Regulating the brave new world of Cryptocurrencies

David Smillie

Global attention is gathering apace on blockchain technologies and cryptocurrencies (such as Bitcoin and Ethereum) as part of the latest wave of financial technology innovation and the digitisation of financial services. This is leading to the first wave of regulatory response, including early guidance from the Financial Markets Authority (FMA) here in New Zealand.

The FMA has recently released commentary on two aspects of cryptocurrencies: Initial Coin Offers and investor cryptocurrency services and how these relate to the existing financial market framework set out in the Financial Markets Conduct Act 2013 (FMCA). This article focuses on investor-facing cryptocurrency services and the FMA’s guidance around these services.

While there is not yet certainty whether cryptocurrencies are treated as a “financial product” for the purposes of the FMCA, it appears that guidance is trending in that direction with the FMA recently announcing that all cryptocurrencies are treated as securities. This means that the services that facilitate investment and trading in cryptocurrencies will be regulated accordingly.

Investment in cryptocurrencies is similar to investment in traditional securities in that it involves dealing with a market (called an exchange) and an account (called a wallet). Exchanges are often the first port of call for investors exchanging New Zealand dollars into a cryptocurrency or vice versa and are then also used to exchange one cryptocurrency for another. A wallet is simply an account that holds the cryptocurrency and can make and receive transfers of cryptocurrencies in the same way a bank account or trading account does. It is likely that businesses operating exchanges that deal with the trading of cryptocurrencies will be deemed to be operating a “value transfer service” and will need to comply with the Financial Service Providers (Registration and Dispute Resolution) Act 2008.  

Wallets both hold and transfer cryptocurrencies and some wallets also contain the ability to exchange an investor’s cryptocurrencies for another cryptocurrency without entering an exchange. Businesses providing wallet services will also need to consider whether they are operating a “value transfer service” and whether investors’ deposits qualify as debt securities under the FMCA, which attract additional regulatory requirements.

As far as retail investors go, the cryptocurrency market within New Zealand is relatively illiquid compared to overseas, with a correspondingly lower number of service providers for investors to use. This means that investors are often procuring services from different jurisdictions, most notably the United States and therefore will not have the same legal protections under the FMCA as investors using local New Zealand based services. Given that there is a smaller market for cryptocurrency services in New Zealand and the additional cost that comes with complying with New Zealand regulation, investors are typically charged a premium for using a local service provider which can range up to 20% for exchange services. Investors dealing only with New Zealand based services should have a higher chance of recovering their funds if things go wrong, which can be all too often in such a fast-moving and volatile environment. Just this week it has been reported that US$280 million of the Ethereum cryptocurrency has been “locked up” due to one person’s error in deleting the software code library required to use the relevant wallet service. Investors using off-shore online-only services will often find it extremely difficult to engage in any dispute resolution or recovery with these services.

Because cryptocurrency technology is evolving at such a rapid rate in a currently lightly-regulated environment, both retail investors and businesses looking to provide cryptocurrency services should look to take good advice before committing themselves. The FMA is expected to continue to release regulatory guidance as the sector develops and matures and it welcomes engagement from prospective service providers.