Financial sanctions and the ‘crypto leak’

The dramatic events in Ukraine of the past weeks have shocked the world, prompting civil, political, economic, and legal action, unprecedented in its scale and scope. Financial sanctions aimed at isolating Russia from the financial system have been at the epicentre of the global response. With the high hopes and tremendous economic and political costs attached to these sanctions, their effectiveness is of extreme importance. It is in this context that the new wave of calls for tightening regulation of crypto markets has emerged.

The war has shed new light on costs and benefits of the wider use of private digital currencies – cryptocurrencies – transacting in which to date remains largely unregulated in most jurisdictions.

On one hand, the current crisis has illuminated the efficiency of crypto as a fast and cheap means of cross-border payment for making donations and raising funds in times of emergency. It has also shown the benefits of cryptocurrencies for preserving privacy of the transacting parties at risk of persecution. Moreover, as already reported earlier in case of the Turkish lira meltdown, in the situation of high volatility of a fiat currency people appear to opt for cryptocurrencies as useful instruments for storing value.

On the other hand, the drastic rise in cryptocurrency transactions made apparent the cyber security threat posed to individual (non-professional) users. At macro level, the environmental harm cause by over-reliance on crypto mining as a competitive advantage as well as the capacity of governments and individuals to avoid financial sanctions has underlined the costs associated with these alternative means of payment. The latter aspect – the ‘crypto leak’ – has provided the impetus for calls for more regulation of the industry.

From the Bank of England, the Federal Reserve, and the IMF, to the European Commission and the ECB, calls for action and regulatory initiatives have been debated over the past years and months. The erupted war gave this debate a new spin with the calls to ‘regulate crypto’ to ensure the effectiveness of individual sanctions imposed on Putin and the allies of his regime. With Russia known as one of the global centres for crypto ‘mining’, adoption, and use of cryptocurrencies, it has been considered possible that crypto transfers could be used to evade sanctions. This has prompted the calls to introduce i) bans on transactions that involve Russian crypto wallet addresses, or ii) blocking of all crypto wallet addresses linked to Russian users. As it stands, major crypto exchanges object to a ‘blanket ban’ of Russian users citing the libertarian ideals behind cryptocurrencies.

Law and blockchain scholars have identified several modes of regulation that could be used by governments to regulate the use of blockchain-based systems, including Bitcoin and other digital currencies. The trade-offs of different regulatory options have been aptly discussed by De Filippi and Wright, who distinguish between regulating end users (e.g. de-anonymisation or vicarious liability), ‘transportation layers’ (e.g. internet service providers); information intermediaries (e.g. social networks), blockchain-specific intermediaries (e.g. wallet providers and exchanges), miners and transaction processors (e.g. regulating ‘mining pools’), code and architecture (e.g. liability for code developers) and hardware manufacturers.

In the last days, the EU leaders have been calling for a faster adoption of its regulatory framework – regulation of markets in crypto-assets (MiCA) – aimed at regulating ‘crypto-asset service providers’, while in the US the calls have been addressed to specific industry players – crypto exchange service providers. On both sides of the ocean the approach followed by regulators is that of regulating crypto-specific intermediaries. The main trade-off of this approach cited in academic literature is its potential to hinder innovation. More seems to be at stake in the current circumstances: while targeting individual wallets or wallets belonging to specific groups of people may define the future development of an entire industry, lack of action or a misaligned channel for that action risks jeopardising the effectiveness of the costly sanctions’ regime. Even if the ‘crypto leak’ is indeed only of minor importance, as some claim, the emerged regulatory momentum underlines the need for but also the challenges of a coordinated global action vis-à-vis crypto markets.

The Florence School of Banking and Finance is offering its first Digital Currencies Academy in April 2022. To check out the programme, please visit our website.
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