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Bitcoin: Regulating the Deregulated

BY PRIMAVERA DE FILIPPI, 25/03/2016

Bitcoin is widely known as a decentralized payment system, which allows for the transfer of funds across borders at virtually no costs and without external control (Abramowicz, 2015). As such, it can serve as a new backbone technology for depository institutions, increasing the speed and efficiency of inter-bank transfers and making it easier for banks to convert funds from one currency to another.  

On the technical level, Bitcoin is a so-called trustless payment system, enabling people or institutions that do not know each other to exchange value directly, without the need for any trusted authority or centralized clearing house (Kiviat, 2015). It is trustless not because there is no trust in the transactions, but because trust is delegated to the network itself, where all transactions are public and verifiable by everyone. The sustainers of the network, the so-called miners or validators, act as an insurance for the actual execution of these transactions.

This is important for two main reasons. Firstly, it allows for a more distributed network of exchange, where people can instantaneously exchange value directly with one another, without relying on any potentially corrupted, unreliable, or monopolistic (rent-taking) financial intermediary. Secondly, it provides a mechanism for banking the unbanked —enabling those who are currently cut off from the financial system, to enter the global economy. This is particularly relevant for the most vulnerable persons who have not been able to access financial services, such as immigrants and the swaths of populations that live under corrupt, authoritarian or unstable governments and political systems.

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Of course, given the lack of a central regulatory authority, Bitcoin also comes along with a number of challenges. Given the ease of access to this decentralized peer-to-peer payment system, Bitcoin provides new opportunities for criminal activities, including tax-evasion and money-laundering, as shown by the case of SilkRoad, where Bitcoin was used as a near-anonymous payment system for the sale of illegal drugs (Lane, 2013).

The response, in the US at least, has been to regulate decentralized virtual currencies, by regulating the commercial operators as if they were regular financial operators or money transmitters —and thus require them to comply with Anti Money Laundering (AML), Know Your Customers (KYC) and money transmission laws (Wright & De Filippi, 2015). These same regulations, when applied into the blockchain space, may undermine standard expectations of financial privacy.

As the Bitcoin network is inherently transparent, once a Bitcoin address has been associated with the identity of a person, it becomes possible for anyone to gain unprecedented insights into the complete transaction history of that person. Hence, before applying current financial regulations to Bitcoin operators, we should first try to understand whether such regulations are equally necessary in a more transparent system like Bitcoin, whose publicly available database can be thoroughly analyzed and scrutinized for suspicious activity by regulators and law enforcement authorities. More generally, as closed and proprietary systems of private institutions are morphing into a public and transparent ledger, it might no longer be sensible to rely on private institutions to collect information.

On the contrary, there is, today, a growing need to reconsider the impact of existing AML/KYC regulations in the light of this new technological framework that provides tools for better governance and fraud prevention – thereby reducing or even eliminating the need for such an extensive set of onerous regulations.   Especially in view of emerging cybersecurity threats and the various data breaches that occurred at the highest level of government security, it becomes urgent to identify new tools to protect individual and financial privacy in an era of public blockchains, without resorting to the centralized collection of personally identifiable information, which can be copied, stolen, and easily faked.

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It is important to remember that the real innovation of Bitcoin is not the currency itself, but its underlying technology —the blockchain, a decentralized trust platform.   Accordingly, before regulating Bitcoin as a virtual currency, it is necessary to understand the real opportunities that its underlying technologies provides, without getting sidetracked by the crypto-currency hype. In particular, the blockchain gives rise to new possibilities that were previously impossible or impractical, and are therefore not fully accounted for in the current regulatory regime. Looking at financial applications, blockchain technologies can be used to execute more secure and trustless transactions (De Filippi, 2014).

Blockchain technologies can also provide a more efficient and secure securities market, by enabling both automatic settlement and clearance by peers, without a centralized clearinghouse. The U.S. Securities and Exchange Commission has understood this and now allows for securities to be issued directly onto the blockchain (Guadamux & Marsden, 2015). The derivatives market can also be made more efficient and transparent, by encoding the terms of a derivative instrument directly into the blockchain, automating both transactions and payment.  A direct monetary connection can be established linking the actual value of collaterals with the derivative, which makes liquidity-freezes like those of 2008 impossible.

Finally, the most recent versions of the blockchain make it possible to execute complex code, in a decentralized and deterministic manner, without relying on any central server. As blockchains enable new forms of value creation and distribution within a particular network, they open up new possibilities for the establishment of decentralized organisation and the generation of social and economic coordination, with greater transparency, lower cost and more equality of access.

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However, the problem is that there is no one to be held responsible for the operations of that blockchain code, for better or worse. These applications do not reside in any actual jurisdiction and could therefore be constructed to be agnostic to any jurisdiction’s rules.

So, can we regulate these new technologies? And if not, should we regulate the various actors interacting with these technologies?

(1) First, end-users could be incriminated to the extent that they use them in an illegal manner. However, incriminating end-users is often not effective, look at the war against copyright infringement.

(2) Second, software developers could be required to implement specific features or “kill-switches” at the risk of being held liable for facilitating illicit activities. However, once the technology has been deployed, incriminating developers will not serve to stop the operations of a decentralized application, unless a kill switch has been built in. Moreover, beyond the negative impact this would have on innovation, preventing people from writing code would be tantamount to restricting freedom of speech.

(3) Third, market players interfacing with these technologies —Bitcoin exchanges, wallet providers, and other commercial operators who accept Bitcoin— could be required to comply with specific formalities and regulations to reduce the likelihood of illicit activities, and to cooperate with public authorities to help identify the wrongdoers.

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As with the Internet, it will be nearly impossible to stop all unlawful activities that will be made possible by blockchain technologies. Yet, while governments might not be able to halt the use of these technologies, they could at least limit the adoption, and regulate the development of these technologies.  So how should this regulation look like?

Back in the 90’s, when the Internet was taking shape, Lawrence Lessig (a prominent law scholar at Harvard law school) argued that, given the specificities of digital technologies, it was not possible to simply apply the existing regulatory framework to the ‘cyberspace’ but it was instead necessary to create a new body of law that would take better account of these specificities (Lessig, 1999). The “law of the cyberspace” was, at that time, considered a ridiculous suggestion; but it has now proven to be necessary to properly address the specificities of digital technologies.

The regulation of blockchain technologies presents a similar issue. Are the specificities of the blockchain distinct enough to require the establishment of a whole new body of law, or can we usefully apply the current regulatory framework to these new technologies?

This question is particularly relevant, because we are currently at the early stages of these technologies. What we are seeing today is only the tip of the iceberg: we do not fully understand the opportunities and challenges raised by these new technologies. While it is clear that blockchain technologies can bring many consumer benefits, in terms of transparency, competition and innovation, it is not yet clear how this potential will materialize in the near future. It is, therefore, dangerous to regulate this technology with laws designed for an entirely different technological framework, as we run the risk of limiting, or even eliminating the future potential of these new technologies.

 

 

Looking at the laws which are being proposed, or have already been adopted in certain countries, the tokens used in most of these new blockchain applications are being compared to existing legal concepts, such as “currency”, “securities”, “or “commodities” (Shadab, 2014). These characterizations tend to limit the deployment of new blockchain technologies because market operators must ensure compliance with regulations and formalities related to existing regulations, which make it increasingly hard for start-ups and small companies to operate in the space. Today, many of the market operators using blockchain technologies for non-financial applications are often caught into a complex net of regulations, which were originally intended to apply only to financial services.  

All of this makes it harder for the global community to meaningfully examine the potential applications of blockchain technologies, not to mention the difficulty to experiment and test for the robustness and safety of the technology in collaboration with market and governmental actors.

Are the specificities of the blockchain distinct enough to require the establishment of a whole new body of law, or can we usefully apply the current regulatory framework to these new technologies?

Most importantly, we should not forget the fact that, even though these technologies can be used to bypass the law, they can also be used as support or as a complement to the law. Blockchain technologies can contribute to increasing transparency and accountability at the government level, improving the efficiency of public administrations, protecting consumers through technological due process, and, more generally, implementing regulations through the combination of legal and technical code. It is therefore important to look at these new technologies not only as a threat to existing regulations, but also as an ally that could actually help the regulatory framework become more transparent and efficient.

To conclude, in spite of the crypto-libertarian discourse that describes the blockchain as a technology that exist beyond the scope of regulation, we need to understand that, in order to achieve massive adoption, the blockchain cannot operate independently of the law. Quite to the opposite, it is a technology that operates in the midst of a complex ecosystem, with many different stakeholders. For this reason, efforts to elaborate a sound regulatory framework for virtual currencies cannot be done in isolation. It is necessary to involve lawyers, engineers, entrepreneurs, economists, policy makers and regulators —all working together to figure out what can effectively be done with this technology both at the technical and regulatory level. For this technology holds great promises and perils, it will require the endeavor of people from many different sectors of activity to fully understand the impact and regulatory issues of these emerging technologies.

 

Primavera di Filippi

Primavera De Filippi is a permanent researcher at the National Center of Scientific Research (CNRS) in Paris as well as a faculty associate at the Berkman Center for Internet & Society at Harvard Law School.

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