Beyond bitcoin – a new paradigm for regulation

So, there is a lot of hype in the room around bitcoin. Even Goldman Sachs is getting excited. So am I; have been that way for a while now. But if you think that the internet changed the world and you think that bitcoin is another dotcom wave, then, when you think about the further disruptive ability of the blockchain, your mind will really start to boggle.

As a lawyer on the blockchain my concern, however, is the direction regulation is going to take and how that will affect this space. Below, we address a few misconceptions when it comes to regulating this space, what the general regulatory position is and how the technology will change that paradigm through decentralisation and then, lastly, touch on use cases of blockchain technology.

1) You can’t stop bitcoin

So first when they say let’s regulate bitcoin you have to answer “do you know what bitcoin actually is?”. The only way to stop or limit people using bitcoin is to shut the internet down, simple as that. How is that possible? The FBI have tried to shut down Pirate Bay for a long time but it is very difficult to shut down a peer-to-peer file transfer system (Bittorrent). Well bitcoin is a mash-up of bittorrent and money, so try and shut that down. Or even better when I hear statements like ‘let’s ban bitcoin or regulate bitcoin’, I just think will they suggest to ban gravity next.

Once we understand the basics of what you can and can’t feasibility do in this space then we can look at bitcoin with a new pair of eyes. What should we regulate then? Is possibly your next question.

Well, we can’t realistically regulate or ban a peer-to-peer currency but what about the intermediaries and service providers that interface with bitcoin?

Sure thing.

Bitcoin exchanges, where you can buy and sell digital currency for fiat (government issued) currency are like money service businesses.

Then how should they be regulated?

Under existing laws: anti-money laundering regulations and payment services regulations.

2) A regulatory framework for bitcoin service providers

AML regulation for bitcoin exchanges is just plain sensible. It has no consumer protection emphasis, but, if it keeps crime out of this technology and reduces the risk profile of bitcoin exchanges (Exchanges) then that can only be a good thing. At the moment, HMRC, in its supervisory capacity under Money Laundering Regulations 2007, won’t officially accept registrations from bitcoin exchanges only dealing in the exchange of fiat for digital currency. This needs to change. A quick tweak to the law or policy to make AML registration an obligation. With that, of course, bodies such as the Joint Money Laundering Steering group will need to pull together an appropriate manual for Exchanges to follow. We don’t need bespoke laws when it comes to AML and bitcoin: AML – as we know – is all about taking a risk-based approach, thus, if you understand the risks posed to your bitcoin business then you need to have appropriate measures to mitigate them.

Our approach at the UK Digital Currency Association, when we devised our regulatory position paper, was to consider three main areas: consumer protection, promotion of the startup ecosystem and non-interference with the technology. Looking at the existing legal framework we felt that Payment Services Directive (PSD) regulation would be most appropriate for Bitcoin exchanges; the FCA disagreed, the jury is out with HM Treasury on this point. In the EU, luxembourg and France think that PSD is just about right. Germany have considered bitcoin to be a financial instrument which means Markets in Financial Instruments Directive (MIFID) applies, which is not very friendly to startups and interferes with the technology itself.

In our view, the right approach is to push industry led standards to address technological weaknesses. At the UKDCA, we have put forwards a proposal to create a British technical standard to address matters such as security aspects surrounding the storage of digital currency. This is part of a greater movement in the industry to fix its own problems. See the Cryptocurrency Certification Consortium’s standard that was launched earlier this month.

3) Hands-off the technology

We are not the only association trying to put the brakes on an overzealous trend to regulate the tech. We at the UKDCA say “hands-off the technology”. Surprisingly, the BBA and Payments Council have said go easy on the “core technology […] so as to support continuing innovation in a positive way”.

Why is there so much concern about protecting this technology from regulation? Well, it is recognised, by even the incumbents, that bitcoin technology has the potential, to name a few instances, of achieving better payment systems and cheaper/more efficient transfer of assets.

4) Tokenisation

So we can see that bitcoin is not just about online money, it is also a ledger for the transfer of pretty much anything.

You can, with bitcoin, create ‘coloured coins’ which are tokens representing something else but built on top of bitcoin. A coloured coin could represent anything: shares, vouchers, products, loyalty points even art work. Check out Counterparty.io for a client wallet that allows you to easily create any token on top of bitcoin. Or you can also have coins whose primary purpose is to access decentralised software-as-a-service, such as decentralised file storage, see Storj.io.

Naturally, the type of token that an Exchange is facilitating the transfer of will affect their own regulated status. If the token is a share then the MSB box will not work and they’ll probably need to be a Multilateral Trading Facility. But if the tokens represent artwork then are they still an MSB due to the incidental effect of bitcoin being the vehicle for the transfer of the token? These are questions regulators will need to chew over.

6) A new regulatory paradigm

That said, the above interpretative quandaries for regulators may only be a temporary headache.

The reality is: if bitcoin ‘lifts off’, the centralised ‘regulatable’ models will be completely eclipsed by the decentralised ‘unregulatable’ models.

In this new world, the regulator will need to change their paradigm.

Augur – a new peer-to-peer betting protocol.

Betfair is a licensed betting exchange. It is licensed as it is the centralised intermediary for betting transactions.

Augur.net, however, is launching a decentralised betting exchange protocol where there is no central intermediary, just market makers and ‘oracles’ – the oracles confirm the results of fixtures and the market makers are the bookies. How do you deal with that from a regulatory point of view? Well… as there is no central intermediary then there is no-one to be the licensed betting exchange. So, who else can we target for licensing purposes? I guess you need to target the bookies and regulate them. And well the oracles, by collusion, can manipulate results, so maybe they should be regulated too.

Basically, regulation is a constant game of ‘whack-a-mole’, technology moves 100x faster than regulators and the decentralisation trend will change the paradigm of regulation altogether.

Thus why we suggest that industry led standards are the best way forward; they are voluntary, more flexible, more relevant.

7) Striking the balance

In summary, there is a balance that needs to be struck: let the industry fix its own problems through standards; fight crime on the blockchain by understanding the relevant tools and by using the existing laws i.e. Proceeds of Crime Act; regulate the obvious businesses that adopt traditional regulatory models such as Exchanges (i.e. they centralise customer assets so are an obvious risk and should fall under existing laws such as Payment services); understand that regulation itself needs a paradigm shift to address decentralised business models; and appreciate the power of this technology to eradicate the need for traditional regulatory safeguards (such as the use of multi-signature wallets instead of capital requirements or even the need for reporting due to assets being on a transparent ledger).

What is an interesting is that the Bank of England itself anticipates a new regulatory paradigm emanating from digital currency technology (see p.31).

Let’s see what HM Treasury has to say. I am confident that HM Treasury will make the UK the epicentre for the global blockchain economy.

8) Use Cases of Blockchain Technology/ Digital Currency

Before I conclude let’s touch on the power of this technology to disrupt. I’m a lawyer and we basically produce bits of paper for others to rely upon. If the contract goes awry for whatever reason then you need to think about enforceability. I’m not a litigation lawyer but enforcing an international contract through court systems sounds expensive, cumbersome and risky. What if you had a contract on a blockchain that made the terms enforceable through code? How is that possible? It is possible because with bitcoin we can now code money and if you can code money then you can make pay-outs conditional on performance. It will be a new world for lawyers if these so-called ‘smart contracts’ take off. Watch Ethereum.org when they launch – their protocol will support smart contracts, if they survive like bitcoin has since 2009, then welcome to the new world of decentralised autonomous organisations (DAOs), a platform for the internet of things and the holy grail of smart contracts.

For another non-financial blockchain related project check out Factom who are date-stamping documents onto the bitcoin blockchain in a way that you can prove 100% the authenticity of a document years ahead in the future. That will change the way we record history – as, for once, we will know when a record has been changed. This will affect land registries in developing countries round the world.

What about counterfeiting? The blockchain is an incontrovertible record as the same ledger is replicated and held by everyone in the network. Goods can be registered on the blockchain to mitigate counterfeiting. If you receive a good you can then check that it has been registered on the blockchain before accepting it. Check out what Block Verify are trying to do with the problem of counterfeit pharmaceuticals.

The use cases are limitless. One area of particular interest for me is bribery act compliance. A bank, such as HSBC, is liable for the actions of its staff in Shanghai, where the perception of a gift to a client might be more culturally acceptable there but illegal in the UK. What if HBSC issues its own digital currency and pays all staff, suppliers and everyone in that coin. Suddenly, they will be able to track the movement of funds internally throughout all their thousands of branches which will help centralise bribery act compliance. Take the same set up and apply it to an international development project in Africa. If the IMF issues its own coin then it won’t need to do a corruption safeguard test, it can issue IMF coins and track the blockchain and disable any account where there is evidence of embezzlement by the country’s politicians. Digital currency heralds a new era of transparency; if I was FATF, I would be designing the perfect AML compliant currency rather than writing more recommendations. Check out Atencoin which should become the benchmark for AML compliant digital coins.
In conclusion, you can’t uninvent bitcoin nor any of its progeny. Regulate what you can feasibly control and be prepared for a new paradigm of regulation – one suited for a decentralised world. Lastly, if you have enjoyed the above please help us at the UKDCA push standards forwards; join the UKDCA and participate in the debate and learn more about the power and potential of digital currency.