Bitcoin Regulation

This is the final part in a series of blogs I have written on the way forward for regulating Bitcoin and other virtual currencies. Last week the Financial Industry Regulatory Authority (FINRA) in the US issued an alert to warn investors of the fraud risks of using Bitcoin. FINRA is one of the latest regulatory agencies to flex its authority when it comes to Bitcoin and other virtual currencies. The recent losses of failure of Mt. Gox have not gone unnoticed by regulators around the world.

Besides the risks involved with speculative trading in bitcoins, Finra said there are companies that fraudulently claim to offer bitcoin payment platforms and other bitcoin-related products and services. "Investors looking to get in on the ground floor of a Bitcoin-related company should realize that fraudsters may see the latest digital currency trend as a chance to steal their money through old-fashioned fraud," said Gerri Walsh, Finra's senior vice president for investor education. The regulatory agency also said platforms that buy and sell bitcoins can be hacked and can fail, and unlike U.S. banks and credit unions, there are no safeguards for bitcoins.

As I continue to think about the regulatory framework for Bitcoin and other virtual currencies, I think there are other issues that are of concerns to both the developers of Bitcoin and regulators. For example, there are a number of important considerations relating to the use of Bitcoin by merchants. First, at this time Bitcoin is exhibiting speculative behaviour and this is not attractive to merchants and trader of goods and services. Merchants typically requires some kind of price guarantee and consumers love stable prices. As the value of Bitcoin is constantly changing it will be difficult for merchants and traders to determine what price to change for their goods and services especially if they are converting back to currencies which have a legal status. If they have to constant change their prices as result of volatility in Bitcoin, this will frustrate both merchants and consumers.

The uncertain mechanism of calculating the transaction fee is also one of the factors that could negatively affect mainstream acceptance of crypto-currencies. Another important point for traders is also the tax implication. In Canada, merchants are required to charge sales tax at the point of sale. If they are using Bitcoins, meeting the tax obligations is going to be a mammoth task given the tiny values that might be involve in Bitcoins values that will have to be converted to Canadian currencies or the other currencies in which taxes are paid. There are also issues with processing time and information security which included confidentiality, integrity and availability. The malleability and related denial of services attack on Mt. Gox and Bitstamp and the subsequent collapse of Mt. Gox on allegation of theft of over 700,000 bitcoins will not help to build confidence.

We can use lessons learned from other large corporate failures to act as a guide for the direction of regulation of Bitcoin and other virtual currencies. What have we learned from large corporate failures? Arising out of the collapse of Enron, Worldcom, Global Crossing, Parmalat and other large corporation in the early 2000s and the global financial crisis in 2008/2009 governments and regulators have created a mechanisms for greater transparency by financial institutions. The culture of Bitcoin firms appears to be one of secrecy. It would be helpful for the public to know that such firms are managed prudently and the public should not have had to wait until Mt. Gox went dark to know about weaknesses in governance, control and security behind such an entity. From this perspective the issue of corporate governance of Bitcoin firms are relevant. The investing public have a right to know what are the institutional conditions governing such firms.

This is a question that is best answer by having better understanding of the manner in which the boards of directors and senior management of Bitcoin firms oversee their businesses. It encompasses the means by which members of the board and senior management are held accountable and responsible for their actions. Corporate governance includes corporate discipline, transparency, independence, accountability, responsibility, fairness and social responsibility. Timely and accurate disclosure on all material matters regarding their operation, including the financial situation, performance, ownership and governance arrangements, is part of a corporate governance framework. The board is the focal point of the corporate governance system. It should ultimately be accountable and responsible for the performance and conduct of their firm.

Bitcoin firms that have clear and transparent policies and state of the art security measures are more likely to generate confidence and have stronger currencies. Arising out of the Mt. Gox failure it is my understanding that some exchanges are contemplating publishing their ledgers as a form of public disclosure and transparency. If firms can publish their ledgers without breaching individual consumer’s privacy this might be a welcome solution towards transparency.

Addressing the issue of corporate governance could be useful in enhancing the confidence and reputation of Bitcoins and others in the virtual currency community. Firms that have a reputation of lengthy delays in settling transactions or meeting commitment will suffer. Since virtual currency payments are not settled in central bank money or commercial bank money, nor is there any lender of last resort, a crucial element affecting the virtual exchange rate is the trust gained by the virtual currency issuer. Another area for consideration relates to the fitness and propriety of significant owners and key functionaries such as board members, senior management, IT personnel and others involved in Bitcoin firms. Most Bitcoin firms are likely to be privately held and very little is known about the significant owners and management. Regulations relating to fit and proper requirements of such persons and their financial soundness would be helpful to build confidence in the Bitcoin and the firms supporting or providing Bitcoins.

Here are some key components that should be considered for the regulations for Bitcoin and other virtual currencies should entail.

As a starting point and as noted by the Lawsky the superintendent of New York Financial Services Department we need a system of registration so let us call it BitLicense. From licensing and registration the following should flow:

a. Capital requirements. We will need a mechanism for determining an appropriate level of capital.

b. Fit and proper requirements for company directors and management including competency. This will call for more information on the people behind Bitcoin. While it would be notice to know more about Satoshi Nakamoto, he is bit irrelevant if Bitcoin and other virtual currencies is going be taken seriously as alternative currencies and payment system. We have to focus on the people who really matters today such as the management of CA Virtex.

c. Requirements for liquidity and reserves. One of my ideas is that virtual currencies might push us back to the gold stand. Alternatively, my preference would be for a virtual currency backed by a currency that has legal status such as the USD or the Euro. The reality is the USD is already recognised as the international reserve currency. In my humble view this might be an area where the Canadian Government might be ahead of the curve with Mintchip which is a form of digital currencies which enormous opportunities for both consumers and business with one slight difference from Bitcoin. Mintchip will be backed by the Canadian Dollar.

d. Requirements for governance, internal controls, risk management, privacy and security. My view is that we are likely to see similar requirements to how banks and other FIs have to disclose information on their capital, risks and models used. This will include requirements for managing transactions, ledger and malleability.

e. Requirements for AML/ATF compliance to mitigate money laundering and terrorist financing risks. The key challenges for Bitcoin firms will be meeting the raft of documentation requirements and reporting to FINTRAC, FINCEN and other financial intelligence units (FIUs) around the globe.

d. There may even be requirements for the creation of safety net similar to a depositors’ insurance scheme like that of FDIC in the US or CIDC in Canada. Remember that in the traditional financial system we already have discussions taking place on the subject of too big to failure issue. Taxpayers should not have to pay for failure of Bitcoin firms.

Mt. Gox and Liberty Reserves will influence the design of regulation and safety net for Bitcoin. The benefit of regulations is that increase market discipline and capital adequacy will help to eliminate regulatory discretion to forbear.

Above I have attempted to highlight some of the specific components of a regulatory framework for Bitcoin to guard against crises, speculation and abuse. Just as the 2008/2009 financial crisis taught us, Bitcoin firms too cannot be left to their own devices. The state needs to set and enforce the rules here as well. Registration and capital requirements are a must for the future of Bitcoin and virtual currencies. Firms must be able to demonstrate their resilience to crises. Mt. Gox should have being forced by the Bitcoin community to demonstrate that it was addressing the challenges that first surfaced in 2013 and that it had contingency and crisis management plan for an orderly dismantling of the firm in the event of failure. Consumers of Mt. Gox will now have to wait out a lengthy bankruptcy and litigation process to know how much of their money they will recover.

There will need to be regulation of high-frequency trading and the ban activities that might be detrimental to the system. The sharing of the cost of failure/crisis through some kind of insurance scheme or safety net is also important. There has to be increased market and product transparency.

At the same time governments and regulators including law enforcement will need appropriate tools and skills to monitor and regulate Bitcoin.

Finally the regulation that emerges should not hinder technological development and progress and therefore, should be pragmatic. It should not force Bitcoin underground. I also believe that the regulation that emerges should be based on a globally accepted stand that involves international cooperation and exchange of information.

Bitcoin is on its current trajectory does not look so well as the currency of the future. However, with changes to transparency and regulation Bitcoin image could change and consequently withstand the test of times.

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.