Cryptocurrency regulation by identification is failing

While authorities around the world target the anonymity of digital currencies with impracticable regulation, the industry innovates at an exceptional speed, complicating effective regulation further. There is a better solution to the problems around regulation of digital currency, but it requires an innovative approach from the authorities.

Members of the European Parliament (MEPs) seek significant regulatory authority over the usage of digital currencies like Bitcoin. With a draft publishing, prepared by the EU Parliament Committee on Economic and Monetary Affairs along with the Committee of Civil Liberties, Justice, and Home Affairs, MEPs are deliberating to extend the scope of the Anti-Money Laundering Directive (AMLD) to include digital currencies.

Global focus on money laundering

The most relevant amendment proposed in last month’s draft explicitly states “virtual currencies should not be anonymous” in order to combat risks related to anonymity.

Europe

The proposed regulation fits recent events concerning money laundering with cryptocurrency. In the Netherlands the prosecution department was able to crack down three cases of money laundering concerning millions of laundered euro’s. Although this seems straightforward and effective, the focus on laundering with digital currencies is remarkable. A recent money laundering scandal revealed that billions of fiat currency are being laundered year after year through regular banks. Banks that don’t facilitate anonymous transactions.

Throughout Europe there’s an extended focus on digital currencies and it’s use in money laundering. This month the Belgian Minister of Justice proposed to confiscate all cryptocurrencies in circulation and start regulating all transactions with digital currencies.

USA and Japan

On the other side of the world, in Japan, a different approach was chosen to regulate digital currencies. After the failure of the bitlicense and it’s succession in the United States of America, Japan proposed regulation in 2016. After the implementation this year it is expected that innovation is pushed out of Japan as well. Due to a bureaucratic assessment process and high compliance costs henceforth only ‘established’ digital currencies can be used by incumbent companies.

It looks like more work is needed figuring out a sound set of rules that fit the needs of regular users and businesses of the technology. And even if an acceptable implementation of digital currency regulation is found, the innovation in this space will be hard to keep up.

A vast and innovative ecosystem

Since the genesis of Blockchain technology, with the implementation of Bitcoin early 2009, thousands of variations have been introduced with new different blockchain networks. Many of these networks introduce new technologies that provide functionality for entirely new usecases and business-models in different fields.

Digital currency

Monero, for example, includes severe anonymity features that allow users to hold and spend their digital currency entirely off the radar.

Besides anonimity features other networks offer on-chain governance of funds. With Dash this feature allows funds, in the form of Dash ‘tokens’ with a fiat value, to remain available within the network for specific purposes. These assets are not owned by anyone in particular but rather by the network itself.

Digital assets

Another area of innovation focuses on the digital representation of assets. Digital tokens that represent assets or ownership-rights from the non-digital world. These systems, for example the bitshares and melon networks, allow automation of exchange and storage of all kinds of value from assets we all know up to entirely new asset classes.

The implementation of most asset classes are relatively straightforward and easy to comprehend for the laymen. But as we progress the assets become smaller, more specialised and, gradually, less significant from a regulatory perspective or simply impossible to regulate in a cost-effective manner.

Extreme innovation

An interesting example of innovation in the space is Pepe The Frog. Rare Pepes are collectible digital cards with illustrations of a frog. The digital assets can be copied but the certified collectibles, issued on the counterparty blockchain by a foundation, are provably scarce and sometimes have digital currency tied to them. The scarcity allows these digital assets to gain value as demand from collectors grows. Value that is in no way reflected by the digital tokens they are tied to on the blockchain. The cards are currently traded up to $6300 by enthusiasts of this peculiar form of art.

More interesting is, in regards to money laundering, the enormous amount of innovation that shoots from these open source projects. The rather odd Pepe cards are currently crossing markets. The collectables are also found in computer games to offer new forms of unique gameplay. With new use-cases the value of digital assets goes up and becomes more stable. As a result Pepes are used in the black markets of Venezuela in a fight against a dismal economy.

Diversifying market

With the increasing number of digital assets in the market, the percentage of the total market capitalisation of each individual token reduces, including Bitcoin’s. In the mean time diversification of the functionality of the assets make it harder to define regulatory standards or translate the value to American Dollars or Euros. Though it is always possible to express the value of a digital asset in fiat, different tokens are focusing increasingly on different expressions of value.

Time is the coin of your life. It is the only coin you have, and only you can determine how it will be spent. Be careful lest you let other people spend it for you. – Carl Sandburg

In 2014 Andreas Antonopoulos, author of two books about Bitcoin and blockchain, described how a new ecosystem is built that, in the future, consists of millions of ‘tokens’ or ‘coins’ that represent all kinds of value and are exchanged between people, organisations and computers. Some of the participating entities will be identifiable, but when transactions need little friction, low cost and fast (automated) processing this might become too burdensome.

Regulation is bound to fail

If we look at the recent years and the growth of innovation that rises from blockchain and digital currencies, it is likely that the amount of (successful) blockchain networks, the related tokens and the underlying features will keep growing exponentially. As more tokens become useful billions of people, and especially computer systems, will exchange the assets efficiently and automatically.

More and more different types of value, that can be efficiently exchanged, will improve our lives in different and increasingly smaller ways.

Digital airmiles, access to a stash of real gold or the value of the data that represents a carefully compiled collection of digital swords inside the MMORPG-account of a child gamer; All sorts of value can be exchanged and controlled more easily with open blockchains, at every time of the day.

Innovation will overtake current regulation

The amount of fraud and illegal activities with cryptocurrencies or digital assets is very small. Especially when it is compared to international terrorism financing, money laundering and other illegal activities using traditional financial methods. Long before the illegal activities with digital currencies or other decentralised assets become slightly significant, distributed systems will have evolved into thousands, sometimes entirely anonymous, highly specialised networks. And these networks will be censorship-resistant, impossible to control.

As automated systems exchange an ever increasing amount of assets, or data, to a decreasing extent people will translate the value of all this data to their net worth, in Euro’s or American Dollars. With this the demarcation of current regulation will become increasingly impossible.

Wrong side of history?

During an IMF panel discussion Marco Santori, a fintech lawyer, was provoked by one of the statements (min 1:12:40). He warned fintech will unavoidably hinder regulatory efforts over the following years. Also he affirmed the irreversible decentralisation trend in finance, led by open transparent blockchain networks. Laws struggle with these innovations, as the new networks will never fit the current regulatory regimes.

For the past decades financial regulations have focused on nodes, but with decentralisation there are no nodes. Nodes aren’t relevant anymore. So how do we regulate this? And who do we regulate? Mr Santori explained that it is not possible to regulate these systems and mentioned he is afraid of knee jerk reactions from the authorities, like we saw in Belgium.

He proclaimed passionately that permission-less open ledgers are bettering lives today! If regulation shifts further to a place that stifles innovation or impedes our day to day lives in terms of privacy, that would be a tremendous loss.

Despite strict money-laundering controls, regulators remain unable to prevent illicit transactions going through large financial institutions on a large scale. With digital currencies and numerous new digital assets, that allow easy anonymous storage and transacting, thousands of new ways seem to emerge to circumvent the authorities. Some experiments with regulation of anonymous digital currencies seem promising but require cooperation between authorities, users and developers of digital currencies. The only way out for the authorities is stepping towards the right side of history; Start collaborating and explore new ways of taxation and regulation.

The problem and the solution

According to Patrick Murck, a fellow at the Harvard Berkman Klein Center, large central repositories of value (or data) lead to ever bigger destabilising risks in the financial markets. The solution for today’s problems in the financial markets cannot be found in the regulation we have introduced at the same level of thinking to prevent them.

Ironically, the solution for problems in the financial markets are found in transparent systems that distribute data across the entire network and promote individual privacy; Open permissionless blockchains!

According to Mr Murck the solution to the regulatory challenges lies in more powerful tools to analyse all the data throughout these blockchain-networks and end the collection of large amounts of data (or value) centrally. When regulators perceive open transparent permission-less blockchain technology as a new possibility, not as a threat, we can progress towards acceptance that we will have to renegotiate the balance between privacy and transparency in our financial system and the markets as a whole.


Also published on Medium.

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