A Common Sense Regulatory Framework for Digital Currency

By: Submissions

John Dunham writes: The phrase, horror vacui, or nature abhors a vacuum, was attributed to Aristotle, who suggested that nature contains no vacuums because the denser surrounding material would immediately fill any void.  This physical postulate is often applied to the idea of government regulation.  If something is not regulated (or in many cases highly regulated) then it is indisputable that some government will step into the void.  In the case of digital currency and/or cryptocurrency, the concept of horror vacui is in full swing as governments from the European Union to the United States to China are all proposing broad regulations on the development and operation of digital currency markets.  This is on top of local court rulings, such as that made by a Miami-Dade Florida circuit court judge who ruled that Bitcoin was not a currency.

With all of this activity, it is important that policy makers don’t simply fill the vacuum with poorly thought out regulations, but rather that they take the time and effort to ensure that a common sense, pro-consumer regulatory framework for the digital currency industry is established.  In establishing such a framework, it is first important to understand exactly what a digital currency is and what it is not.

What exactly is a Digital Currency?

There are many forms of digital currency competing in today’s marketplace, and all of them are descendants of earlier mediums of exchange.  Since the beginning of civilization people have looked for common stores of value that they could use to help complete trading transactions.  Simply put, it is difficult to trade a goat for a loaf of bread since the amount of time and effort to produce a goat is much greater than that to produce bread.  By establishing a common and easily exchangeable measure of value (say gold, salt or wampum shells), societies can encourage trade between individuals, thereby increasing specialization and economic growth.

Digital currencies are just a modern equivalent of an ounce of gold or a peck of salt.  Since World War I, and particularly following the Second World War, the U.S. Dollar became a median of exchange accepted across different societies and countries.  Dollars were easy to store, to transfer, and, for a very long time, maintained their value.  But making payments in dollars comes with a multitude of transaction costs, including conversion fees (to a local currency), storage costs, transportation costs (or wiring fees).  These costs are one important impediment to trade particularly for those in many of the poorest countries.  The development of blockchain technology can change this.

The blockchain is basically a distributed database. Think of a giant, global spreadsheet that runs on millions and millions of computers. It’s distributed and open, so anyone, even participants in a closed network, can see what’s going on in, such as ownership changes. Additionally the blockchain allows people to know their customers and avoid becoming involved with prohibited individuals or illicit behavior. It’s truly peer to peer; it doesn’t require powerful intermediaries to authenticate or to settle transactions.  And it uses state-of-the-art cryptography.  These blockchains are the technology that has helped create a market of competing digital currencies and open up the possibility for them to become an inexpensive and technically-secure method for accounting for financial transactions.

Blockchains allow for a digital currency to replace physical mediums of exchange like gold, salt, or US dollars.  But while digital currencies are in a strict sense a medium of exchange, they are not a form of currency.  This is the distinction that the court in Miami recognized, and is the most important element that policy makers need to understand in developing new regulatory structures.

Why are Digital Currencies Not Money?

While money (or traditional currency) is also a medium of exchange it differs from digital currencies in two important aspects.  First, money is issued by nation states, and the legal authority of the state provides it with certain characteristics that no digital currency can embody.  The most important of these is that governments can require that their currency be accepted for all payments.  Look at the front of any Federal Reserve Note (or US dollar) and it reads This note is legal tender for all debts, public and private. In other words, all stores, governments, post offices, and employees in the United States are compelled to accept Federal Reserve Notes as a form of payment.  A store could also accept gold if it wished, or apples, or really big rocks, but it is not required to.  The same is true for digital currency.  A store can accept one or many of the competing forms of digital currency but it is not required to.  Nor is the Federal Government going to accept a Bitcoin as payment for income taxes.

The other aspect of money that differs from digital currencies is that the monetary base (or the amount of currency in circulation) is up to the whim of the issuing government, and governments can use a range of different economic policies to either deflate or shore up those currencies.  These include raising or lowering taxes, changing the regulatory structure and reducing spending. The base for digital currencies is also limited.  It is however, not arbitrarily set by government fiat, but by some form of cooperative structure or market.  This allows the value of a digital currency to float freely based on supply and demand.  Whether one “mines” their digital currency by answering complicated coding questions or participates in a closed network where digital currency is purchased, the market will only work if everyone involved has information on: 1) The amount of digital currency mined, purchased or otherwise issued over a period of time, and 2) The level of acceptance as a median of exchange in retail or other formats.

What Would Be Appropriate Regulatory Requirements for Digital Currencies?

Since digital currencies constitute a medium of exchange that works as a marketplace rather than one created simply by government fiat, there is a burden of transparency on the industry.  This makes the discussion of corporate disclosure important.  Digital medians of exchange are instruments for settlement and the blockchain technology is an excellent underpinning to this application. However, any digital currency, like any marketplace, is only as good as the management of the company sponsoring it. Therefore, ethical management and transparency are critical to the performance of any form of digital currency.  So too are meaningful, well-informed regulations. Those countries that understand these concepts and adopt common sense regulations will see a tremendous benefit, as digital currency markets cannot work in a vacuum, but will tend to work best under a meaningful regulatory framework.

Without a meaningful regulatory framework, consumers will continue to view the industry as confusing and riddled with misinformation.  Their  knowledge of how digital currencies can benefit them will  be warped by competitive infighting and allegations from the major competitors, some of the which are trying to define themselves as forms of money, drawing in regulators and creating even more confusion.

To foster and encourage blockchain technology advancement and the application to medians of exchange and settlement, a common sense regulatory framework needs to be established.  This framework needs to be based in solid economic theory, and facts, not on emotion and opinion.

As they work to establish such a framework, regulators should focus on the differences between a currency and a medium of exchange, and since digital currencies are no different than any other recognized medium of exchange, the regulatory structure should likely be no different than that applied to similar products line credit cards, travelers’ checks, gift cards and money orders.  

What differentiates digital currencies is that they contain within themselves a free floating price component.  This is like having a traveler’s check that can be traded or exchanged in a market and whose value will fluctuate depending on supply and demand.  Therefore, digital currency is a financial instrument which not only settles a payment, but can serve as an investment whose value can change over time.  Digital currency can also be used electronically with very small transaction costs (which is something very unique to the global payments industry). Additionally, digital currency or cryptocurrency can be sent peer to peer like email in either an open or closed loop system, and finally, transactions are publically recorded on a blockchain ledger utilizing blockchain technology. As stated earlier, the blockchain technology provides transparency and allows sellers to know their customer and avoid becoming involved with or prohibited individuals or in illicit behavior.

Globally, many forms of regulatory regimes exist for mediums of exchange such as credit cards, traveler’s checks, etc. Utilizing the regulatory framework that exists for those payment systems would be the best place to start the regulatory dialogue, as it is the best opportunity to foster innovation in this space and provide consumers with all the benefits this space can provide them. An appropriate and smart regulatory framework should be consumer oriented and not allow government over-regulation to stifle or kill the industry, or create a market designed for one large first mover to take over the industry and become a monopoly player. 

Government should look to existing regulations as a roadmap for how to establish rules for digital currencies.  These are:

• Travelers checks (which are used to settles a payment but are not like a credit card which has debt limits and is a form of a loan);
• Equities (which have a market based free-floating price component);
• Wire Transfers (which are electronically transmitted);
• Email (which operates on a decentralized peer- to- peer network);
• The Internet (which operates a publicly- stored record of addresses and transactions – through the Internet Corporation for Assigned Names and Numbers or ICANN)

Additionally, any new regulatory framework should include reporting and disclosure requirements that are similar to that required by publicly traded companies.  This is because the other distinguishing feature of digital currency is that the value of the “instrument or median of exchange” can fluctuate much like a corporate equity or stock certificate.  The ability for a digital currency’s value to fluctuate comes from the fact that they are traded through a wide variety of exchanges or amongst private individuals. A great deal of dialogue must be spent on exchange integrity and insurance disclosures. In fact, nearly all of the recent issues surrounding digital currencies have come from problems with the exchanges.

The whole world of blockchain technology and digital currencies was not originally set up with a sophisticated governing structure like the internet, or bank transactions, or a highway system.  In the case of the internet for example, there is the Internet Engineering Task Force, which creates standards for the Net; the Internet Governance Forum, which creates policies for governments; the W3C Consortium, which creates standards for the Web; the Internet Society; that’s an advocacy group. There’s the Internet Corporation for Assigned Names and Numbers (ICANN), an operational network that delivers and manages the nomenclature for domain names. 
 
In conclusion, clarity, transparency and consistency are needed to ensure that people worldwide receive the full benefit this emerging market of digital currency. Tremendous value can be unlocked globally through this simple and efficient medium of exchange. To get to this, regulators need to open a comprehensive dialogue on reasonable regulation, and that discussion needs to begin with a thorough understanding about what the product is and which criteria best describe it.

By John Dunham

Managing Partner

John Dunham and Associates

John Dunham is the President of John Dunham & Associates, an economic consulting firm based in New York City.  John specializes in the economics public policy issues and controversial products and has conducted literally hundreds of studies on the effects of excise taxes and regulations.  He is a regular commentator on U.S. economic conditions.

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