The risks, rewards and way forward
The gold (and silver) standard has long since disappeared as a monetary mechanism, replaced by a politically-based system founded on trust in national governments.
In the last decade, currency has become increasingly virtual and consumers have become accustomed to dealing with electronic money, or e-money, as a means of exchange.
Since 2009, cryptocurrencies such as Bitcoin have pushed the boundaries further through the introduction of a decentralised peer-to-peer exchange network. Based on a public ledger known as the blockchain, Bitcoin offers the potential for lower transaction costs and faster payments.
The essentially anonymous nature of cryptocurrencies has prompted regulatory concerns that they could be used to facilitate financial crime. To date, the response to cryptocurrencies has varied with some countries – notably the United States, given its higher exposure to the new technology – taking proactive steps towards regulation. Other countries have chosen to restrict or ban their use outright, whilst the majority are yet to implement any formal regulation. Many commentators emphasise the potential benefits of cryptocurrencies and the need to strike an adequate balance between regulation and encouraging innovation.
Can this be achieved, or are cryptocurrencies too disruptive to tolerate?
Defining virtual currency
During the last two years, a number of public and private sector organisations have issued reports on virtual currency. 1 Governmental bodies have focused on the legal definitions that clarify the boundary between official and unofficial currency. For example, a typology proposed by the intra-governmental Financial Action Task Force (FATF) defines digital currency as an umbrella term for “a digital representation of either virtual currency (non-fiat) or e-money (fiat)”. The major distinction between the two is that fiat currency is backed by the State and the force of law whereas virtual currency is not. Virtual currency, per FATF’s definition, does not have legal tender status whereas e-money is a digital transfer mechanism for fiat currency that has legal tender status. 2
The FATF makes a further distinction between various types of virtual currency, subdividing it into convertible/non-convertible and centralised/decentralised. The resulting combinations are:
- Non-convertible centralised virtual currency (NCCVC)
- Convertible centralised virtual currency (CCVC)
- Decentralised convertible virtual currency (Cryptocurrency)
From a regulatory perspective, NCCVC is considered to present the lowest risk amongst virtual currencies. NCCVC was originally created by its respective developers to function within the boundaries of a virtual world as part of virtual economies in multi-user domains and massively multi-player online role-playing games (MMORPGs). NCCVC is structurally the most similar to fiat currency. Developers control the supply of units of their virtual currency to fill a need for value exchange in the virtual world in a similar way that central banks fulfil a corresponding need in the real world. NCCVCs are however non-convertible and can only be used in their specific virtual spaces. Examples of NCCVCs include World of Warcraft, Q Coins and EVE Online.
In contrast to NCCVC, CCVCs developed with the rise of the life simulation games industry which increasingly blurred the lines between all things real and virtual. This includes the distinction between virtual and real currencies. Interactive virtual worlds like Second Life are a prime example of a CCVC that allows the exchange of its virtual currency, Linden Dollars, into fiat money. The most important feature of all CCVCs is that their respective developers act as a central authority and possess exclusive power to issue and control the supply of the currency.
Unlike centralised virtual currency and e-money, decentralised virtual currency or cryptocurrencies are “distributed, open-source, math-based peer-to-peer virtual currencies that have no central administrating authority, and no central monitoring or oversight”. 3 According to a recent study, there are over 1,700 cryptocurrencies of which approximately 40% are in active operation.4 Current examples include Bitcoin, Ripple, PeerCoin and Litecoin. Bitcoin is the world’s first cryptocurrency and remains the most popular. Launched in 2009, the idea for Bitcoin derived from a combination of various disciplines including IT (cryptography for secure communication), economics (game theory for strategic decision-making) and networking (connections without central coordination).5 In contrast with all centralised virtual currencies which mimic the same single-authority structure of central banking systems, Bitcoin is fully decentralised. Its pseudonymous founder, Satoshi Nakamoto, describes in a white paper that: “what is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party”.6
Bitcoins are not issued by any one authority. They are instead either stored, traded or generated via the process of “mining”. Mining can be described as a process by which individuals or groups of individuals solve complex cryptographic equations in a database called the “blockchain” or the “public ledger” as part of a distributed network that operates to facilitate transactions and ensure their integrity. The financial incentive for miners is that by succeeding in solving the equation, they will be rewarded with Bitcoins as well as with the possibility of a transaction fee. Although Bitcoin is the most actively traded cryptocurrency, it is still subject to a high degree of speculation and price volatility. Bitcoin users who try to exchange Bitcoin for fiat currency face difficulty in predicting the trading range of the currency, because Bitcoin is a new currency with no historical precedent. Bitcoin relies on consensus that it will continue to be of value to its users and function properly.7 Supporters claim that, in the long term, the Bitcoin price will eventually even out and be more predictable. Others however warn that support for Bitcoin could wane, particularly if it continues to be associated with illegal activities.
Bitcoin tokens (the currency) are based on the Bitcoin blockchain (the internet-wide distributed ledger), which records every single transaction that has ever taken place. This data is distributed to every individual who has ever transacted with Bitcoin, effectively making the process public. Blockchain technology, distinct from Bitcoin, has separate application as a mechanism to provide an irrefutable record of facts, given that any transaction on the blockchain cannot be reversed and is inherently fraud-proof. It has application beyond cryptocurrency – for example, to record digital assets such as land titles or legal contracts. Proponents claim that technologies based on the blockchain, such as Ethereum, could remove or significantly reduce the need for third party arbitration, associated costs and complexity.
What are the financial crime risks associated with virtual currencies?
Governments and regulators have reacted with concern to the rapid growth of virtual currencies and their potential as enablers of financial crime. Swift action was taken against operators such as Silk Road and Liberty Reserve, and these cases have been cited widely as examples of new money laundering risks
created by the use of virtual currencies.
Some key questions arise:
- Are the financial crime risks associated with virtual currencies inherent in their structures, or related to specific ways in which they are used
to facilitate criminal activities?
- Is there a way to mitigate the risks of using virtual currencies without compromising the opportunities they purport to offer over fiat currencies?
Issues and risks
The financial crisis of 2008 called into question the benefits of “light touch” regulation. Many governments imposed stricter regulatory controls designed to address perceived shortcomings. Virtual currencies lacked both legal tender status and any regulatory framework to support cross-border transactions. Coupled with mechanisms to facilitate anonymity, virtual currencies appeared to threaten regulatory stability. These threats proved to be more than hypothetical. In 2013, the US government seized Liberty Reserve, an online payment processor, and charged its founders with using its own virtual currency to operate a money-laundering scheme totaling USD 6 billion. The same year saw the closure of Silk Road, an online market place for illicit trade of drugs and other services, where authorities recovered Bitcoins worth USD 100 million. More recently in 2014, the largest bitcoin exchange, Mt. Gox, closed after discovering a loss of 850,000 Bitcoins worth more than USD 500 million8.
Although these cases are often used to highlight the dangers posed by virtual currencies, it is worth assessing them in more detail to better understand the underlying issues.
Liberty Reserve launched in 2006 and was a virtual currency provider that operated its own currency, called Liberty Dollars. US authorities alleged that Liberty Reserve was created explicitly for the purposes of aiding criminal activity – in particular to “distribute, store, and launder the proceeds of credit card fraud, identity theft, investment fraud, computer hacking, narcotics trafficking, and child pornography by enabling them [users] to conduct anonymous and untraceable financial transactions”.9 Generally, users enjoyed a great deal of anonymity; they could open their accounts without any identity checks and could exchange between Liberty Reserve dollars and US dollars (1LR = 1$) using anonymous and mostly unlicensed money transmitters in low disclosure jurisdictions. There were few anti-money laundering or counter terrorist financing requirements. Liberty Reserve itself was registered in Costa Rica but did not have Money Services Business (MSB) licenses in the countries in which it provided its services.
Although it is clear that Liberty Reserve facilitated money laundering to the extent that exchanging between Liberty Reserve and US dollars further obscured the sources of funds of criminals, it is not so much the attributes of the virtual currencies that are to blame but more the intent by the founders to organise their operations in such a way so as to avoid monitoring their users centrally. 10 In this respect, the anonymity risks and the global scale of the operations, as well as the types of illicit activities engaged in by Liberty Reserve users, are exclusive to this case, and do not constitute risks that are inherent in centralised virtual currencies.
However, this is not to say that there are no risks associated with CCVCs. In fact, as it is possible to see with Liberty Reserve, having a central authority which can enforce its own rules but which is entirely unaccountable to any regulatory authority poses potential risks to its users. CCVCs are more at risk of abuse by criminals because the issuing authority can either specifically use its virtual currency as a vehicle to engage in money
laundering activities, or can be corrupted by some other party wishing to use the CCVC for illicit purposes. From a regulatory perspective, a central authority may pose less risk as, unlike Bitcoin, a central authority can potentially be identified. However, it is worth noting a lack of transparency among some centralised virtual currencies. For example, two of the current largest CCVCs, Perfect Money and WebMoney, are registered in low disclosure jurisdictions with nominee directors, providing no public record of beneficial ownership.
Silk Road and Mt. Gox
The cases of Silk Road and Mt. Gox serve to illustrate the risks associated with Bitcoin, as well as cryptocurrencies more generally.
In the case of Silk Road, which hid on the encrypted Tor peer-to-peer network, Bitcoin was the only way users could carry out transactions among themselves on the website. According to the FATF, this “allowed purchasers to further conceal their identity, since senders and recipients of peer-to-peer (P2P) bitcoin transactions are identified by the anonymous bitcoin address/account”.11 Compared to traditional online non-cash payments, there is no doubt that Bitcoin transactions grant some degree of anonymity to Bitcoin users. For example, a PayPal payment always ties a user to his or her bank account. However, Bitcoin can only be described as pseudo-anonymous because, as previously mentioned, all previous transactions that have taken place would be contained in the blockchain.
There are a number of ways in which Bitcoins can be further anonymised, such as putting them through “tumblers” or “mixers”, both of which attempt to disguise where a user’s Bitcoins originated from. However, in a recent paper studying anonymity of Bitcoin, its authors reached the conclusion that Bitcoin transactions can be traced with relative ease, even when they are put through various “mixers”. 12 As a result, the risks involved could be mitigated if users either choose to be transparent with their transaction or/and if online market places or exchanges gather information about their users.
Will cryptocurrency replace fiat currency?
There has been considerable debate in recent years over the potential for Bitcoin and other cryptocurrencies to replace fiat currency. Views expressed on the subject often focus solely on the upside or downside potential of the currency. Cryptocurrencies offer a new way of transacting and the blockchain concept, with its decentralised digital architecture, is highly innovative, offering new consumer options to record digital assets (separate from currency). However, the arguments for and against cryptocurrencies remain balanced. We explore below some of the main areas of contention.
|Arguments in favour of cryptocurrency adoption||Arguments against cryptocurrency adoption|
|Cryptocurrencies represent an efficient and lower-cost means of transacting, particularly cross-border or in small denominations(micropayments). Charges may be nil or negligible compared with traditional charges of 2.5% – 3% for credit card transactions, or over 10%
for international transactions
|Alternative technologies already exist – for example, debit cards that offer very low transaction costs. Cryptocurrencies still require users to exchange for fiat currency, which incurs transaction costs and introduces exchange rate risks, both for a consumer and a merchant.
In the US, stricter regulation of cryptocurrencies will see more individuals and organisations subject to requirements for registration, potentially reducing their cost advantage
|Cryptocurrencies safeguard against fraudulent transactions because payments, once made, are effectively irreversible (cryptocurrencies are bearer instruments transferred from one individual to another)||Consumers may actively seek to safeguard their interests – for example, by using credit cards that offer customer protection in the event of merchant default / dispute. Such protection does not exist with cryptocurrencies|
|Cryptocurrencies can allow the world’s estimated 2.5 billion unbanked individuals to undertake non face-to-face transactions||This assumes that individuals have access to potentially expensive smartphones / computer equipment and communications systems; it also assumes that traditional banking players do not see value in an additional customer base of 2.5 billion individuals. Other e-money (fiat currency) solutions potentially provide alternative options|
|Cryptocurrencies provide additional levels of anonymity and security, and avoid dependency on central authorities. Central authorities may erode value in currencies through inflationary measures||Whether fiat or virtual currency, regulators will not tolerate illegal activities. Cryptocurrencies involve greater anonymity, although this assumes that law enforcement cannot access private encryption keys – if they do, all previous records on the blockchain potentially
become visible, which could present a major risk for criminals. Recent events such as Mt. Gox also illustrate the risk that cryptocurrency exchanges or wallets can be hacked – in which case, an individual does not enjoy government insurance protection over their deposits. Users of cryptocurrencies also potentially need to exchange these for fiat currency at some point; governments have focused on ensuring that MSBs
that permit such currency conversions are properly licenced
What is the future direction for virtual currencies?
As yet, there is no international consensus on regulation of virtual currencies – although a number of countries such as China and Russia have sought to restrict its use13. The European Banking Authority has warned against the risks of using Bitcoins, emphasising that they are unregulated. The United Kingdom is considering options for regulation. The United States has been most active in working towards a regulatory framework for virtual currencies. In March 2013, the US Financial Crimes Enforcement Network (FinCEN) became the first authority to issue guidance on CCVCs and cryptocurrencies. Unlike the FATF, FinCEN defines virtual currency in a narrower sense as “a medium of exchange that operates like a currency in some environments, but does not have all the attributes of real currency”, namely legal tender status 14.
The objective of the guidance was to determine which stakeholders would be required to register as MSBs under the Bank Secrecy Act. FinCEN defined three groups: a “user”, an “exchanger” or an “administrator”, each of which will be evaluated for whether they constitute a “money transmitter”. The guidance implicitly used the cases of Liberty Reserve and Silk Road as precedents for establishing the categories. All three categories are considered high-risk 15. The only category not specifically required to register as an MSB is a user; administrators and exchangers are both classified as money transmitters because both are involved in the exchange of virtual money for real money on behalf of a third party.
The FinCEN definition, however, leaves open the possibility that in some circumstances even users may be considered as money transmitters. A broad interpretation such as this potentially defeats the perceived advantages of virtual currencies as fast and efficient with low-transaction costs. In March 2014, New York made the decision to become the first US State to issue a licence – the “BitLicense” – in accordance with FinCEN guidance, a move that has already resulted in major controversy.
Perhaps the strongest argument against the widespread adoption of Bitcoin and other cryptocurrencies, however, is their potential to subvert central control of nation states by removing dependency on a national currency. The United States, in particular, has made extensive use of the regulated financial sector both at home and abroad to achieve political objectives through the imposition of economic sanctions. Increasingly, sanctions are being seen as an attractive, lower-risk alternative to vastly expensive traditional warfare.
A decentralised currency system, such as Bitcoin, would deprive the US government – or other governments/central authorities – of the levers of control over transactions denominated in their respective currency. Provided cryptocurrencies including Bitcoin remain in limited circulation and do not threaten mainstream banking systems, it is likely that their existence will be tolerated. Current FinCEN guidance provides sufficient opportunity to control their use through additional regulatory measures, if needed. This avoids the implication that the US is seeking to undermine innovation by imposing blanket restrictions or an outright ban. On the other hand, the blockchain presents opportunities for future innovation that do not necessarily threaten central control mechanisms. This may emerge as a source of greater future potential than the currency itself.
If you are a regulated institution which deals with MSBs, other organisations or individuals involved in exchange or transmittal of virtual currencies, contact us today at firstname.lastname@example.org or +44 (0)20 7073 0430 to discuss how we can support your enhanced due diligence procedures.