Regulatory Issues and Challenges Presented by Virtual Currencies

Tuesday, May 30th, 2017

Public discussion regarding virtual currencies tends to center around concerns with familiar themes: new financial technologies are little understood, difficult to regulate in their decentralized forms, and their anonymity and lack of government oversight currently allow significant misuse of virtual currencies in the black economy for purposes including money laundering and terrorist finance. These worries are not baseless, considering that virtual currencies markets are only recently attempting to legitimize their image as bona fide economic exchanges. The origins of bitcoin were part of a project to create an explicitly alternative currency devoid of government control and central oversight, but rather governed “democratically” by its users. Having thus emerged among hackers and anarchists, bitcoin was initially used for informal value exchanges and gaming proceeds, but it soon gained a reputation as a payment medium of choice for drugs, illegal weapons, and stolen goods.

Recent trends show some established bitcoin exchanges seeking government approval for licensing as well as lobbying for regulation of virtual currencies. These attempts reflect an effort to bring a somewhat tainted concept into the mainstream. On the other hand, some blockchain startups resist change and lobby against regulation that is viewed by them as government intervention that stifles innovation. Blockchain uses a distributed database of continually growing lists of encrypted transaction records (blocks) to render them virtually tamper-proof at very low cost. Virtual currencies such as bitcoin use blockchain technology to keep records of transactions. These new companies also attempt to distance themselves from the bitcoin concept, even if they utilize the same or similar technology, by focusing their marketing on “blockchain” as a more legitimate technology label that extends well beyond alternative currency in one of its many contemporary forms, and into the far broader area of smart contracts, authentication of transactions, and distributed ledger record keeping. Furthermore, as virtual currencies are more considered by regulators and recognized as belonging to the sphere of already heavily regulated financial industry, avoiding the label “bitcoin” and opting instead for “blockchain” helps avoid excessive regulatory attention and allows for developing new tools that attract more venture capital.

As with other emerging technologies, newcomers to the market try to avoid oversight in order to establish market share unrestrained by regulatory burden at this initial stage, while established businesses lobby for more regulation that helps protect their reputation from the aberrations of a startup culture while conveniently keeping newcomers from becoming significant competitors.

The stakeholders of virtual currency regulation are companies involved in the blockchain economy, both new entrants and those already controlling part of the market; governments regulating both economic activity and consumer protection; and consumers themselves. The interests of those parties naturally conflict, and given governmental regulatory powers, it is understandable that, faced with the significant risks and difficulties inherent in coming up with a comprehensive regulatory concept, governments take a precautionary stance of wait and see, while in some cases leaning towards a prohibition of virtual currencies.

This cautious approach is reflected in the establishment of various task forces in multiple jurisdictions aimed at studying the potential opportunities and risks of blockchain technologies, including bitcoin. Such initiatives have been introduced or at least attempted in several U.S. states including Delaware, Hawaii, Illinois, Maine, and Vermont, by U.S. federal agencies, as well as by the European Commission. Conclusions delivered by the ensuing reports stress uncertainty and limited benefits for state-level implementation of blockchain, while at the same time emphasizing risks to financial markets and to local economies resulting from the use of little-understood financial technologies that are under-regulated by default.

Arguments that virtual currencies have potential to boost economic activity are unconvincing – since any currency, digital or not, is just a medium of exchange that does not help generate economic revenue per se the way manufacturing does. Although bitcoin is an exception in that its generation is not restricted by any ex-ante decision, technical limitations of usable blockchain length de facto restrict bitcoin supply, which, in time, may end the virtual currency’s life expectancy. After all, miners, the network nodes processing blockchain information, generate bitcoins as payment for their services. Once the supply of bitcoins that is technologically sustainable dries up, the system would have to be fundamentally redesigned to provide for such payments without generation of bitcoins. This could be achieved, for example, by charging bitcoin users fees or interest on their holdings – but would also require introduction of some bodies of oversight, akin to tax authorities in a state-controlled setting. Such an approach, however, might be met with strong opposition by bitcoin users attracted to the open, democratic, decentralized, less regulated system of virtual currencies.

Regulating bitcoin as currency presents numerous challenges for most governments because of the required level of technological capacity and expertise. However, some elements of financial regulation such as consumer protection are still implementable. For example, in the New York, bitcoin exchanges and related services are regulated like other similar financial services. Still, due to the novelty and lack of profound understanding of risk by the public, especially as to how risks relate to the extreme volatility of virtual currencies that are not subject to measures by regulatory bodies such as central banks, requirements placed on virtual currency exchanges need to be higher than those imposed on businesses providing services in established, government-issued currencies, such as money transmitters and currency exchange shops. This was reflected in both the New York legislative approach and in the intended but as yet not enacted California regulation of digital currency businesses.

For future developments, it is crucial for regulators and stakeholders to understand better both the technology and its limitations and risks, but also the opportunities it offers. Once lawmakers are convinced that they are able to provide effective oversight measures and regulate blockchain technology in general, whether it may include decentralized virtual currencies or not, government support may prove invaluable to turn new fintech developments into mainstream products without investors and consumers having to worry about a legal opprobrium endangering their stakes. A predictable regulatory environment decreases cost of capital and boosts innovation. This way, blockchain technology may reach its ambitious potential to serve as the backbone of not just universal, decentralized, and supremely reliable recordkeeping and product tracking, but also for smart contracts and the Internet of Agreements, up to and including networked, interconnected smart cities. Unalterable algorithmic records and commands may spell a new future for how the digital world works and constitute a revolution comparable to the popularization of the internet. It may also change the way public governance works – in a decentralized system where neither the middleman nor the ultimate overseer are needed and validity of actions and transactions is determined by mathematical operations and confirmed by consensus, we can imagine the emergence of pervasive popular democracy as it has never been seen before: where every stakeholder can cast his or her vote, with every vote counted, with a minimized possibility of error, in a system readily transparent to all participants. Of course, such openness of data would also mean increased enforcement of government controls – where every payment, transaction or vote is visible to everyone, even if individual identities are not disclosed to all (but may be to the keeper of a hypothetical master encryption key), there is literally no place left to hide. In some ways, it might be an Orwellian vision come true. It would equal not only absolute surveillance, but also absolute control, since denial of service would strand a man in such an entirely connected world.

But if governments could start, more modestly, by finding ways to monitor virtual currency transactions and reliably identify their counterparties, the problem of money laundering and terrorist finance would be considerably easier to resolve, as if conspirators were openly using bank wires and accounts in their own names. The problem, then, is not that it is impossible to control decentralized virtual currencies, but that state actors lack tools to decipher digital currency networks and gain access to the full measure of information contained therein. That, however, is more a question of cryptography and general computer science than of alien decentralized structures where traditional surveillance methods, such as wiretapping, simply will no longer work.

While governments around the world observe the latest fintech developments, the regulatory approaches, like in the case of many emerging technologies, are notably lagging behind. The new digital economy, with the pace of its technological development, may require fundamental changes in our approach to regulation. Instead of ruling ex post, governments need to legislate ex ante, anticipating developments and preparing the regulatory landscape for robust readiness to meet continually evolving and accelerating challenges.