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Navigating the Legal Landscape of Crypto Adoption: Regulatory Challenges and Opportunities

Navigating the Legal Landscape of Crypto Adoption: Regulatory Challenges and Opportunities.

Cryptocurrency’s regulatory journey offers challenges and opportunities for investors.

As cryptocurrency moves from the fringes into the mainstream, its libertarian roots clash with the reality of financial regulation. Bitcoin directly responded to the 2008 financial crash, introduced in 2009 as a peer-to-peer electronic cash system that operates without intermediaries.

Originally conceived as a decentralized alternative to traditional finance, crypto now finds itself at the negotiation table with all TradFi stakeholders, from governments, institutions, and legacy financial systems.

For the busy crypto investor, understanding this evolving landscape is crucial. Balancing the original utopian vision of crypto with the complex realities of adoption requires keen insight into regulatory challenges and opportunities. Let’s look at an overview of the harsh terrain where disruptive technology meets established governance.

Challenges to Crypto in the Real World

Challenges to widespread crypto adoption tend to fall into two categories: structural issues with cryptocurrency and regulatory challenges.

Structural Challenges With Crypto Adoption

Cryptocurrency and blockchain are innovations; they carry some innate challenges to broader adoption.

  • Scalability: As more users join blockchain networks, the systems can become slower and less efficient, particularly for cryptocurrencies like Bitcoin, which use energy-intensive proof-of-work algorithms.
  • Volatility: The extreme price fluctuations in cryptocurrencies make them less appealing for everyday transactions and as a stable store of value. This volatility is a barrier to both retail and institutional adoption.
  • Security Concerns: While blockchain technology is generally secure, the ecosystem around it, including exchanges and wallets, can be susceptible to hacks. Security breaches shake consumer confidence and present a significant barrier to mainstream acceptance.
  • Environmental Concerns: Proof of work cryptocurrencies like Bitcoin consume large amounts of energy, leading some regulators to call for more accountability and intervention to address the environmental impact.
  • Interoperability: The ability for different blockchains to interact with each other and traditional financial systems is another area needing regulatory guidance.
  • Poor user experience: The early days of online banking were characterized by clunky websites and poor user experience. We are seeing the same dynamic with crypto now. There is still a lot of friction to using crypto for the average user.
  • Lack of Consumer Understanding: Despite growing interest, most people in the general public don’t understand cryptocurrencies and how they work.

Regulatory Challenges for Crypto Adoption:

Governments regulate currency to stimulate economic growth while safeguarding the interests of consumers and maintaining national security.

The fundamental conflict between cryptocurrency theory and government financial systems is that crypto assets in their pure form are digital, decentralized, and anonymous. These characteristics are the opposite of (and directly threaten) the centralized, regulated frameworks underpinning traditional finance.

Below are some of cryptocurrency’s significant regulatory challenges:

  • Anti-money laundering (AML) and Counter-Terrorism Financing (CTF): Regulators are concerned that the anonymity features of cryptocurrencies could facilitate illegal financial activities. For example, reports that terrorist groups like Hamas are partially funded with crypto spurred the Treasury’s FinCEN to propose a rule to categorize crypto mixers as a threat.
  • Tax Compliance: Determining how to tax cryptocurrency transactions is complex, especially with decentralized exchanges and cross-border transactions. Reporting and disclosure requirements need to be clarified.
  • Monetary Policy Impact: Governments are concerned about how widespread cryptocurrency adoption could affect their ability to control monetary policy. Stablecoins, in particular, pose unique regulatory questions, especially when pegged to existing fiat currencies.
  • Securities Classification: The lack of clarity on whether cryptocurrencies or tokens should be classified as securities hinders their broader adoption and trading. ICOs and token sales raise questions about fundraising.
  • Decentralized Finance (DeFi): The rise of decentralized lending, borrowing, and trading platforms presents new regulatory challenges.
  • Licensing and Registration for Consumer Protection: Without adequate regulations, consumers may be exposed to higher fraud risks, scams, and volatile market practices. Determining how to securely custody cryptocurrencies is still a subject of debate and regulation.

These challenges demonstrate the complexity and breadth of issues regulators must address as cryptocurrencies become more integrated into the financial landscape. Check out the World Economic Forum May 2023 report for a deep dive into global progress on regulating crypto.

US Agencies Regulating Crypto

Part of what makes crypto regulation complex is the number of agencies that need to coordinate on a uniform set of regulations. Below are the US agencies involved in cryptocurrency regulation:

  • Securities and Exchange Commission (SEC) – Role: Regulates securities and stock markets. The SEC classifies cryptocurrency and tokens as digital assets. Beginning with a crackdown on Initial Coin Offerings (ICOs) in 2017, the SEC continues pursuing legal actions against various crypto companies.
  • Commodity Futures Trading Commission (CFTC) – Role: Regulates the futures and options markets. The CFTC declared Bitcoin a commodity in 2015 and, in 2017, approved the first Bitcoin futures contracts.
  • Financial Crimes Enforcement Network (FinCEN) – Role: Focuses on anti-money laundering (AML) and counter-terrorism financing (CTF). Starting in 2013, the FinCEN Issued guidance that virtual currency exchanges are Money Services Businesses (MSBs) and are subject to regulation, followed by proposed KYC wallet requirements in 2020.
  • Internal Revenue Service (IRS) – Role: Tax collection and tax law enforcement. In 2014, the IRS issued guidance stating that Bitcoin and other digital currencies are property for tax purposes. In 2019, the agency began sending letters to cryptocurrency holders warning them to report earnings.
  • Office of the Comptroller of the Currency (OCC) – Role: Regulates and supervises all national banks. In 2020, the OCC clarified that national banks can hold cryptocurrency assets for customers.

Current Crypto Regulatory Action

Cryptocurrency has had a complex relationship with regulators since Bitcoin’s launch. The graphic below gives a simplified overview.

Current Crypto Regulatory Action

In September 2022, The US Treasury Department released a 300-page draft outlining potential tax regulations for various crypto assets, including DeFi platforms, NFTs, and digital wallets.

These proposed guidelines are open for public feedback until late October 2022. If sanctioned, the regulations would take effect in 2026 and apply to crypto activities commencing in 2025. Failing to adhere to these regulations could result in a U.S. ban.

The proposal seeks to broaden the criteria for who qualifies as a “broker” within the crypto industry. For example, DEFI exchanges, wallets, multi-sig wallets, and crypto payment processors offering functionalities like fiat-to-crypto exchanges, asset swaps, and dApp integrations could be designated brokers, obligating them to gather KYC data.

Crypto Opportunities Within Regulatory Frameworks

Crypto investors observing how messy the regulatory process is might wonder, what’s the point of HODLing? Is there any good news?

Fortunately, there is a bright spot with the growing trend of institutional adoption.

Regulatory agencies’ speed reflects the speed of government and the courts – progress happens in fits and starts. Market-driven TradFi businesses such as banks, hedge funds, and asset managers are incorporating cryptocurrencies into their operations.

Institutional involvement brings advanced risk-assessment strategies, greater liquidity, and a long-term investment outlook, all of which contribute to a less volatile and more resilient crypto ecosystem. Their interest infuses the market with an important capital influx and brings expertise and governance that can lead to greater market stability.

Regulated financial products such as Bitcoin ETFs and futures contracts pave the way for a broader range of investors to participate in the crypto market, increasing liquidity and overall market maturity.

The real kicker is that as institutional adoption grows, so does mainstream acceptance. Payment processors like Visa and Mastercard are already experimenting with blockchain technology, indicating a future where crypto transactions are as common and seamless as fiat.

The Bottom Line

While navigating the legal landscape of crypto adoption can be frustrating, remember that this is a necessary step in cryptocurrency maturing from a niche asset class to mainstream adoption. Regulatory frameworks are challenging but necessary to legitimize and stabilize the crypto market.

If you trade crypto assets, ZenLedger can help ensure that you remain compliant with the IRS despite changing regulations. The platform automatically aggregates trades across wallets and exchanges, computes your capital gains and losses, and generates the tax forms you must file. And you have access to a single unified ledger to prove your compliance.

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This material has been prepared for informational purposes only and should not be interpreted as professional or legal advice. Please seek independent legal, financial, tax, or other advice specific to your particular situation.