The long arm of the law

When asked to explain Bitcoin during an appearance on the UK’s state-run broadcaster the BBC in November 2013 financial commentator and former trader Max Keiser described it as “an electronic currency that’s used exactly like money except it’s not backed by any state, so you have no state interference and they [the state] can’t print it”. This independence of Bitcoin and other crypto or virtual currencies has been of particular appeal to those who feel that the value of fiat currencies has been seriously degraded by quantitative easing programs around the world.

The founder of Bitcoin, Satoshi Nakamoto, described Bitcoin in a paper published in November 2008 as a “purely peer to peer version of electronic cash [that] would allow online payments to be sent directly from one party to another without going through a financial institution”. Bitcoins are digital coins that can be sent through the internet, transferred person to person, can be used in all countries and accounts cannot be frozen. The coins are generated over the internet using open source software called a Bitcoin miner. Coins are stored in a digital wallet and when they are transferred, an electronic signature is added. The transaction is verified by a miner and permanently and anonymously stored in the network. Currency exchanges have been set up to enable Bitcoin owners to exchange the coins for USD, euros and other currencies.

As momentum has built behind digital currencies, governments have begun to take notice and the idea of no state interference in currencies is being tested. In his 2013 report, Managing Digital Payments Risk: A Regulatory Perspective, Zilvinas Bareisis of research firm Celent says even in markets with well-developed regulatory frameworks, gaps and ambiguities exist in digital payments regulation.

“Significant variation exists between countries in terms of the presence of legislation and regulation targeted at digital banking and payments,” wrote Bareisis. “In most developed markets, the regulations governing traditional electronic payments are well established, despite being patchy in places and having evolved over time.”

With new payments systems entrants and mechanisms, risks are becoming more complex to manage, he argued. Any payments regulatory framework must contain specific regulations aimed at achieving three fundamental objectives across traditional and digital payments:

• Protect the transacting parties, particularly the most vulnerable party;
• Promote a vibrant payments ecosystem by ensuring the health of individual payment providers via prudential regulation and reporting requirements and by focusing on market efficiency; and
• Safeguard broader societal interests, which acknowledges that payments do not operate in a vacuum.

Bareisis differentiated between traditional payments and digital payments. The traditional payments include cash, cheques and electronic payments such as credit cards, debit cards linked to a bank account, open-loop prepaid cards and electronic bank transfers (debit and credit). The associated risk management practices and regulatory landscape are well established for these payments.

Digital payments, he says, are more difficult to define “as hundreds of offerings have been developed around the world, all aiming to address a gap in existing payments solutions or use a new technology”.

To help make sense of these offerings – and to help regulators form policy – Celent has developed a taxonomy that places digital payments into five categories. These five categories are seen through a risk management and regulatory lens, which is different from how marketing or technology professionals would see them. So while a marketing executive may consider mobile payments as a single category, from a risk management and regulatory perspective such payments could fall into several distinct categories depending on the nature of a bank’s involvement, the source of funds, who manages the underlying account and whether the transaction is charged directly to a customer’s mobile phone bill.

The categories are:

• Traditional payment facilitation;
• Non-bank stored value accounts;
• Virtual currencies;
• Mobile billing; and
• Credit facilitation.

Celent argues that the proposed taxonomy enables the banks and regulators to categorise new payment offerings based on the key characteristics and rapidly determine the most critical risk management and regulatory implications. As a result, it will help banks and regulators around the world navigate the complexities of new payment offerings and improve their ability to keep payments regulations up to speed with the market innovations, states the report.

The taxonomy explains the key characteristics of each of the categories, names examples and explains the regulatory implications of the category. For example, virtual currencies such as Bitcoin are described as growing fast and representing “the most challenging regulatory concerns, including potential implications on monetary policies”.

Virtual currencies are perhaps the “most alternative” of the categories. Many consumer protection laws do not apply to virtual currencies, or are ambiguous about them, because they may not be considered financial accounts. This category also raises conceptual questions about where the boundary of financial regulation resides or ought to reside.

On one hand, virtual currencies can be compared to other non-bank stored value accounts. Both require pre-loading of funds into a provider’s ecosystem. However, Bareisis contends that a crucial difference here is the currency exchange aspect. With non-bank stored value accounts, the funds remain denominated in a currency used by a country or group of countries. With virtual currencies, ‘real money’ is exchanged for ‘value tokens’ managed and supervised by a private entity. Distributed currencies, such as Bitcoin, which are not issued by a single entity, pose more complex regulatory questions.

“On the other hand, if we distinguish virtual currencies, should the category also include other value tokens, such as frequent flier miles, which arguably can also be exchanged for goods? We contend that the main difference between virtual currencies and miles or loyalty points is that consumers use their real money to actively buy a virtual currency, whereas they earn miles and other points as a consequence of purchasing real world goods,” states the report.

Since the Celent report was published, little has changed as financial regulators mull the impact of virtual currencies. Perhaps the most innovative approach, however, has emerged in Ecuador. In August, Associated Press (AP) reported that the country was planning to create “the world’s first digital currency issued by a central bank”. The electronic currency is scheduled to be issued from December, but little else is known about it other than that it will not be a crypto currency like Bitcoin.

“Instead of having a payment system based on physical species (bills or coins) that require logistics costs, we will leverage existing infrastructure and reduce transaction costs,” the deputy director of Banco Central del Ecuador, Gustavo Solorzano told AP.  “This is a money flow through the cellular network.”

Ecuador’s authorities say the currency is intended to meet the monetary needs of 2.8 million people in the poorest strata of the population, who are not in the formal economy, but nevertheless regularly use cell phones. The virtual currency will have a one to one parity with the dollar and initially will be used only on the mobile phone network but could be extended to other technology platforms.

Ecuador is an exception to the rule as in general, most countries’ regulators have issued warning notes to consumers and businesses about the risks involved in virtual currencies. Some countries have ‘banned’ them while others have imposed taxation regulations on them. But to date there is little in the way of consensus about how to treat virtual currencies.

In July 2014, the European Banking Authority (EBA) published An Opinion on ‘Virtual Currencies’, the quotation marks suggesting just how new-fangled the EBA considers virtual currencies to be. (The EBA is not the only organisation to do this, however.) The paper was a follow-up to the Authority’s December 2013 warning to consumers that virtual currencies are not regulated and that therefore risks are unmitigated. The EBA identified more than 70 risks connected with virtual currencies including money laundering and other financial crimes. In the opinion paper the EBA addresses the question of virtual currency regulation.

The EBA found numerous causal drivers for these risks, which it says should be addressed via legislation. These drivers included the fact that a virtual currency scheme can be created and then its function subsequently changed by anyone. Moreover, in the case of decentralised schemes, such as Bitcoins, changes can be made by anyone with a sufficient share of computational power. The EBA was also troubled by the fact that payer and payee can remain anonymous and that virtual currency schemes do not respect jurisdictional boundaries and may therefore undermine financial sanctions and seizure of assets. “A regulatory approach that addresses these drivers comprehensively would require a substantial body of regulation, some components of which are untested,” the paper states. “It would need to comprise, amongst other elements, governance requirements for several market participants, the segregation of client accounts, capital requirements and, crucially, the creation of ‘scheme governing authorities’ that are accountable for the integrity of a virtual currency scheme and its key components, including its protocol and transaction ledger.”

This is very far from the original intent of virtual currencies. As an immediate response, the EBA recommended that national supervisory authorities discourage credit institutions, payment institutions and e-money institutions from buying, holding or selling virtual currencies. The EBA also recommended that EU legislators consider declaring market participants at the direct interface between conventional and virtual currencies, such as virtual currency exchanges, to become ‘obliged entities’ under the EU Anti-Money Laundering Directive and thus subject to its anti-money laundering (AML) and counter terrorist financing requirements (CTF).

This immediate response, argues the EBA will ‘shield’ regulated financial services from virtual currency schemes and will mitigate those risks that arise from the interaction between the schemes and regulated financial services. It would not mitigate those risks that arise within, or between, the virtual schemes themselves. Other things being equal, says the EBA, this immediate response will allow virtual schemes to innovate and develop outside of the financial services sector, including the development of solutions that would satisfy regulatory demands. The immediate response would also still allow financial institutions to maintain, for example, a current account relationship with businesses active in the field of virtual currencies.

In February 2014, Brazil’s central bank set out its thoughts on virtual currencies in a policy statement on the risks related to the acquisition of virtual or encrypted currencies and to the transactions carried out with such currencies.

Banco Central do Brasil defined virtual and encrypted currencies as denominated in a different unit of account from the currencies issued by sovereign governments and are not stored in a device or electronic system in the national currency. Such currencies should not be confused with electronic money, it said, which is a resource stored in a device or electronic system that allows the user to make payment transactions in the national currency.

The Bank pointed out that the use of virtual currencies and whether the regulation applicable to financial and payments systems applies to them have been the theme of international debate and public announcements by monetary authorities and other public institutions, with few concrete conclusions thus far. The institutions and people who issue or act as financial intermediaries of the virtual currencies are not regulated nor supervised by any monetary authorities.

“Virtual currencies do not have guaranteed conversion to official currency, nor are they guaranteed by real assets of any nature. The conversion value of an asset known as a virtual currency to a currency issued by monetary authorities depends on the credibility and trust that the market agents have regarding its acceptability as a means of exchange, as well as their expectations regarding its appreciation,” says the statement. “Therefore, there is no government mechanism that guarantees the value in official currency of those instruments known as virtual currencies, which means that all the risk of their acceptance is left in the users’ hands.”

Due to the low volume of transactions, low acceptance as a means of exchange and lack of a clear perception about their reliability, the price variation of virtual currencies can be very wide and fast, leading even to total value loss, warns the Bank.

Like many financial regulators, Banco do Brasil expressed concern about the possibility that virtual currencies could be used in illicit activities. Even users that carry out transactions in good faith could be potentially involved in any investigations by law enforcement bodies.

The Bank concluded that while in Brazil the use of virtual currencies does not yet seem to offer risks to the national financial system, particularly to retail payment transactions, it is monitoring the evolution of the usage of these instruments, as well as the related discussions in international forums, particularly regarding their nature, ownership, and functioning, in order to possibly adopt measures in its sphere of legal competency, if necessary.

Australia’s Payments System Board investigated the policy implications of virtual currencies in a May 2013 meeting. An information paper prepared for the meeting made similar conclusions to those of Brazil, particularly in the view that virtual currencies had not yet been widely traded or adopted and therefore policy concerns were limited. The paper addressed Bitcoin as both an alternative to national currencies and as a payment system. As a payment system, Bitcoin appeared to involve an inefficient use of resources (in how transactions are confirmed), but had some benefits for users that encourage its use over more established payment systems (low fees, anonymity, speed, irrevocability). The system also had the potential to pose risks and concerns for policymakers.

Although the ‘international community’ had been considering Bitcoin’s regulatory status, said the paper, the focus had been on AML/CTF and consumer protection aspects instead of issues more typically associated with central banks. Australia’s AML agency, Austrac, has stated that digital currencies that are not backed either directly or indirectly by precious metal or bullion are not regulated by Australia’s AML/CTF Act. Virtual currency transactions are subject to goods and services, income, and capital gains taxes in Australia.

In Germany, the Finance Ministry has ruled that Bitcoin is a unit of account and therefore mining them is a form of money creation. Bitcoins and other virtual currencies will, like securities, be subject to capital gains tax on any profit unless they are held for more than a year.

In the US, the Commodity Futures Trading Commission recently approved the application of TeraExchange as a swap execution facility. TeraExchange has launched a swap based on Bitcoin and was the first such firm to receive approval from a US federal regulator. Additionally, the Internal Revenue Service ruled that virtual currency is treated as property for US federal tax purposes.

Some countries have banned virtual currencies. In Russia, virtual currencies are banned and entities that use or exchanges that trade in them will be subject to suspicion based on their potential use for money laundering or other activities. The Monetary Authority of Singapore also has concerns about criminal activities and has stated that it will regulate virtual currency intermediaries. The Central Bank of Bolivia has banned any currency or coins not issued or regulated by the government. A resolution stated that Bolivian citizens are prohibited from denominating prices in any currency that is not previously approved by its national institutions.

In China, financial institutions and third party payment providers are banned from accepting, using or selling virtual currencies. Use of virtual currencies by individuals, however, is not banned and the Peoples’ Bank of China governor, Zhou Xiachuan, was recently reported as saying that Bitcoin was more like an asset or collectible than a currency and therefore did not come under the remit of the central bank.

Indonesia’s authorities have stated that virtual currencies are not legal tender, and using them violates the country’s information and electronic transaction laws and currency laws.