Monday, March 10, 2014

Bitcoin and the Importance of Regulation

This is a continuation of my discussion on why I believe Bitcoin and other virtual currencies should be regulated. Two weeks ago I had the opportunity of participating in a Meet-up hosted by Anthony Di Lorio, the executive director of Bitcoin Alliance of Canada, a non-profit organization at Bitcoin Decentral in Toronto. From my estimations there were over 50 Bitcoin enthusiasts salivating either for more information on Bitcoin or trying to determine how to get involved in the “gold rush” to acquire Bitcoins. It was evident to me that the general public is getting involved in Bitcoin and from this perspective governments and regulators have to devise appropriate mechanisms to safeguard the public interest while allowing room for technological development and the evolution of virtual currencies.

From a theoretical perspective Bitcoin functions as any other unit of account with the only difference being it has no physical counterpart with legal tender status. As the European Central Bank stated in its paper titled “Virtual Currency Schemes” the absence of a distinct legal framework leads to other important differences when Bitcoin is compared with other currencies such as the US Dollar or the Euro. The first difference is the absence of any central issuing authority which in most cases is central banks. As governments and policymakers contemplate regulating Bitcoin, the absence of central issuing authority is an important point to note as the issuers of Bitcoin are typically non-financial privately held companies that fall outside of financial sector regulation and supervision arrangements.

Interestingly, this is a challenge that global financial system and regulators was confronted with not so long ago. For example with the emergence of Internet Banking one of the questions that policymakers had to address was whether to allow Internet only banking such as ING. It was also an issue that we had to address with the proliferation of mobile banking technology. The questions at the time with mobile banking was whether we should allow only brick and mortar banks to offer mobile banking or should it be telecommunication companies or should it be companies supported by both brick and mortar banks and telecommunication companies. A related issue to determining who should or should not be regulated for virtual currencies is a question we will have to answer. We will also have to have a clear definition for currencies and more importantly virtual currencies. Let us face, I have a significant amount of the Canadian Tire money thrown down all around my house which are virtually useless.

Another important difference between virtual currencies and other currencies is the link between virtual currency and traditional currency (i.e. currency with a legal tender status) is not regulated by law. The implication of this is that it might be problematic or costly to redeem funds. The final difference is the fact that the currency is denominated differently (i.e. not euro, US dollar, etc.) means that complete control of the virtual currency is given to its issuer, who governs the scheme and manages the supply of money at will.

Policymakers and regulators are more likely to be interested in virtual currency schemes that are open and/or linked to the real economy. Virtual currency schemes that have a unidirectional flow (usually an inflow) involving a conversion rate for purchasing the virtual currency that can subsequently be used to buy virtual goods and services and in exceptionally cases buy real goods and services would be of interest to government and regulators. They are also interested in virtual currency schemes that have bidirectional flows. In this case the virtual currency acts like any other convertible currency, with two exchange rates (buy and sell) and it is subsequently used to buy virtual goods and services as well as purchase real goods and services. Virtual currency schemes that involve bilateral exchange rates create opportunities for speculative behaviour. In addition, if they are used to buy real goods and services they are competing with traditional currencies.

Virtual currencies are of interest to government and regulators especially when the following are considered: a) price stability, b) financial stability, and c) payment system stability. As financial sector regulatory and supervisory experts I would like to focus on financial system stability. According to the ECB the stability of financial markets is based on its ability to withstanding shocks, thereby mitigating the likelihood of disruptions in the financial intermediation process which are severe enough to significantly impair the allocation of savings to profitable investment opportunities.

Based on my understanding of Bitcoin and other virtual currencies issuers of Bitcoin have enormous power in controlling supply and consequently have the ability to be price-makers using fixed or semi- fixed or semi-fixed exchange rate. In traditional financial markets, financial institutions are required to treat their customers fairly. In securities markets for example, insider trading and market manipulations are prohibited. I am not for one minute suggesting that Bitcoin prices are being manipulated. However, I do suspect that innovators have a clear advantage in understanding the convoluted and complex mathematical algorithm or hash function.

Proponents of Bitcoin argue that it is this convoluted and complex process that makes Bitcoin as a virtual currency safe. They argue that Bitcoin is a distributed consensus network that maintains a secure and trusted distributed ledger through a process called “proof-of-work.” Unlike the traditional banking and payment system that achieves trust via various levels of access, KYC and other vetting mechanism, in the case of Bitcoin trust is achieved through computation. Trust in the network is ensured by requiring participants to demonstrate proof-of-work, by solving a computationally difficult problem. The level of complexity does not mean the Bitcoin system will be free of bad actors who might “fake” trust. We also know now that malleability can wreak havoc on Bitcoin exchanges with denial of services attacks. In fact last week for example we learned that hackers ruin Canada-based bitcoin bank, Flexcoin as it lost $600,000. This came a week after Mt. Gox's collapse and ultimately bankruptcy filing in Japan.

Despite “proof of work” that results in trust through computation I still believe rules and regulations are required to reinforce order in Bitcoin. Regulations will add guidance to the behaviour of actors and will help to avert chaos. Bitcoin might be an alternative to the loss of trust within our financial system but is it is panacea purely by itself? Will it be optimal solution if supported by pragmatic regulations?

Proponents of Bitcoin argue that our financial system is broken. We have lost trust in governments because of their poor fiscal and monetary policies that has contributed to weak economies, unemployment, inflation and volatile currencies. We have lost trust in banks and other financial institutions because of their reckless practices that in 2008 and 2009 led to the worst financial crisis since the Great Depression. We have lost trust of regulators because of their forbearance. Regulatory forbearance is not about supervisory incompetence but, rather, the potential for a fully briefed regulator to decide not to intervene. There may be many legitimate occasions when non-intervention is the right call but, when judged with the benefit of hindsight, more supervisory interventions, made sooner, could have ameliorated some of the worst of the issues arising out of the financial crisis.

With our loss of trust in so many actors, why should we today trust those behind Bitcoin? Will those with superior computational skills and computing technology and power act any differently than other actors?

Sources:
Antonopoulos, Andreas.”Bitcoin security model: trust by computation A shift from trusting people to trusting math.” February 20, 2014. http://radar.oreilly.com/2014/02/bitcoin-security-model-trust-by-computation.html
Bradbury, Danny.  “Canada’s Finance Minister Prepares to Regulate Bitcoin.” February 13, 2014. http://www.coindesk.com/canadas-finance-minister-regulate-bitcoin/
Faggiano, Mark. “Tax Trouble May Burst The Bitcoin Bubble For Merchants.”February 24, 2014. http://www.forbes.com/sites/groupthink/2014/02/24/tax-trouble-may-burst-the-bitcoin-bubble-for-merchants/
Gomzin, Slava. “Bitcoin payments will face big challenges heading to brick-and-mortar (but it’ll get there)” January 26, 2014.  http://venturebeat.com/2014/01/26/bitcoin-payments-will-face-big-challenges-heading-to-brick-and-mortar-but-itll-get-there/
Greenwood, John “Canadian Mint ready to test its own digital money project.” September 19, 2013. http://business.financialpost.com/2013/09/19/canadian-mint-pushes-ahead-in-murky-world-of-crypto-currency-with-mintchip-project/
Knight, Sophie and Yamaguchi, Takaya “Japan says any bitcoin regulation should be international” February 27, 2014. http://www.reuters.com/article/2014/02/27/us-bitcoin-mtgox-idUSBREA1Q1YK20140227
Wagstaff, Jeremy. “Beyond Mt. Gox, bitcoin believers keep the faith, see more robust system.” February 26, 2014. http://www.reuters.com/article/2014/02/26/us-bitcoin-future-idUSBREA1P0OT20140226
“New York regulator moving ahead on bitcoin regulation.” February 11, 2014. Reuters. http://www.cnbc.com/id/101408527
“Hackers ruin Canada-based Bitcoin bank.” Reuters and Haaretz. March 5, 2014


Mark McKenzie is a leading Subject Matter Expert in financial services regulation and supervision as well as a professional motivational speaker, corporate trainer and youth mentor.  He can be contacted by email mastbmckenzie@gmail.com or by telephone 647-406-4622. Read my blog  http://mastbmckenzie.blogspot.ca/ and always write me a comment and share. Follow me on Twitter @mackynacky. Connect with me on www.youtube.com, Google+, Facebook and Linkedin.

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