Cryptocurrency is about to face immense legal pressure
The global order is reshuffling quickly, following the Russian invasion of Ukraine. The West has responded to the invasion by imposing heavy sanctions on the Kremlin with the intent to weaken its ability to wage war. The Kremlin has been almost unplugged from the world’s financial system by excluding leading Russian banks from the SWIFT system and the EU has vouched to achieve independence from Russian gas “within years”.
The Kremlin has been forced to go on the defensive on the financial battleground, strict limits have been imposed on capital flight and the Moscow stock exchange has not been opened since the invasion began.
In all of this, there are reports that Russian elites (foremost) are using cryptocurrency and other digital assets to transfer their wealth out of the country.
Since the Russian invasion of Ukraine has started, ECB is urging member states and their institutions to hasten the regulation of cryptocurrency.
The European Union should move quickly to approve cryptocurrency regulation that prevents Russia from evading sanctions after invading Ukraine. — European Central Bank President Christine Lagarde. [1]
During his speech, on March 22nd, 2022, F. Panetta, a member of the Executive Board of the ECB, has stated the following:
The risk of misuse of crypto-assets to circumvent the sanctions against Russia is an important reminder that these markets must be required to comply with the strictest standards — including as regards know your customer, anti-money laundering and disclosure requirements — so that they do not create a major loophole at the heart of the financial system.
This means that ECB and European institutions are well aware of cryptocurrency as a potential loophole to go around the sanctions.
On the other side, Bitfinex, one of the biggest cryptocurrency exchanges, and sister company of the world’s largest stablecoin provider — Tether has declined to comply with Western sanctions stating that it will not do so unless “forced to do so”.
Cryptocurrency is notorious for being used specifically for evading capital controls ever since its inception. However, this fact was not really relevant for global powers as it did not clash with their political goals. But now it does, and this is precisely where I see the most potential for radical changes in the cryptocurrency landscape.
I believe this change in regulator approach will be the dominant signal which will pressure the cryptocurrency landscape to change in the coming years.
Law is coming
Cryptocurrency is long overdue to be regulated. A lot of murky, and straight-up illegal, things have been going on in “crypto” for years and all of this is seemingly tolerated by regulators. But not for long I reckon, as there is finally an excuse to do some house cleaning — Russian sanctions.
Tether has a long history of being used as a vehicle of capital flight out of China, in fact, it has completely taken over this role from Bitcoin following the big crypto crash of 2018. This report, dating to July 2019, goes in-depth on how Tether is being used to skirt capital controls and to enable international trade between China and Russia. It is fair to presume that this practice did not magically end in 2019 or 2020/2021. It is fair to presume that this practice is still going on, even though I have no evidence of it or insider information. I believe it is fair to say that Tether is being used to circumvent all sorts of capital controls.
Now, practices like this go against international sanctions on the Kremlin. And that gives enough justification to regulators to invest some resources to display power over the important actors of the cryptocurrency sphere.
I expect regulators to start hitting at the soft underbelly of cryptocurrency soon. That soft underbelly is foremost Tether, followed by most popular exchanges like Binance, Coinbase, Bitfinex, and many others who are interacting with Western financial systems (Swift, SEPA), especially those with business models heavily linked to Tether — like Kraken. After a few serious litigations against top actors in the space, the rest will fold.
We can see some hints of this already starting, most recently crypto.com has informed its lending service customers in a total of 38 countries that they have until March 15th, 2022 to repay their loans. But why is crypto.com withdrawing its lending service from exactly 38 countries? If you google “OECD member states” you will learn that OECD has exactly 38 member states. And that’s why.
OECD has an agency, FATF, which has been tasked to design a legal framework for all things cryptocurrency. FATF has produced a set of guidelines on cryptocurrency and their guidelines are being implemented into the legal frameworks of OECD member states.
FATF is an inter-governmental body charged with studying money laundering trends, monitoring legislative, financial and law enforcement activities taken at the national and international level, reporting on compliance, and issuing recommendations and standards to combat money laundering.
At the core of FATF guidelines is the concept of a Virtual Asset Service Provider (VASP). According to FATF, a VASP is:
Any natural or legal person that conducts one or more of the following activities or operations for or on behalf of another natural or legal person:
- An exchange between virtual assets and fiat currencies;
- Exchange between one or more forms of virtual assets;
- Transfer of virtual assets;
- Safekeeping and/or administration of virtual assets or instruments enabling control over virtual assets; and
- Participation in and provision of financial services related to an issuer’s offer and/or sale of a virtual asset.
Per FATF recommendations, all VASPs should be licensed and subject to systems for monitoring or supervision by the watchdog agency.
Obviously, actors who are used to providing services that would definitely be heavily regulated, supervised, or straight up banned do not wish to become registered and monitored.
Another interesting thing to notice is that SEC (of USA) is now officially considering Bitcoin to be a manipulated asset, by Tether nonetheless. In SEC ruling №34–94006, published January 20, 2022, SEC declines a bid for Bitcoin ETF stating the risk of: “manipulative activity involving the purported “stablecoin” Tether (USDT)”.
SEC officially sees Tether as a risk to the cryptocurrency scene.
Many will ask if DeFi will be left alone and keep its independence from the legal system. The short answer is no because 1) they can not escape the law even if they claim that “code is law” and 2) the vast majority of them are VASPs indeed and will eventually be regulated and monitored.
You can use the following guidelines to determine if some DeFi service/protocol is a VASP or not:
- If the service has no operator, it’s not a VASP
- If all you do is write software, you’re not a VASP.
Just try to think of popular DeFi protocols and NFT marketplaces which do not have an operator at all.
Code is law, but there is a bigger law.
Currently ongoing is the first lawsuit against an actor in the DeFi space. Cicada 137’s case against Medjedovic will be the first legal test of the “code is law” doctrine, which is widely accepted in the cryptocurrency space. Medjedovic has exploited a flaw in a smart contract and used so-called “flashed loans” to extract $16M worth from the protocol.
Cicada 137 LLC is the name of the entity created by the Indexed Finance (DeFi protocol, deployed on Ethereum) community to sue the defendant.
“Now that crypto is part of that legal regime, the courts are able to engage in it more actively,” says . “Assets are able to be traced more easily. It’s allowing litigants to pursue assets.” — J. Beitchman, Cicadia 137 attorney.
My conclusion is that the law is coming. Better yet, the law is already here but it was not felt yet in its full force. Especially now when the West and its ethos are openly challenged by Russia and its aggression on Ukraine. In Western ethos, the law is above all. That is basically the foundation of the Western order. The West will find a reason to make order in the cryptocurrency space. Other countries will follow swiftly (pun intended), as nobody can afford to lose the connection to Western finance.
Escaping legal responsibility
Life is good in the DeFi/DAO land right now, it’s all roses. Or pink, pink as Snagglepuss. There are no controls on the sale of tokens and there is no legal responsibility when things go horribly wrong. Risk: reward ratio is benefiting token issuers, and that is exactly why we have seen such explosive growth in the total number of issued tokens. It pays to keep issuing new tokens, as there are no repercussions.
But things are bound to change. The times of relaxed and careless fundraisers, liquidity operations, and obscene profits are done. Actors in the space are going to be forced to take responsibility.
Escaping the legal responsibility, or more bluntly — avoiding being considered a VASP will be the driving force of DeFi product development in the coming years. Swaths of existing, already deployed, DeFi protocols will strive to fork to their more decentralized iterations without centralized parties. Or simply try to further obscure the centralized elements of the protocol. Many DAOs will be formed out of protocols of all sorts in the hope to transfer and dilute the responsibility to more people. Some DAOs, which are unmistakably centralized and controlled by a few, will either get shut down or the power of its main actors will get diluted. For example, Uniswap is pretending to be a decentralized organization for a while now even though the top 100 holders collectively own 87.13% tokens of Uniswap. [3]
Protocols will likely be required to publish exact specifications on “what the code is supposed to do” to allow for interpretation of the protocol by legislators, and as a way to have a valid excuse when bugs are exploited. If a protocol has an exact specification and implemented/deployed code happens to have an exploit, the VASP which has deployed the code can not be sued for fraud. It was but an honest error they say.
More and more cryptocurrency service providers will seek to shut their doors to customers who are residents of OECD member states. Some, to avoid being prosecuted and some to avoid changing the nature of the protocol. Some of the protocols and tokens are inherently incompatible with regulations, for example, those who are de facto securities.
Some DAOs, like Maker, will double down on their efforts to interact with the real world legally. Maker DAO already sports quite an elaborate mishmash of smart contracts (automated) and human (manual) roles. [2]
I reckon more DAOs, especially bigger ones, will try to follow in these footsteps and try hard to integrate with existing financial and legal structures. This is probably the best and the most sustainable way forward. I do not think cryptocurrency (as a whole) can truly prosper if it keeps hiding in the shadows. Stepping out of the shadows, integrating with existing institutions will definitely make the wider public take a more positive stance towards cryptocurrency in both investment and adoption sense.
Legal trends point to this direction as well. The state of Wyoming (USA) has recognized decentralized autonomous organizations (DAOs) as a new type of limited liability company. The Wyoming DAO bill is quite elaborate [4] and it defines a DAO quite well. In general terms, it explains how a DAO is an organization made of human agents but governed by a smart contract and its algorithm. However, it won’t cover everything. This line stands out:
The secretary of state shall not issue a certificate of authority for a foreign decentralized autonomous organization.
This means that this bill will only cover the legal needs of domestic DAOs, in the United States.
Legislations of other OECD member states will likely follow the example from Wyoming, but modify it to match their existing legal/financial structures. DAOs will get legalized and integrated.
Many protocols and DAOs will give up and shut down. The costs of acquiring all the future licenses and certifications will be too great for many. Many apply the business models which exploit the fact that they are breaking a regulation or two. Such protocols will be pressured to the breaking point.
Conclusion
The incoming tidal wave of regulation is not a bad thing. It is a good thing. Legal pressure will apply selective pressure on the scene and allow for the proliferation of the fittest to survive the change. And in this case, it is a positive thing as protocols, tokens, coins which are actually decentralized and thus more resilient to all kinds of pressure will survive.
New and upcoming protocols will be designed to be as decentralized and as democratic as possible, to lessen their interaction with legislators and thus lower the costs of the operation.
Smart contract platform providers will have to double down on the smart contract capabilities of their blockchains, especially when it comes to oracles, which serve to deliver off-chain data onto the chain and are thus available to the smart contract and the algorithm.
Smart contract platforms of the future will have to be as decentralized as possible, as scalable as possible, and offer a wide array of tools that allow for the implementation of fully autonomous protocols.
