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EBA Opinion: virtual regulations for virtual currencies

Earlier this summer, the European Banking Authority published analysis and opinion on virtual currencies (pdf) – focussing on if they could or ought to be regulated.  The paper received heated write-ups, ranging from the ‘you can’t regulate the unregulateable’ to the positive view that serious consideration by authorities is a step towards virtual currency legitimacy.

Now that we have had some more time to reflect on the opinion, it seemed time to follow up with some more detailed thoughts.

Non-specificity

A paper on how virtual currencies may be regulated is grapple with when the proposed subject of regulation is a broad and changing group.  The paper outlines eleven ‘market participants’ and the majority of proposed regulations could apply to none, some or all of them (paragraphs 31 – 43).

This is not lawyerly pickiness; the devil really is in the detail here.  Some suggestions might make perfectly good sense in relation to certain market participants, but would be disproportionate or dangerous in relation to other market participants.  For example, paragraph 156 recommends requiring “exchanges and any other non-user market participants that interact with [fiat currency] to comply with consumer due diligence (‘CDD’) requirements”.  Without knowing if and which of merchants, trade platforms, processing service providers, or wallet providers would have new CDD obligations, it is hard to give an opinion on the merit of the proposals.  In this sense, the paper can be somewhat of a Rorschach test – the reader sees the regulations they want.

Red Tape

The opinion proposes some requirements which have brought a wry grin to virtual currency exchanges which have been struggling to establish bank accounts and authorisations in the past months.  Paragraph 164 suggests that market participants (surely not all of them?) hold sufficient capital funds (both in fiat currency and virtual currency) to meet its obligations during bankruptcy, runs on the market, or similar.

“Hold fiat currency funds! Would that I could!” comes the cry from the virtual currency exchanges that have knocked on the door of every bank in the City attempting to open an account.  Admittedly this is proposed as a long term regulatory response, but it does demonstrate the distance still to go in creating a situation in which the dual regulated approach can work in practice.  While capital reserves are a fine idea (but, again, it is hard to respond to without knowing the volume to be held) – the irony of taking an ambition of exchanges today, and asking exchanges how they feel about it being a requirement of the future, has felt like a Kafka riddle to some.

Scheme Governance Authorities

‘Scheme Governance Authorities’ is the most ambitious element of the paper  and attracted the most attention on the paper being published.  The EBA suggests that, in relation to each virtual currency, a ‘Scheme Governance Authority’ is formed which takes on responsibilities for regulatory and supervisory requirements, along with recording IDs and transactions.  After the acknowledgement that this at first seems incompatible with the conceptual origins of VC, the details are unfortunately not fleshed out.  It is difficult to imagine how such an entity would be selected, establish credibility, impose authority, or other similar problems.  If we suppose there is perhaps formed a single scheme governance authority, it is implausible that every market participant will acknowledge it, and so a schism between the ‘regulated’ virtual currencies/coins/market participants and the ‘unregulated’ would form.

This particular proposal led to a range of responses from the virtual currency community, with varying amounts of charity to the EBA.  Some suggest it betrays a misunderstanding of the priorities and values of market participants.  Others suggest that it is a classic over-reach, aiming for a modest middle ground compromise.  Another view is that an attempt to require the community to select, for example, a single bitcoin SGA would inevitably fail, and therefore bolster the argument for tight control by traditional regulatory authorities.

Anti-Money Laundering versus Customer Due Diligence

In the UK, the ‘principal’ money laundering offences come from Part 7 of the Proceeds of Crime Act and Sections 15 to 22 and 39 of the Terrorism Act.  They prohibit certain activities such as dealing with the proceeds of criminal conduct, or tipping off or not disclosing such activity.  These apply to everyone – regulated or not.  As a general rule, they are only triggered where there are actual criminal proceeds, or where a ‘regulated’ entity has a suspicion of money laundering activities.

The Money Laundering Regulations 2007 (the ‘Regulations’) are different as they create an active obligation to check identities (‘customer due diligence’ or ‘CDD’).  The Regulations apply to the ‘classic’ regulated entities (credit institutions, financial institutions, lawyers, etc.) but also to ‘high value dealers’.  High value dealers are those that, by way of business, receive €15,000 or more in cash, in a single transaction, or a series that appear to be linked.  Any entity that falls within scope of the Regulations has an obligation to perform CDD when they carry out a transaction (or series of linked transactions) that hits this €15,000 limit.

This current regime seems to lend itself towards being mapped across to virtual currencies:

  1. everyone is subject to ‘proceeds of crime’ type money laundering restrictions;
  2. financial institutions (exchanges in the digital currency context) must perform active CDD; and
  3. those that deal with €15,000 of cash (or the appropriate amount of virtual currency) must also perform active CDD.

At paragraphs 156 and 157 however, the EBA propose that all market participants (other than users) would have to comply with active CDD requirements.  With respect to non-exchange market participants, this would be a stifling expansion of the scope of the Regulations.  In relation to transactions under €15,000, a whole series of CDD obligations which would not apply if they accepted the money in any other form (including cash) would apply to virtual currencies.

There is a loud group in the virtual currency community that feel that this approach would not be proportional to the increased risks – “it’s digital cash, so treat it as such”.  To expand this, it seems reasonable to observe: (i) the systemic checks and balances and restrictions will apply in any case (proceeds of crime, suspicious activities, etc.), so the key offences are still prohibited; and (ii) if €15,000 is de minimis for cash (and a reasonably portable amount), why is there no de minimis for virtual currencies?

Refunds and reversals

At paragraphs 167 and 168 the paper proposes that market participants will be required to immediate refund unauthorised payment transactions.  Of course, the difficulty is knowing what is authorised and what is not.  This proposes to take a core identity of virtual currencies, and unwind it.  Many of the distinctive characteristics of, for example, bitcoin are only possible because of the technically irreversible nature of transactions.  Historically, this attribute was selected because it removes the need of a central authority.  Unilateral refunds cannot be implemented without having a middle man (trusted or not).  The raison d’être of virtual currencies is a suspicion of trust of middlemen, and therefore the exclusion of them.  One knock on effect is that no middle man directly takes a cut, and transfer fees can be reduced.  Encumbering virtual currencies with a layer of dispute resolution, chargebacks and all the associated consequences of distorted trust and incentives would be rejected by some users and is again likely to form a schism between a few regulated virtual currencies and a majority of unregulated virtual currencies.

As the virtual currency community reflects on constructive responses to the EBA paper, one recurring theme is the potential for the features of virtual currency to be used to provide elegant solutions to the risks identified in the paper, without mimicking current systems as some of the EBA proposals do.  For example, a feature of virtual currency transactions is the ability to create a ‘multisig’, or ‘m of n’ transaction – a transaction which is only valid if any ‘m’ of a pre-selected group of ‘n’ participants signs it.  A ‘2 of 3’ transaction, for example, allows for a transaction to proceed if any two actors sign it: be it the two principals, or either principal, plus a pre-selected escrow agent.  Here we see that a new type of escrow can exist, where a trusted third party can influence a transaction, however such control is pre-constrained, and the third party does not have the ability to abscond with the funds.

One can imagine a virtual currency regulation that requires merchants (in relation to virtual currency transactions) to offer the option of having an escrow in relation to sales transactions in excess of a certain amount – and to be able to charge extra for this feature.  This approach would acknowledge the features of virtual currencies (low transaction fees and peer to peer transfer), but also allow the customer to ‘purchase’ consumer protection (by structuring the transaction as a multisig escrow) at a small cost.  This implementation would supplement the consumers existing theoretical legal protections under, for example, the distance selling regulations, by adding practical protections which can be ‘purchased’ in a free and competitive market.

Summary

The prudential regulatory obligations of central banks make them necessarily cautious.  The EBA paper is a worthy, if careful, advancement of the difficult problem that regulators are having in cataloguing the issues of aligning virtual currencies with existing structures.  There are certainly areas where my personal view is that the EBA’s proposed approach would be too cautious and other areas where it would be untenable.  This is somewhat inevitable, as it is not for the EBA to balance the potential regulatory risks against the economic opportunities of virtual currencies.   That balance will be picked up by HM Treasury and the European Commission as policy is developed.  This document is a helpful contribution to that analysis, both on its own, and as it has pushed the conversation forwards as to whom should be regulated, restricted or excluded in relation to virtual currencies.

For further details please contact Rich Folsom.