The Finance and Expenditure Select Committee of the New Zealand Parliament
This submission is from BitPrime Limited
The intention of our submission
BitPrime is pleased that the Committee has decided to engage with the local industry and experts by initiating this inquiry. We thank you for the opportunity to make a written submission. We would like to outline a bit about our business and our place in the cryptocurrency world in the pages that follow. Our hope is for New Zealand to develop a productive, safe, respected market leadership in what is quintessentially a decentralised global industry. We hope to assist the Committee with some education on cryptocurrencies and blockchain technology along the way and refer to more heavyweight reference materials in the Appendices and links included with this submission. Ultimately, we believe the industry will benefit from sensible and modern regulatory settings to shepherd us through a period of growth ahead. These settings can also guide consumers towards informed decisions, as cryptocurrency usage will likely explode soon and become mainstream. There is an excellent opportunity for New Zealand to advance the international regulatory curve in this area, and we suggest seven key recommendations that could enable that to happen.
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Full Submission Plain Text Below:
What is BitPrime?
BitPrime is a New Zealand based OTC (over the counter) cryptocurrency trading desk that has been in operation since March 2017. Our largest customer segment is the retail market, where we trade over one hundred different cryptocurrencies in the New Zealand domestic market. The retail segment is non-custodial, meaning that customers hold all their assets, reducing counterparty risk to the New Zealand public. Non-custodial is a crucial distinction to make, given the occurrence of exchange hacks in New Zealand and abroad where user funds have been stolen. Our business model was designed with this in mind.
We also operate an institutional OTC desk, BitPrime OTC, which caters to professional investors, institutions, and high-net-worth individuals both in New Zealand and abroad. BitPrime focuses on the premium end of the market by offering a range of personal, educational and technical support services to people and businesses who wish to invest in or trade cryptocurrencies. The support consists of 24/7/365 live chat to assist users with technical issues such as which wallet to use and how to use it, troubleshooting error messages, advising on security best practices, and general enquiries. We also provide paid one-on-one (Zoom) consultations, where these sessions are also offered free of charge to high-risk/need customers or customers with disabilities. We have invested heavily in educational content, including blogs, videos, and an extensive technical knowledge base.
Our knowledge base is our most significant source of new users - they come to solve a problem and then stay for the service and support. We work closely and collaboratively with a range of government regulators and law enforcement, including the Department of Internal Affairs (DIA), Inland Revenue (IRD), Financial Market Authority, and the New Zealand Police (uniformed and FIU). We are a registered financial service provider (FSP595609), registered to provide the services of “operating a money or value transfer service”. We are an AML/CFT reporting entity
supervised by the DIA. We aim to be fully compliant with all financial and taxation regulations affecting BitPrime. Indeed, we seek to be a leader in raising quality control, sensible regulation, and legitimacy of our emerging industry.
We currently have 31,000 users ranging in age from 16 to 92. BitPrime’s trading volumes are tracking towards NZD 80-100 million for the current financial year out of an estimated NZD 200-$300 million trading volume in the New Zealand market. BitPrime employs 23 staff and contractors across New Zealand, the Philippines, and Brazil. Aside from a small physical office in Christchurch, our business is almost wholly cloud-based, with most staff working remotely since 2019. Decentralisation makes our business both resilient and agile - we scale up and down rapidly in response to market conditions. COVID19 has had virtually zero impact on our operations due to this design. We need more nimble and resilient businesses in New Zealand.
We are actively looking to expand into new markets. While we have higher compliance costs than many other jurisdictions, it has been worth the investment. Brand ‘New Zealand’ means that we receive significant interest from overseas investors, be it ex-pat Kiwis or high net worth individuals who want to do business in New Zealand. We are adding Euro and US Dollar trading pairs soon to meet this growing demand.
The evolution of Cryptocurrencies
The cryptocurrency and virtual asset ecosystem are vastly different today from the heady days of 2009, when the Bitcoin genesis block was first minted on 3rd January 2009. It was partly a product of the turmoil created by the GFC, including a poetic message embedded in its coinbase “The Times Jan/03/2009 Chancellor on brink of second bailout for banks”. Bitcoin was created as a peer to peer form of electronic cash, launched on the back of collapsing public sentiment about the propriety of the global financial system and those whose mismanagement contributed to the GFC situation.
Twelve years is like an epoch in the cryptocurrency sector. Trends and technology move as quickly as those in DNA sequencing technology or mobile phone capabilities. What applied in 2009 is miles behind us now, and growth comes so fast that if you blink, you’ll miss it. The cryptocurrency market now has a market capitalisation of NZD 2.9 trillion, with 24-hour trade volumes of NZD 146 billion at the time of writing this. Estimates put Bitcoin as comprising 43% of the market among the leading cryptocurrencies, followed by Ethereum at 19%. Collectively, decentralised finance (DeFi) tokens and protocols now make up NZD 22 billion, or 15% of the market (CoinMarketCap, 2021). And we’re only at the beginning of the mainstream adoption curve.
Most people know about Bitcoin and think of it as a type of Internet gold or digital money. However, there are many types of cryptocurrencies that have a range of different characteristics and use cases. Cryptocurrencies can be categorised into five categories: payment, infrastructure, financial services, and media and entertainment. Many have elements of multiple types. Payment cryptocurrencies include coins that’s primary purpose is a means of exchange or store of value, such as Bitcoin or stablecoins like USD Tether. Infrastructure cryptocurrencies provide utility over and above value transfer, such as smart contract platforms like Ethereum.
Financial tokens are the backbone of DeFi and are used to run DeFi protocols like Uniswap (UNI), where the token is used for governance (user voting), rewards, and interest payments. The Uniswap protocol offers a range of autonomous and decentralised financial products, such as a decentralised exchange (no intermediary) and liquidity pools. Service tokens are used to pay for and govern blockchain-based services such as file storage and online identity management. Media and entertainment tokens include NFT’s (non-fungible-tokens), gaming, and content creation and distribution. These categories are based on the Messari classification
Cryptocurrencies can also be viewed in a generational sense, which groups cryptocurrencies in chronological and technological ways. In that sense, Bitcoin is a first-generation cryptocurrency. It’s like an old Cadillac - reliable, easy to fix, familiar and comfortable enough, and everyone’s heard of it. Of course, it’s pretty slow and a real gas guzzler. But first-mover advantage and brand recognition are as significant in the cryptocurrency market as any other. First-generation blockchains were designed primarily as a means of exchange and a store of value but without the need for any single intermediary like a bank.
Next to arrive were second-generation blockchains like Ethereum. They still work as means of payment but include other layers like smart contracts. These are pieces of software that change digital cash into programmable money, opening up so many other possibilities. The Ethereum blockchain has been used to launch numerous other tokens and is the current backbone of decentralised global finance. However, as it has grown, Ethereum has been a victim of its success and has struggled to scale up to meet surging demand. More advanced competing distributed ledgers are moving in to meet this demand.
Third generation blockchains are designed to resolve fundamental flaws, including scalability and interoperability (cross-chain transactions). Those issues have been hampering mass adoption and driving up transaction fees in generation one and two blockchains. One such example is IOTA, an open, feeless data and value transfer protocol for the internet of things (i.e. connection to smart devices in the future). IOTA technically doesn’t even use blockchain. It uses a transaction validation method known as the Tangle. The IOTA (Tangle) distributed ledger uses new transactions to validate previous transactions. It is resistant to quantum computing, and the more transactions it handles, the faster and more secure it is. Please see Appendix E for more information.
Notably, unlike our gas guzzler, the Tangle uses almost no electricity. We believe that using ‘mining’ based algorithms to secure ledgers in the first generation was a stepping stone technology, but the future of cryptocurrencies will be far more energy-efficient. The banking and finance industry has been slow to innovate. That might be due to massive problems with managing legacy systems and a lack of actual competition. Cryptocurrency will do to banking what Uber has done to the transport industry - crack it wide-open. Areas like
cross-border payments and remittances have been slow, expensive, and highly profitable to banks. However, the banking industry does stand to benefit from the technology if willing to embrace it and – crucially – if an adequate regulatory framework exists, domestically and globally.
See our map of The Cryptocurrency Ecosystem in the appendices. BitPrime’s main areas of operation can be seen to fit mainly in the “trading” sector in the upper-left corner of the map.
Who uses Cryptocurrency and Why?
The Global Market
The number of global crypto users reached 221 million in June 2021. That was more than double the 106 million users recorded as recently as January 2021, according to the crypto.com Measuring Global Crypto Users report. That’s equivalent to the entire population of Brazil adopting cryptocurrency in some form since the beginning of the year.
The NZ Domestic Market
Closer to home, a recent Financial Services Council survey (2021) found that 21.5% of respondents currently held or were planning to use cryptocurrencies in 2021. The results represent an increase of 7% since last year. We believe that this metric is a little high, possibly due to sampling bias, but the trend is unmistakable.
There are several reasons why New Zealanders are adopting cryptocurrency in more significant numbers. The primary motivation is potential investment returns, but there are many secondary reasons. In contrast, in countries with the highest adoption rates to date, customers may be motivated by utility and practical application (especially in nations with corruption), a weak banking system, or a lack of confidence in the local fiat currency.
Sustained record-low interest rates in New Zealand and concerns about asset bubbles are driving new investors to cryptocurrencies. They are looking for returns beyond simple term deposits and heeding advice about looking to diversify. ‘Saving’ is dead, which is reflected in both household debt figures and trends in investing. We have seen an uptick in capital inflows coming from the residential property market in recent months. Many of our customers express concerns about equity markets being overinflated. For example, the P/E ratio (Price to earnings ratio) of the S&P 500 US sharemarket index more than doubled between January 2012 and 2021 to an eye-watering 35.96 (Yahoo Finance, 2021).
Utility is also driving Kiwis to cryptocurrency. We are all spending more time online and getting used to transacting more online and using cloud-based services. The declining use of both physical cash in general and lack of acceptance by some institutions is also a factor.
Let’s take a moment to consider some broad personas of cryptocurrency users. These are, of course, a generalisation, and most people will have a primary persona and some secondary traits. But we consider that they largely ring true.
Personas of Cryptocurrency Users
BitPrime’s community consists predominantly of people driven by potential investments returns, with utility and empowerment as secondary drivers. Evangelists tend to shun mainstream exchanges and trading desks for peer-to-peer trading.
Current Regulatory Environment and Enforcement
BitPrime considers the New Zealand cryptocurrency regulatory system consists of three pillars; AML/CFT, tax, and financial markets & conduct. We recognise that both the Department of Internal Affairs (AML sector supervisor) and Inland Revenue have effectively regulated the cryptocurrency space under existing legislation. We have worked closely with both departments over several years, and they have done an excellent job balancing innovation with their respective mandates and jurisdictional limitations.
We are left with two pressing issues:
- Firstly, the (cryptocurrency) financial markets themselves are not regulated regarding custody, trading, and conduct. That creates a regulatory gap where companies like ours wanting to ‘do things by the book’ are without a book to follow. And it might allow others to exploit the gaps.
- Secondly, regulators are left trying to do their best to use powers and methods designed for traditional markets. That does not easily translate when attempting to apply them to the cryptocurrency sector. There is not one single piece of legislation that has been drafted specifically for the cryptocurrency industry. Additionally, the regulators have different and sometimes overlapping remits, which can confuse their initiatives and complicate life for businesses like ourselves striving to remain compliant.
Even seemingly insignificant things like a lack of consensus on definitions and terminology can cause significant problems. The situation would benefit from some centralised leadership and regulatory framework to guide the various regulators and industry players in the evolution ahead.
The rest of our submission will zero in on seven critical propositions. We recommend that this Inquiry ensures its report and outcomes include consideration of the need to:
- Establish a permanent interdisciplinary cryptocurrency working group.
- License all virtual asset service providers.
- Legislation and regulation must be consistent with overseas jurisdictions.
- Effective central bank monetary policy and cryptocurrency can coexist.
- Any legislation must be future-proofed: A principle and risk-based approach trump rules-based frameworks.
- Government departments and agencies must start using blockchain analytics tools widely and routinely.
- Grow productivity and the economy sustainably through FinTech innovation.
1.0. Establish a Permanent Interdisciplinary Cryptocurrency Working Group
Cryptocurrencies and their underlying technology are evolving at a rapid rate. What may have been current even as recently as 2017-18, when BitPrime started, may seem like decades ago in the tech-world now.
Understandably, traditional law-making processes, and conventional approaches by regulators to guidance or rules, cannot keep up. New coins, applications and use cases, and companies join the market all the time from international sources.
An ongoing working group would be highly desirable for the New Zealand government to stay across these changes. It should consist of experts from across the regulatory, monetary policy, cryptocurrency, and banking sectors. Overseas, similar steering groups or public-private advisory task forces have helped navigate a regulatory path where none existed.
We recommend that an independent working group is created to fill this need for providing ‘real-time’ information and expert advice to the government. The working group could consist of members appointed from:
- AML sector supervisors
- Law enforcement/Justice/Security
○ NZ Police
- Cryptocurrency Industry
○ Industry experts
○ Technical experts
- Legal and regulatory bodies – e.g. NZ Law Commission
- Banking sector representatives
2.0. License all Virtual Asset Service Providers
With regulatory initiatives in this field only just finding their feet, AML bodies have been leading the way so far. BitPrime supports this; we want to ensure criminals cannot misuse our services. The AML community refers to ‘VASPs’ as an umbrella term for the ecosystem of firms transacting in cryptocurrencies or offering digital services. Two pieces of guidance have been particularly valuable: at the international level, the Financial Action Task Force “Guidance for a Risk-Based Approach” (June 2019); and locally, the DIA’s VASP Guideline “Complying with AML CFT Act 2009” (March 2020).
We attempt to follow and integrate these principles into our business. They include a helpful set of risk factors and ‘red flags’ around which the industry can organise its compliance. Currently, VASPs in New Zealand are required to meet many requirements for initial regulatory oversight. That includes such things as having a compliant AML/CFT risk assessment and programme and compliance officer; being registered on the FSPR; undergo regular control checks and AML audits; be a member of an approved consumer disputes resolution scheme, and be a registered reporting body to pass suspicious matters to the Police FIU.
But no specific licensing system exists compared to deposit-taking finance companies, financial advisors, and derivative trading exchanges. That represents a growing regulatory gap.
A licensing system needs to be established to incorporate areas not currently being addressed. That may include developing frameworks such as an industry code of conduct, custody rules and controls, measures for consumer protection, fair dealing, and disclosure upfront to traders.
BitPrime already follows best practices as we see it (in addition to our existing statutory obligations):
- We don’t provide investment, tax, or financial advice.
- We don’t onboard applicants who are attempting to use debt as a source of funds, except for those who meet the definition of a ‘wholesale investor’ under the Financial Markets Conduct Act 2013.
- During the application process, we ascertain the applicants’ reasons for wanting to buy or sell cryptocurrencies. Often this involves a discussion on the phone with a compliance analyst or sometimes a member of the senior management team. If we believe that they can’t use a wallet safely and securely or if they are potentially involved in high-risk activity, we don’t onboard them. In cases where we become aware of a possible investment scam, we may refer them to an independent vetting agency such as a QRisk, sometimes at our own cost.
- We provide regular education around security and backing-up wallets, whether the individual requests (or wants) the information or not.
Any entity that executes transactions, manages wallets, or collects and maintains KYC data, should be captured by the licensing regime. These entities should include custodial exchanges, OTC desks (like BitPrime), custody providers, and centralised peer-to-peer platforms. Other VASP firms that hold custody of assets or wallets, hosting them in a way similar to banks, are particularly exposed to digital assets/data loss.
The cryptocurrency industry in New Zealand is still tiny compared to the broader financial services industry. Therefore, consideration must be given to the costs of compliance and small firms in meeting the requirements for licensing. The licensing system must be transparent and streamlined with standardised channels of reporting. Consistent with the online, FinTech nature of our industry, that should be preferably automated.
Licensing matters could be handled by the DIA, with whom we already engage, or the RBNZ if more currency/monetary oversight is desired. The New Zealand authority could develop mutual recognition processes with overseas counterparts who already license their VASPs, such as Japan and many US states.
It may seem unusual for an industry player to ask for this type of regulation, as it will inevitably cost us in the compliance area. But we have a vested interest in keeping any ‘cowboy’ operators out of the market and growing the credibility of our industry. We are already leading the way with many of these best practices. What is desirable is some agreed frameworks to ensure a level playing field and consequences for those who cannot comply (or are unwilling to invest in it properly).
3.0. Legislation and Regulation must be Consistent with Overseas Jurisdictions
All proposed new legislation or regulation must be considered in the context of approaches taken in other jurisdictions. Parliament must be conscious that some players can relocate or ‘shop around’ for more accessible forums to base themselves in a global market. That would help avoid the ‘waterbed’ effect, where one lax operator is pressed down by quality regulation in NZ but pops up in another place or another guise.
If an overly expensive or hard to comply with regime is enacted, it will push cryptocurrency trading to overseas jurisdictions with weaker regulations or a lack of effective enforcement. Apart from simply sending problem operators elsewhere, it may leave the legitimate New Zealand industry uncompetitive and at a disadvantage.
A vital part of this is having a deep understanding of how cryptocurrencies work from a technical perspective. Some regulatory requirements that might be easy for a bank to comply with would need to be completely re-engineered to work with cryptocurrencies.
However, other aspects of cryptocurrencies have some advantages over the banking sector in risk scoring. Advanced blockchain analytics tools allow us to risk-score a wallet or transaction in seconds, tracing them through dozens of previous transactions on the public blockchain or looking forward and seeing where the funds may have gone afterwards. The same exercise in the banking sector would take considerable manual resources, information requests between banks and correspondent banks.
The NZ Law Foundation report “Regulating Cryptocurrencies in New Zealand” (2018) noted back at that stage that there was not yet any standard international treatment of cryptocurrencies. It was of the view that while New Zealand is not alone in using existing laws to stretch over the uncertainty of where cryptocurrencies sit legally, a few other jurisdictions have been proactive and introduced regulations with the intent of fostering the industry.
Since New Zealand has not progressed far since the report was written (apart from in the crucial area of AML/CFT), our country urgently needs to ensure that it is not left behind other countries in weaving regulatory and policy fabrics.
One crucial role of the task force or expert working group would be to monitor and evaluate the best-emerging ideas from overseas regulatory regimes. We give some examples below.
What Good Cryptocurrency Regulation Looks Like - Estonia
Estonia has been a success story when it comes to both regulation and promoting innovation and economic growth. While the rest of the world was still figuring out what to do about cryptocurrencies, Estonia seized the opportunity to include cryptocurrency licencing in new AML/CFT legislation that came into force in 2017. Cryptocurrency exchanges and wallet (custodial) providers were legalised under a simplified two-tier licensing framework.
When compared to other EU member states, Estonia's cryptocurrency regulations are exceptionally open and innovative. Although not accepted as legal tender, the Estonian government regards cryptocurrency as "value expressed in digital form". Therefore, it classifies cryptocurrency as a digital asset for tax purposes, but no value-added tax is levied. In 2017, their new Anti-Money Laundering and Terrorist Finance Act introduced new solid regulations for crypto companies operating in Estonia. Cryptocurrency exchanges are legal in Estonia and have operated under a well-defined regulatory framework that includes tight reporting and KYC/CDD criteria since 2017. The Estonian government kept its rules under review. It tightened licencing regulations in 2019 and went even further in 2020, declaring that virtual currency service providers would be considered similar to financial institutions under the Money Laundering and Terrorist Financing Prevention Act (Est). After amendments to Estonian law rendered many cryptocurrency service providers non-compliant with regulations, the Estonian government revoked over 1,000 operating licences in late 2020. Now cryptocurrency exchanges apply to the Estonian Financial Intelligence Unit for a singular Estonian Cryptocurrency Exchange License. Meanwhile, the Financial Supervisory Authority assumed regulatory responsibility for monitoring and supervising the sector.
Estonia's Crypto Exchange And E-Wallet License
Estonia was the first country in the European Union to introduce such legislation. There are two classes of licenses in Estonia: an exchange license and a wallet license. An exchange license is granted to the providers of a VASP for exchanging a virtual currency into fiat and vice versa and virtual currency to another virtual currency. A crypto wallet license allows providers to offer a virtual currency wallet service, generate the customers’ security keys, and store the encrypted keys.
As a result, Estonia has a well-established and well-run crypto/FinTech sector. That includes other economic policy levers, alongside licensing, such as the following;
Advantages of Estonia’s Cryptocurrency Regulatory System
- Offering a single “Virtual Currency Service Provider License”. It has been enacted through the Money Laundering and Terrorist Financing Prevention Act (MLTFPA) under the Financial Intelligence Unit (FIU).
- Investors enjoy corporate tax exemption on reinvested profits.
- Low 14% tax on dividends paid to legal entities.
- Options for e-residency card that gives you access to government services.
- Can easily set up and connect EU bank account.
- No restrictions on citizenship or residency.
- Can establish a company and financial licence remotely, but a local physical office is required.
- Licence applications tend to be processed in 2-4 weeks.
US Lawmakers Working on Numerous Cryptocurrency-Related Bills
Lawmakers in the US are scrambling to regulate cryptocurrencies after a long time when some states led the way. This is still a work-in-progress (ideal for the working group to monitor), but we list some of the most promising proposed bills that are moving through the House of Representatives and Congress in 2021 below:
- Infrastructure Investment and Jobs Act (ref H.R.3684). Passed Senate. To update reporting requirements for brokers and digital assets.
- Eliminate Barriers to Innovation Act of 2021 (ref H. R. 1602). Passed House. To direct the Commodity Futures Trading Commission and the Securities and Exchange Commission to establish a digital asset working group jointly.
- Consumer Safety Technology Act (ref H.R.3723). Passed House. To direct the Secretary of Commerce and the Federal Trade Commission to study and report on the use of blockchain technology and digital tokens.
- Digital Asset Market Structure and Investor Protection Act (ref H. R. 4741). Introduced. To provide for the regulation of digital assets.
- Safe Harbor for Taxpayers with Forked Assets Act of 2021 (ref H. R. 3273). Introduced. To provide for the tax treatment of forked convertible virtual currency.
- Securities Clarity Act (ref H. R. 4451). Introduced. To amend the securities laws to exclude investment contract assets from the definition of a security.
- Cryptocurrency Tax Reform Act (ref H. R. 5083). Introduced. To amend the Internal Revenue Code of 1986 to clarify the definition of a broker and for other purposes. This Act may be cited as the “Cryptocurrency Tax Reform Act”.
- Sanction and Stop Ransomware Act of 2021 (ref S. 2666). Introduced. To develop and institute regulatory requirements for cryptocurrency exchanges operating within the United States to reduce the anonymity of users and accounts suspected of ransomware activity and make records available to the Federal Government in connection with ransomware incidents.
- Cryptocurrency Tax Clarity Act (ref H. R. 5082). Introduced. To amend the Internal Revenue Code of 1986 to clarify the definition of a broker. This Act may be cited as the “Cryptocurrency Tax Clarity Act”.
- Ensuring American Global Leadership and Engagement Act (ref H. R. 3524). Introduced. To review and analyse ways in which
the Cross Border Interbank Payment Systems (CIPS), cryptocurrencies, and central bank digital currencies could erode this system of cross-border payment and financial messaging systems.
In many ways, New Zealand is at an advantage in terms of how we go about both regulating the cryptocurrency sector and growing it (and the employment and tax-take that goes along with it). That’s because we can learn from past success stories like Estonia, monitor the passage of the bills currently before the US House of Representatives and Congress, and pick the best parts that work in our local context.
4.0. Effective Central Bank Monetary Policy and Cryptocurrency can coexist
An important issue for central banks and policymakers worldwide is integrating, or transitioning, cryptocurrencies into the models of mainstream currencies and concepts of money. Those traditional models will have to evolve to keep up.
At the current rate of adoption in New Zealand (5-15%) and estimated trade volumes of NZD 200-$300 million a year domestically, there is unlikely to be any immediate threat to the effectiveness of RBNZ monetary policy from the cryptocurrency sector. However, that may change in future, especially given the slow rate of technological advancement by commercial banks in New Zealand. For example, customer expectations in 2021 are that interbank settlements should be completed in seconds, not hours, regardless of the day of the week or a public holiday. We expect the current rate of cryptocurrency adoption and FinTech in general (open-banking) to continue at the current trajectory.
The greatest threat to monetary policy in New Zealand is not from cryptocurrencies like bitcoin but a class of cryptocurrencies called a stablecoin. The reason for this is that if large numbers of Kiwis end up choosing to prefer using cryptocurrency for everyday transactions, it’s more likely that stablecoins would be favoured over cryptocurrencies that have high price volatility.
Fortunately, stablecoins are the easiest type of cryptocurrency to regulate because most (not all) are backed by traditional fiat currencies or physical assets like gold. It is easier to regulate stablecoins because the assets backing them are generally held in the conventional financial system. The RBNZ already has experts grappling with this coming trend (Wadesworth, 2018).
Furthermore, US Congress has already floated a legislative proposal for the aptly named ‘Stable Act’ that would effectively require entities issuing USD backed tokens to obtain full banking licences. The amendments are on the back of concerns about how the dollar reserves of the world’s largest stablecoin, Tether (USD), has managed its USD reserves. Tether holds approximately half NZD 93 billion in reserves, having been converted to ‘commercial paper,’ i.e. corporate debt of unknown quality.
Regulations aside, the most effective way for the RBNZ to ensure the long-term effectiveness of its monetary policy would be to issue its own CBDC (central bank digital currency). RBNZ has been investigating the feasibility of a CBDC for at least the last 2-3 years. The RBNZ Bulletin, “The pros and cons of issuing a central bank digital currency” (Wadesworth, 2018), outlines what form a CBDC might take and discusses the pros and cons. Broadly outlined, Wadesworth’s views in summary included:
- Digital currency is available to the public without restriction.
- This digital currency could take different forms based on either existing payment infrastructure technology or new crypto technology.
- The digital currency co-circulates with cash, and other forms of digital currencies issued by the private sector.
- The digital currency is convertible into cash at a fixed rate (par value).
- The public cannot borrow from the central bank (they cannot have negative holdings of the digital currency).
- The central bank does not pay interest on balances of its digital currency.
Geoff Bascand, Deputy Governor RBNZ, expanded on the NZ CBDC idea in a speech given shortly after the bulletin covering CBDC was released (Bascand, 2018). Bascand suggested that issuing a CBDC would decrease payment inefficiencies related to cash and would allow for certain public access to money.
Cryptocurrency provides an excellent opportunity for unbanked people to be a part of the financial system. According to The World Bank Findex Database (2017), there are 1.9 billion adults globally that have no access to essential banking services (including some of the Pacific Islands). Often this is because they have no ID documents or are hundreds of kilometres from the nearest bank. Most countries don’t even include access to banking services as a human right, including New Zealand. Even though we all need access to financial services to participate in society, especially in the digital age. Many emergent nations, lacking resources, skipped fixed-line internet infrastructure and went straight to mobile. In many remote places, people might have access to mobile coverage and a generator for short periods - That’s all that’s needed to access the plethora of financial services in the cryptocurrency ecosystem.
Distributed ledgers that cryptocurrencies rely on provides a channel, which is constantly online and accessible. Cryptocurrencies can bypass any unfair or unintended restrictions due to their decentralised nature and bring opportunity to the users. Decentralised systems have far fewer potential failure points than centralised databases. Cryptocurrencies' unregulated nature is not something to be feared by governments, as much as it is to be embraced as a tool to provide essential banking services to their citizens.
5.0. Any Legislation must be future-proofed: principles and a risk-based approach trumps rules-based frameworks
Legislation should allow for assessing and using new cryptocurrencies, other virtual assets, and related distributed ledger technologies. The legislation should be risk-based rather than rule-based. Fast-paced environments, such as the cryptocurrency sector, require an analytical approach to identifying risks and ranking those risks accordingly. No rule-based framework can move at the pace of the industry.
As seen with the AML/CFT Act 2009, a risk-based approach is far more effective than a rules-based approach. This approach is especially true when the sector that the government is trying to regulate is in a state of rapid change, perpetually. Rules become outdated and ineffective in months, not years, if they are locked into prescribed boxes.
The European Central Bank advised financial institutions with exposure to crypto assets to put in place appropriate risk-management frameworks. Any introduced legislation will have to adapt to the technological environment and fast transformation of crypto-assets’ risks and activities. A dynamic systems approach has proven to be successfully working for evolving anti-money laundering risks. The same technique should be considered for the financial/market legislation applicable to the virtual assets and blockchain industry.
Brouwer (2019) states that risk-based management is superior to strict rule-based legislation based on the constantly changing digital environment. A risk-based approach to regulation can change the method of legislators and the regulated firms based on the nature of the risk.
In New Zealand, both our AML/CFT and Privacy legislation are deliberately principles-based legislative frameworks. This type of system sets out necessary standards at a high level, making them flexible in nature. Each firm must then consider carefully and adopt an approach of controls that meet the high-level standard proportionately to its risks and type of business. Each firm is then held accountable for its decision-making and the effectiveness of the system it chooses to apply.
In the DIA’s AML Guideline for VASPs (referred to above), it explains the principle this way as it applies to AML/CFT Compliance Programme Guidelines:
“…the guidance is generic in nature. It does not provide prescriptive instructions on how
businesses can ensure they are compliant with the Act. This is because each business
has unique circumstances that determine their exposure to ML/TF risks, which they need
to understand and factor into their unique AML/CFT programme. Businesses will need to
apply their judgement, and where there are questions about compliance, they can either
ask the Department for general information or seek independent advice.”
We would agree with that. Although risk-based legislation involves some uncertainty and discretionary choices, it can react better to changing digital uses/inventions that policy-makers may not have foreseen.
6.0. Government Departments and Agencies should start using blockchain analytics tools widely and routinely
The best way (perhaps, the only way) for customers and regulators to effectively deal with new technology is to start using it – in safe, experimental ways at first. Only then will its benefits and potential risk areas come more clearly into view. We encourage central agencies and ministries to engage directly to get experience with cryptocurrency and digital assets.
As well as commercial applications, law enforcement and cyber-security agencies can find real benefits in the transaction monitoring capability for cryptocurrency transactions. Using technology to track cryptocurrency transactions is much easier than tracing back any other financial records. As a secure and reliable ledger, blockchain records the path of cryptocurrency coins from the origination (fiat to crypto exchange, or minting of the crypto coins) up to the extraction from the system (crypto back to fiat).
The endpoints of the crypto flow (i.e. when it converts to the mainstream financial system again) are typically regulated by the AML/CFT legislation, where the DIA understands and excels already.
At any step of the path, the enforcement agencies can obtain the CDD/KYC information about the initiator of the transaction or the owner of the wallet address that was provided. Blockchain analytics companies like Chainalysis, MerkleScience, and Coinfirm can track connections between the customer wallet and transaction and any risky or suspicious activity (Darknet, scams, ransomware, extortion).
These technological solutions provide an excellent opportunity for the enforcement agencies to not only identify the criminal but to receive proof of the wrongdoing that has been documented on the blockchain and can be presented as evidence in court.
There are endless possibilities to improve transaction monitoring when it comes to cryptocurrency tracking. One such option is to retain potential bad actors under the umbrella of legitimately operating companies. These crypto businesses can proceed with the standard CDD but enhance the transaction monitoring processes. The users (legitimate or otherwise) will then not move towards unregulated peer-to-peer exchanges and still be captured by the regulated industry players.
Despite (currently) being perceived as a criminal tool, cryptocurrency represents a legitimate investment opportunity for many people. A significant factor behind the illicit use of cryptocurrency is that enforcement agencies sometimes fall behind the technological curve. Once adequately equipped and trained, enforcement agencies can leverage the inherent transparency of blockchains against the criminal element. The shift towards learning and developing computer science, economic, and forensic knowledge in the enforcement agencies will help facilitate crypto investigations. We would encourage the Inquiry to seek the views of experts in the NZ Police FIU as to the technology’s potential for good outcomes.
In Appendix H, you can see the example of how blockchain analytics software can provide the details about the wallet address’ incoming and outgoing transactions along with any potential connections to suspicious wallets or transactions. The information kept on the blockchain allows for excellent transparency and is available at the click of a button once you know what to look for.
Cyber threats to cryptocurrency are similar to those in other types of remittance. Caution must be exercised equally by the user of traditional payment networks (credit cards & online banking) as with cryptocurrencies. Users must store their credentials (password for bank accounts and private keys for wallets) at a secure and protected location. Cyber threats affect users of all payment networks in similar ways.
We reject the assertion by many in the banking industry that interbank transfers are reversible (compared to cryptocurrency transactions being irreversible). To reverse a domestic bank transfer, the receiver of the funds must first give explicit permission. International money transfers are even harder to recall. By the time a transaction has been identified as fraudulent, it is usually too late to recall the transaction from the beneficiary bank, assuming that they’re even co-operative in the first place.
The most significant hacking attacks and thefts the industry has observed have been directed at private keys information stored at exchanges. There are no inherent security flaws in cryptocurrency technology itself, as most people tend to believe. Like any other financial infrastructure, the vulnerability lies at the level of the individual user or institution.
The gatekeepers must protect the customers’ data and privacy, whether banks or a cryptocurrency exchange. Investors have to make sure they trade and hold their crypto on a platform that offers robust security measures at an individual level. They should consider
keeping a significant amount of holdings in their own cold storage and use two-factor authentication. Some exchanges may offer private insurance policies in case of theft or hacking.
BitPrime does not store customer’s wallet keys and does not provide direct custodial services, significantly reducing the possibility of hacking or other such cyber attacks.
The 2020 Sentinel Data Book produced by the U.S. Federal Trade Commission indicated that the most significant amounts of fraud reports by the payments method recorded in 2020 were attributed to credit and debit cards (91K and 63K reports, respectively). Cryptocurrency-related reports were significantly lower at 11K reports per annum. The total loss for cryptocurrency frauds equalled USD 129 million compared to the USD 3.3 billion total fraud losses. The most considerable losses came from bank transfers and payments (USD 314 million) and wire transfers (USD 311 million). The share of cryptocurrency in the total fraudulent activity remains small, although frequently overstated by the mainstream media.
At BitPrime, we exert great effort into educating the public about the risks of cryptocurrency investments and the impossibility of retrieving funds. A considerable portion of vulnerable customers (mostly older people who invest retirement funds), whom we come across often, are aware of the risks and very cautious making decisions about their money. That is an obvious sign of growing investor awareness of the risks of the industry.
The latest Chainalysis Crypto Crime report (2021) demonstrates a downward trend of the criminal transaction volume from 2.1% in 2019 to 0.34% in 2020 of all cryptocurrency volume.
The most significant share of crimes includes scams, ransomware attacks, darknet markets, and stolen funds. Cryptocurrency-related crime remains a small part of the overall cryptocurrency economy. The development of technologies to track down crypto crimes does not go unnoticed by the bad actors. At the same time, the infrastructure surrounding cryptocurrency continues to improve and offer more and more protection. The most prominent players in the industry (e.g.Cardano blockchain) continue to become AML/CFT legislation compliant. This is additional proof that cryptocurrency follows the path of a legally accepted means of trade and is here to stay for a long time.
As far as possible, other existing regulatory work-streams that are already underway could be considered and co-opted to assist in these changes. We note just a few examples here:
- With the Commerce Commission’s support, the government is examining potential reforms to the payments industry merchant and interchange fees for card transactions. That work could ideally look broader, to whether future-proofing changes could help ensure that merchants and retailers can accept (if they so choose) cryptocurrencies from their customers, and in turn, use those cryptocurrencies to bring down the costs of transacting through the banking system, and the payment network operators that the banking system owns. This could also reduce de-banking risk to those shops, small businesses, and merchants threatened that they might lose access to their bank accounts if they wish to accept cryptocurrencies from customers.
- Digital identity workstreams, led by the DIA, can and should extend to the benefits and corroboration offered by blockchain and cryptocurrency solutions. Identification of customers, transactions and verification/reconciliation processes are inherent in the design of most blockchain solutions and the Tangle (as described above).
- As a result of the FATF Mutual Evaluation Report on New Zealand earlier this year, a significant statutory review of AML/CFT laws is underway. A possible issue identified by FATF is the need for more precise licensing roles, including for money remitters and potentially new payments providers and VASPs. Those international hints also reinforce the local industry’s desire to see clear licensing frameworks introduced. (Incidentally, BitPrime was invited to participate in a Ministry of Justice expert working group on this AML/CFT statutory review and is very happy and proud to contribute to that critical legislative work).
7.0. Grow Productivity and the Economy Sustainably Through FinTech Innovation
Cryptocurrencies present an opportunity to grow the economy sustainably without the supply chain and other challenges facing our traditional primary industries/export-led economy. In the services sector, especially digital, a long distance to market is not a factor, and cryptocurrency and FinTech will likely be a greener option than traditional agriculture, manufacturing and extractive industries. As New Zealand seeks to recover from the COVID-19 disruptions, a more diverse economy is a robust economy. For instance, the pandemic has decimated the tourism industry that we relied on for NZD 16.2 billion (5.8% of GDP), contributing 21% of foreign exchange earnings (Statistics New Zealand, 2020).
“Crypto-currencies, and the blockchain technology they rely on, are bringing about more far-reaching changes in the payments system and the way we view money. Blockchain technology is unique because no central agent manages industry leaders there is no separation between sending the payment instruction and the final funds settlement. It’s a different type of payment system. It could bring new opportunities to payments and currency.” - Geoff Bascand, Deputy Governor RBNZ, speech delivered to The Point Conference, hosted by Payments New Zealand, Auckland, June 2018.
The challenge for the government is to enact legislation that protects both cryptocurrency users and the effectiveness of the monetary policy while also allowing for and promoting significant innovation and investment in the cryptocurrency sector. If done correctly, New Zealand could become a global cryptocurrency, blockchain, and FinTech hub. We may not get the settings just right the first time, but we need to begin.
A whole range of ancillary policy measures might be helpful, alongside an expert group, licensing regime, and bespoke legislative reform. The government may want to consider concessions or incentives to stimulate overseas investment in the local industry. It could choose to promote the establishment of domestic custody solutions, support start-up incubators, and fund research and development.
New Zealand is already an attractive jurisdiction to do business and store virtual assets due to our international reputation, stable government, personal property rights, and low corruption. We are not looking for handouts or preferential treatment in the industry. But the potential is clear.
But we need specific legislation and funding to make it happen. Let us use custody as an example. Cold vault storage requires a lot of infrastructure, not only physical but also trust accounts and insurance. Those things are difficult to obtain due to the lack of a comprehensive cryptocurrency regulatory framework.
A stretch goal for New Zealand over time might be the establishment of a crypto-bank. Crypto banks are financial institutions that conduct traditional monetary transactions such as deposits and withdrawals, savings, lending and borrowing, and investing in a broader range of instruments and markets. While this perfectly describes a traditional bank, crypto banks have integrated cryptocurrency into these financial functions. An example is Germany’s Nuri, which already boasts over 250,000 customers. Nuri takes the best parts of traditional banking, including a deposit guarantee, but is fully integrated with the global cryptocurrency ecosystem. We are light years behind in New Zealand, but it doesn’t have to stay that way.
We have a short window to seize this opportunity, and it will require both the government and the cryptocurrency industry to work together. In a report as long ago (in tech-timeframes) as 2017, the United Kingdom House of Lords (“Distributed Ledger Technologies for Public Good: Leadership, Collaboration and Innovation)” identified blockchain as potentially assisting the Government in many policy and administration areas, including:
- border control, customs, trade and immigration;
- national security, criminal investigations, police and public safety;
- taxation and benefits payments;
- health assurance, patient record management, drug safety and treatment accountability;
- food standards and safety, traceability and accountability;
- privacy, cybersecurity and counter-fraud; and
- public procurement, contracting, payments, visibility of spending and asset traceability.
All those potential benefits remain within reach and could be acted upon without delay.
Separately, in the commercial world, the cryptocurrency industry has been experiencing a slew of issues due to being treated with disdain by the banking sector. A significant problem has been collective banking sector refusal to allow access to fiat bank accounts (known as “de-banking” or “de-risking”), and this has continued despite the RBNZ's advice to its regulated banks to the contrary. Some exchanges and retailers struggle to find a bank to meet the fiat demands. BitPrime’s customers often recount anecdotes of their bank accounts being frozen after making cryptocurrency purchases. We have seen recent signs that some more enlightened banks are re-setting their traditional scepticism of cryptocurrencies. We hope that will continue and believe more clear regulatory settings that are properly enforced can help move towards a more inclusive, fairer financial system.
We urge the Committee to consider tasking officials of Treasury to work closely with the RBNZ in developing draft legislation to support a regulatory framework for New Zealand. That task-force group should include as part of its work-streams the seven propositions we
recommended above, i.e.:
- Establish a cryptocurrency working group that is interdisciplinary, permanently available, and includes industry leaders.
- A licensing regime for all virtual asset service providers resident or based in NZ.
- Strive to keep legislation and regulation consistent with overseas jurisdictions and evaluate the Estonian aspects of US regulatory schemes for best practice.
- A joined-up approach with RBNZ to ensure central bank monetary policy and cryptocurrency can coexist.
- Any legislation must be future-proofed: ideally, a risk-based approach based on broadly agreed principles rather than a fixed rule-based framework.
- Urge or encourage government departments and agencies to begin using blockchain analytics tools to gain confidence and familiarity with the technology, assess its benefits, and identify any regulatory loopholes.
- Recognise the growing contribution of FinTech innovation (including cryptocurrencies) to Aotearoa New Zealand’s productivity, job creation and sustainable growth of our economy and post-Covid recovery.
Ministry officials should be tasked with pursuing this work and place emphasis on reporting back to the Select Committee or appropriate Members of Cabinet. Officials need not reinvent the wheel. The RBNZ, FMA, and DIA already have been developing high levels of expertise in the subject. Further, much groundwork was already done in the NZ Law Foundation-sponsored report “Regulating Cryptocurrencies in New Zealand”, published in September 2018 and authored by academic writers Associate Professor Alexandra Sims, Dr Kanchana Kariyawasam, and the late central banking expert Professor David Mayes.
The key steps to advance and build upon that earlier work will be to:
- Engage with industry and experts directly, rather than work in a regulatory/policy making bubble; and
- Update that earlier work. Three years (from 2018) is, in reality, almost a lifetime of change in fast-moving digital sectors.
BitPrime, as an industry leader, would like to assist and remain part of that conversation.
Despite New Zealand being late to the party, you, the Finance and Expenditure Committee members, have the power to make history or at least steer it. We look forward to looking back in a decade at the outcome of this Inquiry and being proud of the world-leading FinTech industry you, we, and New Zealand will have built.
We look forward to discussing these issues with the Committee and are available to answer questions or provide further information throughout this Inquiry process.
Appendix A: Jargon-busting
What we deal with day-to-day is high tech, and we know it can be a challenge for newcomers to get a handle on. And while we try to avoid the worst of the tech-jargon speak that our industry falls into, some technical language may be inevitable. So we include a small, simplified glossary of terms here to assist the Committee:
- Blockchain - The term blockchain refers to a distributed database (also known as a ledger). Multiple computers, or nodes, host the ledger simultaneously. A blockchain is comprised of blocks of data that, in theory, can’t be changed without consensus. These blocks tend to represent movements of value, such as a currency or can work as an access instrument for a platform providing services. Blockchain ensures that a digital token can’t be transacted twice, even without the use of a third-party observer.
- Distributed Ledger Technology - Distributed Ledger Technology is a shared database where transactions and associated details are simultaneously recorded in multiple places. This could be either under the control of a central authority or maintained by a decentralised network of nodes.
- Cryptocurrency - Cryptocurrency/crypto is a digital asset that circulates on the internet as a medium of exchange. It uses blockchain technology and is secured by cryptography. Some cryptocurrencies include bitcoin (BTC), IOTA, Ethereum (ETH), Cardano (ADA), along with many others.
- Bitcoin - Bitcoin (typically denoted with a capital B) is a type of blockchain. The native currency of Bitcoin is the cryptocurrency bitcoin (typically told apart from Bitcoin with a lowercase b). Bitcoin is the first blockchain and cryptocurrency.
- Token - “Token” generally refers to a unit of value for a programmable asset that is managed by a smart contract and an underlying distributed ledger.
- Wallet - A cryptocurrency wallet is a device or service that stores users' information, allowing them to interact with various blockchains and to send and receive crypto assets. Wallets can be digital (software) or physical (hardware), hot (connected to the internet) or cold (disconnected from the internet), custodial (a trusted third party has control of a user’s private keys) or non-custodial (only the user controls their private keys).
- Cold Vault Storage - Cold storage refers to the offline storage of a cryptocurrency wallet. "Offline" means that the wallet is disconnected from the internet, preventing hackers from accessing it. Cold storage is considered to be the most secure way to hold crypto assets.
- Exchange - A cryptocurrency exchange is a type of digital currency exchange where digital assets can be bought, sold, and traded for fiat currency or other digital assets. They are similar to mainstream exchanges where traditional stocks are bought and sold in the type of transactions and orders that users can execute.
- OTC/Over the Counter trading - Over-the-Counter (OTC) trading is a procedure in which two parties enter into an
agreement to acquire a specific asset without the use of a centralised exchange. OTC desks are often used to obtain large amounts of an item in order to increase transparency, reduce time and expenses, and ensure the security of the product purchased. OTC trading is typically accompanied by a third-party custody solution.
- Virtual Asset Service Provider (VASP) - A Virtual Asset Service Provider (VASP) means any business that conducts one
or more of the following activities or operations on behalf of another person or entity:
i. exchange between virtual assets and fiat currencies;
ii. exchange between one or more forms of virtual assets;
iii. transfer of virtual assets;
iv. safekeeping and/or administration of virtual assets or instruments enabling control over virtual assets; and
v. participation in and provision of financial services related to an issuer’s offer and/or sale of a virtual asset.
- Decentralised Finance - Decentralised Finance, or DeFi, refers to a system in which software developed on blockchains allows people to buy, sell, lend, and borrow. This can be peer to peer or with an utterly software-based intermediary rather than a corporation or organisation mediating a transaction.
Appendix B: The Cryptocurrency Ecosystem
Image URL for easier viewing: https://www.bitprime.co.nz/wp-content/uploads/2021/09/The-Cryptocurrency-Ecosystem_image.
Appendix C: Cryptocurrency Adoption By Country
Statista Global Consumer Survey. (2021, February).
Appendix D: Comparative Electricity Consumption of Cryptocurrencies and Other Distributed Ledgers
Appendix E: IOTA Tangle - Beyond Blockchain
Iota's consensus algorithm is Tangle, a DAG (directed asynchronous graph) consensus. Prior to sending an Iota transaction, you must first confirm that you have received two previous transactions. As per the example here, DAG represents each transaction individually.
View the live Tangle visualiser here: https://explorer.iota.org/mainnet/visualizer/. Each point is an individual transaction.
Appendix F: Cryptocurrency Regulation by Country
Appendix G: Fraud Reports by Payment Method
Appendix H: Blockchain Analytics
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Authorised by Ross Carter-Brown, Chief Executive Officer, BitPrime Limited.