Financial Services & Fintech

Virtual Currencies – A Question of Trust

03 Nov 2013

9 min read

The pressing need for regulatory clarification on Bitcoin and other virtual currencies in Europe and beyond.

With the networked world becoming increasingly aware of Bitcoin and other virtual currencies within the past months, there are still several unknowns in the realm of virtual currencies. And the unknown doesn’t exist only at the level of consumers. Regulators are having clear difficulty in tackling the phenomenon of virtual currencies. A full year has gone by since the publication of the European Central Bank’s analysis of Virtual Currencies in October 2012 and little, if any, action appears to have ensued within the EU’s institutions.

In essence, the ECB’s analysis acknowledges that given the technical innovation and ease of proliferation brought about by the internet, it is inevitable that interest in and use of virtual currency schemes will grow in an exponential manner. It also recognises the fact that since such currencies are not often bound to a specific      country or currency    area, the law-making, regulating and law-enforcing is difficult, to say the least. Focussing on its specific objective, the ECB report concludes that as things currently stand virtual currencies do not pose a risk to price stability or jeopardise financial stability, primarily owing to their limited connection with the real economy, the low volumes traded and a lack of wide user acceptance. However, the sterility of the ECB’s report lies in the fact that no hard recommendations were provided, ostensibly on the basis that such currencies are “immaterial” at their stage of development one year ago.

Still, even after 12 months from its publication – within which period the number of Bitcoins in circulation have doubled – it is disappointing that regulatory authorities in the EU and in the rest of the developed world haven’t taken any clear stance as to whether or not they intend to recognise and/or regulate these schemes. The prevailing uncertainty is discomforting and poses several risks to naive consumers who are becoming increasingly interested in such virtual currencies, based on their mis-perception that such currencies could present investment or other opportunities, or real alternatives to traditional forms of money.

Whilst it is clear is that traditional forms of money as we know them, duly issued by a central authority on behalf of a government or group of governments, will be challenged by new technological developments. However one must be extremely cautious about treating every technological development as positive, especially when the issuer of the currency seeks to elude the transparency that is so critical for people to trust in order to store value.

What is a Virtual Currency?

The ECB’s paper provides the following definition of a virtual currency: “a virtual currency is a type of unregulated, digital money, which is issued and usually controlled by its developers, and used and accepted among the members of a specific virtual community”.

Whilst the ECB creates a distinction between three different types of virtual currency models, we are here interested in what are referred to in the ECB report as “Type 3” currencies. Type 3 virtual currencies have bidirectional flows, meaning that two exchange rates (buy and sell) exist, and they can be used to buy virtual goods and services, but also to purchase real goods and services.

An observation to be made at this juncture is the fact that the unregulated nature of such currencies is proposed to us as a defining feature of virtual currencies. If we define virtual currencies as necessarily unregulated, it is clear that anyone with enough technical competence or financial backing looking to create a new virtual currency can do so without the obligation of seeking any license or permit from the regulators.

The implications of this are significant and the inertia currently being demonstrated by the European regulatory authorities in dealing with such currencies provides no solace whatsoever. The truth is that it will most likely take a scandal to provide the necessary motivation to establish the clear regulatory treatment for virtual currencies. The recent Silk Road incident could very well be a foreboding of things to come.

Fiat money – fiat lux!

Fiat money is money that is not commodity backed. It goes without saying that trust is critical if the money is to be looked upon as a secure store of value and wealth. All currencies that are not based on the gold standard (or comparable asset backing) represent fiat money, and the bare-naked truth is that the world’s major currencies are not backed by anything more than the trust that we continue to have in the governments that issue that money.  A corollary of this central trust issue is that, as a very minimum, any issuers of virtual currencies should be transparent to and identifiable by the public at large.

Whilst the purpose of this article is not to single out any specific offeror of virtual currencies, Bitcoin certainly represents the single most recognized form of virtual currency today and, in our view, poses a real risk to the credibility of virtual currencies, particularly because there cannot be any element of trust in a virtual currency controlled by a person or entity that has jealously guarded its identity from the public domain.

In God we Trust – Bitcoin’s Satoshi Nakamoto pays cash

The central “trust” issue with Bitcoin lies firmly rooted in the fact that the identity of its creator and programmer, a certain Satoshi Nakamoto, remains unknown. This Japanese pseudonym is all we have as a clue about the identity of the otherwise unknown creator of Bitcoin.

Moreover, the rules governing the supply of such a currency remain unclear to say the least. Whilst it appears to be widely accepted by technologists that the currency may be legitimately earned by resolving complex computer algorithms, through the use of computers, my research hasn’t provided me with any satisfactory answers to various questions that I’ve posed over the past months, including the following:

  • What interest does Bitcoin’s creator have in resolving these algorithms?
  • Could Bitcoin actually be an (illusory) incentive for the world’s technological community to commit their computer processing power towards resolving a critical computational problem identified by the currency’s creator?
  • What would happen if Nakamoto / Bitcoin decided to double the supply of Bitcoins in circulation, thereby potentially halving the market value of a Bitcoin in an instant?
  • What prevents Nakamoto / Bitcoin from manipulating the “mining” of such Bitcoins to vest himself (or itself) with a windfall of Bitcoins over a period of time?
  • What if the entire Bitcoin infrastructure or centralized register is “wiped out”, whether due to a technical fault or deliberately?
  • What protection would there be for consumers holding Bitcoins at the time of the “wipe-out”
  • Who is Nakamoto?
  • Why should anyone trust Bitcoin?

The questions are many. The answers, on the other hand, are scarce.

Keep Calm and Go Virtual … or maybe not!

Because of this opacity and lack of information, Bitcoin cannot be considered to be safe money. It undermines one of the central functions of money, namely the function of acting as a store of value since its value depends to a large extent on the proper management of the currency by Bitcoin / Nakamoto, and it is not really conceivable to entrust the fruits of one’s labour to the whims of the unknown operators of this currency.

Bitcoin aside, all virtual currencies share the same fundamental risk. They are not regulated and do not involve any kind of supervision or oversight. No one appears to be accountable for their acts, and there is nothing comparable to an investor / depositor protection compensation scheme in place. As a consequence, users bear all of these risks themselves.

The prevailing uncertainty in respect of the correct regulatory treatment of such virtual currencies and their issuers is in nobody’s interest, except the virtual currency issuers themselves. Merchants, businesses, entrepreneurs and consumers continue to suffer the consequences of the ambivalence created by the lack of regulatory direction from the relevant authorities. In this regard it is worth mentioning that even the Electronic Frontier Foundation (EFF), the organisation established in 1990 with the sole objective of championing freedom in the networked world, has taken a stance against accepting donations in Bitcoin due to the ambivalence and complications presented by this virtual currency. This action speaks volumes.

Where to from here?

Whilst we should certainly look towards embracing the incredible potential that technology is unlocking in many aspects of our lives, the fact remains that regulators’ obligation to protect consumers against the risk of being defrauded of their hard earned money remains paramount. The fact that the Bitcoins currently in circulation have an accumulated value of less than Eur 2 billion[1] in no way exonerates regulators from providing such protection. This value is growing exponentially and evidently becomes more material should there be any jump in the virtual currency’s market value.

The delay on the part of governments and regulators to take concerted action in taking positive steps towards imposing more transparency on virtual currencies and their operators continues to create risks for merchants and consumers. It provides a huge window of opportunity for ill-meaning characters to create unregulated currency schemes and carry on their activities, however shady, with little, if any, risk.

It seems sufficiently clear that traditional fiat currencies as we know them will be challenged and radically changed, if not replaced, within a relatively short time-period, and if law and order are to be preserved in the course of this process, it is up to the world’s governments to act fast and ensure that the development of alternative forms of money is conducted within a framework of fundamental principles intended to preserve financial stability in the long run.

[1] At the time of writing there are 11,884,675 Bitcoins in circulation. Taking the average exchange rate of Eur 150 per Bitcoin, gives a total circulation value of Eur1.8 billion.