Several months ago, the collapse of FTX, a major cryptocurrency exchange headquartered in the Bahamas, highlighted an important fact: The cryptocurrency sector has been subject to relatively little regulation, and this presents big risks for investors. However, to many longtime observers, the FTX debacle was not very surprising, as it is only one in a long string of major crises within the cryptocurrency sector. Indeed, there is a long history of questionable and illegal activity within the cryptocurrency space, including widespread theft, fraud, scams, and activity that has long since been banned on Wall Street.
Cryptocurrency analysis firm Chainalysis estimates that illegal activity within the cryptocurrency sector totaled $20 billion in 2022 alone, and these numbers continue to grow each year. Given the large sums of money involved in illegal activity, there is a clear need to regulate the cryptocurrency sector effectively. So why have countries been slow to regulate the sector, and what is the state of regulation today?
Because cryptocurrencies rely on decentralized technology, there is no clear entity that states can regulate to control their supply. Instead, most regulatory efforts have focused on cryptocurrency exchanges, which allow people to trade cryptocurrency for (government-issued) fiat currency and vice versa. These exchanges act as middlemen by facilitating swaps between people interested in buying and selling cryptocurrency and, importantly, provide the primary link connecting cryptocurrency to the broader financial system. Thus, cryptocurrency exchanges offer a way for states to regulate cryptocurrency at the point at which it touches the broader economy, but they also present a major challenge: because exchanges are primarily online businesses, they have managed to evade national regulations through the use of encryption and other technology.
FATF countries have managed to register and begin regulating exchanges, which were previously not subject to regulation in most countries. Importantly, this success was made possible through international cooperation.
Known as regulatory arbitrage, this risk is especially acute for cryptocurrency because nearly all activity takes place online. Individuals have used virtual private networks or VPNs to hide the country in which they are located, and some exchanges have “moved” to new jurisdictions in response to evolving national laws. For example, Binance, one of the biggest cryptocurrency exchanges, changed addresses across five countries in as many years and was called out by two national regulators (Malta and Malaysia) for falsely claiming to be regulated by them. Throughout, it was often unclear what physical presence, if any, Binance maintained in these countries. Since then, CEOs of Binance and another major exchange, Coinbase, have argued that their companies should not be regulated because they are online businesses without physical headquarters.
Given the risk of regulatory arbitrage, any large-scale regulatory effort must leverage international cooperation to succeed. One recent effort spearheaded by the Financial Action Task Force (FATF), an intergovernmental organization, sought to do just this. Headquartered in Paris, the FATF was formed by the G7 countries in 1989 to help coordinate an international response to money laundering emerging from the illegal narcotics trade in the 1980s. In the three decades since, the FATF has successfully urged most countries to adopt wide-ranging anti-money laundering laws. Building on these efforts, the FATF became the first international body to introduce regulatory standards for the cryptocurrency sector.
In 2019, the FATF issued regulatory guidelines for the cryptocurrency sector that detail “know your customer” obligations for exchanges and build on the FATF’s anti-money laundering framework for other sectors. Importantly, the FATF has no regulatory power of its own, and so instead, the FATF’s 36 member countries — including the G7 countries and many European Union members — pledged to incorporate the new standards into national law by July 2020. States then faced the hard work of passing new laws and extending the human and financial capital necessary to ensure their new regulatory systems would function in practice. Given these challenges, how have states fared?
Recent research suggests that FATF countries have made significant progress toward regulating the cryptocurrency sector. Evidence from cryptocurrency transactions suggests that exchanges in FATF countries screen their customers for money laundering risk for transactions above a key threshold. Although the evidence also suggests FATF countries struggle to enforce other parts of the new standards, this represents important progress. It suggests that FATF countries have managed to register and begin regulating exchanges, which were previously not subject to regulation in most countries. Importantly, this success was made possible through international cooperation.
LESSONS FOR CRYPTOCURRENCY
We can draw several lessons from this case that are relevant for cryptocurrency regulation more broadly. First, international efforts can build on existing frameworks of international cooperation — including international agreements and organizations — to expand regulation into the cryptocurrency sector. For example, the Basel Committee, which forged an international agreement around bank capital minimums and other measures aimed at reducing financial risk following the global financial crisis, could form an agreement around capital requirements for cryptocurrency exchanges and stable coin issuers. Similarly, the International Monetary Fund, which issues reports on global financial stability and offers training to bank regulators focused on mitigating systemic financial risk, could issue assessments and offer training to reduce systemic risk within the cryptocurrency sector.
Second, the support of powerful countries such as the United States and major EU countries can help increase the chances of success of a cooperative effort (and may even be necessary). Third, regulatory efforts may have a wide-ranging impact beyond a group’s initial goals. Since the FATF issued regulatory guidelines in 2019, 16 non-member countries have adopted laws in line with these regulations, and they continue to have a ripple effect throughout the international system. For non-member countries, adopting the FATF’s standards allows them to stay at the forefront of international regulation and can help put foreign investors’ minds at ease.
Of course, we should not overstate the importance of these developments, as they are still only part of a much broader framework needed to effectively regulate the cryptocurrency sector. There are still major gaps at both the national and international levels, including the need for stable coin regulation and better enforcement of existing regulations. Despite this, the FATF-led effort provides reason to be optimistic about the future of international cooperation to regulate cryptocurrency and highlights that states have moved decisively to regulate a technology that was once viewed as beyond their reach.
Karen Nershi is a postdoctoral fellow at the Stanford Internet Observatory and an incoming Assistant Professor at IE University in Spain.