January 22, 2016
The International Monetary Fund (IMF) staff released a paper today that talks about the problems and risks associated with virtual currencies (VCs) and how can the financial industry could benefit from virtual currencies, if it is regulated. For those who might not be familiar, The International Monetary Fund (IMF) is an organization of 188 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world. Created in 1945, the IMF is governed by and accountable to the 188 countries that make up its near-global membership. The IMF's primary purpose is to ensure the stability of the international monetary system—the system of exchange rates and international payments that enables countries (and their citizens) to transact with each other. And to serve this purpose, IMF realized the increasing popularity of virtual currencies and a need to regulate them as soon as possible.
The paper on virtual currencies talks about how virtual currencies have many potential benefits, including greater speed and efficiency in making payments and transfers, particularly across the globe and how the distributed ledger technology (blockchain) underlying some VC schemes (bitcoin) has a bigger potential to bring a transformation in the financial industry. However the IMF is worried about the fact that virtual currencies like bitcoin have potential risks that make money laundering, terrorist financing, tax evasion and fraud easier to execute.
Pointing out these risks, the paper emphasizes the legal and regulatory aspects of virtual currencies like bitcoin. VCs fall short of the legal concept of currency or money, according to the IMF staff. The legal concept of currency is associated with the power of the sovereign to establish a legal framework providing for central issuance of banknotes and coins and is based on the power of the state to regulate the monetary system
Pointing to the definition of money, the paper states why virtual currencies do not completely fulfill the three economic roles associated with money. High price volatility, limited acceptance network and absence of an independent unit of account are the reasons why virtual currencies can still not be accepted as money. What they are trying to say is that one can still not survive only with bitcoin in his/her wallet. Retailers who accept payment in bitcoin will quote prices in fiat currency, with the price in bitcoin based on the exchange rate at a particular point in time. In fact, bitcoin has been more volatile than any other key currency or asset, even more than oil.
Emerging Uses of Distributed Ledgers:
The paper also praises the blockchain technology and its increasing popularity in the financial technology industry as opposed to virtual currencies. It mentions the following emerging uses of distributed ledgers or blockchain:
- Several startups, especially in the area of money transfer, offer blockchain-based platforms. Established financial institutions are also joining the competition. Some global banks have jointly started an initiative to develop distributed ledger technologies for use in global financial markets.
- Distributed ledger technology could reduce the cost of international transfers, especially remittances.
- Distributed ledgers can shorten the time required to settle securities transactions.
- Distributed ledger technologies can improve back office functions for securities dealers and enhance their transparency.
- Together with other developments in financial technology, distributed ledger modalities could portend important structural shifts in the financial industry.
Image Source: Virtual Currencies and Beyond: Initial Considerations, IMF, January 2016
As the main intention of this paper is to address the regulatory and policy challenges associated with virtual currencies, the report continues with the topic after emphasizing the importance of distributed ledgers (blockchain).
The paper mentions the follows regulatory challenges associated with virtual currencies:
Defining virtual currencies is tough: VCs combine properties of currencies, commodities, and payments systems, and their classification as one or the other will often have implications for their legal and regulatory treatment—in particular, in determining which national agencies should regulate them. In the U.S., the tax authority, the IRS, has classified VCs as property for the purpose of federal taxation while the Treasury Department’s FinCEN has classified VCs as value for the purpose of AML/CFT obligations.
VC schemes are difficult to monitor: Their opaque nature makes it difficult to gather information, including statistical data, or to monitor their operation.
The transnational reach of VCs complicates regulation. National authorities may find it difficult to enforce laws and regulations in a virtual (online) environment, especially when cross-border transactions will be involved.
Cryptocurrencies pose particularly difficult challenges: Their decentralized nature does not fit easily within traditional regulatory models. A decentralized system leads to the question of whom to regulate – the individual VC users or other parties within the system.
However, efforts have been taken by regulatory bodies in different countries around the globe to deal with virtual currencies fairly by either amending/clarifying the interpretations of existing laws and regulations or by issuing consumer warnings. In determining who to regulate, national authorities have mostly targeted VC market participants and financial institutions that interact with them by either regulating virtual currency market participants that provide an interface with the broader economy (for example, virtual currency exchanges) or by restricting the ability of regulated entities like banks to interact with virtual currencies and virtual currency market participants. In September 2015, we covered the news about banks in Australia closing accounts of bitcoin companies without giving any formal explanation. The probable reason for this could be questions raised by regulatory bodies for the banks. Not just in Australia but the resistance for bitcoin has been observed in many other countries. As we previously covered this on LTP, the Russian government is concerned about illegal use of Bitcoin and has even blacklisted certain Bitcoin websites. The European Union’s security watchdog has issued a call for evidence to ascertain whether the blockchain technology is viable to enter the financial mainstream. And these are valid concerns for many reasons. The European Securities and Markets Authority is keeping a close eye on Bitcoin, and is monitoring investments in the sector. Some U.S. states like California and New York are coming up with new regulations and license requirements that could affect peer-to-peer Bitcoin exchanges.
The paper states that a number of international bodies like the Financial Action Task Force (FATF), the AML/CFT standard-setter and the United Nations Office on Drugs and Crime (UNODC) have both provided a forum to discuss issues related to VCs and contributed to the debate through the issuance of reports, guidance and manuals in their areas of expertise. The paper suggests considering developing international standards and best practices to provide guidance on the most appropriate regulatory responses in different fields, thereby promoting harmonization across jurisdictions.
Risks Associated & How Are They Being Dealt With:
Financial Integrity: Virtual currencies are being used to hide or disguise the illicit origin or sanctioned destination of funds, thus leading to money laundering (ML), terrorist financing (TF) and other illegal activities. The paper talks about applying anti-money laundering (AML) and combating the financing of terrorism (CFT) controls to virtual currencies. The FATF, the international standard-setter for AML/CFT, has also provided some guidance on the application of the AML/CFT standards to virtual currencies. The paper also discussed the application of these controls on wallet service providers and payment processors within that currency system if the currency were to become widely accepted.
Consumer Protection: The paper talks about consumer protection too. We have seen leading bitcoin exchange players like Mt. Gox shutting down suddenly and people losing millions of dollars because of it. People weren’t protected from these virtual currency fraud and thus they have no one to complain to about their loss. Virtual currency holders are also vulnerable to scams, such as stealing VCs through hacking, fraud, or misrepresentations about fraudulent investment schemes. Moreover, errors in virtual currencies cannot be reversed. In an attempt to fight against these risks, most countries have issued statements highlighting the above risk. Jurisdictions are also beginning to clarify how existing consumer protection legislation applies to virtual currencies.
Taxation: Taxation is particularly complex with cryptocurrencies, where participants need not disclose their identity, and transactions are peer-to-peer and can take place across borders. The paper suggests that tax record keeping requirements for virtual currencies will be substantial and may reduce the attractiveness of VCs in everyday use.
The paper discusses other risks like exchange controls and capital flow management and financial stability and how can they be dealt with in the coming future as virtual currencies gain popularity.
Future: What the IMF Suggests
Virtual currencies and their underlying technologies can provide faster and cheaper financial services, and can become a powerful tool for deepening financial inclusion in the developing world, said IMF Managing Director Christine Lagarde, who presented the report at the World Economic Forum, in Davos, during the panel Transformation of Finance. The challenge will be how to reap all these benefits and at the same time prevent illegal uses, such as money laundering, terror financing, fraud, and even circumvention of capital controls.
The paper concludes with a list of guiding principles to national authorities in further developing their regulatory responses so that they are prepared if virtual currencies like bitcoin start becoming widely accepted in the future. They include:
- Regulatory responses should be commensurate to the risks without stifling innovation.
- Regulators should design approaches that take into account the novel business models inherent in VC schemes.
- Regulation may need to address not only market conduct issues (for example, AML/CFT, fraud), but also the financial soundness of VC intermediaries.
- Due consideration should be given to the degree of integration between the conventional financial system and the VC market.