Governments want to control cryptocurrencies — but there's a danger to too many rules

Cryptocurrencies have exploded in popularity in recent years, thanks to innovation in blockchain, the distributed ledger technology underpinning those virtual tokens such as bitcoin.

That has led to a red-hot fundraising trend where start-ups are pulling in millions of dollars in capital by issuing virtual coins to investors in exchange for money.

As a result, there is renewed interest from regulators in Singapore, the United States, Japan and China to have oversight in the cryptocurrency space and curb the potential of widespread money laundering and fraud. But some worry that too many rules could potentially deter firms from innovating on the blockchain.

On Wednesday, Japanese media reported that the country is set to introduce regulatory oversight on cryptocurrency exchanges in October. The challenges that authorities need to figure out include settling on accounting rules for virtual currencies and deciding how to handle initial coin offerings (ICOs), according to the Nikkei business daily.

Earlier this month, Chinese authorities said ICOs, which have become a primary means of fundraising for projects that are built on blockchain technology, are now illegal in the country.

Chinese regulators called ICOs unauthorized illegal fundraising activity and recent reports indicated they have clamped down on local bitcoin exchanges. Bitcoin is the most commonly used cryptocurrency.

“The only way you can really stop bitcoin in China completely is if you shut down the internet. So the regulators are really focused on the points where bitcoin hits fiat currency,” Zennon Kapron, founder and director at consultancy firm Kapronasia, told CNBC’s “Squawk Box” on Wednesday.

“The current regulation that’s being talked about is banning bitcoin exchanges, which would cut out a lot of the trade flows we’re seeing in China right now and the exchanges around bitcoin,” Kapron added. “So we’ll likely see them focused around those activities where there is an entity or person or some kind of connection to the traditional financial system that they can control.”

On Tuesday, reports said a senior official at China’s central bank defended the move to ban ICOs but also said the move should not stop firms from studying blockchain technology further.

The way ICOs work is fairly straightforward: Companies create and issue digital tokens that can be used to pay for goods and services on their platform or stashed away as an investment. They put out whitepapers describing the platform, software or product they’re trying to build, and then people buy those tokens using widely-accepted cryptocurrencies (like bitcoin and ethereum) or fiat currencies like the U.S. dollar.

Start-ups have raised more than a billion dollars this year in coin sales and in recent months. In China, ICOs have raised at least 2.62 billion yuan (about $ 400 million), Reuters reported, citing local media.

All of that is done with minimal regulatory oversight. Moreover, digital currencies are pseudonymous, decentralized and encrypted, making it harder to track each of the transactions made, and the individuals behind them. Theoretically, anyone with an internet connection and a digital wallet can be part of a coin sale event.

That, many worry, leaves plenty of room for people to launder money or finance terrorism activities and engage in other fraudulent behaviors — especially in countries where corruption is rampant.

In August, Singapore’s financial regulatory body and central bank, the Monetary Authority of Singapore (MAS), said in a missive that ICOs are “vulnerable to money laundering and terrorist financing risks due to the anonymous nature of the transactions, and the ease with which large sums of monies may be raise in a short period of time.”

The MAS also clarified that it will regulate the sale of digital tokens in the city-state if they constitute products regulated under Singapore’s securities and futures regulation.

In turn, some groups behind digital tokens have taken pains to emphasize that their cryptocurrencies are not “securities,” but rather act more like rewards program points (like airline miles). As in the case of Singapore, securities are oftentimes more stringently regulated than other kinds of assets.

Meanwhile, the U.S. Securities and Exchange Commission (SEC) provides guidelines on its website for investors to consider before participating in token sales. Some of the key points the SEC asks potential buyers to consider are ways to identify fraudulent investment schemes.

Previously, the SEC released an investigative report in which it said companies that planned to use distributed ledger or blockchain-enabled ways to raise capital must take appropriate steps to comply with the U.S. federal securities laws.

Regulatory oversight for ICOs will see net benefits, multiple sources have told CNBC before. Most agreed that having proper rules in place can protect investors in the same manner they are safeguarded in the securities market.

Having the proper regulation in place is particularly important as this form of fundraising is expected to gain more traction, especially among retail investors. Smith + Crown data showed that in the first half of 2017, there were more token sales than there were in all of 2016, with fundraising amounts increasing month to month since March. Token Data, another website that tracks upcoming token sales, listed dozens of ICOs in the coming months.

While regulation can sometimes be expensive for companies, it could also bring in benefits.

Currently, token sales are restricted mostly to retail investors who are not bogged down by the compliance rules faced by institutional investors. A regulated ICO market, with proper checks in place, could draw in professional investors, Syed Musheer Ahmed, a senior financial technology consultant and a member of the board at the FinTech Association of Hong Kong, told CNBC previously.

If the industry opens up to professional investors, who have more capital to invest, companies can raise more money, he said.

On the flip side, the argument goes that heavy-handed regulation of digital currencies could stifle innovation in blockchain as companies may need to set aside a larger portion of their budget for regulatory compliance.

It would also reduce or remove layers of privacy which is one of the central tenets of cryptocurrencies.

“(Many see that) fiat currency is corrupted by the heavy-handed intervention of central governments and banks. Cryptocurrencies are anonymous (to a certain extent) and decentralized, meaning decisions affecting the currency are not centrally dictated,” Justin Hall, principal at early-stage venture capital firm Golden Gate Ventures, previously told CNBC. “In fiat, trust is enforced by a third-party.”

But critics would call back to investor protection to argue in favor of regulations, he said, adding it may be difficult to reconcile the two sides. Moreover, Hall said, given how new the technology is, many regulators still “do not fully understand this emerging industry.”

Implementing poorly planned policies may do more harm than good, he warned.

Others suggest that there’s a general misconception among investors and companies that ICOs are not regulated already. Hence, many of the ICO campaigns are being done with little or no professional or technical guidance. That may result in misleading information and unfair sales processes, inappropriately designed token features and poorly written smart contracts that are vulnerable to hacking.

Currently, to get around regulatory scrutiny, many ICOs prevent residents from the United States and Singapore to participate in their token sales — either by blocking internet protocol addresses from those locations or by relying on self-declarations from the participants.

But experts say that people are easily able to get around it by either using a virtual private network connection to mask their location or by simply asking a third party in a different place to participate on their behalf.

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