Meeting crypto’s regulatory challenge

Mercy Corps Ventures, the venture capital arm of Mercy Corps, invests in startups building climate resilience and financial resilience for communities across the world. We’ve supported 32+ ventures to scale and raise over $125 million in follow-on capital. This article was originally published on World Economic Forum.

Global adoption of cryptocurrencies has soared across low, middle, and high-income countries in recent years. Regulators worldwide are still evaluating how to address the novel issues posed by digital currencies, however. The Global Future Council on cryptocurrencies recently published paper on navigating cryptocurrency regulation shows how past eras of innovation, such as the early days of the internet, could help meet this challenge.

Here are three lessons that could support the development of crypto regulation that is fit for purpose:

1. Follow the actual, real-world drivers of adoption globally

For years, most central banks and treasury departments have focused on risk-based reporting and containment policies for virtual assets. Meanwhile, these markets have grown exponentially, with global adoption increasing by more than 2300% since 2019 and 881% in the last year alone. During this time, Bitcoin, for example, has evolved from a small niche internet community into a well-known asset for investors, private firms, and even nation-states.

Actual trends vary widely between geographies and are telling. Centralized and decentralized forms of finance (DeFi) are accelerating in the developed world, while peer-to-peer (P2P) platforms are driving adoption in emerging markets, like Vietnam, Kenya, Togo, and Tanzania.

Many of these new users have turned to cryptocurrency to preserve their savings in the face of currency devaluation, to send and receive remittances, and for business transactions. Such transactions have grown even as central banks have banned access between banks and crypto exchanges in countries like Nigeria, while threatening the same in countries like India.

Several key factors are driving interest in cryptocurrencies:

• Central bank policies, hyperinflation, and macroeconomic instability have driven volatility and devaluation of local fiat currencies relative to other global currencies before and particularly during the COVID-19 pandemic. This has caused individuals and corporations such as Microstrategy, Tesla, and Square to hold bitcoin and other digital monies. It has also inspired increased advocacy by users and awareness among policymakers from the U.S. to El Salvador who are crafting new policies around cryptocurrencies.
• Remittance costs remain exorbitant for traditional payment systems at 6.8% globally and almost 9% in Sub-Saharan Africa, potentially explaining increasing P2P cryptocurrency transactions.
• The invention and rapid scaling of stablecoins as frictionless mediums of exchange between cryptocurrencies and fiat currencies. The market cap of USD Coin, for instance, has passed $25 billion with a compound annual growth rate of more than 6,100%. Such traction has even inspired Sweden to pivot its planned e-krona in order to compete with such cryptocurrencies and central bank digital currencies (CBDCs).
• New cryptocurrency networks such as Stellar, Algorand, and Solana are gaining users by promising less energy consumption and faster transaction speeds. Layer 2 solutions, such as Lightning Network and India-based Polygon, are being integrated with public blockchains to extend scalability and efficiency. Such improvements are also propelling DeFi application usage. The rapid proliferation and maturation of these innovations is in large part due to the open-source architecture and global developer communities that undergird crypto networks.

2. Understand the technological significance and the many diverse use cases for crypto

Much like the development of early internet protocols, the vast potential for cryptocurrency applications makes it challenging to automatically apply existing legal frameworks and definitions ex-ante. In this context, hasty regulation will likely lead — wittingly or unwittingly — to picking winners and favoring incumbents. Even worse, it could further exacerbate a yawning digital divide within and across countries.

Cryptocurrency networks provide a new paradigm for secure data and value transmission, storage and access over the internet, thereby creating fundamentally new resources and business models. As one example, they offer secure, immutable storage that is resilient to single points of failure and censorship, as was recently evidenced by the use of Arweave by Hong Kong residents. Another distinct use case is Helium, a crypto-economic protocol for deploying and managing wireless networks at about 100x lower cost than traditional top-down telecom business models — and, currently, this is the world’s fastest growing wireless network. Another emergent application of cryptocurrency technology is the NFT gaming platform Axie Infinity (now worth over $1 billion) which provides stable income for the un- and underemployed in the Philippines, which makes up 40% of the user base. A myriad of examples including DeFi, digital art and gaming (non-fungible tokens or NFTs), and digital entity formation via DAOs (decentralized autonomous organizations ) demonstrate how people and communities use cryptocurrencies to embed digital rights and capabilities within tokens in a transformational way.

Much like the development of early internet protocols, the vast potential for cryptocurrency applications makes it challenging to automatically apply existing legal frameworks and definitions.

As with previous generations of new technology paradigms, regulators will need to determine where existing policy categories are applicable or not — and whether new regulatory paradigms are required. As one example, regulators evaluating cryptocurrency activities in the financial context can distinguish between the risks of centralized versus decentralized activities. For centralized entities, such as exchanges and custodial financial services, cryptocurrencies pose risks congruent with financial risks that are familiar to financial authorities, capital markets regulators, consumer protection, privacy bureaus and tax authorities around the world. Meanwhile, regulators will need new frameworks for activities and self-custody-based networks, for which most financial regulations were not designed in the first place.

One set of risks in particular are often highlighted in the context of cryptocurrencies and decentralized networks. The pseudonymous and borderless nature of cryptocurrency systems are often seen as potential money laundering and terrorist financing risks. Yet, illicit activity is significantly less than in the traditional financial system, comprising just 0.34% of all cryptocurrency transactions.

Cryptocurrencies can enable transparency and provide an opportunity for regulators actively seeking to shift more transactions from the informal to the formal economy.

While pseudonymity preserves user privacy, the auditability of cryptocurrencies actually enhances real-time transaction monitoring, record-keeping and mitigation. Instances of money laundering can be detected and deterred, creating the evidence needed to prosecute offenses. Examined from this perspective, cryptocurrencies can enable transparency and provide an opportunity for regulators actively seeking to shift more transactions from the informal to the formal economy.

3. Create more inclusive global governance

Today, the differences between jurisdictions create new regulatory arbitrage opportunities as well as market uncertainty. One missing lever for global harmonization is the lack of genuinely inclusive policy platforms. For example, global standards formulated to mitigate illicit activity have resulted in blunt derisking policies (similar to redlining) that contribute to financial exclusion, especially in Latin America, the Caribbean and Sub-Saharan Africa.

Unfortunately, many, if not most, developing countries in these regions are not members of the main standard-setting bodies such as the Bank for International Settlements (BIS) and Financial Action Taskforce (FATF) but are disproportionately affected by such financial rule-making. This disparity and its impact on un- and underbanked individuals living in these countries has contributed to financial exclusion over the past several decades, and consequently the rising appeal of cryptocurrencies in these same jurisdictions.

The big challenge for regulators is that open-source cryptocurrency networks such as Bitcoin and Ethereum are computer protocols available to the public directly via the internet. They are permissionless interfaces for the issuance of tokens, self-hosted wallets and other DeFi services without the need for an intermediary.

Banning cryptocurrencies will not prevent adoption, however, it will only limit regulators’ abilities to guide market activity around these networks and address their unique potential risks.

Regulations informed by actual use cases and consultations with technology innovators will prove more robust in the long run and will reinforce important policy objectives driving economic inclusion, competition and growth.