Virtual currencies: a boon or scourge?

Last year, PCM delved into the world of virtual currencies, looking at how emerging (and

unregulated) methods like Bitcoin could impact the payments industry. In less than a year, the pace of activity has been breathtaking.

It seems that every week virtual currencies in all their forms are gathering momentum across the world, with more merchants in all sectors starting to accept them as valid of forms of payment, and in some cases, being used to buy real estate and other big-ticket purchases – writes Victoria Conroy, Editor Payments Cards and Mobile.

The appeal of virtual currencies lies in the fact that they can be used anonymously, leaving no trace, and carry little to non-existent transaction fees in some cases. Bitcoin is by far the most widely used virtual currency and although market cap estimates vary wildly, it is thought that Bitcoin currently has a total market cap of around $1 billion.

Virtual currency exchanges are springing up all over the world as users scramble to trade the currency online in much the same way as physical currencies and commodities are traded. And virtual currencies are also being incorporated into several consumer services as companies recognise the tangible interest in a form of payment that in most cases is anonymous to use and has no discernable transaction fees.

But there are mounting concerns over Bitcoin, given that it essentially operates as an autonomous network spanning thousands of computers across the world. There is no central organisation or hierarchy to answer to. And despite many Bitcoin exchanges being perfectly legal, the currency’s unregulated nature is now attracting rapidly mounting interest from central banks and regulators across the world.

Regulators start to pay attention

In July 2013, a Bitcoin exchange based in Thailand announced that the country’s central bank had effectively outlawed Bitcoin by declaring it illegal to buy and sell the virtual currency or use it to make purchases. The exchange claimed that it had spent several months registering with various Thai government agencies and was initially told by the Bank of Thailand that it did not need a money exchange licence because Bitcoin is not a currency.

However, the exchange subsequently announced that Bank of Thailand officials had concluded that Bitcoin would be made illegal, “due to lack of existing applicable laws, capital controls and the fact that Bitcoin straddles multiple financial facets.”

In the same month in the US, the Securities and Exchange Commission (SEC) charged a Texas man with running a Bitcoin Ponzi scheme that raked in 700,000 Bitcoins, worth $4.5 million at the time, from unwary investors. The SEC alleged that Trendon Shavers, who is the founder and operator of Bitcoin Savings and Trust (BTCST), promised investors up to 7% weekly interest based on BTCST’s Bitcoin market arbitrage activity, which supposedly included selling to individuals who wished to buy Bitcoin anonymously.

Shavers raised at least 700,000 Bitcoin in BTCST investments, which amounted to more than $4.5 million based on the average price of Bitcoin in 2011 and 2012 when the investments were offered and sold. Currently, the value of 700,000 Bitcoin exceeds $60 million.

Although the focus of the SEC’s investigation centred on allegedly fraudulent activity, it highlighted how regulators had been slow to catch up with the world of virtual currencies. All that changed in August of 2013, when a US federal judge ruled that Bitcoin was a valid form of money, paving the way for the legal case against Shavers to continue.

Shavers had argued that the case should be ditched because the SEC has no jurisdiction given that the Bitcoin investments he was offering were not securities because the crypto-currency is not money or subject to any regulations.

However, US Magistrate Judge Amos Mazzant rejected the claim, ruling that “it is clear that Bitcoin can be used as money” and “is a currency or form of money, and investors wishing to invest in BTCST provided an investment of money.”

This ruling could potentially have massive implications, not least because it conflicts with other US investigations into Bitcoin. An example of this is the US  Department of Homeland Security, which has served payments start-up Dwolla with a court order telling it to stop processing transactions linked to Bitcoin exchange MT. Gox.

On 14 August 2013, the New York State Department of Financial Services (DFS), which has already sent out subpoenas to 22 Bitcoin-related firms, confirmed that it is pondering new rules for virtual currencies.

The regulator warns that firms engaged in money transmission are already required to post collateral to safeguard customer money, as well as undergo periodic safety and soundness examinations to ensure compliance with money laundering laws. It added that new rules could also be introduced specifically aimed at virtual currencies, tailored to their “unique characteristics”, and designed to stop the area turning into a “virtual Wild West”.

Bitcoin groups push for self-regulation

The DFS highlights three areas of particular concern: ensuring payments are processed quickly to build user confidence that money will not “get stuck in a digital black hole”; ensuring virtual currencies do not become the tool of choice for terrorists, drug smugglers, illegal weapons dealers, money launderers, and human traffickers; and making sure that the use of Bitcoin as an investment is governed properly.

Additionally, the US Senate’s committee on homeland security has stepped up its interest in virtual currencies with the launch of an inquiry, and has written to Homeland Security secretary Janet Napolitano asking for details on her department’s policies and procedures relating to the likes of Bitcoin.

In the face of this regulatory surge, virtual currency firms are joining together to create self-regulatory organisations in a bid to work with governments and help shape future rules. The committee for the establishment of the Digital Asset Transfer Authority (Data) says it wants to promote the prudent, responsible development of emerging payment networks, establish common rules to protect users, and work as a liaison among businesses, customers and public officials.

Founding members of the committee include the CEOs of BitInstant, BitPay, Coinsetter, CoinX, Epiphyte, eToro, Hub Culture (Ven), OpenCoin, Payward, QikCoin, SnapSwap, Tradehill, Yoyocard and ZipZap.

Jon Matonis, executive director of the Bitcoin Foundation, said: “Self-regulatory organisations are excellent non-governmental solutions for industry best practices and the Bitcoin Foundation supports inclusive efforts to improve the quality of businesses engaged in exchanging Bitcoin.”

As PCM detailed in its feature on virtual currencies last year, the European Central Bank (ECB) has already conducted a study on the implications of virtual currencies. But according to Dr. Hugo Godschalk, managing director of the PaySys Consultancy, the ECB has failed to fully understand the nature of virtual currencies, which could confuse future regulatory efforts in this area.

“The ECB is not worried at the moment because the volume of virtual currencies is still low. Therefore it does not see them as a threat to financial stability. But the ECB notes that such virtual currencies could have a negative impact on the reputation of central banks,” Dr. Godschalk told PCM.

“Moreover, the ECB points out that the high degree of anonymity of virtual currencies poses a challenge to public authorities because virtual currencies could be used as means of payment for illegal activities and money laundering.

“Virtual currencies are not regulated per definition used by the ECB. Therefore electronic money, which is regulated in the EU since the first E-Money-Directive of 2000, cannot be a virtual currency. Analysing the impact of virtual currency schemes, a proper definition and categorisation between virtual money and e-money, which is compliant with EU-regulation, is crucial.

“It is remarkable to see that the ECB is using an outdated definition of e-money (of the invalid EMD I) which is not complying with the current e-money definition of the EMD II and the regulation within the EU. Second, no matter whether the EMD I (not relevant since 2009) is used or EMD II, the core characteristic of e-money has remained the same: issuance on receipt of funds (= prepaid). This implies that every virtual currency which is issued (not traded!) in exchange for traditional money is legally defined as e-money (if the other requirements are fulfilled too).

“Thus, the equation ‘virtual currency = unregulated’ applies only in special cases like Bitcoin. Otherwise, those currencies defined by the ECB as ‘virtual currencies’, which are issued via an inflow of traditional currency, are subject to e-money regulation in the EU! Linden Dollars or Liberty Reserve Dollars (both ‘prepaid’) would be subject to e-money-regulation if issued within the EU jurisdiction. All of these schemes would have to be redeemable at par. This is a regulatory requirement (Article 11 of EMD II) and cannot be part of a definition or a criterion for categorisation, as in the ECB report.

“Third, the report states that e-money is (in contrast to virtual currencies) always issued in units of account of existing legal tender currencies. This is also not correct. Regulated e-money can be issued in fantasy units but the exchange rate vis-à-vis the legal tender currencies must be fixed (‘issuers issue electronic money at par value on the receipt of funds’, ‘issuers redeem, at any moment and at par value’).

“The denomination is not essential! The ECB is missing the point by stating: ‘lastly, the fact that the currency is denominated differently (i.e. not euro, US dollar, etc.) means that complete control of the virtual currency is given to its issuer, who governs the scheme and manages the supply of money at will.

“Central banks are monopolist providers of cash. So, they may be forgiven when they do not spend an awful lot of time observing and analysing competitors. But central banks are also regulators and as such they should – at least after 10 years of experience – understand what they are regulating and what the regulations are.”

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