Investing into cryptocurrencies combines a myriad of risks. Some are structural, as we have discussed, but others relate to the limitation of the digital currencies.

Plus there is the uncertainty of the regulatory response, which has been far from uniform. 

Accessibility is a key issue. Digital currency and digital tokens are generally only accessible by an individual who possesses a unique public key and a unique private key to unlock a digital wallet in which the digital asset is held. But if the private key is lost or destroyed and there’s no backup, the user cannot get to their assets. The private key generally cannot be restored. 

Competition for digital currency asset investments is also on the rise, as more retail and even institutional investors look to take advantage of the mounting interest. The supply of certain digital assets such as bitcoin is either fixed or increases only at pre-established rates set by the digital asset’s protocol, which means the risk of mismatches between the demand for and supply of these assets will remain high. That looks set to continue driving opportunity and risk in the asset class.

While the assets are becoming more popular, they are also controversial. Banks, brokers, custodians, insurers and other service providers are refusing to provide services to certain businesses engaged in transactions in digital currencies at an accelerating rate in Hong Kong and many other jurisdictions. And when these services continue to be provided, they are often excessively costly.

That has left affected businesses with no choice but to either pay very high rates for these services or to obtain them from less established service providers. This typically fuels a vicious cycle that promotes still greater risk.

REGULATORY RESPONSE

For regulators, cryptocurrency has offered an existential challenge. The anonymous nature of the digital world makes the digital asset well suited to facilitate private and nefarious activities such as tax evasion, money laundering and the circumvention of capital controls.

Across the world, financial watchdogs are struggling to assess the legal character of such digital assets, and assess how best to regulate them. This uncertain legal environment has often led to a patchwork of conflicting or overlapping rules. In the US, for example, the Securities and Exchange Commission, Commodities Future Trading Commission, Internal Revenue Service, Office of Comptroller of the Currency, state regulators and non-governmental self-regulatory organisations have each taken their own approaches to regulation. 

There are similar discrepancies between jurisdictions. Singapore, for example, has adopted a more accommodative approach to regulating digital assets, while nations such as China and India, have essentially outlawed trading and ownership of certain types of digital assets entirely. 

Many exchanges and other market participants have relocated to jurisdictions perceived to be friendlier to digital assets, but they may also provide far fewer protections for persons transacting in the assets. Plus, the borderless nature of digital currency and digital token transactions leaves considerable uncertainty as to which jurisdiction’s laws and regulations should apply to a particular asset or transaction.

The most common approach to date has been to regulate cryptocurrencies using existing laws and regulations. Regulators in Hong Kong regard cryptocurrencies as a virtual commodity that does not fall under the jurisdiction of any financial regulatory body. But in 2014, the Secretary for financial services and the treasury of Hong Kong stated that unlawful activities involving cryptocurrency would be sanctioned under existing laws, such as the Organised and Serious Crimes Ordinance.

More recently, in September 2017, the SFC set forth the potential circumstances in which cryptocurrencies could be a proxy for an investment into “securities”, and therefore be subject to its supervision. Three months later, it warned that providing business services relating to cryptocurrency futures contracts and related investment products might require appropriate licensing or authorisation. The Hong Kong regulator reminded market participants again this year of the requirement to hold a licence to trade cryptocurrencies that effectively amounted to an offer of “securities”.

As cryptocurrencies and their associated blockchain technology continue to evolve, further regulatory responses are expected. Any of these could impact the intrinsic viability of this evolving asset class.

Please click here to read part one of this two-part focus on the risks of investing into cryptocurrencies.