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Cryptocurrencies bypass the regulations of the current financial system.
This concerns authorities because cryptocurrency payments can be used to evade taxes and engage in criminal activity.
Governments have so far taken measures to regulate local cryptocurrency exchanges so that people cannot easily buy cryptocurrency within their jurisdiction.
However, cryptocurrency is global without any location and borders. As long as governments do not shut down the internet, there has not been an effective way to stop cryptocurrencies. This allowed them to enjoy massive gains and adoption since their debut in 2009.
The number of cryptocurrency users has already reached 220 million people as of July 2021. So cryptocurrency has been adopted by a wide and legitimate user base.
Still, regulations caused a lot of turmoil in the past for cryptocurrencies in terms of their accessibility and price volatility, so going forward they have the potential to significantly impact growth, price action, and thus your own cryptocurrency investment.
In this article, we will discuss:
- Possible future regulations
- How regulations can impact cryptocurrency prices
- How you can protect your cryptocurrency from negative regulatory effects
But in order to understand regulations and their possible impacts, let’s first discuss the basics of cryptocurrencies.
Basics of Cryptocurrencies
Cryptocurrency is a new online payment and exchange system without using a bank or an intermediary. It works globally without any borders, wherever there is internet access.
Cryptocurrency constitutes a decentralized network of computers around the globe without any center or server. Instead of using a server, cryptocurrency transactions are recorded in every individual computer on the network, known as a “blockchain”.
A blockchain eliminates the need for a physical intermediary like a bank, a broker, or an exchange that employs a central server, and allows for non-governed, autonomous peer-to-peer transactions.
The unit of cryptocurrency is a digital coin. Cryptocurrency coins exist solely in the virtual world. There are two available digital processes to create a coin:
- “mining”, which creates a new coin by running specialized software on your computer for a certain period of time
- “staking”, which gives you the right to instantaneously mint new coins, based on how many coins of that cryptocurrency you hold. It is akin to voting rights in a company by the ratio of shares you own
Everybody can mine or mint a coin, it is not in the monopoly of any entity. Each newly created coin is added to the blockchain.
Bitcoin, born in 2009, is the original cryptocurrency as well as the most valuable and popular. Ethereum, which debuted in late 2015, is the second-largest cryptocurrency after Bitcoin.
Both Bitcoin and Ethereum are mineable currencies. Mining their coins consumes a lot of computing power and energy. The more energy you spend, the more coins you mine and the more transactions you can validate in the network.
Mining earns you coins and validating transactions earns you transaction fees as a return for the energy you spend.
On the other hand, “staking” cryptocurrencies consume negligible energy as you can instantly create coins or validate transactions in that system. You earn new minted coins and transaction fees as a return for staking.
Some popular staking cryptocurrencies are Cardano, Binance Coin, Polkadot, and Solana. Today, there are over 8,000 cryptocurrencies. There is a lot of demand for cryptocurrencies because over 220 million people see them as the future of money.
China, the largest population in the world, closed down all its local cryptocurrency exchanges in 2017. In May 2021, it banned financial institutions and payment companies from offering services related to any cryptocurrency trading.
China holds 65% of the world’s entire Bitcoin mining activity, but in June 2021 the government shut down mining centers in a number of states due to the immense energy required to mine Bitcoin.
The US has registered extensive anti-money laundering (“AML”) and know-your-customer (“KYC”) laws, due to which US investors need to provide comprehensive documentation to open an account in any cryptocurrency exchange.
A large number of major global cryptocurrency exchanges cannot operate in the US because they are unable to satisfy these transparency laws.
In the US, only the approved cryptocurrencies can be traded, in an effort to prevent illicit transactions and protect US investors from scams. However, there are no laws that recognize cryptocurrency as a legitimate asset class by legally defining what a cryptocurrency is.
The spirit of cryptocurrency is anti-government. But whenever there is money, the government will want to control and take its share. Since it is technologically difficult to ban cryptocurrencies altogether, governments will at least want to control their activity.
Ironically, further growth in the cryptocurrency market may actually be difficult without more regulations, because the next round of adoption requires retail investors, who have been reluctant to buy cryptocurrency due to its legal uncertainties.
For this next round of adoption, cryptocurrency assets need to be accessed easily, taxed fairly, legalized as a legitimate asset class, and protected by law, all of which constitute the likely subjects for future cryptocurrency regulations.
There is also an ongoing debate about the high energy consumption of mineable cryptocurrencies, the legal resolution of which should give investors further clarity about which currencies may legitimately be used in the future.
1. Accessing Cryptocurrency
Cryptocurrency exchanges are where you access cryptocurrency by wiring traditional (fiat) cash to the exchange’s bank account and buying cryptocurrency with that cash. Similarly, you exit cryptocurrency by wiring fiat from the exchange back to your bank account.
If exchanges get banned in your country or jurisdiction and you want to hold on to your cryptocurrency investment, you need to download a compatible software wallet into your computer, browser, or smartphone and transfer your coins from the exchange to that wallet to be able to access your investment later.
Cryptocurrency’s decentralized, global technology manages to create products that overcome the bans of governments.
For example, there are “decentralized exchanges”, which are exchanges not owned and operated by any entity, but work autonomously and allow for direct, peer-to-peer cryptocurrency trading with another person on the web.
A decentralized exchange is not owned by any company, and does not host any individuals to deal with, so governments are not able to impose laws on them. Chinese investors largely benefit from decentralized exchanges to bypass the exchange bans in their country.
If more countries ban regular cryptocurrency exchanges, demand for decentralized exchanges may skyrocket which would help maintain the growth in the cryptocurrency market.
Despite the bans and inconveniences in the short term, market forces may also eventually come to the rescue in the longer term. As we discussed, there is a lot of demand for cryptocurrencies all over the world, so there is a lot of money entering this market.
If governments act too restrictive, they would miss out on billions of dollars of cryptocurrency investments, which would instead flow to countries that enforce market-friendly cryptocurrency regulations and allow easy access to cryptocurrency.
If a large number of governments legitimize cryptocurrencies, competition may force once prohibitive governments to eventually ease access to cryptocurrencies in an effort to get a share from the pie.
Governments have the power to tax the heck out of cryptocurrency investments if they want to discourage their usage and adoption.
In the US, profits made from cryptocurrency investments are already subject to a capital gains tax but as of yet, it only applies to cryptocurrencies that you sell and make a profit, not to investments you hold on to. Plus, the highest rate you would have to pay for capital gains is 20%.
Nobody can know if the tax rate would increase dramatically in the future or if there would be additional clauses, such as taxing cryptocurrency assets that you also hold on to based on their par value, like a property tax.
However, the same market forces that can force easy access to cryptocurrencies can also play a part in the enacting of fair tax laws.
In the US, the Securities and Commissions Exchange (SEC) is expected to legally define what a cryptocurrency is in terms of its utility and its decentralization, and classify whatever falls out of that definition as a security.
By the nature of its technology, no single participant in any cryptocurrency should hold more than 50% of the total computing power or the total circulating coins in its blockchain.
Otherwise, the blockchain would in practice be a centralized organization, where the majority stakeholder gains the power to interfere with its autonomous functioning, such as confiscating users’ coins and reversing transactions. This would cause a cryptocurrency to lose its utility as a medium of exchange without an intermediary.
The majority of the total 8,000 cryptocurrencies are highly “centralized”, in which way more than 50% of the total computing power or the existing coins are likely possessed by the project teams. These are generally projects that imitate established, popular products like Bitcoin and Ethereum.
Such projects may fail to be legally accepted as cryptocurrency.
On the other hand, a cryptocurrency is unlikely to exist as a security either because a security is a centrally regulated investment contract that represents a fractional ownership right and is backed by an asset. Cryptocurrencies are not backed with any other assets and they do not give ownership rights to the entity that issues the cryptocurrency.
Thus, the SEC’s possible future regulations have the potential to wipe out a large portion of cryptocurrencies from the market.
I personally find this beneficial for the overall market because this clearance could provide clarity and assurance to millions of individuals who have not yet bought cryptocurrency due to their future uncertainty.
Even as a veteran crypto investor, I feel like I have to bet on every square on a roulette table when I want to invest in some cryptocurrencies. Because there are just too many alternatives offering the same functionality, and as all are in their early stages of development, nobody can know which ones of those will succeed.
If regulations could eliminate all those that legally fail to be a cryptocurrency, I could invest more in the remaining ones with greater confidence.
4. Legal Protection
Software wallets that store cryptocurrency coins can get hacked, just like your physical wallet getting robbed on the street.
This happened to me once, when the private key to access one of my software wallets was stolen by an impersonator on the web, who drained all coins out of my wallet. I was unable to take legal action because wallets contain only an address, consisting of a combination of numbers and letters, without an account name or any identification.
The alternative is storing your coins in a cryptocurrency exchange, which provides custody for your cryptocurrency just like a regular bank. But these exchanges are not officially financial institutions, so your funds there are not insured by the government. If they were a legal financial institution, your deposits there would be insured up to a certain amount by the government (up to $250,000 in the US).
In short, the lack of legal protection currently discourages many potential investors from investing in cryptocurrency.
In the future, KYC laws already enforced for cryptocurrency exchanges are likely to spread to opening software wallets. This way, software wallets can become legal custody and their activity will be more transparent, thus taking legal action against hacks and thefts will become much easier.
Cryptocurrency exchanges, on the other hand, are likely to transform into official financial institutions, which would insure user funds under their custody.
This process may wipe out more cryptocurrency exchanges out of business though, especially in the US, because they need to comply with the identical AML and KYC laws that apply to banks.
5. Energy Consumption
If more governments attempt to restrict cryptocurrencies that consume too much energy, mineable cryptocurrencies like Bitcoin and Ethereum could get affected adversely. There are speculations that the Bitcoin network consumes more energy than many countries like the Netherlands or Switzerland.
This could in return benefit staking cryptocurrencies like Cardano, Binance Coin, Polkadot, or Solana due to their low energy consumption.
But I am not saying Bitcoin and Ethereum may disappear. I think they are too big and too firmly established by now, with perfectly functioning technologies and shouldering a $2 trillion ecosystem on their networks. If these two disappear, I think there would be no cryptocurrency.
Still, there is competition between the two types of cryptocurrencies. Mineable cryptocurrencies promote the fact that you cannot make income based on your capital, while staking cryptocurrencies promote environmental friendliness.
The market is very fearful of regulations due to the factors we discussed above, but I am of the opposite opinion considering the too many cryptocurrencies in circulation, the legal uncertainties afflicted with them, and the lack of any legal protection for cryptocurrency assets.
Yes, regulations may cause short term pandemonium, but I believe in the long run, regulations will bring massive retail adoption and reduce related uncertainty and price volatility.
Less uncertainty and price volatility would bring even more adoption, they would positively keep affecting each other like in a virtuous circle.
With regulations, governments will also get what they want at the end of the day. They will be legally able to monitor all software wallets and exchange accounts, track the monetary activity, and get their taxes thereout.
Regulations caused a lot of price crashes for cryptocurrencies in the past. However, these have been short-term reactions. Prices managed to get up from the ground every time and go to new all time highs. I have been in the cryptocurrency space since 2017 and I keep experiencing the same cycle.
News regarding regulations have historically been spread out either right before a massive cryptocurrency run to scare out weak, amateur investors OR right after a massive run to start a massive, long-term downtrend.
As a recent example, cryptocurrencies had a massive, crazy run in the first four months of 2021, during which the price of Bitcoin spiked from $20,000 to $65,000 and Ethereum from $500 to $4,500, while staking cryptocurrencies like Cardano, Binance Coin, and Solana enjoyed at least 20x gains.
This explosive price action was preceded by a series of negative events and news during late 2020.
The SEC filed a lawsuit against the Tether coin (the 5th largest cryptocurrency) in September and the XRP coin (used to be the 3rd largest cryptocurrency) in December, on the charges that XRP was an unregistered security while Tether was not backed with enough real-world assets.
These lawsuits were followed with a flux of negative news that the SEC would continue cracking down on as many cryptocurrencies and exchanges as possible. During those days, there was a lot of escape from cryptocurrencies by newer, amateur investors.
But nothing material happened at the end and the crazy run of 2021 followed.
If new all-time high prices are realized for cryptocurrencies in the following months, they are likely to be followed with regulations making a return to the agenda.
The epic 2017 cryptocurrency run also started with a regulatory crackdown at the beginning of that year when nothing material happened, and then the year-long market rally ensued. The rally was followed with regulations and their rumors throughout 2018 and 2019, during which cryptocurrency prices dropped by at least 90%.
Still, there is never a guarantee in which direction markets will move. Markets are not always rational; prices may still go up when you see new regulations coming, or they may fall without any government taking any legal action.
Although future regulations can in the longer-run be favorable for the cryptocurrency market, your particular situation may come out to be different. You need to keep an eye on the market and take your own precautions both before and after you invest in cryptocurrency. Below are some measures that you can take against risks that may result from regulations.
- Access risk: You may need to learn how to use a software wallet and a decentralized exchange if you decide to invest in cryptocurrency. You never know if your government will one day ban or restrict cryptocurrency exchanges so you need to be prepared for that day. Separating your investment under different platforms, such as exchanges and wallets would be a wise idea to distribute the risk of access to your assets.
- Conversion risk: Even if you trade your cryptocurrency in decentralized exchanges, in case you want to sell your crypto someday, you will still need a fiat-money platform like Apple Pay, PayPal, or the traditional SWIFT to be able to redeem your fiat cash from overseas. And even after you manage to transfer your funds to their final destination in your local bank account, you may still get faced with regulatory hurdles. It may get blocked or investigated for taxing purposes by your government. You have to consult your local attorney or advisor to get actual, legal advice regarding overseas money transfers.
- Legalization risk: If you want to protect yourself against legalization risk, you have to only invest in cryptocurrencies that are already approved by the SEC. If you like to invest in non-approved cryptocurrencies in decentralized exchanges in the hopes of better returns, you may want to diversify among a number of cryptocurrencies. If you invest in only one cryptocurrency with your capital, and your cryptocurrency gets classified as a security, the value of your investment could go to zero.
- Mining cryptocurrency risk: If regulatory pressure ever hits mineable cryptocurrencies, your mineable cryptocurrency like Bitcoin could take a toll in value. If you are worried about that risk, you may again consider diversifying your investment, this time between mining and staking cryptocurrencies.
Regardless of which direction prices move and how you want to diversify your cryptocurrency investment, you have to first decide what type of investor you want to become, short-term or long-term, before you invest in cryptocurrency.
Then you have to develop an investment plan around that choice, for example establishing your target top or bottom prices (If the coin reaches a certain low threshold, you buy, or if it rises to a certain point, you sell etc).
The Bottom Line
Despite a number of restrictions and bans, cryptocurrencies had the opportunity to grow in generally freer market conditions, thanks to the decentralized, global nature of blockchain technology. However, further growth may require new regulations.
If enough governments regulate cryptocurrencies:
- There could be competition among governments to attract cryptocurrency investments, which would likely force them to ease access to cryptocurrency and tax it fairly.
- Legalized cryptocurrencies can trigger the expected next round in mainstream retail adoption.
- Legalized software wallets and institutionalized cryptocurrency exchanges will give existing and prospective cryptocurrency investors piece of mind to invest.
- Governments will in return lawfully monitor all software wallets and exchange accounts, track the monetary activity, and get their taxes thereout.
All of the above can eventually reduce cryptocurrency’s current price volatility, which would trigger even more retail adoption like in a virtuous circle.
Although future regulations may benefit the overall market, you still have to take your own precautions by keeping an eye on the regulatory developments specific to your jurisdiction and to your cryptocurrency investment, both before and after you invest.
And you have to keep in mind that before you invest, you need to decide whether you want to become a short-term or a long-term investor and establish an investment goal around that choice.