Cryptocurrencies are attracting a lot of unfriendly attention. UK Prime Minister Theresa May is concerned about criminal activity, and US Treasury Secretary Steven Mnuchin has also said this is his number one cryptocurrency concern. Leading US financial regulators have also expressed concerns about fraud and unregistered business platforms where people exchange cryptocurrencies.
The concerns are legitimate. But rushing in with regulations may be counterproductive because our historic regulatory approaches do not fit cryptocurrencies.
What are cryptocurrencies?
A cryptocurrency, or coin, is simply an entry on a distributed ledger, stored on computers worldwide, which in most cases contains all the transactions that have ever occurred for that cryptocurrency.
A person engages in transactions through a wallet, which is just software that interacts with the distributed ledger. A person controls his or her wallet with a private key — a code — that is required to transfer coin out of a wallet. Each wallet also has a public key, which people can use to send coin to it.
What keeps someone from changing the ledger and stealing coin? A technology called blockchain. Blockchain incorporates the existing ledger into a code called a “hash.” If someone tries to steal coin, the hash automatically changes and the computers that store the ledger notice and cry foul. In fact, every time someone engages in a transaction, these computers, called miners, verify the transaction by solving a complex mathematical puzzle that involves the hash. The miner that does so the fastest is rewarded with coin, which keeps the system financially viable.
Why are illicit activities an issue?
It is hard to determine who owns the private keys. Wallets are not generally subject to know-your-customer regulations, so key owners can remain anonymous. Tech-savvy people can sometimes figure out the identities of key owners, such as in this study by some Australian researchers.
People wanting to engage in illicit trade, such as illegal drugs, find the privacy valuable, so they have begun using cryptocurrencies for their activities. The Australian study made a rough estimate that about half of bitcoin transactions in 2017 were in illegal trade, although the percentage is falling.
Why are there issues of fraud?
At least some users of cryptocurrencies think of them as traditional currencies or securities and do not conduct due diligence before buying or using coin. Whenever buyers lack expertise, disreputable people take advantage of the situation by, for example, creating and selling coins that have no underlying business purpose.
Over 200 new types of coin were created last year by entrepreneurs that were bypassing traditional venture capital and angel investor systems. Some of these business creators were amateurs, as were some of the coin buyers, resulting in business failures in a sector where constant innovation already makes failure rates unusually high. This could look like fraud.
What should be done?
The issue isn’t whether fraud or illicit trade should be illegal — they already are, and they were occurring long before cryptocurrencies were created. Rather it is that the tools underlying coin are new and defy our traditional ways of thinking about regulation.
Our historical approach to regulation is to define a category of business activity, like debt securities, and establish a regulatory system around it. This has been workable because our pre-digital technologies were so stable.
But the software tools that create cryptocurrencies — such as blockchain, wallets, mining, smart contracts, and exchanges — are anything but stable. Their adaptability is undoing our traditional regulatory categories and, along with the internet, may represent the beginning of the end of traditional regulatory frameworks.
Industry, governments, and customers should create what some call regulatory sandboxes where developers and customers can experiment with new forms of relationships and transactions and where governments can learn. These test beds can try methods of self-regulation and smart contracts that make fraud and illicit trade harder, with government regulation filling in where a trusted third party is needed. Perhaps these tools can even improve people’s trust in government.