Thursday, February 27, 2014

Mount Gox tumbles off the learning-curve

This week, Mount Gox, a very large provider of bitcoin services, couldn't live up any more to its services agreements with bitcoin users. It provided exchange and storage services for bitcoins, but due to a technical implementation flaw, the bitcoin holdings of users were compromised. Essentially it wasn't clear who really owned the bitcoins. The website went black and users can no longer claim their bitcoins.

Tumbling off the learning curve
I view the failure of Mt Gox as a logical consequence of the learning curve that bitcoin holders and bitcoin companies face. The bitcoin, although considered decentralized, is just as centralised a system as any other value transfer mechanism. However, for ideological reasons, the developers chose to only describe the technical heart of the system (the algorithm) leaving the rest up to the market.

This open source code approach has some advantages, among which a very speedy development of applications. Yet, we are for some time now witnessing what it means if systems lack a central authority or scheme manager. There is no entity taking responsibility and chasing users or companies because they don't abide by:
- usage conditions (demanding user identification),
- security requirements and certification of tools,
- specific legal frameworks.

As a result we have seen a whole community of interested companies and users climbing up the payments, banking, investments and monetary learning curve. The inevitable consequence is that those who do not get it right, will pay a price, while the others continue to learn. Due to the digital nature of bitcoin, these developments unfold rapidly, allowing us a compressed overview of lessons from financial history.

Frijda's theory of money (1914)
The essential lesson at stake is that the usage of any value transfer mechanism does not just rest on its acceptance by users, but just as well on the rules and regulations that underly the value transfer. In 1914, the Dutch lawyer Frijda analysed this topic in his dissertation on the theory of money. At that time discussions emerged on the nature of banknotes. Did they have value because they were exchangeable for bullion, because they were defined as legal tender or because the public used and accepted it?

Frijda pointed out that the underlying legal framework that safeguards property in a society constitute a necessary precondition for the use of payment instruments. Without such safeguards, people will tend to stick to other stores of value rather than attaching value to local bank notes. Until today this effect is clearly visible: consumers tend to hold and use foreign cash or commodities if they live in country with a lot of curruption, a weak system of justice and an instable monetary climate.

Trust is built by institutions and markets
What makes money tick is a solid institutional basis, upon which trust can be further developed. The latter part can be done by a combination of regulation (supervision) and self-regulation (market action). Which brings us back to the Mt Gox case.

Following the events of this week, a statement was released by the bitcoin companies Coinbase, Kraken, BitStamp, Circle, and BTC China. The industry leaders committ to safeguarding the assets of customers, to applying strong security measures, to using independent auditors to ensure integrity of their systems and to have adequate balance sheets and reserves to be able to ensure continuity.

In sum we can now see both a gradual development of both the institutional framework for virtual currencies and the market-driven self-regulation. This reflects the fact that - whether you like it or not - trust for financial services is always built on institutions, regulations and self-regulation.

Wednesday, February 19, 2014

The bitlicense: current state of thinking in New York

A week ago, the New America Foundation organised a meeting (Cryptocurrencies, the new coin of the realm) on the topic of virtual currencies and regulation in New York. Some news bulletins picked up on the meeting and the future New York Bitlicense regime. The good thing is that the New America Foundation has streamed the whole event, so it allows me (and you) to listen first hand to the speech by Benjamin M. Lawsky, Superintendent of Financial Services, New York State Department of Financial Services (DFS).

I will outline some of the highlights of his contribution below as I think that the New York discussion represents a good example of the issues at stake when it comes to regulation of Bitcoin. I expect to further touch on those issues in my contribution to the Bitcoin Pre-conference expert session of the EPCA-summit in Brussels (March 12-13).

Open source code currencies and open source code regulation
In his speech, Lawsky outlines the current remit of the NY department of Financial Services. It acts as the supervisor for money transmission companies in New York. The DFS-starting point is therefore that in some instances dealing with virtual money may effectively constitute money transmission, which needs to be regulatred. This is similar to the approach in the FINcen guidance of one year ago.

The New York regulator chose to emulate the open source code approach of virtual currencies. And thus, Lawsky refers to the DFS-approach as 'open source code regulation': regulation based on a public exchange of thoughts, allowing the best insights to be used. Given their current remit, the main idea is to see where the money transmitter rules need to change in order to suit the nature of virtual currencies.

As for the further process in 2014, Lawsky explained that the DFS will move towards further regulation this year and will most likely hold a  market consultation for the proposed regulatory framework for companies that want a so-called 'bit-license.'

What will the bitlicense be like?
When listening to the speech, my impression is that the core fundamentals of the bitlicense will be:
- very strong customer disclosure, requiring companies to outline that transactions are irreversible and that the digital currency may be very volatile,
- a strict adherence to know-your-customer requirements, essentially demanding that anti-money laundering rules are adhered to,
- a robustness/capital requirement, ensuring that the company will be able to withstand some of the market shocks that may occur when dealing with volatile digital currencies/commodities,
- safety and soundness requirements, ensuring a certain quality of operations and consumer protection.

As for the nature of capital and collateral requirements, the DFS is still wrestling with the concept of virtual currencies. This has to do with the angle and object of regulation. While it is easy to require capital safeguards for banks that deal with attracting and lending money, this is harder to apply for companies that issue, distribute or redeem virtual currencies.

Similar questions arise when defining the scope of transaction monitoring. Should only the purchase and redeem-transactions be subject to rules or does the supervision extend to a full transaction logging of all transactions with the virtual currency? Should those transactions be in a public ledger and to which extend can they be anonimized?

Step-up regulatory approach with a safe harbour
Although the DFS is still contemplating its exact licensing regime, I expect it to also contain a safe harbour provision. This would allow companies that comply with customer disclosure and know-your-customer rules, to continue to operate, while further obtaining the full bitlicense. Such a regime would assist in lowering the barriers for virtual currency platforms/traders/exchanges and create an easy entry towards the proper regulatory regime.

Lawsky outlined that the regulator prefers companies to be in his state and regulated, rather than driven off-shore. A safe harbour rule helps achieve that and fits a model where a light-weight, low-barrier entry model is developed to prevent legitimate providers from leaving the jurisdiction, while creating a sufficient barrier for the illegitimate players in the market. This is also a realistic approach considering the alternative channels for illegitimate behaviour: cash and banks. In the words of Lawsky:
Let's be frank: a lot more money has been laundered through banks than through virtual currencies'
Boldly go where no man has gone before?
I commend the DFS for their open minded approach to the topic of regulation of virtual currencies. I do disagree however with one of the remarks of the Superintendent. He outlined that regulators are in new and unchartered waters when it comes to virtual currencies.

I don't think they are.

Since day and age, people have used all kinds of symbols, coins and means of representation of goods that worked fine for transferring ownership of property. We created a number of laws and institutions to ensure these property rights and a fair treatment of parties to certain contracts. In doing so we were able to move from coins to paper-based money to deposit accounts. At the same time we created digital representations of shares, bonds, IOUs and agreed that ledgers at private companies and government institutions could officially represent a claim on goods, services, bits of land, anything.

Then, when it comes to new forms of money, we also have recent experience. In the late 1990s we witnessed a very similar type of discussion on bank supervision and specialised supervision regimes for new forms of 'electronic-money' as it was called in those days. It took some time and deliberation to get to grips with pre-paid digital representations of fiat-currencies, but we found our way in the end.

The challenge: finding the right regulatory framework
The true challenge is to first consider the fundamental nature of virtual currencies and then determine the appropriate regulatory framework. In essence, the DFS is doing the reverse as their starting point is their existing legal competence as supervisor of money transmitter businesses. While there is a lot of logic to it, it might be useful to reconsider alternative types of regulation that exist.

It's my hunch that perhaps an exchange/trade oriƫnted regulatory framework might make more sense as the basis for regulation, than the money transmitter framework. So that is what I will explore in my next blog.