Cryptocurrency Compliance and Operations: Digital Assets, Blockchain and DeFi

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2022

J. ScharfmanCryptocurrency Compliance and Operations https://doi.org/10.1007/978-3-030-88000-2_1

1. Introduction to Cryptocurrency Compliance and Operations

Jason Scharfman¹  

(1)

Corgentum Consulting, LLC, New York, NY, USA

Keywords

CryptocurrencyFiatBitcoinBlockchain Central Bank Digital Currency (CBDC)Digital YuanStablecoinTokenCrypto CoinDerivatives

Importance of Operations and Compliance to Cryptocurrency Investing

The market capitalization of cryptocurrencies and digital assets has grown in recent years at an exponential rate. There are a wide variety of reasons for this. Firstly, both retail and institutional investors are seemingly continually hungry for new types of non-traditional, also called alternative investments. Historically, these alternative investments have included vehicles such as hedge funds and private equity funds. Today these types of so-called alternatives are now well-established and well-funded. While hedge funds and private equity still continue to grow, the continued strong performance of large cryptocurrencies such as Bitcoin and Ethereum has reignited investor interest in the space.

Secondly, both technological and financial innovation continue to broaden the investible opportunity set in the crypto and digital space. Outside of simply well-established cryptocurrencies, there are a variety of emerging crypto-related investment options such as yield farming and newer digital investments such as stablecoins, non-fungible tokens (NFT), security tokens and DeFi tokens. As institutional and retail capital continue to invest in the crypto and digital space, the worldwide adoption and continued regulation of cryptocurrencies such as Bitcoin is inevitable.

Finally, cryptocurrencies and digital assets continue to become more accessible. In the early days of the space, there were a number of technical complexities making the direct purchase of cryptocurrencies complex. Today, retail investors can easily create accounts with a variety of well-established multi-billion dollar crypto exchanges and make purchases in a user-friendly way. Similarly, catering to the institutional investor space traditional asset managers are increasingly launching multi-million dollar, and in some cases multi-billion dollar, investment vehicles to invest in cryptocurrencies. Additionally, a whole host of industries and related service providers have developed to support these new capital flows into the space.

The goal of this book is to provide an introduction to both the operational and compliance aspects related to cryptocurrency investing. While this book does provide an introductory background to allow the reader to gain a basic understanding of the technical aspects of how cryptocurrencies work, the focus is not on technology. A key reason for this is that there are a myriad of technologies and computer languages supporting cryptocurrencies that are constantly evolving. Examples of these are blockchain, distributed ledger technology, Ethereum virtual machine (EVM) platform technology for smart contracts and Dapps. The specifics of these different technologies continue to be researched and refined as new applications for them are developed. New cryptocurrencies are being developed and rolled out on a regular basis and these evolving technologies are utilized to support them. Topic-specific books on these crypto-related technologies can be referenced to learn about each specific technology.

Introduction to Cryptocurrencies

What is a cryptocurrency? If you are reading this book you likely have some general idea of what the term cryptocurrency, often simply abbreviated as crypto, means but you might not be able to clearly come up with a universal definition of what crypto is specifically. A key reason for the difficulty in defining what crypto is relates to the fact that the space continues to rapidly evolve. These evolutions in the crypto space have across a number of fronts. From a technology perspective, there have been continued technological advances in the underlying capabilities of cryptocurrencies, the ways crypto is stored and traded as well as the technical applications of their use. From a capital markets perspective, the amount of money that has been invested in crypto has continued to increase exponentially in recent years and this has fueled a number of new advances with regard to the ways in which cryptocurrencies can be profited off of including increased platforms for the profitable lending of cryptocurrencies.

When most people are asked the question of what a cryptocurrency is, they immediately think of Bitcoin. This is understandable as Bitcoin has received not only the bulk of media attention related to the cryptocurrency markets, but also the bulk of capital in the space. Recent estimates mark Bitcoin as having a market capitalization of approximately $650 billion which makes up approximately 68% of the total cryptocurrency market.¹ While Bitcoin’s percentage of the overall crypto markets has not always been so large, with this type of current market dominance it is no wonder, that Bitcoin has been at the forefront of investor’s initial interest in the cryptocurrency space.

While certainly important, Bitcoin is only one cryptocurrency option in an ever growing constellation of cryptocurrencies. But what exactly is a cryptocurrency? Merriam-Webster defines a cryptocurrency as, "any form of currency that only exists digitally, that usually has no central issuing or regulating authority but instead uses a decentralized system to record transactions and manage the issuance of new units, and that relies on cryptography to prevent counterfeiting and fraudulent transactions."²

This definition is a good starting point for our understanding of cryptocurrencies. Let us unpack it to understand some key areas it addresses. First of all, the definition states that a cryptocurrency only exists digitally. While this is true, a cryptocurrency is only one type of a broader category of digital assets. We will address the larger concept of digital assets as compared to cryptocurrencies throughout this book, but for now let us acknowledge that a cryptocurrency is not something we can physically hold or touch in the real world, but instead cryptocurrencies only exist digitally. In contrast, an example of a non-digital asset would be actual paper money or physical coins.

Traditional Definitions of Money

Historically there were two broad categories of non-crypto money. The first is known as representative money. This type of money is a certificate or a token that can be exchanged for an actual physical underlying commodity. An example of this would be paper money or coins that could be exchanged for gold. In this way, the money or coins was a representative placeholder for holding gold. The United States adhered to a gold standard for much of its history up until June 1933 when spurred in large part by gold hoarding caused by the Great Depression, the decision was made to transition away from the gold standard.³ This transition process ultimately ended in August 1971 when the US would no longer convert US currency to gold.

When money is no longer backed by a commodity, it falls into the other broad category of money known as fiat money. Fiat money derives its value from simply being declared so-called, legal tender by the government of a country that issues it.⁴ From a legal perspective in the United States the Article IV, Section 1 of the U.S. Constitution, also known as the Full Faith and Credit Clause, outlines in part that the government agrees to repay any debt it owes such as those incurred by issuing money. Despite the fact that there is no physical commodity behind the paper bills and coins, as is the case with representative money, it is this full faith and credit promise by the government that gives people confidence in fiat money. For reference, fiat money is also sometimes called fiat currency, or simply fiat.

Civilizations have been utilizing representative money and fiat currency for thousands of years. Historians believe the first metal money and coins were utilized in China at the end of the Stone Age around 1,000 B.C. Fiat currency has historically traditionally simply been referred to as money. Modern economists generally classify something fulfilling the role of money if it meets three functions:

Medium of exchange—the concept that money can be used to transact for goods or services

Unit of account—this refers to the concept that there is a common measure of value for money

Store of value—the notion that money will generally retain its value.

Prior to the use of fiat money, people engaged in barter systems where goods or services were directly exchanged. In between barter systems and the development of metal coins and paper fiat, there were intermediary means of exchange utilized such as commodities as salt, cattle, the exchanging of ceremonial objects such as the Kula system of the Trobriand Islands and cowrie shells.⁶ As societies transitioned from barter and commodity type exchange systems to fiat money there was a shift in the perception of the way the concept of wealth or value can be stored and transacted in. Today as cryptocurrencies become increasingly popular and attract more investments from both retail and institutional investors, there has once again been a shift in the perception of what constitutes a currency and how value can be stored and transacted in.

General Properties of Cryptocurrencies

Leveraging off of our discussion of the traditional characteristics of money, we can now proceed to discuss general properties shared by cryptocurrencies. Cryptocurrencies such as Bitcoin however are based on the properties of mathematics rather than relying on physical properties such as gold and silver, or trust in central authorities like fiat currencies do.⁷ Furthermore, cryptocurrencies maintain many of the same characteristics of money including:

Transportability/Portability—Cryptocurrencies meet this requirement because they can be easily stored, moved or transferred

Divisibility—Cryptocurrencies can be divided into smaller amounts. For example, Bitcoin is divisible up to 8 decimal points

Durability—Unlike fiat coins, paper money or physical precious metals cryptocurrencies cannot be physically damaged or deteriorate over time

Fungibility—An asset or good is fungible when two separate units of the same asset can be exchanged at the same rate.⁸ In a crypto context, this means that one Bitcoin has exactly the same value as another Bitcoin. Some have argued that differences in crypto prices such as Bitcoin on decentralized exchanges (DEXs) at different points in time bolster the argument that cryptocurrencies such as Bitcoin are not truly fungible because of this lack of uniform synchronicity of prices. As a counter to this argument, as the cryptocurrency markets have continued to mature the pricing of large market capitalization coins such as Bitcoin have become more uniform across both centralized and decentralized exchanges.

Scarcity—When a cryptocurrency has a finite supply it makes it what is known as scarce. Scarcity exists in different forms in the crypto space. Bitcoin for example has a finite supply of 21 million coins. Ethereum on the other hand does not have a hard cap on the number of coins but caps have been proposed and measures such as Ethereum’s Difficulty Bomb have been proposed to slow the mining of new blocks and therefore reduce the speed at which new coins are mined.⁹

Recognizability—In order to be utilized and valued similar to money cryptocurrency has to be widely recognized as a store of value, medium of exchange and unit of account by market participants. Large market capitalization cryptocurrencies such as Bitcoin and Ethereum fulfill these criteria by being widely utilized for investment purposes and increasingly being utilized for a variety of transactions

Utility—A Cryptocurrency has to have use cases which allow for the current or future anticipated use of the crypto for purposes such as purchasing goods or services or facilitating transactions.

Digital Fiat Currencies?

Returning to our definition of cryptocurrency, a key element of the definition was that cryptocurrencies exist only digitally, and not physically. It is important to highlight this point, that cryptocurrencies are only in digital form because this is in contrast to fiat money which can exist both in digital and in physical form. Based on our discussion of fiat money above, this statement might cause you to pause. We previously only discussed the physical aspects of fiat money, such as paper notes or coins. Fiat can exist digitally as well. As the economic and financial systems of the world have increasingly become digitized through technology this has resulted in the expansion of people not only utilizing physical fiat money (i.e., bills and coins) to pay for goods and services to other methods, but other fiat-based methods as well that do not directly involve the actual holding of fiat currency.

An example of this would be the use of debit cards. When an individual utilizes a debit card to pay for something such as a good, fiat money from their bank account is transferred to the bank account of the merchant. The debit card itself is not fiat, but its use causes the real-world transfer of fiat. In practice, this transfer does not involve banks physically moving currency among account but rather transferring the money electronically and recording the transactions in digital ledgers accordingly. A similar process digital process is employed for electronic wire transfers of funds. In this way, the use of fiat currency has both real-world and digital applications.

Central Bank Digital Currency (CBDC)

Continuing the extension of fiat currency into the digital realm are new forms of digital fiat currency called a Central Bank Digital Currency (CBDC). CBDCs are effectively a form of digital cash that can be utilized to facilitate regular financial and banking activity such as the two example transactions we described previously, debit cards and electronic wire transfers. That being said, the area of CBDCs are still evolving and there is no universal definition in place either by policymakers or academics.¹⁰

While there are many similarities between the physical fiat money issued by the central banks of countries and CBDC, a key point of distinction is that money held by a CBDC website or app will be the fiat equivalent of a deposit at the central bank of the CBDC issuer.¹¹ This would represent a centralized type of digital money, sometimes called e-money, where a central authority maintains control over the money. To be clear this could be distinguished from the traditional concept of money that investors would store at a commercial bank instead of directly with the central bank of their respective country. Furthermore, the centralization of CBDCs is an important difference from cryptocurrencies such as Bitcoin which are decentralized types of digital money, where there is no centralized government control or authority. The Bahamas launched what is considered to be the first CBDC, the Sand Dollar, in October 2020.¹²

In October 2020, the country of Cambodia also announced the launch of an e-money initiative called Bakong which supports transactions in the dollar and riel, the Cambodian currency.¹³ As of April 2021, the Sand Dollar and Bakong represent the only fully launched retail CBDC products.¹⁴

FedCoin and FedNow

The U.S. Federal Reserve has been exploring issues related to digital currencies as well as potentially issuing its own digital currency which has been called a Digital Dollar and FedCoin by the media.¹⁵ Additionally, the Federal Reserve is in the process of launching a phased implementation of a service called FedNow that is expected to be fully implemented in 2023 or 2024.¹⁶ FedNow is viewed by many as the next generation of the existing Fedwire system and National Settlement Service (NSS) that facilitates liquid management for instant payments.¹⁷ The goal of the FedNow service will be available to US banks and will allow individuals and businesses to send instant payments at any time through their bank accounts.¹⁸ There have been criticisms of the Fed’s expansion into the digital currency and digital payments arena and the Fed received more than 2,200 letters from commenters arguing that the Fed’s actions are an inappropriate extension of its role as well as are operating in unacceptable competition with the private sector.¹⁹ Former U.S. Texas congressman Ron Paul has also expressed criticism of the FedNow project stating, "A Federal Reserve-run real payments system will crowd out private alternatives, leaving consumers with one government-run option for real-time payments. This will be bad for consumers and real-time entrepreneurs but good for power-hungry Federal Reserve bureaucrats who will no doubt use FedNow to help ‘protect’ the Federal Reserve’s fiat currency system from competition from crypto currencies."²⁰

Despite these criticisms, there remains continued interest and support for the Federal Reserve’s digital currency efforts. These efforts include the 2020 announcement of the Digital Currency Initiative project undertaken by the Federal Reserve Bank of Boston in coordination with the Massachusetts Institute of Technology to perform technical research related to a central bank digital currency.²¹ In March 2020 coronavirus relief-related bills were proposed by U.S. House and Senate democratic lawmakers that would encourage the Fed to establish accounts for retail consumers that would have then facilitated the Fed’s subsequent depositing of CBDC for economic relief.²²

In February 2021, Federal Reserve Chair Jerome Powell reiterated that a digital currency issued by the federal reserve is a high-priority project.²³ Echoing that sentiment, in February 2021 Treasury Secretary Janet Yellen stated, "Too many Americans don’t have access to easy payments systems and banking accounts, and I think this is something that a digital dollar, a central bank digital currency, could help with."²⁴ Additionally, comments by the Federal Reserve Governor Lael Brainard have indicated that the Fed is paying close attention to the digital currency efforts of China, which are also motivating the continued pace of the Fed’s focus in this area.²⁵

Digital Yuan and Oher CBDC Trial Projects

China’s version of a CBDC project that goes by the official name is the Digital Currency Electronic Payment (DCEP) and has been under development since 2014.²⁶ It is also called the digital yuan or digital renminbi (RMB). DCEP seeks to distinguish itself from cryptocurrencies such as Bitcoin as well as other stablecoins. To this point, Mu Changchun, the head of the People’s Bank of China’s (PBOC) digital currency research institute, stated in December 2019 that, "The currency is not for speculation. It is different to bitcoin or stable tokens, which can be used for speculation or require the support of a basket of currencies."²⁷

China has continued to rollout the digital yuan through a variety of pilot programs. One example are what are referred to as a variety of pilot program payment scenarios. An example of such a scenario are the so-called "red envelope" giveaways in the Chinese city of Shenzhen. One such giveaway was during October 2020 when the PBOC gave 200 digital yuan each, worth approximately $29.75, to 50,000 consumers that were selected in a lottery to be spent in select stores.²⁸ This was followed by another Shenzhen red envelope giveaway where Shenzhen residents registered through the i Shenzhen platform were eligible to win 20 million digital yuan, worth approximately over $3 million USD, that could be spent at approximately 100,000 different physical merchants.²⁹ These types of red envelope giveaways are not unique to Shenzhen and have taken place in other cities such as the February 2021 giveaway of 30 million digital yuan, worth approximately $5 million, in the Chinese city of Suzhou. In total, the PBOC gave away more than 2 billion digital yuan, worth approximately $300 million USD in 2020 alone.³¹

There has also been a push to have more Chinese companies facilitate the use of digital yuan and in 2021 Alibaba’s Ant Group also announced that it would allow select users to participate in a trial where they can link their digital yuan accounts with accounts in an online bank, MYbank, in which Ant Group has a 30% stake.³² Furthermore, in what was largely seen as an attempt to further encourage the utilization of the digital yuan in China, in May 2021 China banned financial institutions and payment companies from providing services related to cryptocurrency transactions.³³ This was not the first time China had taken anti-crypto measures. For example, in September 2017 China banned Initial Coin Offerings.³⁴ The argument has been made that while China’s push toward a digital currency intensifies, it would actually drive the demand up for the use of other cryptocurrencies such as Bitcoin in China because of the encryption and perceived anonymity they offer as compared to a centralized digital yuan.³⁵

In addition to the action of China, other governments are also in various stages of developing CBDC’s. Exhibits 1.1 and 1.2 show the ranking of central banks’ retail digital currency project maturity ranked with the Bahamas and Cambodia ranking first and second, respectively, and China ranking third.

Exhibit 1.1

Ranking of retail CBDC development and project maturity

Notes

1. Source PwC CBDC global index, 1st Edition, April 2021

2. Retail CBDC are defined as being held directly by citizens and corporates

Exhibit 1.2

Ranking of interbank CBDC development and project maturity

Notes

Source PwC CBDC global index, 1st Edition, April 2021

Interbank of Wholesale CBDC are defined as being restricted to Financial Institutions with the primary purpose of being utilized primary for interbank payments and financial settlements

Motivations for Growth of Interest in CBDC

Central banks are increasingly researching the possibilities of issuing CBDCs for a number of reasons. One reason is it would allow country’s central banks to maintain more control over digital transactions as opposed to having them carried out almost exclusively over networks of private companies such as Apple Pay or Alipay. A second reason that central banks are increasingly recognizing the importance of CBDCs is because there is a general decline in the use of physical cash coupled with an adoption of various forms of digital forms of cash. This has spurred the desire by central banks to remain relevant while accepting the increasing realities of a transition to digitization. Highlighting this point, Deputy Governor of the Bank of Italy, Piero Cipollone, stated in a February 2021 interview, "in an environment where cash is used less and less by both the customer and the merchant because the whole ecosystem is shifting towards (being) digitalized … you want to replace the functionality of cash with something that is digital but is as conceptually as close as possible to cash."³⁶

Another reason central banks have increasingly become interested in CBDC issuance has been because of the actions by non-governmental entities in the crypto space. Particularly, the work of private sector companies’ stablecoin proposals, such as the announcement of Facebook’s Libra project in 2019, has spurred the exploratory work of central banks in the area of CBDCs.³⁷ A January 2021 survey by the Bank for International Settlements (BIS), an international organization of central banks, found that central banks collectively representing a fifth of the world's population are likely to launch retail CBDCs in the next three years and this timeline may likely be further sped up by the implications of the Covid19 pandemic.³⁸

Implications of CBDC Issuance

The issuance of CBDC’s by a central bank has a number of broad potential implications on a country’s monetary policy, and overall financial stability. For example, in one study a dynamic stochastic general equilibrium (DSGE) model with sticky prices and adjustment costs was built to study the macroeconomic effects of CBDCs.³⁹ This study also assumed a one-for-one exchange of CBDC with government debt, such as a US Dollar. The study concluded that by introducing the CBDC under a one-to-one exchange ratio there would be a decrease in interest rates and distortionary taxes, thus increasing long-run GDP.

Other studies have examined the risks CBDCs can play in initiating what are known as bank runs. A bank run is when many clients of a bank all seek to withdraw their money at one time. This creates a problem for banks that utilize what is known as a fractional-reserve system, where only a portion of deposits is maintained on hand by the bank as cash. Once a large number of deposits are requested at a single time, or very close together, the bank therefore does not have enough cash on hand to meet their requests and the bank can ultimately become insolvent. Bank runs often occur during times of broader economic stress such as during the Great Depression from 1929 and into the early 1930s.

CBDC Impact on Underbanked and Unbanked

More studies have also examined the effect of CBDCs on two categories of individuals referred to as the unbanked and underbanked. Unbanked individuals are those that do not use banks in any way, and this includes not maintaining a checking or saving account. Instead, the unbanked rely on other types of alternative financial services from other institutions. These include other services, such as short-term payday loan, prepaid credit cards and money orders. Underbanked individuals do utilize banking institutions they do so on a limited basis in conjunction with alternative financial services.

There are a number of problems associated with being unbanked and underbanked. Firstly, the use of alternative financial services often comes with increased fees as compared to traditional banking products. Secondly, being unbanked or underbanked can either totally prevent or at the very least stymie the ability of an individual to build a credit history. This lack of credit history can negatively impact an individual’s ability to secure a loan. Thirdly, when not using the traditional banking channels the unbanked and underbanked do not have access to traditional banking products and online tools. Further exacerbating the problem is that unbanked and underbanked individuals are often low-income families who feel the impacts associated with higher fees and inability to take out loans more harshly than higher income families.⁴⁰ Research has suggested