THE PROBLEM OF NON-REGULATED CRYPTO TRADING PLATFORM AND THE OFFERED SOLUTION ON OFFICIAL PLATFORM IN THE UAE

. Introduction

In only one decade, virtual currencies (VCs) have witnessed significant growth, with Bitcoin being the most dominant among over 2300 VCs. At first, one may define virtual currencies as “digital representations of value created by private developers and denominated in their own unit of account. Although, their real nature is discussed (they may be characterized as currencies, commodities, securities, payment systems) one thing is certain: they are not fiat currencies. While fiat currencies are backed by the credibility of the issuing central bank and government, virtual currencies are not backed by any source4. Besides, it is of no coincidence that they were created in the aftermath of the financial crisis, where trust in central banks was compromised. VCs have therefore no value other than the one which is assigned to them by their users and their value against dollar or other currencies is determined on VC trading platforms, often referred to as VC exchanges, by investors buying and selling them.

Virtual currency schemes can be either centralized (e.g. Second Life’s Linden Dollar) or decentralized (e.g. Bitcoin, Ethereum, Litecoin, Ripple, to name but a few decentralized VCs). In a centralized scheme, the system is administered by a central private party. In a decentralized system, the central administrator is replaced by the protocols, which govern the operation of the system, and many administrative functions, such as the verification of transactions, are performed by the system’s participants themselves.

1.2. The function of cryptocurrencies

The way that cryptocurrencies work is innovative and is supposed to bring several advantages for their users.

How do they work?

Cryptocurrencies rely on three elements. First, the “protocol”, which is a computer code determining the way transactions are made. Second, a ledger, that can be regarded as a file that records the history of transactions. Third, a decentralized network of participants that update, store and read the ledger of transactions according to the rules set out by the protocol.

The main challenge cryptocurrencies face is the so-called “spending problem”. How may one ensure that the same cryptocurrencies are not spent twice? To prevent this from happening, one needs trust. But rather than trusting a third accountable party, like a bank, to keep the ledger, cryptocurrencies resort to a distributed ledger. This means that an up to date copy of the entire ledger is kept by each participant. This is what makes it a distributed ledger, through which, everyone keeps an eye on everyone else.

All cryptocurrencies rely on a distributed ledger, but can be classified into two different categories, depending on how the ledger is updated. One category of cryptocurrencies is based on “permissioned” distributed ledger technology (DLT). For such cryptocurrencies, the ledger can only be updated by trusted participants in the cryptocurrency – often referred to as “trusted nodes”. These nodes are selected and subject to supervision by a central entity, in most cases the firm that developed the cryptocurrency. However, this category of cryptocurrencies does not radically differ from traditional fiat money: they both rely on the same principle of trust on third accountable parties.

A second class of cryptocurrencies is based on a unique innovation, called “permission less” DLT. Anyone can become one of the multiple participants who employ a process known as a consensus mechanism, in order to come to an agreement on the contents of, and updates to, the ledger.

The concept of permission less cryptocurrencies was first laid out in 2009, by an anonymous programmer or group of programmers under the pseudonym Satoshi Nakamoto, who proposed the Bitcoin, a currency based on a specific type of distributed ledger, the ‘Block chain’. Block chain is a single chain of discrete blocks of transactions, arranged chronologically, for example: Person A Sent X bitcoin to person B, who sent Y bitcoin to person C, etc.

Bitcoin and other Block chain-based permission less cryptocurrencies have two groups of participants: “users” who want to transact in the cryptocurrency and “miners” who act as bookkeepers. Miners update the ledger, by using their computer’s processing power to solve complicated computer algorithms, and are remunerated for their work by newly-created Bitcoins. The update is subsequently stored by all users and miners.

That said, cryptocurrencies cannot function without other supporting infrastructures such as exchange platforms and digital wallet providers. Users of cryptocurrencies purchase cryptocurrencies from exchanges using traditional currencies, unless the user in question has acquired cryptocurrencies by another user through a peer to peer transaction or is a miner who earns cryptocurrencies by mining. Then users need to store their cryptocurrencies and often use third-party administered digital wallets. Cryptocurrency exchanges and wallet providers are comparable to traditional financial institutions. They are third-party intermediaries who operate on the same principle of trust.

It results from the above that the actors of the cryptocurrencies’ ecosystem are the software developers, who design the cryptocurrency scheme, the users, who transact in cryptocurrencies, the miners who validate transactions, the exchange platforms, where cryptocurrencies are traded, and the custodian wallet providers who hold cryptocurrencies on behalf of their owners. The cryptocurrency system is therefore sophisticated but is supposed to bring several benefits for its participants.

Which are their advantages?

It is often contended that Bitcoin and decentralized virtual currencies in general offer the promise of a global system of payments that would be more efficient than the one that currently exists, and that regulation should not hinder their development. A strong argument is made that they have two potential advantages relative to traditional payment services, i.e., they are cheap and they are efficient payment methods. Nevertheless, these advantages are more talking points than true attributes of cryptocurrencies.

Firstly, they are usually not so cheap. The system participants who validate transactions, the so- called miners, are not only rewarded by newly created virtual currencies but they also charge transaction fees. From 2015 to 2017, transaction fees for bitcoins have even witnessed an increase of 1200 % -, reaching almost 40 dollars per transaction; today fees have significantly fallen, but nothing excludes that they may rise again, especially if Bitcoin price rises as well.

Secondly, they are not as efficient as their promoters pretend in terms of payment methods. The Bitcoin Block chain is estimated to be able to realize a maximum of between 3.3 and 7 transactions per second, while VISA manages 24000 per second. In addition, the Bitcoin Block chain is estimated to use per year a quantity of electricity, which corresponds to the annual consumption of electricity in Austria (73 TWh). The energy efficiency of the Bitcoin Block chain is therefore extremely poor, while being extremely harmful to the environment.

The so-called advantages of cryptocurrencies may therefore be virtual. In reality, they present two advantages that are related more to the underlying technology than to the cryptocurrencies themselves. First, the log of transactions recorded cannot be tampered with. This implies that historical records are definitive, a feature that is invaluable to any business that relies on data tracking. Second, information is stored in many places at the same time, and the integrity of the system is not guaranteed by a single guardian. Therefore, a technical problem or loss of confidence in a participant does not normally cause any damage to the system.

Cryptocurrencies proponents also put forth another advantage: they advance that cryptocurrencies can easily escape regulation. And our objective in this report will precisely be to assess the relevance of this argument.

To this end, we will examine in the following section the problem of non-regulated cryptocurrencies platform.

2. The problems of non-regulated crypto-currencies

Cryptocurrencies pose risks, some of which being remote and others immediate.

2.1. Remote risks

It is said that in the long run, cryptocurrencies may have important implications for the monetary policy. For example, it is argued that the widespread use of VCs may lower the demand for traditional central-bank issued cash and that in an extreme scenario, central banks may lose their ability to monitor money supply. This risk is nonetheless extremely remote. Cryptocurrencies are, in our opinion, unlikely to replace traditional payments systems, as they offer no guarantee of security, convertibility and value, contrary to legal tenders. Moreover, people in different countries typically transact in their own local currency and are obliged to do so by Law. Besides, since most jurisdictions require tax obligations to be paid in domestic currency, national currencies are likely to remain an important payment mechanism.

Last, cryptocurrencies do not appear to pose any risk to financial stability yet. One reason is that they are small compared to the financial system as a whole. Their market capitalization was USD 130 billion at the end of 2018, about 0.6% of the market capitalization of the S&P500 (22 trillion). But if banks and financial firms were to hold huge unhedged exposures to cryptocurrencies, a crash could affect the stability of the wider financial system.

Similarly, a threat to central bank money and financial stability must not be ruled out if the Facebooks’ so-called “Libra project”, which contemplates the use of a crypto-coin by the billions of Facebook users, is finally implemented.

2.2. Immediate risks

Other risks are more immediate and require, in our view, regulatory intervention. These are risks for cryptocurrency users/investors and risks related to cryptocurrency uses.

Risks for cryptocurrency users/investors

Some of the risks posed to users are linked to the functioning of the cryptocurrency scheme itself. Cryptocurrency transactions may never be executed, as miners may decide not to validate them, and erroneous transactions registered on the Block chain cannot be cancelled, as they are designed by the system to be irreversible.

The most important risks are however linked to cryptocurrency trading. Cryptocurrencies have a high level of price volatility with daily changes often in the hundreds of dollars. For example, the value of Bitcoin increased sharply in 2017 from around €1,000 in January to over €16,000 in mid- December and then fell almost 80%. Today Bitcoin is traded at around $3900. Buyers of cryptocurrencies are therefore exposed to the risk of losing a large amount, or even all, of the money invested.

Moreover, cryptocurrencies have the potential to give rise to frauds or hacking, as the market is still opaque and the regulation in process of development. In recent years, hackers have infiltrated trading platforms and stolen billions of dollars’ worth of virtual currency. For example, in January 2018, $500 million in cryptocurrency were stolen by hackers from the Coin Check platform of exchange, which is based in Japan.

Furthermore, delays and outages on trading platforms are common, leaving customers unable to withdraw funds and susceptible to significant losses given volatile prices. Platforms often refuse any responsibility for not ensuring an operational continuity. For example, bit stamp, a UK based exchange platform, declares in its website the following: “We do not represent that this Site will be available 100% of the time to meet your needs. We will strive to provide you with the Service as soon as possible, but there are no guarantees that access will not be interrupted, or that there will be no delays, failures, errors, omissions or a loss of transmitted information”.

In addition, public reports and research articles have linked certain trading platforms to deceptive and predatory practices, market manipulation and insider abuses. In particular, unlike traditional trading venues who are subject to stringent regulation, platforms lack robust real-time and historical market surveillance capabilities, to prevent, identify and stop suspicious trading activities. Several platforms have no formal policies governing manipulative and automated trading and do not suspend or block traders who submit an excessive number of small orders in a given timestamp (e.g. Bit stamp). Certain platforms even deny any responsibility for stopping traders from artificially affecting prices or even declare that “market manipulation doesn’t matter to most crypto- traders” (Kraken37).

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Lastly, platforms often not only serve as venues of exchange, but also perform other roles. They may act as broken dealers, representing traders and executing trades on their behalf. They may be money transmitters, transferring virtual and fiat currency and converting it from one form to another. They may function as proprietary traders, buying and selling cryptocurrencies for their own accounts, even on their own platforms and often allowing their employees to trade directly on their venue as well. Each of these roles has a different set of incentives and introduces substantial potential conflicts between the interests of the platform, the platform insiders and the platform customers.

For all these reasons, regulation is required to protect cryptocurrency investors. However, the regulation is also required to protect against certain cryptocurrency uses.

Risks related to cryptocurrency uses

The pseudo-anonymous and peer-to-peer (P2P) nature of cryptocurrencies make them an ideal mechanism to obfuscate the transaction chain. While all transactions are recorded in the distributed ledger available to all participants, the users behind these transactions are known only by their cryptographic “addresses” and not by their real identity. These features enable cryptocurrencies to be used to conceal the illicit origin or destination of funds, facilitating money laundering (ML), terrorist financing (TF) and the evasion of sanctions. There have already been a number of serious and well-known cases of criminal activity involving cryptocurrency schemes. For example, Bitcoin was used as the currency of choice in “Alphabay”, a “dark web” marketplace for illegal goods that was shut down by US law enforcement authorities in 2017.

Regulatory intervention is therefore crucial in order to avoid the type of abuses described above. Designing regulation from a payment service and financial standpoint does not, nonetheless, seem to be an easy task.

3. Solution to Regulate Bitcoin in UAE

Government must play a role in regulating the industries enabling crypto-currencies and create an enabling platform in the conversion of virtual currency to national currency. All providers must be licensed and subject to security checks, insurance, and capitalization in the event of bankruptcy. The Know Your Customer (KYC) policy should be adopted across board with mandatory checks and records which need not necessarily be made open to the public but should be a pre- condition for transaction in order to give credibility to the transaction process. The European Union has had considerable contributions in the crypto-currency environment through various studies such as the “European Union Agency for Network and Information Security (ENISA) 2017.” There is however, need for future work in the area of regulating the crypto-currency environment in UAE. International instruments will no doubt, propel the ratification and development of national laws in this critical area of legal development. The UAE Central Bank published the "Regulatory Framework for Stored Values and Electronic Payment Systems" on January 1st, 2017 to promote consumer protection and financial stability. However, on February 1st 2017, the Governor of the UAE Central Bank issued a statement clarifying that "these regulations do not apply to bitcoin or other cryptocurrencies, currency exchanges, or underlying technology but this need to be addressed and some from the govt. bodies should take responsibility to the consumer virtual currencies.

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