The recent dramatic increase in the value of Bitcoin and a growing number of Initial Coin Offerings has attracted a lot of attention from investors, innovators, policy-makers, regulators and supervisors. With this increasing attention have come a number of questions: What are these new, cryptographically created and secured virtual currencies or assets? Are they the future of finance or just a temporary fad? Is there more to the technology underpinning cryptocurrencies than meets the eye? And what is the EU's response to these developments? Peter Kerstens, Advisor at the European Commission, takes a look at the issue in more detail.

A new financial asset class?

The name 'cryptocurrency' is, to say the least, misleading. Even though they were invented – almost a decade ago now – as a means of payment, they are not really currencies in the traditional sense of the word. This is because they are missing some essential characteristics of conventional money. For instance, they are not issued by central banks or authorities. And because they are so volatile, they are not widely used as a means of exchange. Furthermore, according to established definitions, 'money' or 'currency' should constitute a unit of measure that allows value – for example of goods or services – to be clearly expressed in monetary terms. It must also be a 'store of value', meaning that people can save, retrieve and exchange assets and that they will retain their value over time. As cryptocurrencies score poorly on all of these points, 'crypto-assets' or 'crypto-tokens' are probably more suitable names. In reality they are nothing more than unique cryptographically generated alphanumeric strings of characters that give access to, and control over, a piece of computer code.

But that piece of computer code can be worth a lot of money. It may not have any intrinsic value. But investors around the world demonstrated that they are prepared to spend huge amounts of money on them. Indeed until its value more than halved at the beginning of 2018, the price of a single Bitcoin had skyrocketed to over €15,000. But while their completely virtual nature has not prevented crypto-assets from being touted as potentially the next big technological revolution in finance, there is no way of knowing if they will develop into a major financial asset class. However, the underlying blockchain technology on which they are based holds a lot a promise and is very likely to transform the way we do business. Blockchain is a digitised, decentralised technology to agree on information and permanently record it in a shared database.

There are currently around 1,500 different crypto-tokens and new ones are emerging every day. Of course Bitcoin and some of the other major alt-coins such as Ethereum, Ripple, Bitcoin Cash, Litecoin or Cardano make up more than 80% of the market, both in terms of market capitalisation and daily trading volume. Crypto-tokens are actively traded on so-called crypto-exchanges. At the moment, Europe represents only a small share of global cryptocurrency trading, with most of the largest exchanges located in Asia. Crypto-tokens have also proven to be a novel – if frequently very risky and un-transparent – way of raising capital. In an Initial Coin Offering (ICO), startups looking for funding for the development of their activities create and then sell crypto-tokens to investors. According to Coinschedule.com, in 2017 ICOs raised an estimated $3.9 billion. And in the first quarter of 2018, the figure is already a staggering $6 billion.

Regulating crypto-assets

Existing financial regulation was not designed with crypto-assets in mind. So their legal and regulatory status within this regulation needs to be assessed. This is why regulators are currently reviewing crypto-assets and ICOs and the rules that apply to them. The Commission is carrying out this work together with the European Supervisory Authorities (ESAs) and, given the global nature of crypto-asset markets, international partners such as the Financial Stability Board. As part of this effort, at the end of February, the Commission held a roundtable devoted to cryptocurrencies. The event focused on the implications of cryptocurrencies for financial markets, the risks and opportunities associated with their use, and the recent development of ICOs.

Crypto-assets and blockchain play an important role in Fintech innovation and it is important that any regulation should not stifle technological innovation. However, in the short time that they have been in existence, crypto-assets have also shown themselves to be highly speculative and volatile instruments. What's more, they have been associated with the financing of illicit activities and money laundering and have been both targets of cyber-attacks, as well as the means for hackers to demand hard-to-trace ransom payments. For this reason, cryptocurrency exchanges and providers of cryptocurrency wallet services are now subject to the anti-money laundering directive. Furthermore, at the Commission’s request, the ESAs in February issued a warning to investors about the risks involved in investing in crypto-assets.

The Commission, together with its international partners in the G20 and Financial Stability Board, as well as the ESAs and the European Central Bank, will continue to monitor developments in crypto-assets and ICOs. Based on an assessment of the risks, opportunities and the suitability of existing rules, the Commission will determine whether any regulatory action at EU level is required.

Read more about cryptocurrencies and the FinTech action plan and also the EU blockchain observatory and forum