This opinion article is penned by Roy Keidar, Adv., special counsel at Israeli law firm Yigal Arnon and co & Stephane Blemus, legal counsel at Kalexius law firm, and PhD candidate on blockchain regulation at Paris Sorbonne University, France. The views expressed are those of the authors alone and should not be attributed to CCN.
This end of 2017 has been marked by a high price volatility on cryptocurrency markets, where even the price of dominant market share cryptocurrencies like Bitcoin, Ripple and Ether has fluctuated substantially. While quite a bit of emphasis has been given to the reasonableness of the value of the cryptocurrencies (or some would say, the lack thereof), and the regulatory oversight on the offering of such cryptocurrencies to the public, namely the process called Initial Coin Offering (ICO), the risks of market abuse have been far less discussed, not to say properly dealt with.
Market manipulation still represents a substantial issue for investors. The UK prudential regulator found in a 2016 report that possible insider trading could have occurred in as many as 30% of takeovers in the UK in the four years prior to 2009 and in around a fifth of takeovers in 2015. Besides, in the modern age of financial markets, new kinds of cybernetic market manipulation, driven by artificial intelligence, digital technology and social media, is not exclusive to cryptocurrency markets and could cause massive and instantaneous distortion of information and prices in other markets, as well. For instance, the US regulator Commodity Futures Trading Commission has concluded that the Flash Crash of 6 May 2010, which resulted in a trillion-dollar stock market crash during only half an hour on that day, has been at least significantly provoked by market manipulation.
Since its inception, the distributed ledger technology (“DLT”) has been thought as a way to improve transactions transparency, mitigate systemic risk and strengthen financial stability. Experts of the regulatory technology industry (known as “RegTech”) have even described blockchain as having the potential effect to create compliance partnerships between regulators and market participants, by directly inputting compliance rules inside the blockchain (i.e. via a smart contract) and therefore facilitating an almost real-time access, analysis and processing of data.
Nevertheless, in reality, market abuse risks have not been eliminated by DLT, and, given the nature of unregulated ICOs or cryptocurrencies investments, such risks are, in many ways, far greater. Lack of information on price formation and order execution, central order book manipulation, or price manipulations such as “pump and dump” and “spoofing” practices represent only some of the potential issues for investors in cryptocurrencies.
A quick survey of current regulations shows that most countries have taken broad legal measures to allow regulators to intervene in any market abuse, provided they can identify its existence. In European Union (“EU”) member states, the key regulation related to market manipulation and insider trading is the Market Abuse Regulation No 596/2014 of 14 April 2014 (“MAR”), which replaced the EU Market Abuse Directive of 28 January 2003 and entered into effect on 3 July 2016. In addition to several disclosure requirements, the MAR regulation outlaws in the EU three types of abuse on financial, commodity and related derivatives markets:
- Market manipulation (i.e. disseminating false or misleading information or securing the price of one or several financial instrument(s) at an abnormal or artificial level);
- Insider dealing (i.e. use of inside information by a person in possession of such information: (a) by transacting in financial instrument(s) to which that information relates, on his own account or for the account of a third-party, directly or indirectly; or (b) by recommending or advising a third-party to engage in insider dealing), and;
- Unlawful disclosure of non-public information (i.e. abnormal disclosure of inside information to a third-party by a person in possession of such information).
However, the application of the MAR regulation to cryptocurrencies appears to be limited, due to the fact that these rules only apply to financial instruments under the definition of the MIF Directive 2014/65/EU (“MIF”). According to several EU member states (e.g. Austria, France, Czech Republic, Poland), in the current state of law, most existing cryptocurrencies do not meet the characteristics of a financial instrument. In the EU, only the German financial regulator has classified the virtual currencies, including Bitcoins, as financial instruments, in accordance with section §1(11) of the German Banking Act (Kreditwesengesetz). Yet this decision by the German regulator has not been completed by the publication of the precise legal implications of such classification.
Similarly to the EU, the Israeli Securities Act prohibits the use of various market manipulations, such as insider trading and unlawful disclosure of information. The Israeli Securities Authority (“ISA“) has been vested with investigative and enforcement powers to enforce such misconducts. The Act applies to the use of various securities, however, as in most EU countries, there is currently no clear interpretation that securities under Israeli law include cryptocurrencies. Therefore, one would argue that both the sale and trade of cryptocurrency under Israeli law are not regulated by the securities law and that market manipulation is not clearly prohibited.
Even if the regulators adopt a broader view of existing legislation and apply existing prohibitions under the law to market manipulations, they would face a significant barrier of identifying such manipulations and their sources. One thing that stands out when dealing with cryptocurrencies is their anonymous nature. Cryptocurrencies move from one digital wallet to another at a fast pace without real names or IDs, using cryptographic (private) keys as the only identification. While blockchain technology registers every single transaction over the distributed ledger, making and proving the connection between a certain misconduct and the person behind it can turn into very complicated issue. One explanation for this is because the industry lacks the technological tools that can be used to spot and identify certain illegal actions, like the ones regulators and market participants use for the regulated markets (e.g. the stock exchanges).
Furthermore, unlike controlling the trading in stock exchanges, when it comes to cryptocurrencies there is no single public authority officially in charge of enforcing market manipulations. Indeed, cryptocurrencies are usually not registered as securities, derivatives and/or financial instruments and therefore are traded over various platforms spread around the world. Many regulators would find it hard to claim responsibility and legal powers to enforce such misconduct, where in reality the exchange platform is located in a foreign jurisdiction, and the actual misconduct was committed over the internet, by using social platforms, like Slack, Telegram, Twitter and Facebook.
Despite the obvious challenges of enforcing crypto-market-manipulation sanctions, there are early signs of change. One example was pointed out by the Polish Deputy Finance Minister who said publicly in 2014 that options, futures and swap instruments denominated in cryptocurrencies (or whose underlyings are related to cryptocurrencies) may be considered as derivatives and thus potentially as financial instruments. In Israel, the ISA published in December 2017 a draft amendment to the Israeli Stock Exchange articles suggesting banning from its indexes companies whose main business is investing, holding or mining cryptocurrencies. This announcement was a quick reaction to an unusual trade in an Israeli company capital stock which was a direct result of the company’s announcement of its intentions to get involved in the crypto mining business. The director of the ISA has expressed his deep concerns to Israeli investors in the share market, where there is little-to-no correlation between the real economic value of the company and the price of its shares.
Yet, most regulators tend to move slow, especially in uncharted territory such as blockchain. In contrast, exchange platforms and investments can move faster. Overall, as the crypto-currencies market rapidly shifts from its ‘avant-garde’ state to the ‘mainstream’, exchanges will be pressured to install more controls and tools designed to prevent and stop market manipulations. One such control may very well be the use of the integral technology of blockchain and require the creation of a structure which would permit the storage of immutable regulatory data communicated by companies through public, consortium or fully private distributed ledgers. Under such a storage structure, discussions should emerge to use smart contracts for regulatory control automation and to include financial market regulators directly into the information integrity validation and verification process.
This form of ‘self-regulation’, which means automated compliance and monitoring by market participants represents strategic development on mitigating market abuse risks. As the public statement by cryptocurrency exchange platform Bittrex showed on 25 November 2017, cryptocurrencies exchanges would be wisely advised to provide general statements to their clients discouraging market manipulation tactics and providing legal wording in their terms and conditions as well as internal processes and technical alert rules (to efficiently analyze unusual price movements, order-to-cancel ratios, pumps and dumps etc.) and harsh policies with the established violations. To face these issues, ICO funders, cryptocurrencies exchanges and wallet providers would also need to train actively and regularly their personnel on market abuse risks and compliance with regulations. Finally, beyond the constraints and legal burdens, the emergence of regulatory compliance via the use of DLT and smart contracts could represent a significant opportunity for financial institutions from a cost perspective.
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