and are not issued by, insured by, guaranteed by, or obligations of the FDIC or the Federal Reserve Board. Securities involve investment risks, including possible loss of principal.