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Regulating Bitcoin: Cryptocurrency, commodity or gambling?

Nayeem Syed  Assistant General Counsel at Thomson Reuters

Nayeem Syed  Assistant General Counsel at Thomson Reuters

Bitcoin's rise in value has everyday investors wanting to enter the market. That may force authorities to get involved, even if regulating the cryptocurrency is difficult.

With Bitcoin reaching a high of $18,000 this week, there have been excited reports that its rise in value indicates either a bubble or the arrival of an unstoppable (and irreversible) force.  Those with some investable cash have been talking around the water cooler about how to (access and) get rich with Bitcoin. If Bitcoin moves from an almost theoretical instrument of a few to a source of investment for many, authorities may have to take steps to regulate it – even as difficult as it may be to take those steps.

Why the Bitcoin frenzy?

Value in holding Bitcoin (or any cryptocurrency) is only crystallized when it can be traded for a real currency by a legal means. At the moment, Bitcoin’s exchange rate is highly volatile because it has no real precedent in modern history.  This may be because there is a theoretical limit on the number of Bitcoins; the supply is set at 21 million units.  The inflation implications of this cap have not been conclusively studied, but the crucial determinant of its price has been the nature of its demand. There are no natural buyers for Bitcoin in the traditional sense of a commodity, so the market’s perception of its potential to go ever higher is for now the main analyzable driver.

Previously, many respected analysts and industry leaders had opined that Bitcoin, as a currency, was inherently spurious, something akin to a Ponzi scheme or fraud. However, as the price has risen from $1,000 at the start of the year, it can no longer be easily dismissed as a fad, and many regulators have begun to backpedal from their initial hard-line stance against it.  Now, as the much-reported speed at which Bitcoin’s price keeps rising begins to create interest at the retail level, many well-off (but far from high net-worth) individuals are actively searching for ways to enter the market. This forcibly compels an accelerated response.

Regulating cryptocurrency: A daunting task

Broadly speaking, regulators are tasked with protecting investors, maintaining market integrity and fostering the conditions for innovation and competition.  Regulators in a number of jurisdictions are publishing positioning papers and, in some cases, beginning to issue soft rules to manage cryptocurrencies.  Each jurisdiction has its own economic and, ultimately, political objectives.

A man walks past an electric board showing exchange rates of various cryptocurrencies including Bitcoin (top L) at a cryptocurrencies exchange in Seoul, South Korea December 13, 2017. REUTERS/Kim Hong-Ji
A man walks past an electric board showing exchange rates of various cryptocurrencies including Bitcoin (top L) at a cryptocurrencies exchange in Seoul, South Korea December 13, 2017. REUTERS/Kim Hong-Ji

One approach to Bitcoin regulation’s challenges

To date, much of the official regulatory attention has been around preventing the use of Bitcoin to fund terror and other illegal activities.  In 2015, the European Commission introduced amendments to the fourth Anti-Money-Laundering Directive and proposed amendments to the Payment Services Directive. In its 2014 Opinion on Virtual Currency, the European Banking Authority identified 70 risks across several categories. It concluded any comprehensive approach would require a substantial body of regulation and it was simply too early to be able to do more than study and monitor developments. It went on to recommend that member states not hold or sell virtual currencies and to make intermediaries “obliged entities,” thereby subjecting them to anti-money-laundering and counterterrorism measures.

Regulators have thus far said there is little to no impact on the wider economy in terms of direction or overall stability.  But it is now becoming clear that Bitcoin does have enormous reputational risk implications. Each time there is any kind of market failure, it knocks confidence in other emerging assets classes and impacts the development of other less controversial (and perhaps more socially useful) financial developments such as blockchain.

There, however, is the real pressing problem for regulators.  Even if does not serve as an alternative to, or ever seriously threatens to replace, traditional currencies, there may still be compelling need to regulate Bitcoin because it starts to become a sizeable alternative to a traded regulated commodity.  That is, if it begins to seriously compete with, say, gold, as an alternative asset class.  It does not matter that gold takes a physical form or has incomparable credibility, if Bitcoin has more present speculative potential for financial traders.  Indeed, Bitcoin’s volatility is part of the appeal for them.

While many financial innovation cheerleaders will freely speak of the heresy of inhibiting economic development, they rarely address the risks of an unregulated alternative to established currencies or commodities. One reason for that may be they raise some fairly fundamental but inconvenient regulatory and legal questions.  These questions are very difficult to answer, as the very nature of this cryptocurrency is that it is entirely decentralized and its origin story opaque:

  • If there is a fraud, who is prosecutable?
  • Who would have jurisdiction with a cross-border failure or dispute?
  • If there are errors or technical failures, who should (or even could) legitimately restore order and re-establish “the truth”?
  • If there is a systemic failure, how can such a market be placed on hold until there’s been a root-cause analysis?  In any event, what would be the protocols for re-establishing good order?

A final overarching question: How can the oversight be structured and intended to work to ensure a level playing field?  Why should Bitcoin escape the complex controls and rigorous data collecting and reporting requirements imposed on other regulated asset classes?

The philosophical and technical issues are mind-bending even for Nobel Prize winners.  A critical question for policymakers is whether to approach Bitcoin as a legitimate alternative to a traditional currency or a commodity with a use value still to be determined or simply a form of gambling.

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