The debate over cryptocurrencies has reached a cacophonous point. It is indeed common to come across statements such as "bitcoin has failed", "Bitcoin is the future", "bitcoin needs to be regulated" and "bitcoin needs to be regulated". All of the above mentioned different viewpoints show that there are yet many concerns being raised by cryptocurrencies as they continue to gain importance. Particularly, the fundamental question that remains relates to the legal classification of cryptocurrencies for regulatory purposes. Bitcoin, one of the most popular virtual currencies, has presented significant challenges to regulators. Lawmakers all around the world have been wondering whether the time to regulate Bitcoin has come. However, there has been caution not to hastily regulate Bitcoin and other cryptocurrencies as the implications in regards to their innovation, competition, and regulation have not been fully understood. This paper discusses bitcoins from a regulator's perspective. Despite Bitcoins being considered as the modern evolution of money, the aim of this paper is to answer the question of whether money can exist outside of the State and the law.
Digital revolution in banking
It would be true be assert that digital technologies are likely to be deployed in nearly all areas of the global economy. Today, we are seeing a new marriage of financial services and technology, mostly referred to as "FinTech". Being a contraction of the terms financial technology, Fintech is used to refer to technology-enabled financial solutions which have been constantly evolving first in the analogue context and then in the digital era. As we are going see later in this essay, this new wave of Fintech technological innovations has accelerated a number of changes in the financial sector. Mainly, the impact of Fintech to financial services and how regulation should respond to Fintech has been a main subject of discussion. Before we evaluate virtual currencies from a regulator’s perspective, it is important to discuss the digital revolution in banking.
The speed with which the digital economy has developed is distinctive. Mobile devices account for 25% of the web usage globally. As a matter of fact, the amount of data that has been digitized has unimaginably increased. The rapid data growth can be affiliated to the rapid decline in transmission, storing and analysis of data. Consequently, the extraordinary shift in mobility, storage, and data collection has led to the rise of social technology use. There is an extraordinary amount of human activity that is mobile-based. With almost seventy percent of internet users using social networking sites, the field of commerce and banking has also been transformed as customers are being able to undertake commercial activities quickly and flexibly. The financial sector is thus transforming rapidly. The combination of the social media, smartphone, applications and cloud computing has put immense power to financial sector consumers. The digitization of the commerce sector is not only limited to the distribution and retailing phenomena, commercial banks are adopting new technologies. Banking services, operations, and services have been automated.
The digital revolution of the banking sector has not come without challenges. Despite the impact of digital revolution being in the early stages, there are many questions that are continually being raised. With different countries adopting different approaches to internet-based services, it is indeed common for questions about the general regulation of the internet drawing the attention of leader, regulators, and lawmakers. It is, however, important to note that the early impacts of the financial system are slowly beginning to get clear. We will proceed to discuss some most standing observations related to the digital revolution of banking from a policy perspective.
There is the issue of new boundaries. While the boundaries of banking have never been properly articulated, activities that are difficult to regulate may have a potentially unseen profound bank system impact. The poorly understood innovation in the banking sector, in fact, has brought a challenge for the setting a standard perimeter for the financial system. Regulators have indeed been increasingly speaking on the need of regulating activities and not entities. The challenge of a standard regulation perimeter and how dynamic the supervision needs to be will likely continue as a wider range of entities are involved in banking activities. Businesses are continually extending from traditional operational arrangement becoming more global in nature. With the blurring of traditional and geographic boundaries, there has been a need for policymakers to rethink some regulation aspects. Though it may prove challenging new policy need to focus to the entrants of the financial sectors in order to protect the financial system. As a whole.
Another issue that has emerged with the digital revolution of the banking sector is the need to maintain confidence while protecting the privacy of the system. Before digitization of the financial sector, there was reliance on well-established players that were licensed and subject to prudent supervision and regulation. Digital technologies are however leading to rapid growth of those participating in the banking processes. With more sophisticated operations and customer usage, there has been an emergence of new risks. The confidentiality and the privacy of customers' personal and private data are critical issues of concern. Cybersecurity has been the greatest financial system security issue. Most of the attacks in the financial system have targeted private consumer data. While there have been efforts to increase the creation of defenses and encryption of data, attacks on the perimeter security are increasingly becoming sophisticated. The security of the financial sector extends beyond the security of the individual banks. Since banking activity has extended beyond banks, it is unclear that the security arrangements of individual banks will provide sufficient security for the system as a whole. With many businesses integrating e-commerce operations, failures in one element of the system has the potential to lead to the loss of confidence in the banking system as a whole. Consequently, there is a need for collaboration and high engagement of all banking sector's stakeholders to ensure that the financial system trust is not comprised.
Digital revolution has led to the advent of cryptocurrencies. Digital currencies have largely been a novelty. Despite the early attempts of building them having been deeply flawed, consumer's interest in the virtual currencies has grown rapidly. Bitcoin usage has particularly gained popularity over the recent years. While controlled currency can be controlled and is the key to the stability of the financial system, the introduction of a large number of unsupported currencies has been deemed as unwise. It is, however, important to understand what virtual currencies are before discussing the underlying risk that emanates from their usage.
Virtual currencies
Virtual currencies can be defined as a digital representation of value which has been issued by private developers. The digital currencies are denominated into their own account unit. Everything to do with storing, obtaining and transacting the digital currencies is electronic and they can indeed be used for a number of purposes as long as the transacting parties agree. The concept of digital currencies is however wide as it ranges from cryptocurrencies, mobile coupons, airline miles and even virtual currencies backed by gold assets. Virtual currencies differ from electronic money in that they have they have their own unit of account and are not denominated in terms of fiat currency. The digital currencies comprise two main key elements. There is the representation of value in digital form. As the currency is transferable between parties the virtual currencies also constitute of underlying settlement and payment mechanisms. There are different convertibility levels for virtual currencies. For the non-convertible virtual currencies, they operate exclusively within a virtual self-contained environment. For such non-convertible digital currencies, the exchange with any other form of currency is significantly restricted. Convertible virtual currencies also referred to as open schemes allow for the exchange with any other form of currency and even the payment for goods in real economy.
There are several ways through which virtual currency schemes can operate. These include centralized, decentralized and hybrid models. For the centralized models, operations are managed by a central party. For the hybrid schemes, the operations may be performed by a central authority or distributed to other stakeholders. Talking about decentralized virtual currency schemes, they use cryptography techniques to operate. In decentralized schemes or the cryptography moniker, there is no centrality in the administration system. The central party is replaced by internet protocols framework which governs the system operations and allow transactions' verification. As all the operations are performed through the system, the participants or the miners are rewarded in the minted virtual currency for payment processing functions commonly known as mining. Unlike the fiat currencies, cryptocurrencies do not represent a liability. The process of mining introduces newly minted digital currencies into the system while at the same enabling the decentralized operation of the system. The decentralized virtual currency schemes at times allow for the issuing of limited or unlimited currency units. For many cryptocurrencies including bitcoin, there is a limit to the number of currency units which can be issued. The majority of the cryptocurrencies are pseudo-anonymous. This means that while cryptocurrency operations are transparent and publicly recorded, they are more anonymous and cannot be traced to real-world identities. Decentralized virtual currencies are usually obtained through transaction validation processes. They are stored in digital wallet software which is associated with cryptographic keys.
Cryptocurrencies as a form of decentralized virtual currencies have challenged the concept of standard fiat currencies. For a long time in history, the value of fiat currencies has been backed by the government's and central bank's creditworthiness. Cryptocurrencies, on the other hand, derive their value from expectations that others would use them. The fact that they do not have backing from other sources have raised several questions considering the role of virtual currencies as money. The most common question relates to whether virtual currencies satisfy the legal definition of money. More so, other concerns relate to whether the digital currencies can fulfill all the economic roles of money.
It is true to assert that virtual currencies and most specifically the cryptocurrencies fall short of the legal concept of money. Despite there being no standard definition of money, it is important to note that the legal concept of currency is associated with a sovereign power establishing a central framework for issuing notes and coins from the bank. In a strict sense, the term currency is used to refer to a unit of account with which medium of exchange is denominated by reference to that unit. Currencies are subsequently given the status of legality under a legal framework of the state where the accepted operations and activities must fall within the relevant jurisdiction. The credibility and value of a sovereign currency are thus intrinsically linked with a state's ability to support the currency. Another important point to note about the concept of legal money is that it is dependent on the state's ability to regulate the monetary system. From a legal perspective, the concept of money extends beyond the concept of currency. As a matter of fact, it not only includes notes and coins from the bank but other types of assets which can easily be converted into currency. While the creation of money can be achieved by private parties, legality comes in by denomination in a currency as issued by a sovereign authority. Legal money should also be intended to serve as a medium of exchange generally accepted within a state.
Virtual currencies’ blockchain
A blockchain is a decentralized, digitized public ledger that was originally developed as Bitcoin's accounting method. Bitcoin is a new type of distributed ledger system which enables transactions to be validated and maintained in cryptography databases. Blockchain technology removes the need for trusted centralized authorities. With Bitcoin and other forms of cryptocurrencies receiving criticism especially due to regulatory concerns, the distributed public ledger behind Bitcoin-blockchain has also been said to be an innovation with potential to cause disruption to financial services. The distributed ledger database stores all time transactions which are replicated on all computers worldwide, thus eliminating instances of failure. The blockchain technology thus has the ability to provide the full history of every transaction that is associated with the use of particular units of digital currencies. The use of blockchain distributed ledger technology has the ability to reduce the time required to settle transactions. Distributed ledger technology can also significantly cut international transfer costs while enhancing transparency for the back office security dealers. While the blockchain concept can offer a number of advantages over the traditional system of banking, many big players of the banking sector remain skeptical. Critics of the emerging technology maintain that there are many barriers that prevent a blockchain-driven economy from becoming operational. The often-cited concern relates to the regulatory challenges of the existing virtual currencies’ blockchain distributed ledger systems.
Virtual currencies regulatory and policy challenges
As noted earlier, the potential for the rapid change engendered by virtual currencies in the financial sector has been a challenge for supervisors and the financial regulators. Digital currencies are still in their earlier stages of development and thus there is an absence of effective regulation. Despite the virtual currencies having potential benefits which include low processing and transaction costs, there are many unaddressed risks which digital currencies pose. The virtual currencies financial system risks are evident in different areas. The risks are most serious with respect to cryptocurrencies. A number of continuing concerns relate to financial integrity, tax evasion, and consumer protection. Further, the growing interest in a blockchain technology implementation dependent on the cryptocurrencies schemes raises more policy concerns. We will proceed on to evaluate some of the unique regulatory challenges that emanate from the use of virtual currencies.
First, a number of research findings show that regulators have experienced challenges in trying to define virtual currencies. The fact that virtual currencies combine many properties including those of currencies, payment systems and at times commodities have implications on their regulatory and legal treatment. The inconsistency of defining cryptocurrencies and other forms of digital currencies have led to confusion on how national and international agencies should regulate them. As a matter of fact, consistently classifying virtual currencies has proved a challenge as different authorities have classified them in their own policy priorities. The tax authority in the USA, for example, classifies virtual currencies as property. This is mainly for the purpose of federal taxation. FinCEN Treasury Department classifies virtual currencies for AML/CFT obligation purposes. Those two examples show how different jurisdictions are taking divergent approaches in trying to define digital currencies. Most jurisdictions have however avoided formal classification and instead focused on the nature and types of transactions conducted by the cryptocurrencies.
Another regulatory challenge with the virtual currencies is that they are difficult to monitor. The opaque nature of virtual currencies makes it not only to gather the information of those using them, monitoring their operations is also a challenge. Virtual currencies are designed to maintain the anonymity of their users as there is no tracking of any personal data. This is particularly the case of cryptocurrencies such as Bitcoin. In the process of Bitcoin mining, users can only claim ownership only by attaching a user identification key to the transaction they want to engage in. users will, therefore, generate new user keys every time they initiate a transaction. The keys are stored on the e-wallet and since they are stored forever, the user can trace their activities from the time they started transacting to the present date. The anonymous nature of Bitcoin's transaction processes is a great concern for the regulators. Cryptocurrency users are not required to provide any of their personal identifying information. Most of the existing cryptocurrency transactions are only able to track the approximate geographic location of the users. Bitcoin transfers indeed remain invisible to regulators until they are converted to legal currency. As there are no regulations that govern, monitor or report virtual transactions involving cryptocurrency operations, regulators have a chance to monitor the virtual currencies only at the entry point of the regulated currency market.
Asserting jurisdiction to a particular virtual currency or a scheme is further complicated in light of cross-border differences. The transnational reach of the virtual currencies has indeed proved a difficult challenge to solve mainly because cryptocurrencies operate in a virtual environment. While operating in an online environment, different states and countries have their own laws and regulation. National authorities thus find it difficult to enforce specific regulatory measures to cryptocurrencies. The issue of creation of uniform virtual currencies regulations is indeed complicated as some countries have adopted different jurisdiction measures. For example, some nationalities have come up with special licensing requirements for the virtual currencies. Others countries have regulations that define the extent to which anti-money laundering rules cover administrators and wallet services. Moreover, there are still national regulations that define the extent to which crypto-to-crypto exchange is differentiated to cryptography-fiat exchange. It is important to note that most of the aforementioned legislations cover virtual currency activities that are ambiguous or those which are subject to pending law changes. This creates a challenge in establishing regulations for virtual currencies.
Another regulatory challenge emanating from the use of cryptocurrencies is their decentralized nature. As explained earlier, one of the characteristics of cryptocurrencies is lack of a central intermediary role as in the traditional regulatory models. This eliminates a focal point of regulation and instead creates complication on who is supposed to regulate virtual currencies’ distributed ledger systems. As already noted, blockchain nodes can be located in any part of the world. The ability to cross jurisdiction boundaries indeed poses complex regulatory issues. It is indeed difficult to identify the most appropriate contractual rules to apply in a decentralized environment.
Conclusion
It would thus be true to assert though currency can exist in a virtual form, there are many complications with money existing outside of the State and law. The advent of information technology has prompted a number of advances in the financial industry. This has not only included digitizing some of the traditional banking processes, there has been a creation of virtual money often referred to as cryptocurrencies. With new entrants into the finance industry, the impact has profound. Some cryptocurrencies such Bitcoin are continually gaining popularity of use with some investors adopting the virtual currency as means of transaction. The advantage of use cryptocurrencies’ distributed ledger system is that it has introduced more security and efficiency in many financial processes. However, from a legal perspective, cryptocurrency operation is risky as it is volatile and lacks regulation. We have already looked at a number of critical regulatory issues arising from the use of cryptocurrency as legal money. The decentralization of Bitcoin and other forms of virtual currencies is indeed a serious threat to the financial economy stability.
Different responses have emerged to address cryptocurrencies regulatory risks. The responses vary greatly due to different countries' jurisdictions. Some countries have resorted to banning the use of virtual currencies. Other countries or states have decided to focus on the immediate risks posed by digital currencies by clarifying interpretations and amending interpretations of existing regulations. All of the aforementioned jurisdiction are informal and local. There are no formal regulations for the virtual currencies. The widespread of the use of digital currencies calls for a more comprehensive regulatory response.
Due to the volatile nature of the cryptocurrencies, regulation needs to be flexible to adapt to the evolving circumstances. A more viable solution to cryptocurrencies regulatory challenges, however, will need the collaboration of the financial industry stakeholders. There should be more international level involvement to try and achieve a consensus on the benefits, risks, and areas of future cooperation for the virtual currencies. There is a need for the development of international standards and best practices that provide guidance on the most relevant virtual currencies' regulatory responses. Such standards could articulate frameworks for coordination across different countries over the legality of cryptocurrencies thus promoting harmony.