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Regulating virtual currencies and ICOs

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THE pattern is familiar. Computer geeks develop technology that threatens to overturn established markets and habits. Regulators then scramble to understand and tame the beast. This is what is happening in the financial world in the wake of an explosion of crypto-currencies. Over the past year the pool of virtual currencies has both deepened, from $30bn to $400bn, and widened, with the spread of “initial coin offerings” (ICOs, a form of fundraising in which investors in young companies are issued with virtual tokens). Hedge funds, students and pensioners have all been caught up in the crypto craze.

This worries authorities, because the crypto-sphere is far from risk-free. Valuations can leap and plunge: after a giddy rise, between December and February the price of bitcoin dropped from nearly $20,000 to less than $7,000. (It is now around $9,000.) Several ICOs have turned out to be scams. Legitimate tokens are in danger of being stolen. Some crypto-currency exchanges have been hacked.

In response, national authorities are starting to think seriously about a legal framework for finance’s unruly frontier. Regulators fret about how to classify ICOs and tokens (are they securities, or not?) and how to tax them. They want to stop their use for such evils as money-laundering and financing terrorism. And they worry about how to protect retail investors from the risk of losing their shirts.

Indeed, scarcely a day passes without a supervisor somewhere calling for tighter regulation, or taking action. On April 6th the Financial Conduct Authority in Britain warned firms offering services linked to crypto-derivatives that they were subject to its rules. On April 10th Taiwan’s finance ministry said it was planning crypto regulation aimed at money-launderers. On April 17th New York state’s attorney-general asked 13 crypto-exchanges for information about their operations, conflicts of interest and safeguards for customers.

Regulators are plotting together as well as separately. When the governors of the G20 countries’ central banks met in Buenos Aires in March, crypto was high on their agenda. They agreed that at present these assets are too small to be of systemic importance, but they committed themselves to extending standards to which financial institutions already adhere—such as know-your-customer (KYC) rules and procedures for monitoring unusual transactions—to the crypto-world, in order to thwart the illicit use of virtual currencies.

When bitcoin entered public awareness it was chiefly as a facilitator of anonymous, illegal sales on the “dark web” and as the currency of choice for online ransoms. Many in law enforcement thought its anonymity would make it ideal for criminals of all stripes. But until recently evidence of this was scarce. “The overwhelming view was that crypto-currencies had great utility to cyber-criminals but limited use to other criminals,” says David Carlisle of the Royal United Services Institute, a think-tank. Volatility and illiquidity limited their use for money-laundering. But evidence that crooks are making more use of them is mounting (see article).

The most logical parts of the crypto-infrastructure to regulate are the platforms on which virtual currencies are exchanged for ordinary money. Several countries, such as Australia and South Korea, already do this. The EU’s fifth anti-money-laundering directive, which was passed by the European Parliament on April 19th, also includes measures to regulate exchanges. But many places have no rules at all.

That may suit many crypto-entrepreneurs, but not all. Several exchanges are, for example, voluntarily implementing KYC standards (eg, by asking new customers to prove their identities), banning coins promising extra privacy or using software to monitor unusual transactions.

Agreed rules would help to tie exchanges into the mainstream banking system. Many of them currently choose unfussy jurisdictions or institutions, because conventional banks will not serve them. Lenders are wary both of credit risk and of abetting crime if exchanges don’t police users. Proponents of regulation say that once exchanges operate in a clear legal framework, those risks should be reduced and banks will take them on. That in turn will make it easier to keep an eye on exchanges.

Regulators disagree about consumer protection. Some see shielding investors from harm as their job; others think people should be free to gamble if this poses no wider risk. Many have warned investors to be wary of ICOs. Some authorities want both to protect consumers and to allow legitimate crypto-businesses to flourish in their jurisdictions. Gibraltar already licenses some crypto-companies. France is working on a system of voluntary licensing. Iqbal Gandham of CryptoUK, which represents some of Britain’s largest crypto-companies, believes such initiatives could help legitimate businesses gain access to banks and perhaps even advertising. “We also don’t want to have criminals on our platforms,” he says.

Authorities also worry about taxation. They spy a new source of revenue: because trading crypto can be lucrative, they are keen to levy capital-gains tax on any profits. And they fear losing existing income: virtual currencies might be used to hide money. Because most exchanges have operated in the dark, reliable data on crypto-evasion do not exist. Most countries are still working out how to define tokens, let alone tax them. Some are stepping up, however. In February Coinbase, an exchange, said it had unsuccessfully fought an American court order and would have to hand the identities of 13,000 customers to the Internal Revenue Service. Other exchanges have fled to offshore jurisdictions with more favourable tax regimes.

With so many poorly understood risks, some regulators think the only safe answer is to shut the whole crypto-sphere down. China, for example, has banned ICOs and exchanges. But elsewhere this is neither desirable nor practical (it requires tight censorship of the internet). Crypto-enthusiasts see parallels with the early days of the internet, when authorities also strove to control a new arena—and declared it a nest of criminality. Most countries have since decided that the web’s benefits outweigh its costs. It is too early to say whether this will be true of crypto-assets or the blockchain technology that underpins them. But it would be wrong to outlaw them before knowing the answer.

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Japan still has great influence on global financial markets

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IT IS the summer of 1979 and Harry “Rabbit” Angstrom, the everyman-hero of John Updike’s series of novels, is running a car showroom in Brewer, Pennsylvania. There is a pervasive mood of decline. Local textile mills have closed. Gas prices are soaring. No one wants the traded-in, Detroit-made cars clogging the lot. Yet Rabbit is serene. His is a Toyota franchise. So his cars have the best mileage and lowest servicing costs. When you buy one, he tells his customers, you are turning your dollars into yen.

“Rabbit is Rich” evokes the time when America was first unnerved by the rise of a rival economic power. Japan had taken leadership from America in a succession of industries, including textiles, consumer electronics and steel. It was threatening to topple the car industry, too. Today Japan’s economic position is much reduced. It has lost its place as the world’s second-largest economy (and primary target of American trade hawks) to China. Yet in one regard, its sway still holds.

This week the board of the Bank of Japan (BoJ) voted to leave its monetary policy broadly unchanged. But leading up to its policy meeting, rumours that it might make a substantial change caused a few jitters in global bond markets. The anxiety was justified. A sudden change of tack by the BoJ would be felt far beyond Japan’s shores.

One reason is that Japan’s influence on global asset markets has kept growing as decades of the country’s surplus savings have piled up. Japan’s net foreign assets—what its residents own abroad minus what they owe to foreigners—have risen to around $3trn, or 60% of the country’s annual GDP (see top chart).

But it is also a consequence of very loose monetary policy. The BoJ has deployed an arsenal of special measures to battle Japan’s persistently low inflation. Its benchmark interest rate is negative (-0.1%). It is committed to purchasing ¥80trn ($715bn) of government bonds each year with the aim of keeping Japan’s ten-year bond yield around zero. And it is buying baskets of Japan’s leading stocks to the tune of ¥6trn a year.

Tokyo storm warning

These measures, once unorthodox but now familiar, have pushed Japan’s banks, insurance firms and ordinary savers into buying foreign stocks and bonds that offer better returns than they can get at home. Indeed, Japanese investors have loaded up on short-term foreign debt to enable them to buy even more. Holdings of foreign assets in Japan rose from 111% of GDP in 2010 to 185% in 2017 (see bottom chart). The impact of capital outflows is evident in currency markets. The yen is cheap. On The Economist’s Big Mac index, a gauge based on burger prices, it is the most undervalued of any major currency.

Investors from Japan have also kept a lid on bond yields in the rich world. They own almost a tenth of the sovereign bonds issued by France, for instance, and more than 15% of those issued by Australia and Sweden, according to analysts at J.P. Morgan. Japanese insurance companies own lots of corporate bonds in America, although this year the rising cost of hedging dollars has caused a switch into European corporate bonds. The value of Japan’s holdings of foreign equities has tripled since 2012. They now make up almost a fifth of its overseas assets.

What happens in Japan thus matters a great deal to an array of global asset prices. A meaningful shift in monetary policy would probably have a dramatic effect. It is not natural for Japan to be the cheapest place to buy a Big Mac, a latté or an iPad, says Kit Juckes of Société Générale. The yen would surge. A retreat from special measures by the BoJ would be a signal that the era of quantitative easing was truly ending. Broader market turbulence would be likely. Yet a corollary is that as long as the BoJ maintains its current policies—and it seems minded to do so for a while—it will continue to be a prop to global asset prices.

Rabbit’s sales patter seemed to have a similar foundation. Anyone sceptical of his mileage figures would be referred to the April issue of Consumer Reports. Yet one part of his spiel proved suspect. The dollar, which he thought was decaying in 1979, was actually about to revive. This recovery owed a lot to a big increase in interest rates by the Federal Reserve. It was also, in part, made in Japan. In 1980 Japan liberalised its capital account. Its investors began selling yen to buy dollars. The shopping spree for foreign assets that started then has yet to cease.

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