ADBI Working Paper Series

CRYPTOCURRENCY REGULATIONS:
INSTITUTIONS AND FINANCIAL OPENNESS

Jacinta Bernadette Rico Shirakawa

and Upalat Korwatanasakul

No. 978
July 2019

Asian Development Bank Institute

 Jacinta Bernadette Rico Shirakawa is an assistant professor at Waseda University, Tokyo.
Upalat Korwatanasakul is a program manager at the Research and Policy Analysis Cluster
of ASEAN-Japan Centre, Tokyo.
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Suggested citation:

Rico Shirakawa, J. B. and U. Korwatanasakul. 2019. Cryptocurrency Regulations: Institutions

and Financial Openness. ADBI Working Paper 978. Tokyo: Asian Development Bank Institute.
Available: https://www.adb.org/publications/cryptocurrency-regulations-institutions-financial-
openness

Please contact the authors for information about this paper.

Email: jbrico@aoni.waseda.jp, upalat@asean.or.jp

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© 2019 Asian Development Bank Institute

ADBI Working Paper 978 Rico Shirakawa and Korwatanasakul

Abstract

This study assesses how effective governance institutions and de jure financial openness
influence the attitude of policy makers in pursuing further financial development by
allowing the use of cryptocurrency. In other words, we examine the relationships between
a) de jure openness to cryptocurrency and institutional strength and b) de jure openness
to cryptocurrency and de jure capital openness. Our main method of estimation is a
cross-sectional ordered probit model using institutional and macroeconomic data drawn from
several sources, including the Chinn-Ito index, the World Bank’s Worldwide Governance
Indicators, and the World Bank’s World Development Indicators, among others, over the
period 2010‒2018. To measure the de jure openness to cryptocurrency, we compose an index
of 218 economies by using the current legal and regulatory status of cryptocurrency compiled
in 2018. Our results show that effective governance institutions are associated
with a less restrictive regulatory stance on cryptocurrency, whereas financial openness is
not found to be significant. The results imply that a certain level of institutional quality may
be necessary before opening up to new forms of financial technology. As cryptocurrency is
recognized as a risky speculative financial instrument, its current state of many unknowns can
prevent policy makers from conducting a thorough surveillance to avoid system-wide
vulnerabilities.

Keywords: cryptocurrency, institutions, financial regulations, financial development,

financial openness

JEL Classification: E44, F36, G18, G28

ADBI Working Paper 978 Rico Shirakawa and Korwatanasakul

Contents

1. INTRODUCTION ......................................................................................................... 1

2. CRYPTOCURRENCY AND ITS POLICY ENVIRONMENT ........................................ 3

3. FINANCIAL DEVELOPMENT, LEGAL SYSTEMS, AND POLICIES

TOWARD CRYPTOCURRENCY ................................................................................ 5

4. ECONOMETRIC FRAMEWORK ................................................................................ 6

4.1 Model Specification ......................................................................................... 6

4.2 Data ................................................................................................................. 7

5. EMPIRICAL RESULTS AND DISCUSSION ............................................................... 9

6. CONCLUSION .......................................................................................................... 12

REFERENCES ..................................................................................................................... 13

APPENDICES

A Index of Cryptocurrency Regulation .......................................................................... 15

B Descriptive Statistics ................................................................................................. 17

ADBI Working Paper 978 Rico Shirakawa and Korwatanasakul

1. INTRODUCTION
Cryptocurrency is currently at the frontier of financial development. It provides both
opportunities and risks in financial markets and has attracted significant attention in
recent years. Accordingly, the number of market players involved in the cryptocurrency
business has risen (Farell 2015). The new business model provided by cryptocurrency
along with the exponential increases in the prices of cryptocurrency may have
enticed investors toward cryptocurrency, with many utilizing cryptocurrencies as a
speculative asset to take advantage of the early gains. However, the subsequent
crash in prices acted as a wake-up call to speculators dealing with cryptocurrency.
Additionally, risks related to price manipulation in cryptocurrency markets are not
unheard of (Gandal et al. 2018).
Although many central banks issue warnings about the use of cryptocurrency and have
explicitly denied its status as a currency, only a few have banned its use as a financial
asset. Policy makers are concerned about the low liquidity, the use of leverage, market
risks from volatility, and the operational risks of cryptocurrency (FSB 2018). Many central
banks emphasize that cryptocurrency is not legal tender and that users face the risk of
unenforceability of cryptocurrency transactions. The Global Research Center (2018)
compiled regulations on cryptocurrency and its report shows that, in countries where
cryptocurrency is allowed, it can be legally traded as long as it follows existing rules or
laws related to financial instruments. Regardless of the regulatory stance, policy makers
are wary that cryptocurrency would be used for illegal activities, such as money
laundering, trade in illegal or controlled substances, or terrorism finance. Policy makers
are also aware of the potential lack of consumer and investor protection. Deposit
insurance for holders of cryptocurrency is limited and not supplied by
domestic monetary authorities. The combination of its potential benefits as well as
macroeconomic risks begs the question of what determines policy openness or aversion
to cryptocurrency.
Research on cryptocurrency encompasses several fields of study, from economics and
finance to computer science and engineering, as well as applied mathematics. The
breadth of the research field is not surprising given the nature of cryptocurrency as a
financial innovation with its roots in blockchain technology and the fact that it uses
cryptography intensively. Farell (2015) provides a brief historical background to
cryptocurrency and discusses the security networks used by major cryptocurrency
providers and the implications for the cryptocurrency industry. DeVries (2016) presents
an examination of the bitcoin market and industry players using a SWOT (Strengths,
Weaknesses, Opportunities, and Threats) framework, which is a common management
analysis tool. Recent economic literature on cryptocurrency delves into issues such as
determinants of cryptocurrency prices (Liu and Tsyvinski 2018; Corbet, Lucey, and
Yarovaya 2018), cryptocurrency exchange rates (Li and Wang 2017), and persistence in
the cryptocurrency market (Caporale, Gil-Alana, and Plastun 2019; Bouri et al. 2019),
among other things. To date, there are no studies specifically investigating the factors
influencing the policy stance on cryptocurrency.
In this study, we examine whether the presence or absence of credible surveillance and
regulatory authorities influences the extent to which policy makers would allow, regulate,
or take a hands-off approach to cryptocurrency. This study contributes to literature by
bringing together two strands of literature—one examining cryptocurrency regulation and
the other investigating financial development through legal institutions and financial
openness. On the one hand, the need to balance promoting innovation while mitigating
economic risks has sparked interest in the appropriate legal and regulatory framework

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ADBI Working Paper 978 Rico Shirakawa and Korwatanasakul

surrounding cryptocurrency. Marian (2015) proposes a regulatory system that imposes

costs on anonymity to curtail potential illicit uses of cryptocurrency, such as tax evasion,
money laundering, or financing terrorism, without disincentivizing the innovation that
cryptocurrency could bring. On the other hand, previous research has provided evidence
linking the quality of institutions and governance effectiveness to financial development
(La Porta et al. 1998; Beck, Demirgüç-Kunt, and Levine 2001; Nee and Opper 2009).
Furthermore, several research works have delved into the relationship between
increased financial openness through capital account liberalization and financial
development. A recent research by Ozkok (2015) shows that financial openness, along
with other institutional variables, explains a large proportion of the variations in financial
development across countries and over time. Meanwhile, Klein and Olivei (2008) show
that the link between capital mobility and financial depth is significant in countries with
high levels of institutional quality, i.e. industrialized countries. While regulation of
cryptocurrency, a decentralized asset, is difficult, its potential destabilizing effects on
vulnerable financial markets emphasize the need for vigilance in cryptocurrency market
development.
To provide an empirical examination of the policy stance toward cryptocurrency,
we begin by composing an index of de jure openness to cryptocurrency using the current
legal and regulatory status of cryptocurrency compiled in 2018 by the Global Legal
Research Center, the Bitcoin Market Journal, and CoinStaker. We identify three broad
types of regulation system in 218 economies—fully liberalized, regulated, and banned.
The policy choice of allowing the use, regulating, or prohibiting the use of cryptocurrency
can represent, on the one hand, how open policy makers are to new avenues in financial
development or, on the other, how prudent they are in adopting new financial technology.
Then, we refer to Chinn and Ito (2006) as our baseline model to investigate empirically
whether both institutional quality and a higher level of financial openness are associated
with a less restrictive policy stance toward cryptocurrency. We use a cross-sectional
ordered probit model and regress the de jure index of cryptocurrency, on the one hand,
and a well-developed policy environment and de jure capital openness on the other.
Then, we control variables representing institutional and macroeconomic factors that can
affect cryptocurrency regulation. The analysis is based on data covering 124 economies.
Our results show that a well-functioning policy environment is associated with a
greater likelihood of a less restrictive regulatory stance on cryptocurrency. Meanwhile,
financial openness is not found to be significant. Our results are robust to alternate
specifications, testing the sensitivity of the results to alternate measures of policy
environment, and also the choice of year in the data used for the econometric estimation.
The paper is structured as follows. Section 2 provides a brief overview of what
cryptocurrency is and its current legal and policy environment. Section 3 discusses the
links between financial development, on the one hand, and financial openness and legal
systems, on the other, as well as their implications for the policy stance on
cryptocurrency. Section 4 presents our econometric model, describes the data, and
provides descriptive statistics of the variables. In addition, we also explain our index of
de jure openness to cryptocurrency (cc) in detail on the data source and the method of
compilation and classification. Section 5 provides empirical results, discussion, and
policy implications, particularly for emerging Asian economies. Robustness checks are
also provided in this section. Section 6 concludes.

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2. CRYPTOCURRENCY AND ITS POLICY

ENVIRONMENT
Cryptocurrency is an electronic token, which originates from the need for direct
peer-to-peer online payments (Peters et al. 2015). The most widely used and
known cryptocurrency is bitcoin, introduced by an unknown developer or a group
of developers with the pseudonym Satoshi Nakamura. It uses a decentralized
public ledger to record ownership and transfers of value. The innovation behind
cryptocurrency is that transactions are verified by several “miners,” who solve a
complicated cryptographic problem to verify the ownership of the cryptocurrency and the
subsequent transfer. The miner who solves the cryptographic problem first and validates
the transaction receives cryptocurrency as remuneration. The mining process is an open-
source program that can be accessed by the public. The peer-to-peer verification system
bypasses typical trusted third parties such as a bank or a credit card company. Various
innovations in cryptocurrency have emerged since bitcoin rose to popularity, thereby
broadening the definition of cryptocurrency. While some central banks are mulling over
establishing their own cryptocurrency, the industry is mainly a market-driven
phenomenon.
Cryptocurrency in its current state is not considered a substitute for money. One of the
largest points of contention regarding its value comes from the fact that it is not issued
by any sovereign authority, thus its intrinsic value is questionable. Money has three basic
features—a unit of account, a generally accepted medium of exchange, and a stable
store of value. Cryptocurrency cannot take the role of a unit of account and a store of
value because the market valuation of cryptocurrency is characterized by large volatility
in prices. Bitcoin, the largest cryptocurrency in terms of market capitalization
(Coinmarketcap.com 2017), saw its value rise in December 2017, before subsequently
losing 30% of its value in December 2018 (Kollewe 2018). The unenforceable nature of
cryptocurrency transactions in many countries also prevents it from becoming a common
means of payment.
In its beginnings, cryptocurrency was used as a payment instrument (Farell 2015). Since
cryptocurrencies use distributed ledger systems that bypass intermediaries, they can
potentially reduce the cost of international transfers, including remittances. Lower
transaction costs can ultimately contribute to financial development and increased
financial access. Thus, while the large uncertainty over the value of cryptocurrency
currently prevents it from being recognized as a currency that functions as a unit of
account or a store of value, it is largely used for payment that promises anonymity and
the elimination of intermediation costs.
As cryptocurrency gained more recognition in the financial sector, market players began
to use it as a speculative investment asset. Similarly to other financial instruments,
cryptocurrency began to be traded in cryptocurrency exchanges. Baur, Hong, and Lee
(2018) found that bitcoin, holding the largest share of the cryptocurrency market, is
mainly used as a speculative instrument rather than an alternative currency. Speculative
trading is conducted in exchanges where consumers can buy, sell, and exchange
cryptocurrencies using dollars, euros, or yen, or other cryptocurrencies. Currently, over
200 exchanges support cryptocurrency trading all over the world (Hansen 2018). The
major exchanges are located in countries such as, the US, the Republic of Korea, and
Samoa, among others (Hansen 2018).

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ADBI Working Paper 978 Rico Shirakawa and Korwatanasakul

Despite the recognition of policy makers of the risks of cryptocurrency, the policy stance
on cryptocurrency among countries remains heterogeneous, with some countries being
open to its use, silent in terms of regulation, or explicit in its prohibition. The Global Legal
Research Center (2018) provides a comprehensive report on the legal and policy
landscape surrounding cryptocurrency. While some countries ban cryptocurrency
outright (Nepal, Pakistan, Viet Nam, etc.), most countries neither regulate nor promote
it. Italy, Australia, and Japan, among other countries, require the registration and
licensing of cryptocurrency operations. Meanwhile, the report shows that the Isle of Man
and Mexico allow the use of cryptocurrency as a means of payment.
Uncertainty over security, the legality of its transactions, and the extent of consumer and
investor protection has kept policy makers wary about its operations. Because of this,
many central banks around the world try to inform the public about the difference
between legal tender, which is backed by their central bank, and cryptocurrency, which
is neither backed by the domestic nor other foreign monetary authorities. Furthermore,
the combination of the speculative nature of cryptocurrency and its lack of supervision
poses a threat to both investors and consumers. Although the cryptocurrency market
itself is not large enough to pose a global risk at this time (FSB 2018), it may still
pose risks to consumers and investors in smaller countries where cryptocurrencies are
being used.
For countries where cryptocurrency transactions take place, policy makers also need
to consider other policy or legal issues. In particular, the anonymous nature of
cryptocurrency leads to concerns about using it to finance illegal activities such as trade
in illegal substances, tax evasion, and financing of terrorism. Thus, particular regulations
are put in place on top of existing laws on commercial activities. The Global Legal
Research Center (2018) reports that the Republic of Korea, for instance, prohibits the
use of anonymous bank accounts in cryptocurrency trading. The government of the
Republic of Korea also requires banks to report activities deemed suspicious under the
regulations in its thrust to prevent money laundering. In addition, the report shows
another example of cryptocurrency regulation with the licensing requirement of Israel’s
Supervision of Financial Services for financial asset service providers, which includes
virtual currency. While cryptocurrency operations have started to face registration and
licensing requirements, they have remained outside most supervisory reach, thus they
maintain that users of cryptocurrency do so at their own risk.
As opportunities and threats connected with cryptocurrencies become clearer as news
about cryptocurrency operations unfolds, policy makers adopt their attitudes and
policy stance toward cryptocurrency. For instance, the Global Legal Research Center
(2018) reports that Japan revised its regulations on cryptocurrency to respond to
the increasing speculation in the market. In April 2017, Japan revised the Payment
Services Act to explicitly define cryptocurrency and to require the registration of dealers
who exchange cryptocurrency with legal tender such as yen (Jiji 2018). In March
2018, Japanese regulators issued business improvement orders to cryptocurrency
exchanges as a response to the incident when Coincheck, one of the biggest
cryptocurrency exchanges in Japan, lost about $400 million in cryptocurrency. From this
episode, we see that regulators can be quick to respond to the threats that unfold from
new financial technology.
In contrast, some policy makers decide not to regulate cryptocurrency specifically and
allow existing laws on commodities or financial instruments to govern the use of
cryptocurrency. The regulations compiled by the Global Legal Research Center (2018)
present several examples. Austria considers cryptocurrency to be a business asset,
classified under other intangible commodities. The Czech Republic similarly considers
cryptocurrency to be a commodity, which explains their “liberal approach” to

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ADBI Working Paper 978 Rico Shirakawa and Korwatanasakul

cryptocurrency, essentially neither promoting nor hindering its development as they

would do in other commodity trading. Australia sees cryptocurrency as assets for the
purpose of capital gains tax. Anguilla treats cryptocurrency that functions as securities
to be regulated under the existing securities framework. Meanwhile, some other
countries, such as Bermuda and the Bahamas, currently do not have specific regulations
on cryptocurrency and are in the process of exploring their regulatory or legislative
options.
The risks of cryptocurrency are undisputed but the policies toward it vary widely.
With its increasing presence in financial markets, cryptocurrency cannot be ignored,
particularly by policy makers. Policy makers have been vocal about giving warnings but
not all have been active in banning or regulating it. Even the policy choice of no regulation
is a policy decision in itself in that policy makers are not prohibiting, but essentially
allowing people or firms to engage in cryptocurrency transactions at their own risk. In the
next section, we discuss how some policy choices or legal frameworks affect the
attitudes of policy makers in permitting or regulating cryptocurrency.

3. FINANCIAL DEVELOPMENT, LEGAL SYSTEMS,

AND POLICIES TOWARD CRYPTOCURRENCY
In this study, we examine whether the quality of governance and the degree of financial
openness contribute to the attitude of policy makers in pursuing further financial
development by allowing the use of cryptocurrency.
We posit that the characteristics of government institutions can also influence the policy
stance taken toward cryptocurrency. In particular, we test whether effective governance
is more likely to be supportive of financial development as characterized in this paper by
a less restrictive stance to a burgeoning cryptocurrency industry. Nee and Opper (2009)
show that the quality of the state bureaucracy can contribute to financial market
development. They argue that financial markets develop when institutions provide a
stable environment where risks can be calculated. Enforcing contracts and protecting
property rights can foster the confidence of economic actors. In particular, they
emphasize the importance of credible, predictable, and reliable support from the public
administration in facilitating the development of the securities market where control and
ownership are separated.
Further, studies examining the link between legal institutions, an important component
of governance, and financial development are not scarce. La Porta et al. (1998) show
that differences in the legal system influence the development of financial markets. In
particular, financial markets develop when legal institutions protect property rights,
contracts, and the rights of owners. Beck and Levine (2003) explain that in contrast
to supportive legal institutions, uncertainty in the legal environment where a central
political power can usurp private capital can impede the development of financial markets
by discouraging investment. In the same way, centralization of political power can stifle
the progress of financial markets (Beck, Demirgüç-Kunt, and Levine 2001). Legal
institutions may also vary in the degree to which they are flexible in adapting to changing
times. More flexible institutions can support financial innovations that serve market gaps
as shown by Beck, Demirgüç-Kunt, and Levine (2001) when they investigated the link
between legal origin and financial development. Thus, in this study we conjecture that
institutions and the quality of governance that supports financial development are more
likely to be supportive of burgeoning cryptocurrency industries.

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ADBI Working Paper 978 Rico Shirakawa and Korwatanasakul

In addition, we investigate whether de jure financial openness is related to policy decision

on cryptocurrency. On the one hand, countries with a more liberal capital flow policy may
also be open to developments in new financial instruments to keep up with competition
in international markets. Klein and Olivei (2008) discuss how capital account
liberalization contributes to financial development by introducing international standards,
servicing niche markets, and broadening financial services through financial innovation,
among other things. With financial innovation offering new opportunities, many countries
face the incentive to keep up with new financial instruments to compete internationally.
In the same vein, we posit that countries that are more financially open tend to be more
open to the adoption of cryptocurrency, otherwise they risk lagging behind their peers by
ignoring the current financial market developments.
On the other hand, countries with a higher degree of financial openness may be more
prudent in exposing themselves to risk through new financial instruments. Greater
financial openness can exacerbate the risks that cryptocurrency can bring through large
and volatile flows, which can destabilize the financial sector (Kaminsky and Reinhart,
1999). Cubillas and González (2014) show that financial liberalization encourages bank
risk taking in both advanced and developing countries. In particular, competition in banks
encourages risk taking in advanced countries, whereas the presence of opportunities to
take risks increases bank risk in developing countries. Thus, an alternative hypothesis
could be that the potential risk that cryptocurrency brings with it could influence policy
makers in financially open economies to be more prudent and impose regulations to
repress the use of cryptocurrency, especially because it is primarily used as a
speculative instrument.

4. ECONOMETRIC FRAMEWORK
4.1 Model Specification
To estimate the link between de jure openness to cryptocurrency, on the one hand,
and de jure capital openness and institutional strength, on the other, we use a model that
estimates the determinants of financial development. Since cryptocurrency represents a
new financial technology, permission for the operation of cryptocurrency can be likened
to further development of the financial sector. For this purpose, we
base the empirical model on Chinn and Ito’s (2006) empirical specification examining the
link between financial development and other policy, legal, institutional, and
macroeconomic factors.
Chinn and Ito (2006)’s regression equation is the following:
𝑖𝑖 𝑖𝑖 𝑖𝑖 𝑖𝑖
𝐹𝐹𝐹𝐹𝑡𝑡𝑖𝑖 − 𝐹𝐹𝐹𝐹𝑡𝑡−5 = 𝛾𝛾0 + 𝜌𝜌𝜌𝜌𝜌𝜌𝑡𝑡−5 + 𝛾𝛾1 𝐾𝐾𝐾𝐾𝐾𝐾𝐾𝐾𝐾𝐾𝐾𝐾𝑡𝑡−5 + 𝛾𝛾2 𝐿𝐿𝑖𝑖 + 𝛾𝛾3 �𝐿𝐿𝑖𝑖 × 𝐾𝐾𝐾𝐾𝐾𝐾𝐾𝐾𝐾𝐾𝐾𝐾𝑡𝑡−5 �+
𝑖𝑖 𝑖𝑖
𝑋𝑋𝑡𝑡−5 𝜏𝜏 + 𝑢𝑢𝑡𝑡 (1)

where FD refers to a measure of financial development; KAOPEN is a measure of

financial openness; Li represents a measure of legal and institutional development; and
X is a vector of macroeconomic control variables.
As the main purpose of their research is to examine the determinants of the development
of equity markets, FD represents any indicators that measure equity market
development, e.g. the size of the market and the market activeness, among others. Stock
market capitalization (SMKC), the total value of stocks traded (SMTV), and the stock
market turnover ratio (SMTO) were used as a different proxy for FD.

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ADBI Working Paper 978 Rico Shirakawa and Korwatanasakul

In contrast, instead of equity markets, our study investigates the degree of

cryptocurrency market development. Thus, we adopt a de jure openness to
cryptocurrency (cc) variable as our dependent variable. The cc variable is described in
greater detail in the data section. Our model is specified as:
𝑖𝑖
𝑐𝑐𝑐𝑐 𝑖𝑖 = 𝛿𝛿0 + 𝛿𝛿1 𝐾𝐾𝐾𝐾𝐾𝐾𝐾𝐾𝐾𝐾𝐾𝐾𝑡𝑡−3 + 𝛿𝛿2 𝐿𝐿𝑖𝑖𝑡𝑡−3 + 𝑋𝑋𝑡𝑡−3
𝑖𝑖
𝜏𝜏 + 𝑣𝑣 𝑖𝑖

We use the Chinn-Ito index for the financial openness variable (ka_open) and Worldwide
Governance Indicators’ (WGIs) government effectiveness (bureau_quality) for a
measure of legal and institutional development. The indexes are also discussed
in more detail in the following section. To control for macroeconomic factors, log per
capita income (log_gdp_pc), inflation rate (inflation), and trade openness (trade_open)
are incorporated in the vector X. As stated in Chinn and Ito’s (2006) work, the rationale
behind the inclusion of each control variable also applies in the case of cryptocurrency
market development. For example, the inclusion of log per capita income is to capture
the effect of rising income that may contribute to more sophisticated economic and
financial structures that can support the development of the cryptocurrency market. The
inflation rate is included in the model as high inflation may encourage the use of
cryptocurrency, rather than paper money or other assets.
Due to the unavailability of multiple-year cc data, our main estimation method
is a cross-sectional ordered probit model using the cross-sectional data from 2018.
Three-year-lagged independent variables are used in the main regression since
new legislation takes time to adjust. We also use four-year- and five-year-lagged
independent variables to check whether our results are robust to the choice of lag period.
Moreover, we estimate alternate model specifications using different definitions of legal
and institutional factors to check whether our results are robust to different measures of
our key variables.
Except for the dependent variable and the time dimension, we strictly follow Chinn
and Ito’s (2006) model specification since 1) the model offers clean and clear
interpretations of its results and each variable in relation to financial development, and
2) it is also interesting to compare our results (the cryptocurrency market development)
to those of different financial markets, e.g. the equity market.

4.2 Data
The data are originally recorded at an annual frequency over the 2010‒2018 period,
covering 180 economies and drawn from several sources, primarily the Chinn-Ito index,
the World Bank’s Worldwide Governance Indicators (WGIs), and the World Bank’s World
Development Indicators, among others.

4.2.1 Index of Cryptocurrency Regulation

The index of cryptocurrency regulation (cc) is an index measuring an economy’s degree
of de jure openness to cryptocurrency. “cc” is based on the ordinal variables that codify
the current legal and regulatory status of cryptocurrency in 218 economies, 1 using the
current legal and regulatory status of cryptocurrency compiled in 2018 from the Global
Legal Research Center, the Bitcoin Market Journal, and CoinStaker. We classified the
economies based on their policy stance toward cryptocurrency as follows: first, we assign
the value 0 when the economy is “banned”; 1 when “regulated”; 2 when “fully liberalized”;
or “no explicit prohibitions/regulations.” The higher the figure, the more liberal the

1 For a complete list of the economies, see Appendix A.

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ADBI Working Paper 978 Rico Shirakawa and Korwatanasakul

economy is toward cryptocurrency. We found that 135 economies allow the free use of
cryptocurrency, 61 economies regulate its use, and 22 economies ban it.

4.2.2 Measures of De Jure Capital Openness

We adopted the 2016 capital account openness index developed by Chinn and Ito
|as a proxy of financial liberalization since the Chinn-Ito index (ka_open) is the most
widely used in the financial literature. The Chinn-Ito index was first introduced in 2006
and has been continuously updated. The index covers the time period of 1970‒2016 for
182 economies. It is the first standardized principal component of the four binary dummy
variables reported in the IMF’s Annual Report on Exchange Arrangements
and Exchange Restrictions (AREAER). The variables include variables indicating the
presence of multiple exchange rates, restrictions on current account transactions,
restrictions on capital account transactions, and the requirement to surrender export
proceeds. The higher the value, the more liberal the economy is to cross-border
capital transactions.

4.2.3 Measures of Legal and Institutional Factors

In our main regression, we use the WGIs’ government effectiveness (bureau_quality) to
control for legal and institutional factors. Government effectiveness is one of the WGIs’
six aggregate indicators of governance. With an unobserved components model, it is
computed from various data sources and reported in percentile rank where a higher
percentile corresponds to higher quality. 2 The indicator of government effectiveness
reflects the overall quality and credibility of the government in terms of public and civil
services, legislation, and policy formation.
Similarly, legal2 captures a broader effectiveness and quality of the government.
legal2 is the first principal component of all the WGIs’ six aggregate dimensions of
governance, namely voice and accountability (VA), political stability and absence of
violence (PV), government effectiveness (GE), regulatory quality (RQ), rule of law (RL),
and control of corruption (Corrupt). The first eigenvector for legal2 was found to be
(VA, PV, GE, RQ, RL, Corrupt)’ = (0.415, 0.337, 0.428, 0.408, 0.401, 0.452),’ showing
that the variability of legal2 is not driven by any particular dimensions of governance. We
extend legal2 from Chinn and Ito’s (2006) legal1, which covers only three dimensions,
namely the level of corruption, law and order, and the quality of the bureaucratic system.
As legal1 has a relatively limited definition and there is no compelling reason to omit
other WGI indicators, we opt to use legal2 in the robustness check of our main results.
We normalized legal2 in order to simplify our interpretation of the regression results.
Used for another robustness check, Polity IV’s polity2 controls for legal and institutional
factors. It captures a state’s level of democracy, which ranges from –10 (strongly
autocratic) to +10 (strongly democratic). The polity2 score is derived from a difference
between the scores for democracy and autocracy. Both scores are evaluated from the
state’s elections for competitiveness and openness, the nature of political participation,
and the extent of checks on executive authority. Even though polity2 does not directly
capture the quality of a legal but institutional framework, a higher level of democracy may
imply more refined and sophisticated legislation (Habermas 1995; Raban 2015), which
may also contribute to financial development.
We also use the Heritage Foundation’s index of financial freedom (fn_freedom) as
a proxy of the legal and institutional factors. The index assesses the extent of
government regulation and intervention in the financial sector, including openness

2 For more details on the methodology, refer to Kaufmann, Kraay, and Mastruzzi (2010).

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ADBI Working Paper 978 Rico Shirakawa and Korwatanasakul

to foreign competition, on a scale of 0 to 100. Higher values of the index indicate

less government interference and thus greater financial freedom. The underlying
assumption is that well-established legal and institutional frameworks such as
enforcement of contractual obligations and fraud prevention, among others, would lead
to greater financial freedom without further government intervention or with a very
minimal level of government interference. We also normalized fn_freedom.

5. EMPIRICAL RESULTS AND DISCUSSION

Table 1 presents the ordered probit regression result with marginal effects of the main
model specification (equation (2)). It shows the effects of legal and institutional
development and financial development on the degree of cryptocurrency market
development. In addition, the results of different robustness checks are presented in
Table 2. We test our results against alternative specifications using alternate measures
of government quality and effectiveness and also the choice of year in the data used for
the econometric estimation. It is worth noting that our research does not delve deeper
into the actual cryptocurrency mining or exchanges but highlights the linkage between
the policy environment and financial market development from the institutional
perspective.

Table 1: Ordered Probit Regression Results and Marginal Effects

Dependent Variable: De Jure Openness to Cryptocurrency (cc) in 2018
Marginal Effects
Independent Variable Coefficient Banned Regulated Fully Liberalized
Bureaucratic quality 1.509** -0.264** -0.329** 0.592**
(bureau_quality) (0.647) (0.118) (0.155) (0.253)
De jure capital openness 0.262 –0.046 –0.057 0.103
(ka_open) (0.382) (0.067) (0.084) (0.150)
GDP per capita –0.673*** 0.118*** 0.147*** –0.264***
(log_gdp_pc) (0.170) (0.033) (0.047) (0.066)
Inflation 0.053* –0.009* –0.011 0.021*
(inflation) (0.032) (0.006) (0.007) (0.012)
Trade openness 0.006*** –0.001** –0.001** 0.003***
(trade_open) (0.003) (0.000) (0.001) (0.001)
Constant cut1 –5.877***
(1.347)
Constant cut2 –4.773***
(1.325)
Observations 124 124 124 124
Note: a) Standard errors in parentheses; *** p < 0.01, ** p < 0.05, * p < 0.1.
Source: Authors’ compilation and calculation.

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ADBI Working Paper 978 Rico Shirakawa and Korwatanasakul

As shown in Table 1 and columns 1‒3 of Table 2, the coefficients on bureaucratic quality
are statistically significant and robust across different specifications with three-year-,
four-year-, and five-year-lagged independent variables. Our result shows that one unit
increase in the index of bureaucratic quality is associated with a higher chance of full
cryptocurrency liberalization by 59 percentage points. In contrast, the probability of being
banned and regulated is lower by 26 and 33 percentage points, respectively, when the
index of bureaucratic quality rises by one unit. Therefore, the results show that the quality
of legal system and institution strongly relates to the attitude of policy makers toward the
cryptocurrency liberalization. In other words, cryptocurrency
is less regulated when the legislation is more refined and sophisticated. On the
other hand, it seems that de jure capital openness is not relevant in the context
of cryptocurrency development as the capital openness variable is not statistically
significant in all the different model specifications.

Table 2: Ordered Probit Regression Results and Robustness Check

Dependent Variable: De Jure Openness to Cryptocurrency (cc) in 2018
(1) (2) (3) * (4) (5) (6)
Five- Four-
year year
Independent Variable Lag Lag Three-year Lag
Bureaucratic quality 1.098* 1.194* 1.509**
(bureau_quality) (0.592) (0.614) (0.647)
Level of governance 1.567*
(legal2_n) (0.920)
Level of democracy (polity2) 0.063***
(0.020)
Financial freedom (fn_free_n) 1.378*
(0.710)
De jure capital openness 0.241 0.320 0.262 0.174 –0.091 –0.142
(ka_open) (0.342) (0.370) (0.382) (0.391) (0.380) (0.358)
GDP per capita (log_gdp_pc) – – – – – –
0.637*** 0.651*** 0.673*** 0.612*** 0.388*** 0.476***
(0.158) (0.165) (0.170) (0.169) (0.118) (0.124)
Inflation (inflation) 0.005 0.040* 0.053* 0.049 0.035 0.017
(0.019) (0.023) (0.032) (0.032) (0.027) (0.022)
Trade openness (trade_open) 0.004* 0.006** 0.006*** 0.006** 0.007*** 0.006**
(0.002) (0.002) (0.003) (0.002) (0.003) (0.002)
Constant cut1 – – – – – –
6.031*** 5.880*** 5.877*** 5.349*** 3.876*** 4.451***
(1.258) (1.306) (1.347) (1.292) (1.037) (1.009)
Constant cut2 – – – – – –
4.966*** 4.798*** 4.773*** 4.254*** 2.800*** 3.430***
(1.236) (1.284) (1.325) (1.268) (1.019) (0.991)
Observations 128 126 124 124 139 151
Note: a) Standard errors in parentheses; *** p < 0.01, ** p < 0.05, * p < 0.1.
b) All independent variables are lag variables (please refer to the title of each column).
c) * Model (3) is the main regression specification.
Source: Authors’ compilation and calculation.

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ADBI Working Paper 978 Rico Shirakawa and Korwatanasakul

We also check the robustness of our results with the alternative measures of legal
and institutional frameworks, including legal2, polity2, and fn_freedom. Even though
legal and institutional frameworks are measured or proxied differently, our results of
the robustness check (columns 4‒6 of Table 2) show that our regression model
is quantitively and qualitatively robust across different specifications, except for the
magnitude of polity2’s coefficient. As discussed in the previous section, polity2 possibly
captures only the quality of the institutional framework, and not the legal one. This may
explain the reason why the coefficient of polity2 is lower than the other alternate
measures.
By considering our control variables, we observed some interesting patterns. Firstly,
economic development has a negative effect on the development of cryptocurrency since
a percentage change in real income per capita decreases the probability of full
cryptocurrency liberalization by 26 percentage points (Table 1). In contrast, we found
that trade openness positively affects a policymaker’s attitude toward cryptocurrency
liberalization. The result indicates that an additional unit of trade openness raises the
chance of full cryptocurrency liberalization by 0.3 of a percentage point. However, the
magnitude of trade openness’s coefficient seems negligible compared with the effects of
bureaucratic quality and real income per capita. Lastly, we did not find a relationship
between inflation and the development of cryptocurrency.
The results can contribute to policy discussions on the timing of adopting financial
technology in line with developing financial markets. This study reaffirms previous
findings that institutional quality contributes to financial development even after taking
into consideration factors such as de jure financial openness, economic development,
inflation, and trade openness, which may also influence the decision of policy makers to
be open to cryptocurrency. Putting it differently, the results imply that a certain level of
institutional quality may be necessary before opening up to new forms of financial
technology. Cryptocurrency in particular is recognized as a risky speculative financial
instrument. Its current state of many unknowns can also prevent policy makers from
conducting a thorough surveillance to avoid system-wide vulnerabilities.
Furthermore, our findings invite policy makers to consider the different pace in the
development of institutions and the financial market. Financial market developments
appear to outrun institutional development. In 2011, other cryptocurrencies emerged
three years after the inception of bitcoin in 2008 (Farell 2015). In this short period of time,
various players joined in to take advantage of the opportunities. Since then, however,
several legal and security problems have also emerged. In the meantime, the pace of
strengthening institutions by enhancing bureaucratic effectiveness or the credibility of
legal systems may not keep up with the demands of the financial sector. Some policy
makers and industry players acknowledge the gap in the institutional capacity to regulate
and intervene and thus advocate a hands-off government approach to market
development. Nevertheless, whether the government decides to intervene, to regulate,
or to let markets be, the quality of governance gives policy makers credibility in enforcing
their policy choice. Hence, improving institutions could still be a worthwhile aim moving
forward even if it is outpaced by financial development.
Finally, the decentralized and international nature of the cryptocurrency industry
underlies a need for international cooperation. Standing issues include avoiding potential
circumvention of regulation and supervision in the international trade of cryptocurrency,
particularly for preventing money laundering or terrorism finance. Policy makers also
need to be wary of potential spillover effects of volatility in the cryptocurrency market.
Increasing macro-financial linkages could make the real sector vulnerable to amplified
adverse effects coming from new financial technology, especially if the presence of
cryptocurrency continues to rise in the coming years.

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ADBI Working Paper 978 Rico Shirakawa and Korwatanasakul

6. CONCLUSION
In this study, we investigate how effective governance institutions and de jure financial
openness influence the attitude of policy makers in pursuing further financial
development by allowing the use of cryptocurrency. Although several sources have
developed a regulatory stance on cryptocurrency (Global Legal Research Center 2018;
Bitcoin Market Journal 2018; CoinStaker 2018), a systematic investigation of the policy,
economic, and institutional factors influencing policy choice has not been conducted. As
a first step, we compose an index of de jure openness to cryptocurrency in 218
economies, using the current legal and regulatory status of cryptocurrency compiled
in 2018. We categorize policy stance into “banned,” “regulated,” and “permitted” and
investigate its determinants using a cross-sectional ordered probit model.
The regression analysis shows that effective governance institutions are associated with
a greater likelihood of a less restrictive regulatory stance on cryptocurrency. The results
are robust when we use different measures of effective governance, namely bureaucratic
quality, a calculated governance indicator index, democratic institutions, and financial
freedom. This provides evidence that policy makers in an environment with institutions
conducive to financial development are more likely to be open to cryptocurrency.
Meanwhile, financial openness is not found to be significant. Thus, the results do not
support the hypothesis that a higher degree of financial openness would translate to
higher openness to new financial technology presented by cryptocurrency. The empirical
results imply that policy and institutions associated with financial development, rather
than financial openness itself, determine de jure openness to cryptocurrency.
The limitations of this paper can pave the way for future research. For one, the index of
de jure openness to cryptocurrency is constructed based on the policy stance of
economies toward cryptocurrency in 2018. Our index does not capture changes in the
regulatory stance of government. It would be interesting to investigate the drivers of
policy change over the years. Examining the policy stance vis-à-vis the size of the
cryptocurrency market in an economy can also provide a more nuanced interpretation of
the policy choice based on how large the cryptocurrency industry is relative to the size
of the financial market or economy.

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APPENDIX A: INDEX OF CRYPTOCURRENCY

REGULATION
East Asia and the Pacific Nepal 0 Comoros 2
Australia 1 Pakistan 2 Congo, Dem. 2
Brunei Darussalam 2 Sri Lanka 1 Congo, Rep. 1
Cambodia 2 Other Economies Cook Islands 2
PRC 0 Abkhazia 1 Costa Rica 1
Fiji 2 Albania 2 Croatia 1
Hong Kong, China 2 Algeria 0 Cuba 2
Indonesia 0 Andorra 1 Cyprus 2
Japan 1 Angola 1 Czech Republic 2
Kiribati 2 Anguilla 2 Denmark 2
Democratic People’s Antigua and Barbuda 2 Djibouti 2
1
Republic of Korea
Republic of Korea 1 Argentina 1 Dominica 2
Lao PDR 2 Armenia 2 Dominican Republic 0
Macau, China 0 Artsakh 1 Ecuador 0
Malaysia 2 Austria 1 Egypt 0
Marshall Islands 2 Azerbaijan 2 El Salvador 2
Micronesia 1 Bahamas 2 Equatorial Guinea 2
Mongolia 2 Bahrain 0 Eritrea 2
Myanmar 1 Barbados 2 Estonia 2
Nauru 2 Belarus 2 Ethiopia 2
New Zealand 2 Belgium 2 Finland 1
Palau 2 Belize 2 France 1
Papua New Guinea 1 Benin 1 Gabon 2
Philippines 1 Bermuda 2 Gambia 2
Samoa 2 Bolivia 0 Georgia 2
Singapore 2 Bosnia and Herzegovina 2 Germany 1
Solomon Islands 2 Botswana 1 Ghana 2
Taipei,China 1 Brazil 2 Gibraltar 1
Thailand 1 British Virgin Islands 2 Greece 2
Timor-Leste 2 Bulgaria 1 Grenada 2
Tonga 2 Burkina Faso 2 Guatemala 2
Tuvalu 2 Burundi 2 Guernsey 2
Vanuatu 2 Cameroon 2 Guinea 2
Viet Nam 0 Canada 1 Guinea-Bissau 2
South Asia Cape Verde 1 Guyana 2
Afghanistan 1 Cayman Islands 1 Haiti 2
Bangladesh 0 Central African Republic 2 Honduras 2
Bhutan 1 Chad 2 Hungary 2
India 2 Chile 2 Iceland 1
Maldives 2 Colombia 2 Iran, Islamic Rep. 0
continued on next page

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Appendix A table continued

Iraq 0 Morocco 0 South Africa 2
Ireland 2 Mozambique 2 Tskhinvali Region 2
Isle of Man 1 Namibia 2 South Sudan 2
Israel 1 Netherlands 2 Spain 1
Italy 1 Nicaragua 1 St. Kitts and Nevis 2
Ivory Coast 2 Niger 2 St. Lucia 2
Jamaica 2 Nigeria 2 St. Vincent and the Grenadines 2
Jersey 1 Niue 2 Sudan 2
Jordan 1 Northern Cyprus 2 Suriname 2
Kazakhstan 2 Norway 1 Swaziland 2
Kenya 2 Oman 0 Sweden 1
Kosovo 2 Palestine 2 Syrian Arab Republic 2
Kuwait 0 Panama 1 Tajikistan 2
Kyrgyz Republic 1 Paraguay 2 Tanzania 1
Latvia 1 Peru 2 Togo 2
Lebanon 1 Poland 2 Transnistria 1
Lesotho 0 Portugal 2 Trinidad and Tobago 2
Liberia 2 Puerto Rico 1 Tunisia 2
Libya 0 Qatar 0 Turkey 2
Liechtenstein 1 Romania 1 Turkmenistan 2
Lithuania 1 Russian Federation 2 Uganda 2
Luxembourg 1 Rwanda 2 Ukraine 2
Macedonia, FYR 2 Sahrawi Republic 2 United Arab Emirates 0
Madagascar 2 San Marino 2 United Kingdom 1
Malawi 2 São Tomé and Príncipe 2 United States 1
Mali 2 Saudi Arabia 0 Uruguay 1
Malta 2 Senegal 2 Uzbekistan 2
Mauritania 2 Serbia 2 Vatican City 2
Mauritius 1 Seychelles 2 Venezuela, RB 2
Mexico 2 Sierra Leone 1 Yemen, Rep. 2
Moldova 2 Slovak Republic 2 Zambia 2
Monaco 2 Slovenia 1 Zimbabwe 1
Montenegro 2 Somalia 2
Montserrat 2 Somaliland 2
Note: a) Economy groupings are based on the World Bank Country and Lending Groups.
b) 0 = “banned”; 1 = “regulated”; 2 = “fully liberalized.”
Source: Authors’ compilation and calculation.

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APPENDIX B: DESCRIPTIVE STATISTICS

Standard
Variable Observations Mean Deviation Min. Max.
De jure openness to cryptocurrency (cc) 124 1.411 0.721 0 2
Bureaucratic quality (bureau_quality) 124 0.561 0.267 0 1
De jure capital openness (ka_open) 124 0.580 0.207 0.158 0.996
GDP per capita (log_gdp_pc) 118 5.068 5.801 –10 10
Inflation 123 0.594 0.200 0.111 1
Trade openness (trade_open) 124 1.411 0.721 0 2
Level of governance (legal2_n) 124 0.561 0.267 0 1
Level of democracy (polity2) 124 0.600 0.381 0 1
Financial freedom (fn_free_n) 124 9.458 1.187 6.729 11.756
Source: Authors’ compilation and calculation.

17