• Hossein Nabilou

The Dark Side of Licensing Cryptocurrency Exchanges as Payment Institutions

The advent of bitcoin in 2009 was followed by a whole host of various cryptoassets having different features with oftentimes hybrid nature, which allow them to be used as a means of payment (cryptocurrencies), investment (security tokens), and access (utility tokens). The ultimate objective of payment tokens or cryptocurrencies and their underlying technology is to become a payment system substituting, complementing, or competing with the existing conventional payment systems. Irrespective of whether such an objective could be accomplished, the functional similarities between cryptocurrencies and fiat money, and the urge to bring cryptocurrencies within the regulatory net persuaded competent authorities of certain EU Member States to use licensing as a first step in regulating cryptocurrencies. Unlike certain jurisdictions, such as New York, where Bitlicense is introduced as a specific license for cryptocurrency businesses, other jurisdictions, including Luxembourg, opted for granting payment institution license to cryptocurrency exchanges such as Bitstamp Europe S.A. and bitFlyer Europe S.A.

My recent working paper analyzes granting such a license to cryptocurrency exchanges by highlighting its threefold problem. It argues that such authorization not only faces major legal challenges related to the definition of a payment institution but also introduces two new lesser-known risks with respect to the liquidity of the settlement assets and finality of payments. Regarding the definitional problem, it is not clear whether a cryptocurrency exchange can fall under the definitional scope of a payment institution under the existing EU payment laws and regulations. As the definition of a payment institution relies on the terms cash, money, and fund, under the current legal framework for payments in Europe, although certain types of stablecoins may be categorized as e-money, other cryptocurrencies cannot fall under the definitional scope of cash, money or funds. This puts a question mark on the applicability of European payment services directives and regulations to cryptocurrency exchanges and by the same token on granting a payment institution license to such exchanges.

But, even assuming the full applicability of the payment services laws to cryptocurrency exchanges, such exchanges would be subject to idiosyncratic risks that are either taken for granted or addressed in a way that is not suited for cryptocurrency exchanges. Therefore, those risks would go unaddressed under the current payment regulations. The two such idiosyncratic risks are those associated with cryptocurrency exchanges’ reliance on an illiquid and volatile settlement asset whose convertibility to central bank money (CeBM) is not guaranteed, and the risks associated with the settlement finality within certain major cryptocurrency blockchains.

To stave off liquidity risks, payment and settlement systems often use assets bearing the least credit and liquidity risks as their settlement asset. This ensures that there is no volatility risk associated with the settlement asset. However, unlike CeBM, to reduce inflation risk, bitcoin - as the largest and widely used cryptocurrency - has a capped and fixed supply schedule. Such an inflexible monetary policy begets price volatility in response to demand shocks. In addition to the fixed supply schedule of bitcoin, since cryptocurrency exchanges offer bidirectional flows between fiat money (the most liquid asset) and cryptocurrencies, market participants have an easy way out to fiat money, which could give rise to the extreme volatility of the settlement asset in cryptocurrency payment systems in times of illiquidity. Where cryptocurrency exchanges - licensed as payment institutions - use illiquid, highly volatile and unconvertible settlement assets without access to a lender of last resort, the liquidity and volatility shocks to the settlement asset would put their solvency at risk. Needless to say, mixing conventional payments and cryptocurrency payments increases the magnitude of the exposure of conventional payment systems to cryptocurrency payments and elevates the probability of the failure of cryptocurrency exchanges which also offer payment services.

If such risks were not otherwise dealt with internally, one policy option would be to require ring-fencing the conventional regulated payment operations from cryptocurrency payment operations within cryptocurrency exchanges on prudential grounds. In addition, based on such prudential considerations the relevant competent regulatory authorities may cut direct or indirect access to the financial market infrastructure for payment institutions that mix cryptocurrency payments with conventional payments.

Another major risk about cryptocurrency payments, which may not be covered by the existing payment laws and regulations, concerns the probabilistic finality of certain cryptocurrencies such as bitcoin. The finality of payments and settlements on the Bitcoin blockchain is probabilistic due to the likelihood that the most recent transactions embedded in the Bitcoin blockchain may be undone, or bitcoins maybe double-spent mainly due to a formation of a fork or other operational or technical failures.

It would seem that the concerns about probabilistic finality and the absence of legal protections might be reduced as certain developments, such as the Lightning Network, may significantly diminish the use of the Bitcoin blockchain for large volume, low-value transactions. To the contrary, such developments may eventually increase the number of large value, low volume transactions on the Bitcoin blockchain. If this case, as the Bitcoin blockchain would become similar to the Large Value Payment Systems (LVPS), probabilistic finality would pose even greater risks to the safety of payments.

In addition, it seems that most transactions within cryptocurrency exchanges take place through book entries rather than using blockchains to transfer tokens, however, transactions among exchanges are often batched and relayed through the relevant blockchain or by using other smart contracts. Therefore, at the time of writing, due to transaction batching used for discharging large liabilities, which is essentially similar to the Deferred Net Settlement (DNS) system, the number of transactions that settle on the Bitcoin blockchain does not appear to be large, however, the amounts that would be settled remain sizeable. In other words, these inter-exchange markets exhibit the attributes of an LPVS, where the systemic risks are prevalent. If cryptocurrency markets become sufficiently large, these markets would become the Achilles heel of the cryptocurrency industry due to settlement finality risks as well as the volatility and illiquidity of the settlement asset.

As these types of risks are not addressed under the current laws and regulations, granting payment institution license would allow the risks stemming from probabilistic finality and the illiquidity and volatility of the settlement assets to permeate from cryptocurrency ecosystem to fiat payment systems if adequate safeguards are not in place. It is not clear if cryptocurrencies grow large enough, whether regulators or even central banks could readily deal with such risks.

Hossein Nabilou is a postdoctoral researcher in Banking and Financial Law at the University of Luxembourg; Faculty of Law, Economics and Finance.

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