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The Risks of Cryptocurrency and How the Government Will Protect Consumers
November 30, 2017

The Risks of Cryptocurrency and How the Government Will Protect Consumers

By: Steven Eichorn

Bitcoin and a host of cryptocurrencies have taken both Wall Street and Main Street by storm in 2017.  The nearly continuous gains in the price of Bitcoin have spawned numerous imitators and led a number of companies to raise critical start-up funds by selling their own token/cryptocurrency in a process similar to an initial public offering (IPO): the initial coin offering (ICO).

Raising funds via an ICO is attractive because of its nearly completely unregulated structure, which allows companies to raise significantly larger sums and at a significantly earlier stage than standard IPOs. However, because of ICOs’ similarity to IPOs and to securities offerings in general, ICOs have attracted the scrutiny of federal regulators (most notably, the SEC and CFTC). This scrutiny poses the risk of shutting down the ICO market and other nascent cryptocurrencies.

This regulatory scrutiny arises primarily from concerns with transparency and security risks, and whether adequate consumer protections exist in the current ICO process.

What are the Risks?

  • Hacking

Cryptocurrencies often tout that the process is super secure because it is based on the blockchain and there is no counter-party risk. Everything is transparent and there is no default risk. However, there is still an often overlooked technology risk:  consumers/investors can lose their cryptocurrencies because of the security flaws and hackers are present up and down the cryptocurrency ecosystem.

For example, when one decides to purchase a cryptocurrency, one needs an online wallet to store their cryptocurrency. These online wallets are separate from the underlying cryptocurrency, and a security flaw and/or hack of the online wallet can lead to the loss of all funds. This recently occurred with the online wallet, Parity, and there is really little recourse for the former owner of the cryptocurrency.

Similarly, the lack of government regulation has a harsh downside when users no longer have access to their accounts (e.g. lost passwords and backup recovery methods, death of the account holder without a backup person having access) or when online exchanges get hacked. For example, in 2014, the Mt. Gox exchange (then the world’s largest bitcoin exchange) filed for bankruptcy because it lost at least $460 million, which were apparently stolen by hackers. Consumers were not reimbursed for their lost funds, nor was this an isolated event: Mt. Gox had already been hacked in 2011 and lost $8.75 million at that time.

The whole blockchain technology that supports the tokens/coins issued in ICOs remains a relatively new technology, thus there remains the possibility of a future hack of an unforeseen flaw in the technology. This was partially borne out in “The DAO” hack in 2016 that eventually caused a hard fork in the Ethereum blockchain. In that hack, a total of 3.6m Ether (worth around $70M at the time) was drained from The DAO by the hacker in the first few hours.

  • False Claims

Claims by ICO promoters of being “super secure” could be considered false claims and/or a material misrepresentations by government regulators.

There is also the thorny point about how promoters use the outlandish historical returns seen recently in the industry. The massive returns realized by investors in bitcoins could cause investors to wrongly perceive the potential returns and risks in cryptocurrencies, and these outsized returns would be promoted by links and articles in respectable media because they represent legitimate returns.

Regulatory Options for Consumer Protection

Recognizing that legitimate security risks to consumers are still possible in cryptocurrencies, how might regulators approach safeguarding the cryptocurrency industry?

  • Industry Clearinghouse

In traditional financial markets, security concerns are usually mitigated because by an entity that operates as a clearinghouse for the industry for all transactions, eliminating counterparty risk and ensuring the funds are actually available. In exchange, the clearinghouse entity usually charges a small fee per transaction (or per share) to fund its operations.

However, the very attractiveness of the blockchain is that it is decentralized so it is nearly certain the industry would not be receptive to a clearinghouse type of process.

  • Insurance

Another option would be to require companies to obtain insurance on their deposits to permit them to offer an ICO or for online exchanges/wallets to offer their services, but that is likely to be cost-prohibitive because of the riskiness and the security concerns (which itself speaks to the risk that the regulators would be concerned about).

  • Reserve Fund

Another proposed solution would be to require companies offering an ICO or an online exchange/wallet to set aside a certain percentage of the proceeds to ensure there is an adequate reserve fund, similar to the reserves required by banks or the settlement reserves required in payment processing arrangements.

Even in the current unregulated environment, most companies offering an ICO already withhold a substantial amount of their tokens in their ICO for the company/founders who can benefit from the anticipated growth in the tokens value. So, this proposed solution would really be adding an additional layer and require some of the actual proceeds to be held in escrow by a third party.

Realistically, it would be difficult to implement an adequate reserve to compensate for a total loss of all funds, but the reserve amount can be enough to address the more likely amount of losses due to security risks and at least permit a respectable recovery on any losses suffered by consumers/investors.

The proposed solution of requiring a reserve fund strikes a balance between allowing the innovative technology to thrive while still maintaining adequate protections for investors/consumers.

  • Disclosure

Traditionally, regulations require disclosure of material risks, prominent disclosures of actual historical returns and that past returns do not guarantee future returns, etc.

It is difficult to see a legitimate method for regulators to control the promotions of recent cryptocurrency windfalls because they are simply repeating the real-world experiences in the industry. Unfortunately, this could lead unsophisticated investors to lose their investments in cryptocurrencies.

Regulating ICOs without Choking Growth

The protection of consumers from falling into the lure of the promised “super secure” cryptocurrencies with outsized returns is part of the impetus for the SEC and CFTC to regulate the cryptocurrency world.

However, the government should be careful about imposing regulations that would choke the thriving ICO and cryptocurrency industry. Often, innovative technologies can seem somewhat illegitimate to regulators who are used to established financial markets.  A fine line must be drawn to ensure that the legitimate operators are permitted to flourish while simultaneously keeping out fraudsters and scammers.