Cryptocurrency Regulation – Governments, Please don’t Screw this up!
Perhaps the single largest impediment to wider adoption of bitcoin is the lack of a regulatory framework governing the market. Were bitcoin to be regulated in the states, for instance, it would quickly lead to wall street trading and crypto currency funds, which would most likely massively boost liquidity and demand. No doubt there are many mainstream companies and financial institutions intrigued by bitcoin, but scared away by the lack of governmental guidance. Regulation would remove this barrier.
It now seems only a matter of time before bitcoin is regulated across all major Western markets, which will most likely speed adoption elsewhere. Below we take a look at the status of bitcoin regulation where it has most progressed – in the United States, the United Kingdom, and the European Union.
US Bitcoin Regulation
If you’d like the long yet relatively simple answer that summarizes the The US Department of Treasury Financial Crimes Enforcement Network’s (FinCEN) current guidance on the matter, it is as follows:
Most current online payment laws are built on the assumption that currencies are issued by a central authority. FinCEN defines currency as “the coin and paper money of the United States or of any other country that [i] is designated as legal tender and that [ii] circulates and [iii] is customarily used and accepted as a medium of exchange in the country of issuance”. As bitcoin is entirely decentralized it does not fit under existing US regulations, and thus has operated for the first four years of existence in a legal gray zone.
In March 2013, FinCEN released a new regulatory framework for virtual currencies which they define as a currency that “does not have legal tender status in any jurisdiction”. Though the document does not mention bitcoin by name, it is clear that the regulation has been written in response to its rising popularity. The purpose of the document is to define the participants in the bitcoin market place as money services businesses (MSBs) or money transmitters. Once defined as such, FinCEN could use existing law to regulate bitcoin exchanges and other participants.
FinCEN split participants into three groups: users, exchangers and administrators. The user is one who obtains the virtual currency to purchase goods or services. The user is not considered an MSB, and thus is not subject to FinCEN’s MSB regulations.
Administrators are obviously meant to refer to miners, and are those that “create units of…virtual currency and use it to purchase good or services that are not subject to regulations as a money transmitter. By contrast, a person that creates units of convertible virtual currency and sends those units to another person for real currency…is a money transmitter”. This would cause serious problems for miners, as exchanging bitcoin for fiat currency would seem to be fingered here as requiring regulation as a money transmitter. However, when requested to provide an official answer on this subject in August 2013, FinCEN stated that miners do not need to register as a money transmitter so long as the purchase of goods or services, or the exchange of bitcoin into fiat, is done for personal reasons (i.e. not in the capacity of an exchange business).
Before proceeding to the exchange regulation, there is an important distinction to make between money service businesses and money transmitters. MSBs could be considered similar to currency exchanges in which a guy behind a desk trades directly with a customer, while paypal and western union would be two examples of money transmitters, who transmit money between people and institutions. FinCEN clarifies that “as long as a broker or dealer in real currency or other commodities accepts and transmits funds solely for the purpose of effecting a bona fide purchase or sale of the real currency or other commodities for or with a customer, such person is not acting as a money transmitter under the regulations.”
Thus, bitcoin brokers are considered MSBs and can be regulated by FinCEN. Exchanges on the other hand must be regulated as money transmitters state by state. This is difficult operationally and extremely expensive. Just as important,state opinion on the legality of bitcoin are currently being formulated. As there is greater clarity on state legal positions, some exchanges will begin the regulation process. Indeed, as of January 2015, Coinbase has been regulated in a number of states as an exchange, currently offering trading to residents.
The next big issue on the agenda is New York’s so called Bit License, a set of regulations meant to govern virtual currency services. Not only is this important due to New York’s being a major market, but the eventual bill will most likely be used as a template in subsequent state regulations. The initial iteration in August of 2014 met with much criticism, and the newest draft is unlikely to quiet the comments. Perhaps most problematic is section 200:10 requiring any business to receive written approval from the superintendent prior to making “a material change to any product, service, or activity involving…New York residents”. The bitcoin industry is moving incredibly fast, with new innovations and applications of the technology discovered almost daily – this section seems likely to stifle such progress.
One last sign of increasing mainstream acceptance – while the Winklevoss twins have been busy working with the SEC to launch the first bitcoin ETF meant to trade on the NYSE, a competing company called the Bitcoin Investment Trust has exploited a rule which has allowed their launch as a pink sheet fund in April. Not only does this allow an alternative method for investing in bitcoin, it contributes to a growing sense that bitcoin is here to stay and regulatory agencies must simply recognize the reality.
UK Bitcoin Regulation
The Financial Conduct Authority (FCA) has indicated a desire to ensure a supportive regulatory environment for bitcoin in particular and financial innovation in general. To date, the FCA has watched the development of the industry from the sidelines and has not taken a definitive regulatory position.
The FCAs non-intervention has meant there is no obligation to prevent money laundering through bitcoin, and UK exchanges needn’t register with HM Revenue and Customs under money laundering regulations. It should be noted that local businesses are by and large abiding by the regulations in any event. However, banks must of course register with HMRC, and they are justifiably concerned that supporting exchanges could bring them afoul of these regulations. The result has been that banks are unwilling to provide services to UK bitcoin exchanges, which has forced exchanges to rely on foreign banks.
However, in August of 2014, George Osborne, the Chancellor of the Exchequer, announced an initiative meant to make the UK a “global centre of financial innovation”, a statement widely interpreted as providing an opening for cryptocurrency regulation. And indeed, in March of 2015, the government announced the intention to regulate digital currency exchanges in the UK with an eye towards supporting innovation and preventing crime. In issuing a call for information, the government sought to gain insight as to the current and potential barriers to entry digital currency businesses face, and whether governmental intervention is needed to counter these obstacles.
The government set out a list of questions concerning both the potential benefits and risks of digital currencies which were answered by members of the public, the summary of which can be seen here.
It was further stated that the government would seek to apply AML regulation to the digital currency market early in the next parliament, which should serve to knock down the current barriers to bitcoin exchanges establishing local banking partnerships.
EU Bitcoin Regulation
The EU is currently working on determining an appropriate regulatory response to bitcoin. The latest major movement towards this goal was the European Bank Authority’s (EBA) nonbinding July 2014 report entitled “EBA Opinion on Virtual Currencies’” (VC), which seeks to answer the question “can or should virtual currency be regulated?” and is meant to serve as a guide to European lawmakers.
In short, their recommendation is that in the near term exchanges should be responsible for enforcing anti-money laundering and terrorist financing requirements, and financial institutions should avoid working with bitcoin. In the long term, they see the need for a comprehensive set of regulations outlining client fund and capital reserve management, which seems a very reasonable demand. However, they also recommended that virtual currencies themselves be placed under the governance of a “scheme governing authority”. This, of of course, neglects a fundamental aspect of bitcoin and other currencies which are decentralized and have no governing authority by definition.
Below we outline what is an extremely interesting opinion.
The EBA first runs through the benefits of virtual currencies. Some – reduced transaction costs and faster transactions for instance – are termed less relevant in the EU, where the SEPA system encourages greater speed and efficiency of currency transfer. The avoidance of chargebacks is also acknowledged, but the flipside is also stressed; the irrevocability of transactions can lead to erosion of consumer protection from fraudulent merchants.
However, the EBA does acknowledge others, such as: greater financial inclusion to the disenfranchised; micropayments; contribution to new forms of economic growth; and protection against identity theft. Interestingly, another benefit cited, the protection against government devaluation of currency, raises the opposing argument, namely that VCs are not automatically a superior alternative, given characteristically extreme volatility.
The ECB goes on to flag 70 different risks associated with VCs. While we will not list all of them here, they are separated into the categories below, with representative examples:
Risks to users (33). Users are the buyers and sellers of VC. Risks range from fraudulent/insolvent exchanges (Mt. Gox example) to exchange rate fluctuations resulting in heavy losses.
Risks to non-users market participants (11). Non-user market participants include exchanges, platforms, wallet providers and merchants. Risks range from exchanges being unable to fulfill their payment obligations, to merchants not receiving payments due to “double-spending” to wallet or exchange operators “losing e-wallets”.
Risks to financial integrity (14). These risks include terror financing and money laundering. Anonymity and no need for intermediaries allows for trafficking in illegal commodities; criminals can extort anonymously; and VC can be utilized to avoid taxation or sanction.
Risks to fiat currency payment systems (4). Risks cited range from disruptions and economic loss in the financial markets due to VC assets blocked, to contracts based on VC deemed illegal which can impact payment service providers.
Risks to regulatory authorities (8). Risks range from VCs undermining the viability of regulated financial institutions, to incentive, because of lower compliance costs, for market participation in the VC markets as opposed to the mainstream fiat market.
The ECB then outlines two regulatory approaches. A long term approach would require substantial regulation including: governance for the management of user funds; capital/reserve requirements; and most crucially, the creation of “‘scheme governing authorities’ that are accountable for the integrity of a VC scheme and its key components, including its protocol and central ledger.”
In the short term, the EBA recommends having supervisory authorities discourage payment and e-money institutions from buying, selling or holding VCs. Furthermore, exchanges should be designated as ‘obliged entities’, subject to anti-money laundering and counter terrorist financing requirements.