Thoughtful Blockchain Regulation without Stifling Innovation

In this post I would be discussing the hot debate going on regarding blockchain regulations and the way it can be balanced with innovation. Blockchain technology, as we have discussed quite a lot of times before, is a distributed ledger that underlies crypto-currencies, and has become a vital factor for financial industry as virtual currencies like bitcoin are becoming increasingly popular. The rise of the blockchain technology can greatly transform how monetary transactions are carried out around the globe, leading to major disruptions for many industries, especially banking and finance. And like anything else concerned with money, the emerging blockchain technology is also raising cyber security and regulatory compliance questions both for businesses and consumers it serves.

In view of the polarizing debate regarding bitcoin, the regulators must think whether blockchain technology is equivalent to Internet of 25 years ago. Bitcoin, which raised the concept of blockchain in 2009[1], is a value transfer mechanism that works like a commodity or currency. It is questionably, the most significant financial innovation since global financial crisis of 2008. At first, only few people were aware of or cared about the bitcoin; however, widespread coverage by media of the Silk Road, an online platform for illegal drugs selling and buying that is transacted in bitcoin, introduced virtual currency to the public, with immense bad publicity. Since 2013, the bitcoin’s blockchain innovation however, has got much focus by numerous venture capitalists. In 2015, for instance, a number of huge Wall Street investments were seen in blockchain technology.

It is to be noted that apart from all the transformational benefits of blockchain, there are still some inherent risks that have immensely gained the focus of regulators. We are still unaware of all the implications involving this novel technology, including the unwanted consequences, theoretic failure scenarios and the complete extent to which it can be misused for terrorism financing and money laundering. The distributed nature of the blockchain based systems upsets the customer identification pattern central to laws on countering the financing of terrorism and anti-money laundering (CFT/AML)[2]. For instance, each financial institution is liable for its KYC (Know Your Customer) investigations; however, how can business carry out due diligence on each user across a distributed and decentralized payment system?

The criminal misuse of the bitcoin currency has already been seen in numerous high profile fraud and laundering cases. One of the board members of a nonprofit Bitcoin Foundation faced charges for money laundering in 2014, for supposedly conspiring with bitcoin exchange operator to sell USD 1 million in bitcoin to the Silk Road black market users[3]. In the same year, Mt. Gox, a Japan based world’s biggest bitcoin exchange, announced the stealing of USD 500 million in bitcoins by hacker from its poorly protected system. Former Gox CEO Marl Karpeles was charged by the Japanese prosecutors later with embezzlement, with an accusation of stealing USD 2.66 million from the clients[4]. Other regulatory and compliance challenges include global reach of the virtual currencies, consumer protection, feeble internet governance and cyber security.

While many countries like China, Thailand and Russia at first banned bitcoin, the other states like the United States, Germany and United Kingdom have been seen as more supportive for this innovation, though with a careful attitude. In the United States, the regulators are aggressively looking into matters of virtual currency compliance, regulation and related issues. For instance[5]:

  • The Office of Foreign Asset Control (OFAC) possesses the authority on digital currency exchanges made by the citizens of the United States to sanctioned bodies and entities.
  • The Financial Crime Enforcement Network (FinCEN) has published guidance and rulings regarding when virtual currency businesses must register as the money service entities.

It is quite early to predict the efficiency of these primary regulatory measures and how they will impact the financial industry. Benjamin Lawsky, New York DFS Commissioner fluently summarized the problem of balancing regulation and innovation in a Reddit Ask-Me-Anything session, conducted recently, stating that if we can avail proper guardrails in place to avoid money laundering, we can take a deep breath and in fact pay attention to make sure that virtual currency businesses progress and keep developing and innovating themselves. Nonetheless, we all are very excited regarding what the future brings with this powerful innovation.