Forecast

Regulatory uncertainty will continue to inhibit the widespread adoption of cryptocurrencies.
Though the U.S. federal government has made progress in regulating cryptocurrencies, uncertainty and ambiguity at the state level will be more difficult to overcome.
Blockchain, the technology underpinning cryptocurrencies, will have a greater impact than the cryptocurrencies derived from it.

Analysis

If cryptocurrencies are ever to be widely trusted and accepted, the regulations surrounding them must be clear. But as these rules are formed, they are redefining the currencies themselves. On July 25, Miami-Dade Circuit Judge Teresa Mary Pooler cleared Michell Espinoza of all charges against him — one count of unauthorized money transmission and two counts of money laundering using bitcoins. Pooler justified the ruling by saying bitcoins have no "tangible wealth" and are far from being equivalent to fiat currency; instead she found that in selling bitcoins, Espinoza was merely selling his own property. This is believed to be the first state-level money laundering case involving a cryptocurrency in the United States, and proponents of bitcoin watched it closely.

Pooler's ruling was made at a low-level state court and will become legally important only if it is appealed, thereby moving up through the U.S. court system. But it sheds light on the fragmented and ambiguous regulatory and legal structure surrounding cryptocurrencies in the United States, particularly at the state level. This ambiguity has stifled the acceptance of cryptocurrencies and blurred their meaning. And though the United States is not the only country lacking clear regulations on cryptocurrencies, as the heart of the global financial system, it is the most important in determining the currencies' future.

The Regulatory Maze

Regulation, through legislation and legal rulings, is often the key factor determining how quickly an emerging technology — be it drones or autonomous vehicles — is adopted. Mounting regulation in the banking and services sector over the past 15 years, sparked first by 9/11 and then by the global financial crisis, has slowed the acceptance of new technologies. Individuals and businesses must inevitably wait for laws to be figured out and enacted before new technologies can be fully utilized. This has been particularly true of cryptocurrencies — most notably, bitcoin and financial technologies — which have been hindered by a lack of regulation and an abundance of confusion.

In the United States, several different courts and agencies have claimed jurisdiction over cryptocurrencies and have made conflicting rulings on them. This has muddled the very definition of cryptocurrencies and the way they are used. Most states have taken a reactive, rather than proactive, approach to regulating the digital currencies, which means that for the most part they are governed by the same laws as fiat currencies. But as Pooler noted, that is like trying to fit a square peg into a round hole.At the federal level, the United States has taken a more pragmatic approach, albeit slowly. But cryptocurrencies still involve many different agencies. The IRS, for example, defines cryptocurrencies for tax purposes, while the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) oversee their use in trade.

Currency, Property or Commodity?

In March 2014, the IRS ruled that for the purpose of federal taxes, bitcoins and other cryptocurrencies should be treated as property, not as money, just as Pooler did. This interpretation, at least in theory, has complicated the use of bitcoins in the United States as a medium of exchange because, as property, it is subject to federal capital gains taxes. Of course, how often capital gains or losses related to bitcoins are reported to the IRS, especially by individuals, is unclear.

By contrast, the SEC treats cryptocurrencies like fiat currencies. Though the commission has not explicitly defined cryptocurrencies as a security or currency, it has regulated them and their derivatives as if they fall under its jurisdiction. So far, the most noteworthy case has been the 2013 conviction of Trendon Shavers for running Bitcoin Savings and Trust as a Ponzi scheme. Shavers ultimately pleaded guilty to the charges in September 2015 and was sentenced to 18 months in prison. Before that, the SEC had been challenged in a U.S. district court in Texas, where the judge ruled in the SEC's favor, concluding that "bitcoin is a currency or form of money." According to this determination, a Ponzi scheme based upon bitcoin investment would fall under the SEC's jurisdiction. Similarly, the SEC charged the leader of two bitcoin mining companies with securities fraud in 2015.

While the SEC has taken a tough stance against obvious fraudulent activities, it has moved more slowly in clarifying regulations on legally investing with cryptocurrencies. Bitcoin entrepreneurs Tyler and Cameron Winklevoss have been trying to get the SEC's approval to set up a bitcoin-linked exchange-traded fund since July 2013. If approved, it would be the first fund of its kind based on the cryptocurrency's value and would allow more mainstream investors to access bitcoin as an asset class. In the meantime, Bitcoin Investment Trust, the first bitcoin fund similar to an exchange-traded fund that is not registered with the SEC, began trading in over-the-counter markets in 2015, though it is open only to qualified, accredited investors. Earlier this month, a potential challenger, SolidX Bitcoin Trust, filed for its own SEC approval.

Though the SEC has made gradual progress on regulating traded derivatives based on bitcoins, the CFTC has taken a more active role over the past year. But it, like the IRS, considers cryptocurrencies to be a commodity. Since September 2015, when the CFTC found that bitcoins were a commodity, it has had the jurisdiction to regulate futures, options and swaps on cryptocurrencies, and it has been aggressive in its enforcement. Most recently, it reached a $75,000 settlement with the Hong Kong-based bitcoin exchange Bitfinex for illegally permitting "users to borrow funds from other users on the platform in order to trade bitcoins on a leveraged, margined, or financed basis." Under the Dodd-Frank Act, such activity is permitted if the bitcoins are delivered within 28 days of the transaction. But the commission found that Bitfinex did not actually deliver bitcoins to the traders who purchased them.

The CFTC's rulings may be strict, but they have also formalized and clarified regulations on cryptocurrencies that had previously been unclear. Bitcoins and other cryptocurrencies have been criticized for facilitating money laundering and other illegal activities, but they are also part of a new cryptography-based asset class with legal applications. And the SEC and CFTC, which regulate trading on exchanges, have been slow to recognize and take advantage of it.

The Pitfalls of State Regulation

Despite the handful of rulings that cryptocurrency companies must register with the states out of which they operate, only a few states have any guidance on cryptocurrencies — and even then, the rules of the states and the federal government tend to be contradictory. Registering as a money transmitter is relatively simple at the federal level, but receiving a state license in one of the 48 states that require one is much more difficult and time consuming.

New York has made the most progress toward regulating bitcoin, which is unsurprising considering its place at the center of the U.S. financial system. In June 2015, New York finalized BitLicense, which will likely become a model for other states to emulate. Under the new regulations, anyone with a virtual currency business must obtain a BitLicense and maintain certain cybersecurity, anti-money laundering and customer protection standards. A number of business categories, such as merchants and consumers who use virtual currencies in transactions for goods and services and bitcoin mining operations, are excluded from the rules. Still, it is important to note that though the new regulations resolved many questions surrounding cryptocurrencies, they also prompted many bitcoin startups to leave New York because of the high cost of complying with the licensing requirements (estimated to range from $5,000 to $100,000). In fact, during the first year, New York issued only two BitLicenses.

Behind New York, several other states have issued guidance, regulations and legislation governing bitcoins and other cryptocurrencies. The Texas Department of Banking noted that under the state's Money Services Act, cryptocurrencies are not currencies and thus the exchange of one cryptocurrency for another is not money transmission (though its exchange for fiat currency is). This contrasts, for example, with Washington's interpretation, which says the practice counts as money transmission.

The importance of the states in this issue cannot be overstated. Though federal law generally governs financial crime cases and federal regulatory oversight is important, it is the state regulations that are severely impeding cryptocurrencies' adoption. The lack of consensus and the prohibitive cost of registering in certain states has severely decreased the interest of venture capitalists in the technology. New decisions that could require cryptocurrency exchanges to register in every state they operate in have put a damper on their use even further. Venture capital investment in cryptocurrencies peaked at $228 million in the first quarter of 2015 before declining to just $26 million in the fourth quarter. In the first quarter of 2016, investment increased again to $160 million, at least partially because of the enactment of some regulation.