Digital assets, also known as cryptocurrencies, are making news! In April 2021, a large digital asset exchange, Coinbase Global, Inc. (NASDAQ: COIN) went public, achieving a current market capitalization in excess of $50 billion. Some well-known global companies such as Square have adopted digital assets for payment acceptance and for treasury management. Several global investment banks are adding digital assets to their product offerings. In 2021, Goldman Sachs (“GS”) launched its newly-formed cryptocurrency trading desk, which will function as part of GS’s global currencies and emerging markets trading team. Despite this recent embrace by the capital markets, digital assets are still not at the point of widespread, global adoption.
Digital assets have been loosely regulated and have no central marketplace for their exchange. They are decentralized and do not rely on either governmental authorities or financial institutions to create, transmit, or determine the value of a cryptocurrency. Supply is determined by a computer code, not by a central bank, and prices can be extremely volatile. Over the past decade we have witnessed digital asset exchanges being closed down due to fraud, failure or security breaches.
Within the United States, there currently exists no uniformity in the regulatory framework with respect to how businesses that deal in digital assets should conduct themselves. For companies in this business, often the first question asked when deciding whether to operate within a state is whether existing state money transmitter rules apply to the sale or exchange of virtual currencies.
The New York State Department of Financial Services (“NYDFS”), which supervises and regulates the activities of financial institutions, took notice of cryptocurrency businesses and created a crypto regulation called the “BitLicense”. Under that “BitLicense” regulation or the limited purpose trust company provisions of the New York Banking Law, NYDFS has granted numerous virtual currency licenses and charters to ensure that New Yorkers have a well-regulated way to access the virtual currency marketplace.
New York is one of the few states that has a functional regulatory regime. Meeting compliance in New York has become a badge of legitimacy. However, there are also a significant number of companies that have chosen not to operate in New York due to these regulations.
Wyoming, which has adopted a lighter regulatory framework, is widely considered the most crypto-friendly jurisdiction in the United States. Other states have issued guidance, opinion letters, or other information from their financial regulatory agencies regarding whether virtual currencies are “money” under existing state rules, while others have enacted piecemeal legislation amending existing definitions to either specifically include or exclude digital currencies from the definition.
Countries generally have not developed a strong regulatory framework surrounding digital assets, although some have started to lay the groundwork.
U.S. Congress passes bill addressing crypto regulation
In April 2021, the U.S. House of Representatives passed “The Eliminate Barriers to Innovation Act,”
a bill that directs the Commodity Futures Trading Commission (“CFTC”) and the Securities and Exchange Commission (“SEC”) to establish a digital asset working group and open new regulatory frameworks for both digital assets and cryptocurrencies.
Once passed and signed as law, the bipartisan bill would initiate the commission of a specialized working group that would evaluate regulation of digital assets in the U.S. This would directly impact the status of digital assets such as cryptocurrencies.
The bill sets up a joint working group between the SEC and CFTC, in collaboration with financial technology firms, financial firms, academic institutions, small and medium businesses that leverage financial technology, and investor protection groups, as well as business or non-profit entities that are working to support historically underserved businesses. The working group will be tasked with drafting recommendations to improve the current regulatory landscape in the U.S., which will then be extended internationally, where possible, given the global nature of cryptocurrency. The working group will be given a full year to evaluate and provide technical documentation on how these recommendations should be implemented through compliance frameworks, once signed.
Regulation ensures market stability
Bitcoin, the most widely held and well-known digital asset was originally designed to facilitate peer-to-peer transactions across the internet. This meant that there was no need for any intermediary or monetary regulations. While some people believe that cryptocurrencies should operate completely independently from any form of regulation, publicly accountable businesses are vigorously regulated in order to protect consumers and economic stability.
Independent audits are similarly required to protect the interests of all stakeholders, ensure that the applicable laws and regulations are adhered to, and that the financial statements are free from material misstatement, as well as fraud (to a certain extent).
Regulation and fraud prevention
South Africa’s infamous Mirror Trading International (“MTI”) was crowned as the world’s largest cryptocurrency Ponzi scam in 2020. $589 million was lost, affecting thousands of investors, according to Chain Analysis’s 2020 Crypto Crime Report.
Unfortunately, MTI’s illicit scheme using cryptocurrencies to commit fraud has overshadowed the thriving cryptocurrency industry in South Africa.
Regulators around the world regularly warn crypto asset investors to be extremely cautious and vigilant, partially due to a lack of regulation, which creates an opportunity for fraudsters to prey on uninformed investors.
Fraud and error can usually be mitigated by prevention, detection, and recourse. The introduction of regulations to govern the cryptocurrency industry will mean preventative measures are in place to ensure fraud on the magnitude of MTI doesn’t occur again and that there is appropriate legal recourse for victims.
Supporting regulations, there is a significant role for auditors in detecting possible instances of fraud or error, as well as assisting with the recourse process.
Digital Asset Outlook
The evolution of digital assets like cryptocurrencies has a phenomenal potential to change the financial industry. However, it also creates challenges. By getting regulations in place, consumers will be better protected and the industry will be enabled to develop further and better provide an alternative financial system.
Mazars will be keeping a close watch on the progress of the Innovation Bill. We believe positive regulatory changes are ahead. As a MIT Sloan School of Management Professor conducting research and teaching on blockchain technology, digital currencies, financial technology as well as being the former head of the CFTC, recently-confirmed head of the SEC, Gary Gensler has a keen knowledge of, and appreciation for, the applicability of digital assets in the global financial services ecosystem. In a recent in interview with CNBC, Chair Gensler said, that there needed to be authority for a regulator to oversee the crypto exchanges, similar to the equity and futures markets. He said many crypto coins were trading like assets and should fall under the purview of the SEC.
We welcome this level of engagement and improved regulation, which will be good for the industry, investors, consumers and society at large. Without regulation, cryptocurrencies are unlikely to become a standard part of investment portfolios due to the current high level of risk.
MTI’s fraud: a case study
There are various ways that MTI’s fraud could have been prevented or limited with the use of a financial audit or having regulations in place. According to the Companies Intellectual Property Commission, MTI was registered as a South African company on April 30, 2019 by the sole director, Johannes Steynberg, to commence business on the very same day.
The South African Companies Act (“Companies Act”) required MTI to be audited as a result of them holding customers’ bitcoin and fiat currency in a fiduciary capacity where that value was in excess 5 million Rand. Based on the application of relevant accounting frameworks, each Rand or bitcoin invested into MTI would have resulted in a corresponding customer liability on the balance sheet. This massive liability would have resulted in a significant public interest score (as calculated by the Companies Act) that would have also required the company to be audited and to have a social and ethics committee made up of various individuals, further reducing the possibility of fraud as a result of a single director denominated company.
MTI also has a February year-end and, in terms of the Companies Act, they were required to have audited financial statements by no later than August 31, 2020, which is six months after their financial year end. If they had been regulated by the FSCA, the period may have decreased to three months. At the rate funds were flowing into MTI and out the back door, these losses could have been limited to August or even May of 2020.
The director had, however, neglected to appoint an auditor, and there was no regulating body overseeing or requesting MTI to provide audited financial statements. Several red flags on their extremely complex multi-level marketing business plan would normally have been raised by both regulators and auditors. If a company such as MTI made it past the acceptance procedures of an audit firm, the challenge would be to identify the fictitious assets that a Ponzi scheme relies on in addition to ascertain the level of pseudo-anonymity that bitcoin provides.
Wiehann Olivier, Partner | email@example.com
Barry Goodman, Partner | firstname.lastname@example.org