Crypto Regulation in the EU: Practical Implications and Game Theory

On 31 March, the European Parliament voted to expand and tighten controls over cryptoassets. Since the introduction of the MiCA framework (markets in cryptoassets regulation), there has been a regulatory expansion at the European level, even showing intentions to hinder or limit the development of blockchain technology and cryptoassets. Indeed, a couple of weeks ago there was another vote that sought to limit the amount of emissions linked to crypto mining, indirectly alluding to the Proof of Work consensus protocol. All this without setting out a thorough analysis of the implementation or consequences it would have on the sector. Fortunately, it did not make it through, although there is nothing to prevent there being another bill specifically designed for this issue in the future.

Thus, the vote at the end of last month seeks to introduce information on both the payer and the payee when making a crypto transaction, in order to prevent money laundering or terrorist financing. The famous "Travel Rule" already applies outside the crypto space.

This would follow the recommendations of the FATF (Financial Action Task Force), applicable to any Virtual Asset Service Provider (VASP) such as exchanges. But recently, the intention is to extend this rule to "non-custodial" wallets. That is, individual wallets that are not linked to third parties.

The implications of such a rule would be numerous, ranging from practical to ethical issues. The consequences for the European Union go far beyond the simple control of cryptoassets. Let us look at some of these points.


I) Practical Limitations

---

First of all, the practical application of the Travel Rule, and in particular to non-custodial wallets, is yet to be seen. Any VASP would then have to adapt to the necessary measures to comply with the requirements, and therefore integrate such functionality into its services. It remains to be seen whether this would be done on a unified basis (ie. using the same tool provided specifically for EU requirements) or whether it would be free-form for each VASP. In the case of non-custodial wallets it would get more complicated. Take an individual wallet that has never interacted with an intermediary, but has been on HODL mode for a long time and/or simply performs P2P transactions. It seems unlikely that under the proposed rule a non-custodial wallet could practically integrate a reporting and data storage system, not to mention the authorities would not have the tools to enforce it.

Another aspect related to the implementation of the rule would be data management. The Travel Rule would imply the need to maintain a database with all relevant information when reporting to the authorities. This therefore incurs additional expenses for VASPs who have to manage and monitor the transactions of millions of users. Having to devote so many resources to comply with the arbitrariness of legislators is a step backwards for the growth of the sector. For smaller providers, it could even be a constraint that is difficult to maintain adequately, as data management demands ressources and above all security at different levels.


II) Security

---

Security is precisely the second key issue. The risk of holding personal information relative to cryptoassets has damaging ramifications for individuals. There are many examples of sensitive data leaks in the crypto world, with notable cases such as Ledger in 2020. Following the publication of private data of the France-based company's customers, these fell victim to all manner of phishing and harassment by fraudsters seeking to ransack their cryptoassets. Publicly revealing data such as full names, phone numbers and even home addresses makes any individual an easy target for criminals. Even more so for crypto, where the only barrier to accessing funds is often nothing more than a password (without third party intervention). A data breach associated with cryptoassets generates more physical and capital risks than other similar situations.

Therefore, entrusting a huge amount of personal data to third parties is guaranteed to expose such data to the wrong hands, putting the security of individuals at risk in order to satisfy the authorities' craving for control. Even more serious is the case of non-custodial wallets, which in some cases will have to provide their data to an entity with which they have not even interacted. This would be the case of a VASP that must store wallet information even if it belongs to an individual who is not a customer of the VASP itself. Moreover, the purpose of using non-custodial wallets is precisely to safeguard a minimum of privacy and anonymity. A public address cannot be linked to a physical person, if needed. The Travel Rule completely contradicts this principle.


III) Game Theory for the EU

---

Thirdly, imposing any measures that seek to restrict the free use of technology may have a negative impact on the EU's role in the development of this sector. As a technology that stands out precisely because of its flexibility and lack of geographic lock-in, companies and investments that accumulate in cryptoassets will move to where it is most favourable for them. This was already seen with the mining ban in China, where the Bitcoin hashrate recovered in record time as miners simply had to move to jurisdictions favourable to their activities, mainly Kazakhstan and the United States.

It was precisely after this event that several Senators in the United States raised their voices in favour of Bitcoin and the crypto sector in general, appealing to the need for their country to become the main hub for this technology. This attitude was undoubtedly spurred by the frontal opposition that China had adopted towards mining. Here we enter into a dynamic of geopolitics and game theory at an international level, where powers try to position themselves to their advantage vis-à-vis their competitors. The relationship these States have with cryptoassets will be yet another tool.

Given that cryptoassets do not understand political borders or logistical obstacles, their only obstacle is regulation. The entire development of the industry depends on States attracting investment through incentives. If the EU has been sending clear messages of hostility, it will be left behind in the race to benefit from the value created by this nascent industry. Given the unanimous disapproval of the crypto community towards the European Parliament's vote, the EU should consider finding a middle ground in which it does not drive the entire industry away, but can still introduce a degree of control, if it considers the latter so important.

In the book "Bank to The Future'', written in 2012 by Simon Dixon (one of the first promoters of Bitcoin), he argued that countries with less international clout would be the first to adopt Bitcoin and try to attract investors in the sector, while the major powers would be reluctant to see this technology that escapes their usual control mechanisms. Despite the fact that a decade has already passed, we see how Dixon's prediction is gradually coming true with the case of El Salvador and other countries similar in their international positioning, which accept Bitcoin or at least are considering it as an increasingly realistic option. These are the States most likely to benefit from the wealth generated by the wide range of financial services, mining, tourism, digitalisation and social progress associated with cryptoassets.

However, the EU is currently positioned at the opposite end of the spectrum, which could have negative consequences in the medium/long term. Imagine that in the 1990s, the European Union or the United States had decided to slow down the development associated with 2G/3G, software or the Internet. Today, many of the world's largest companies are precisely the technology companies that forged their success 30 years ago thanks to the possibility of safely establishing their developments in these geographical areas. To make such a mistake for blockchain technology would be to shoot oneself in the foot, all the more so given that there are many minor States on the international scene that would eventually occupy the vacant space if given the opportunity.

In fact, just a few days after the parliamentary vote, the UK Finance Minister made a statement in favour of cryptoassets, expressing his desire to transform the UK into a new crypto hub. All of this undoubtedly taking advantage of the decoupling from EU regulations after Brexit. This is a clear example of the aforementioned Game Theory, where States rationalise the incentives they would obtain by carrying out actions contrary to those of their counterparts. In the case of the UK it may or may not be effectively real, but it clearly shows how cryptoassets can be weaponized or to apply pressure on a geopolitical level, becoming an instrument to be taken into account in global power struggles.


IV) Legitimacy Issue

---

Finally, the problem of legitimacy can be mentioned. The question is whether such a rule would have the desired effect, since a similar regulation for fiat money does not prevent illicit activities. On the contrary, there are numerous financial institutions that launder and finance terrorism without particularly serious consequences, as was seen in 2020 with HSBC, JP Morgan or Deutsche Bank, who laundered billions of dollars during two decades without respecting anti-fraud rules. The fact that various regulations are implemented does not mean they will be complied with, as the banking sector shows on a daily basis.

Perhaps there is not (yet) a clear alignment of interests between legislators and crypto service providers, as there is with the traditional financial system. As a result, there is a certain logic in wanting to hinder a booming sector that for the time being operates more or less on its own.

Legitimacy also clashes head-on with ethics. This type of regulation goes against the fundamentals of crypto-assets: the possibility of holding value individually without the intervention of a third party. Having to expose all information about it undermines the concept of sovereignty associated with self-custody. Even if the rule does not affect the use of the assets themselves, since most crypto transactions have nothing to do with money laundering or terrorist financing, and if they do, the volume is practically insignificant compared to its fiat counterpart (mainly dollars).

Thus, the FATF recommendation introduces a control system that removes any hint of privacy and systemizes suspicion, de facto the possibility that an individual is carrying out an illicit activity even if it is not supported by evidence, thus requiring data collection. In case any cryptoasset transaction is linked to activities of this type, there are several entities that could prosecute and prosecute such actions, from State security forces or judicial bodies to blockchain analysis companies such as Chainalysis, which already collaborate with various authorities. All this calls into question the validity of European legislators.

Moreover, the initiative for European legislation is almost exclusively in the hands of the European Commission, as it monopolises legislative proposals. The European Parliament is reduced in most cases to ratifying proposals or introducing amendments over which the Parliament itself has no power. Considering the source of legislative power is not composed of elected officials: does the implementation of laws that do not emanate from democratically elected individuals and with such a wide scope (28 countries) have any legitimacy? Not to mention that many of these laws merely implement recommendations from international institutions (such as FATF), entities over which European citizens have no influence despite being affected by their guidelines.

This is a question that is beyond the scope of blockchain and cryptoassets, but it is worth reflecting on whether many of the rules imposed from Brussels are acceptable and legitimate.



Author: Bernabé L.
*This article only represents the views of observers and does not constitute any investment advice.
*The content of this article is original and the copyright belongs to Gate.io. If you need to reprint, please indicate the author and source, otherwise legal responsibility will be pursued.