This piece was kindly produced for The Cobden Centre by Sean F. Ennis and Gert Wehinger at the OECD as part of the The Cobden Centre’s guide to policy makers on blockchain.
Sean F. Ennis and Gert Wehinger, OECD
Both authors are Senior Economists in the Directorate of Financial and Enterprise Affairs of the Organisation for Economic Co-operation and Development (OECD). This article is based on a statement that one of the authors prepared for a Hearing of the Economic Committee of the European Parliament, held on 25 January 2016. The author is grateful for comments received but is solely responsible for any remaining errors. The paper draws extensively on Blundell-Wignall (2014). The opinions expressed and arguments employed herein do not necessarily reflect the official views of the OECD or of the governments of its member countries.
Virtual currencies, sometimes called cryptocurrencies, are stores of value that can be traded between users. While the best known such currency is Bitcoin, there are more than a hundred others. In 2015, the ECB has estimated the combined value of virtual currencies around the world as about EUR 3.3 bn, while Bohme et al. (2015) estimated USD 3.5 bn, which has grown to USD 16.9bn as of March 2017 for Bitcoin alone. In short, they represent a very small portion of existing money, even though they are growing fast, with U.S. money supply (M1) being USD 3.3tn at the end of 2016.
Trades of the currencies currently occur largely over currency “exchanges” on the internet, not only for speculative reasons but often with the exchange of virtual currency used as a payment for goods and services. The distinguishing features of virtual currencies are that:
- they have limited issuance (and often specific means of extending the amount of currency available);
- they use digital technologies for securing the transactions that:
- on the one hand, provide public confirmation of the ownership of each coin keeping track of at least part of the history of ownership (in a “block chain”), to ensure that one unit of virtual currency cannot be sold multiple times by one owner and is that owner’s legitimate property.
- on the other do not necessarily identify the trader’s full identity publicly (“pseudanimity”).
Unlike currencies issued by central banks, virtual currencies are not backed by the full faith and credit of a monetary authority, nor are they governed by a regulation that, for example, mandates their acceptance as a means of exchange or restricts private issuance. However, as long as the expectation of a purchaser is that others will accept the virtual currency as a store of value, they may be willing to purchase it.
The existence of non-governmental stores of value or mediums of exchange is not new, but these have normally restricted use, such as frequent flyer miles or store vouchers. One major difference between these and virtual currencies is the ease with which the virtual currencies can be transformed back into legal tender currency, mainly, but not exclusively, through a number of exchanges and trading platforms that perform this conversion.
Virtual currencies tend to be more portable (e-wallet) and more secure than paper currency, and they tend to have lower transaction costs than traditional card payments or bank transfers, especially cross-border. Virtual currency owners can make money both from the float and from issuing initial currency to themselves.
As a result of the apparent anonymity of transactions, it seems that virtual currencies gained special attraction for those involved in improper and illegal activities, including money laundering and transfer of value for illegal goods. As a result, certain governments have sought to take measures that effectively rule out its use as a currency. It is important, though, to recognise virtual currencies’ potentially beneficial role.
In addition to the private benefits from use of the virtual currencies, beneficial roles can include:
- Serving as an alternative means of exchange and store of value to a central bank currency, which can lay the basis for continued economic activity even in the presence of a currency crisis, such as one arising from hyper-inflation or other extreme events;
- Permitting potentially low cost direct transfer of value between two parties within a country, with transaction costs being much lower than for electronic card systems that involve trusted third parties to facilitate the transaction;
- Permitting quick transfer of value across borders that can avoid high commission rates for traditional currency transactions.
2.0 Regulatory challenges
Virtual currencies have at the same time raised a number of questions that policymakers are still grappling with, sometimes with consequences that appear to treat virtual currencies in inconsistent ways. Due to the potentially beneficial pro-competitive impacts of virtual currencies, it is important to ensure that government actions do not disable the creation of valuable financial innovations and that such actions are internationally consistent, cross-domain consistent and focused on the real problems. It would be valuable for governments and legislators to lay the appropriate legal and regulatory framework that will enable the creation and operation such currencies and instill confidence in the future viability of such currencies, without endorsing one over the other. National regulatory treatment may handicap the emergence of virtual currencies before they have had a chance to prove themselves, and internationally different approaches to regulatory treatment may impede consumers to benefit from cross-border operation of such currencies. As with other domains of regulation, it is important that regulations respond to a market failure or other policy imperative, that the regulations actually resolve the problem and that they do so in a minimally invasive way while addressing financial stability and consumer protection concerns. However, a number of concerns about risks of virtual currencies may be somewhat exaggerated.
2.1 Risks from virtual currency: some risks are real, others may be exaggerated
Risks from using virtual currency are real. While transactions in these currencies are supposedly tamper-free, exchanges may be breached, with resultant theft of virtual currency. If people lose their assets, there may be a perceived failure of consumer protection. The Mt. Gox episode is a clear demonstration of risks. Problems also arise from the immutability of the Blockchain, if transactions made by error or in a fraudulent manner cannot be cancelled or reverted. For virtual currencies to succeed and grow, rules will be needed that “provide clear guidelines on registration and know-your-customer rules.”
The focus on virtual currencies as a means of fraudulent transactions is perhaps due to its position for certain illegal and illicit transactions and thus a perceived high frequency of improper motives behind use of virtual currencies, which in turn is a result of the apparent anonymity built into the system. While cash is likely a much more anonymous means of transferring value than virtual currencies, virtual currencies like Bitcoin lower transaction cost and allow a relatively costless scaling up of a transaction, saving transport and security costs. The ownership string for virtual currency is public, though not the actual owner name and address. If that name and address are at one point identified by law enforcers, law enforcers have a powerful mechanism to track entire chains of transfer of value, in a way that cash would never allow. The arguments used against virtual currency anonymity may thus be much weaker than comparable arguments against cash. Regulators may therefore explicitly support the creation of virtual currencies, especially those that are more traceable.
Governments may be particularly anxious to ensure that virtual currencies do not supplant the currencies they issue, as the worry has been expressed that if virtual currencies substantially supplanted cash, central bank ability to conduct monetary policy might be placed at risk and the seigniorage from issuing currency could be reduced. However, Blundell-Wignall (2014) argues that virtual currencies cannot undermine the ability of central banks to conduct monetary policy, as long as taxes are paid in legal tender which, in turn, requires that banks “be able to clear with the government’s bank, most the central bank.” Moreover, supplanting does not currently appear to be a real risk, as outstanding amounts are relatively small the level of public trust in virtual currencies is limited. Nonetheless, to the extent a regulator is selected for virtual currencies in the future, there is an open question as to whether central banks should be given the role to regulate virtual currency, or whether other bodies with a less direct financial interest in the regulatory outcome may be more appropriate. While central banks and finance ministries may have an interest to maintain seigniorage, they also may have a counterbalancing strong experience with oversight of currency. Indeed, some central banks are looking into possibilities of issuing virtual currencies themselves. While some argue that improve the efficiency of the retail payment system, from an innovation perspective this could have a stifling effect.
2.2 Legal clarity needed
The case law on virtual currencies is still developing and there is unclarity, in some respects, about what regulatory treatment would apply to virtual currencies. Virtual currencies bear similarities to money, commodities and securities, which can make the appropriate regulation unclear. Bilateral contracts may not necessarily provide all the protections needed to users; the quality of protection in such contracts may depend largely on the overall legal framework for redress and compensation. Providing a ‘regulatory umbrella’ for virtual currency operators and engaging in certain regulatory enforcement actions could enhance the confidence of users and other financial actors in virtual currencies. Specific legal questions may need to be addressed in conjunction with experts in the virtual currency area. Three particular topics that may need to be addressed are the legal obligations of service providers to owners (exchanges, for example) notably in case of allegedly improper transactions, the extent to which legal title is guaranteed to pass with the delivery of a virtual currency unit (finality of transaction), and the extent to which virtual currencies can be used as collateral, including what happens in case of insolvency by the entity that has put up the collateral. It may also be worth establishing rules that clarify the legal treatment accorded to one or more entities acting in concert to take over the computing power that influence the decisions of what constitutes legitimate transactions or to change the rules of a network.
2.3 Different policy domains: worth seeking consistent treatment
Different policy domains are, at times, treating virtual currencies in inconsistent ways. Within a government, treatment should be uniform, but some cross-border consistency of virtual currency regulation may be warranted to avoid regulatory and tax arbitrage and address risks related to money laundering and financing of terrorism. As it stands, regulatory treatment still differs. For example, as discussed in Blundell-Wignall (2014), some countries are treating Bitcoin as a “commodity”, such as the Canada Revenue Agency that “issued a news release which states that gains from trading a digital currency would be considered taxable income or capital for the taxpayer. The United States Internal Revenue Service has taken a similar position for tax purposes. In other words, the position is that Bitcoin is not a currency, with valuation for tax purposes being whatever the value of Bitcoin is on the date of payment or receipt.” If competition from virtual currencies is encouraged, a clear identification of virtual currencies as currencies would be needed. The UK has taken a position on virtual currencies that exempts them from VAT, thus treating them, in and of themselves, as currencies and not as goods or services. At the same time, the UK is requiring that virtual currencies provide mechanisms to prevent money laundering. According to a 4 August 2015 article, the Australian Senate was expected to announce that cryptocurrencies will be treated as currencies in Australia.
On the other hand, other agencies are giving Bitcoins different treatment. The fact that identities of account holders are not immediately visible makes money laundering a concern. “The Financial Crimes Enforcement Network (FinCen) of the US Treasury determined in March 2013 the circumstances under which Bitcoins would come within the Bank Secrecy Act. They have guided that Bitcoins are ‘convertible virtual currencies’ and should be treated like a currency for the purposes of US anti-money laundering laws in the cases where Bitcoin money service providers can be classified as ‘money transmitters’ (where Federal and State registration, recording, reporting and ‘know your customer’ rules come into play).”
The challenge of determining the appropriate tax status of virtual currencies remains to be settled in the future. Presumably, though, a uniform government position on whether virtual currencies are to be treated as currencies or not would ensure a coherent cross-government approach to such regulations.
As decisions taken on regulation can have a profound impact on the spread of innovative products, a key challenge that arises in all these areas is how to ensure consumer protection is maintained for new products and business models, particularly when new products are not adequately covered or regulated by existing rules. In addition, for financial products and services, financial stability concerns may arise. A risk is that one bad event, such as a movement of funds by virtual currencies, could lead to an over-handed and over-restrictive government response, when many other alternatives for badly-intentioned transacters will still exist.
Key factors to consider for consumer protection will include:
- What mechanisms exist for building consumer trust?
- What responsibilities are held by platforms?
- What responsibilities are held by platform users?
Another key challenge is how, and to what extent, should rules intended to pursue the broad public interest, such as know-your-customer rules, be interpreted for new products, especially to the extent that such rules, if interpreted at the strictest level, could potentially yield market power to established financial industry companies, excluding competitors and restricting options of consumers.
As governments face the challenge of producing regulations for innovative financial products, they may be called upon to determine whether to pursue a level playing field for new products or whether, even, to consider giving such products a better playing field, to the extent that they may be disadvantaged in competing with to existing products. While such proportionality in regulation has to be balanced against concerns over consumer protection and financial stability, it would support innovation and enhance consumer choice.
Blundell-Wignall, Adrian (2014) “The Bitcoin Question: Currency versus Trust-less Transfer Technolgoy”, OECD Working Papers on Finance, Insurance and Private Pensions, No. 37, OECD Publishing. http://dx.doi.org/10.1787/5jz2pwjd9t20-en.
Böhme, Rainer, Nicolas Christin, Benjamin Edelman, and Tyler Moore (2015) “Bitcoin: Economics, Technology, and Governance” Journal of Economic Perspectives, vol. 29(2) (Spring): 213-238
Briere, Marie and Oosterlinck, Kim and Szafarz, Ariane, Virtual Currency, Tangible Return: Portfolio Diversification with Bitcoins (September 12, 2013). Available at SSRN: https://ssrn.com/abstract=2324780. or http://dx.doi.org/10.2139/ssrn.2324780
Broadbent, Ben (2106), Central banks and digital currencies, Speech given at the London School of Economics, 2 March; available at http://www.bankofengland.co.uk/publications/Pages/speeches/2016/886.aspx.
European Central Bank (2012) “Virtual currency schemes” ECB report, October.
European Central Bank (2015) “Virtual currency schemes – a further analysis” ECB report, February.
FATF – Financial Action Task Force (2015), Guidance for a Risk-based Approach to Virtual Currencies, FATF/OECD report (June); available at http://www.fatf-gafi.org/media/fatf/documents/reports/Guidance-RBA-Virtual-Currencies.pdf.
Financial Markets Law Committee (2016) “Issues of Legal Uncertainty Arising in the Context of Virtual Currencies”
Fung, Ben S. C. and Hanna Halaburda (2016), “Central Bank Digital Currencies: A Framework for Assessing Why and How”, Bank of Canada Staff Discussion Paper 2016-22 (November 2016); available at http://www.bankofcanada.ca/wp-content/uploads/2016/11/sdp2016-22.pdf.
Gandal, Neil and Halaburda, Hanna (2014) “Competition in the cryptocurrency market,” Bank of Canada Working Paper 2014-33.
Makin, Paul (2010), “Regulatory Issues around Mobile Banking”, in OECD, ICTs for Development: Improving Policy Coherence, OECD Publishing. http://dx.doi.org/10.1787/9789264077409-7-en.
OECD (2015) “Hearing on disruptive innovation” DAF/COMP(2015)3, available at http://www.oecd.org/officialdocuments/publicdisplaydocumentpdf/?cote=DAF/COMP%282015%293&docLanguage=En.
Powell, Jerome H. (2017), Innovation, Technology, and the Payments System, Speech by Governor Jerome H. Powell at Blockchain: The Future of Finance and Capital Markets?, The Yale Law School Center for the Study of Corporate Law, New Haven, Connecticut , March 3, 2017; available at https://www.federalreserve.gov/newsevents/speech/powell20170303a.htm.
 European Central Bank (2015) “Virtual currency schemes – a further analysis” ECB report (February) defines a virtual currency as “a digital representation of value, not used by a central bank, credit institution or e-money institution, which is some circumstances, can be used as an alternative to money.”
 Gandal, Neil and Halaburda, Hanna (2014) “Competition in the cryptocurrency market,” Bank of Canada Working Paper 2014-33 suggest that competition in the digital currency market will not result in a winner-take-all phenomenon (with one digital currency crowding out all others), despite the existence of strong network effects for an initially successful digital currency. While there may initially be strong network effects favouring one currency, these effects ultimately weaken as the currency’s role as a financial asset (vs. means of exchange) becomes more important.
 See http://coinmarketcap.com/currencies/bitcoin/#charts, accessed on 29 March, 2017.
 See e.g. Briere et al. (2013).
 See, for example, ECB (2015) for an overview of the different responses to virtual currency schemes by national authorities across the EU.
 At the Tokyo-based Mt Gox, once the dominant platform for trading and storing Bitcoin, about USD 480m in Bitcoin went missing due to hacking activities that had started in June 2011; Mt. Gox filed for bankruptcy and was liquidated in 2014. Some have argued that the Mt.Gox heist was useful in helping to raise risk awareness and improve Bitcoin’s security features.
 See Blundell-Wignall (2014), p. 11. Note that know-your-customer rules require that financial institutions are satisfied that customers transacting with them are truly the people they say they are.
 Seigniorage is the value earned by institutions that issue currency. It is a powerful generator of revenue, particularly in jurisdictions in which foreign users rely on the currency not only for transactions but also as a (longer-term) store of value.
 European Central Bank (2012) “Virtual currency schemes” ECB report (October) states that virtual currency schemes “do indeed fall within central banks’ responsibility as a result of characteristics shared with payment systems, which give rise to the need for at least an examination of development and the provision of an initial assessment.” The issue of jurisdiction for de-centralised currencies operating independently of state control could require international cooperation (p.42).
 See, e.g., Broadbent (2016), and Fung and Halaburda (2016).
 Fed Governor Powell remarked that “I would expect private-sector systems to be more forward leaning than central banks in providing new features to the public through faster payments systems as they compete to attract retail customers. A central bank issued digital currency would compete with these and other innovative private-sector products and may stifle innovation over the long run.” (Powell, 2017).
 See Financial Market Law Committee (2016) for further suggestions and details specific to UK law.
 See the guidance by FATF (2015) that intends to help national authorities develop regulatory and legal responses to address the ML/TF risk of virtual currency payment products and services.
 Accessed 5 August, 2015. http://www.ibtimes.co.uk/bitcoin-deemed-regular-currency-by-australian-senate-committee-1514009.
 In January 2014 it was further clarified that individuals and companies obtaining Bitcoins for their own use, or as investments, does not constitute being a money transmitter under the Bank Secrecy Act.