We Must Regulate Bitcoin. Problem Is, We Don’t Understand It

By Primavera De Filippi for Wired

Bitcoin has failed. Bitcoin is the future. Bitcoin cannot be regulated. Bitcoin needs to be regulated. The debate over what will happen to the decentralized virtual currency has reached a cacophonous point, and now lawmakers around the world are wondering whether the time has finally come to regulate this emerging technology.

As I have said before, Bitcoin as a virtual currency presents significant challenges to regulators. But one should not be too hasty to regulate Bitcoin, without fully understanding the implications of blockchain technologies more generally, with regard to their impact on innovation, competition and regulation.

With a 5 billion market cap, Bitcoin is slowly making its way into the digital economy, and a growing number of merchants—including Overstock, Newegg, Expedia, Dell and even Microsoft—are now accepting Bitcoin as a possible form of payment for their products. Of course, regulation will be needed eventually, both to address the risks and maximize the benefits of the technology. But it is difficult to regulate today a technology that we do not yet fully understand. Given the experimental nature of blockchain technologies, whose possible uses and applications are still to a large extent unknown, regulation should be elaborated carefully and in a well-informed manner, to avoid precautionary measures from curtailing the future of these new technologies.

Why Regulation Is Needed
Last month, the European Parliament held a public hearing (organized by the Committee on Economic and Monetary Affairs) to discuss the need and possible ways to regulate virtual currencies. Invited to this hearing were representative of the European Commission and the OECD, experts and practitioners from the private sector, and myself, as a representative of academia.

Blockchain technologies can be regarded as some kind of regulatory technology themselves, enabling laws to be enforced more transparently and efficiently.

Because Bitcoin is a decentralized payment system that operates independently of any government or central bank, people can exchange value on a peer-to-peer basis, without passing through any financial intermediary. This means that the Bitcoin network does not reside in any given regulation, and can therefore be constructed to be agnostic to any jurisdictional rules. Given this current lack of a central regulatory authority, people can operate the network in a pseudonymous manner, without disclosing their identity to anyone. This provides opportunities for criminal activities, including tax-evasion and money-laundering.

On the bright side, however, Bitcoin also provides a series of benefits to consumers: it can be used to transfer funds across borders at virtually no costs—providing new opportunities for cheaper and faster international money transfers, and potentially bringing new efficiencies into the remittance market.

A first regulatory response, in the U.S. at least, was the adoption of the New York State’s BitLicense, which purports to regulate virtual currencies by regulating commercial operators (such as wallet providers) as if they were regular financial operators or money transmitters —thus requiring them to comply with AML, KYC, and money transmission laws and regulations.

These rules have been heavily criticized for imposing onerous conditions on Bitcoin operators, and making it difficult for small companies or startups to operate in the space. Even more critical is the fact that, if extended to other blockchain-based applications, similar regulatory approaches could have the effect of seriously slowing down innovation in the blockchain space.

The Power of the Blockchain
The real innovation beyond Bitcoin is not the currency itself; it’s the underlying technology—the blockchain. The blockchain is a decentralized public ledger that is transparent and trustless—in the sense that it enables people to cooperate in a distributed manner, and to transact with one another, without the need for any trusted authority or centralized clearinghouse.

The blockchain is, first of all, an important accounting innovation which can lead to more efficiency and transparency in the field of many financial applications. It has also the potential to bring down the cost of regulatory compliance, thanks to specific features (such as multi-signatures) and other technical mechanisms (such as proof-of-solvency) which can be used to increase the transparency and accountability of traditional fiduciary institutions.

In particular, when it comes to regulation, blockchain technologies can be regarded as some kind of regulatory technology enabling laws to be enforced more transparently and efficiently. One of the key benefits of blockchain to regulation is that it solves the problem of “who watches the watcher”—which is a fairly common problem for many fiduciary institutions.

From a regulatory perspective, therefore, if virtual currencies present a series of challenges relating to taxation, money-laundering and terrorist financing, the real challenge is to figure out how to regulate them in a way that does not impinge upon the actual benefits that blockchain technologies provide, in terms of transparency, accountability, consumer protection and regulatory compliance.

The idea that blockchain technologies can be used as a powerful tool for increasing the transparency and accountability of financial institutions was raised earlier in January at the World Economic Forum in Davos, Switzerland. Similar claims have been presented into the IMF report on virtual currencies, and in a recent report published by the UK Government Office of Science, which describes how blockchain technologies can be used both by the public and private sector, to improve governance and regulation.

The bottom line is that the objectives of regulation are the same —but the mechanisms for achieving these regulatory objectives are different. As they can now be achieved in a way that is better, faster and cheaper by relying on the blockchain as a regulatory technology.

The Challenge to Drafting Regulation
The problem, of course, is that the same technology can also be exploited by other parties, in order to perform illegal activities. Take the case of the Silk Road anonymous drug market, where Bitcoin was used as a payment system for the sale of illegal drugs. So, obviously, this disruptive technology requires some kind of regulation.

The challenge is that most regulations today are defined by the product they are meant to regulate. Regulations thus assume a vertical dimension, whereas the innovation brought about by the blockchain has more of a horizontal dimension: it is a cross-cutting innovation that will affect many different sectors of society. And the compartmentalization of this technology into the crypto-currency debate might actually misframe both the challenges and opportunities of this new technology.

The blockchain is an emerging technology that has yet to disclose its full potential. What we are seeing today is only the tip of the iceberg; we do not know yet how this technology will evolve and what opportunities it will bring. Yet, current applications of the blockchain can be regarded, by analogy, as many things that we do know: it can be seen as a currency, as a security, as a commodity, etc.

The problem is that none of these characterizations properly account for the more horizontal and general-purpose nature of the blockchain. And this, I believe, is a key concept to understand in order to come up with a sound regulatory framework for this new technology, without getting sidetracked by the current hype around Bitcoin and other crypto-currencies.

The author would like to thank Pindar Wong, for his help in researching this article.

The article first appeaed in Wired