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
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