Why Regulating Bitcoin Won’t Work

| Published on February 25, 2014 at 14:00 BST | Analysis, Law, Regulation, US & Canada

In recent months, bitcoin has skyrocketed in usage and popular attention. With all this increased exposure and rapidly growing business activity, the public sector was bound to get involved sooner or later.

Governments everywhere are increasingly taking steps to regulate bitcoin and other cryptocurrencies, but these responses have been anything but uniform. And, while some countries are taking a ‘hands-off’ approach, these are the exceptions to the general trend.

Canada and New York are both poised to enact new regulatory measures, Russia has been the first developed country to ban bitcoin outright, and China came pretty close to doing so back in December. While countries may be far apart in the way they tackle the issues raised by bitcoin, their fears are the same.

When Russian authorities announced that bitcoin was illegal, they outlined “laundering of money obtained through crime, as well as financing terrorism” as chief concerns, and that sentiment is echoed across many regulatory agencies.

This uniting aspiration to prevent money laundering highlights the inability of various governments to grasp how bitcoin really works, and how far out of their control it is.

Perhaps this ignorance was inevitable, due to the currency’s sudden and meteoric rise, which pressured governments to do something without giving them time to fully understand what was happening.

More harm than good

NetworkIndeed, even now it still seems impossible to predict how bitcoin and its surrounding services will continue to develop.

Nonetheless, this widespread failure to understand the fundamental principles behind the Bitcoin protocol and its implications can lead governments to make decisions that will ultimately harm economic development, while impacting criminal activity very little, if at all. One of the glaringly obvious flaws in the patriotic actions of countries like Russia to protect their citizens from terrorists and money laundering is the simple fact they cannot enforce it.

Bitcoin and all other cryptocurrencies are completely decentralized peer-to-peer systems. There is no central server to shut down, no one to catch and, crucially, no one prosecute – no one that will cause the currencies to crumble, at least.

Put simply, no government on the planet can stop me from downloading a wallet or mining client and connecting to the bitcoin network. Just ask the United States and other developed countries, who have been trying rather unsuccessfully to crack down on illegal P2P torrents over the last decade.

Hence, anyone who is intent on using bitcoin to launder funds overseas, for which it is most apt, can still purchase them from individual dealers, trusted miners, or even purchase their own mining hardware to turn that dirty money into crypto-coins.

Indeed, it’s easy enough to imagine how the bitcoin industry would develop in a permanently illegal context to serve the needs of already illegal organizations, potentially allowing them much more flexibility in both storing and moving funds around the world.

This is what scares governments, but the point they seem to miss, is that for better or worse, they can’t do anything about it.

Bitcoin and the Deep Web

Take Silk Road, the infamous anonymous online marketplace that allowed individuals to purchase just about anything with bitcoin.

Many other such markets exist in the Deep Web, and while there will occasionally be a highly publicised bust, criminal activity still continues on a massive basis. Outlawing bitcoin will not affect these already illegal operations in the slightest.

Even in areas where bitcoin isn’t considered illegal, any regulatory hurdles will inevitably hamper innovation.

Increasingly, we are seeing the development of ever more organized Deep Web markets, exchanges, and even private currency systems, as criminals move away from bitcoin to other, more anonymous digital currencies. Guess where most of this development seems to be occurring?

If you guessed the only developed country to fully outlaw all cryptocurrencies, Russia, you would be correct.

Another proposed regulatory measure is a ban on ‘tumblers’ – tools that allow users to confuse the source of their bitcoins. This idea, discussed in New York’s regulatory hearings, further highlights the unwillingness for traditional regulatory institutions to admit that they have no authority over the matter.

Tumblers, like illegal markets and exchanges, can be hosted anonymously from any server in the world. New York’s Department of Financial Services may as well ban the sun from setting, as they’d probably have more leverage there.

Legal trailblazers

The individuals most affected by government regulation are the ones already engaged in legal business activities and ventures – that is, those paving the way for an innovative and competitive financial future, and one with a global reach.

Outlawing bitcoin simply restricts legitimate business and drives the criminals underground, depriving the private sector at large of benefits of the cryptocurrency. Without government approval, legal businesses and users can’t take advantage of bitcoin’s speed, low costs, flexibility, and anonymity.

So, regulation would simply be driving the creation of another black market, while denying the substantial benefits of cryptocurrency to law-abiding citizens everywhere. We can already see in Canada that even naive talk of cracking down on bitcoin has dealt a crushing blow to developing startups.

Even in areas where bitcoin isn’t considered illegal, any regulatory hurdles will inevitably hamper innovation.

Countries with a more laid back approach are the ones likely to benefit most from a bitcoin-fuelled financial revolution – even if it’s still too early to tell what exactly that is going to look like.

Punishing the wrong people

This extrapolates to seemingly conventional regulations, such as requiring exchanges and other services to collect the personal information of customers.

Yes, anonymous exchanges might make it easier for those looking to launder money, but eliminating that avenue by requiring and tracking the personal information of everyone on an exchange does nothing to hinder it, either.

In a world without anonymous exchanges, bitcoin can still be traded privately from person to person, and nothing is stopping fully anonymous Deep Web exchanges and similar services from appearing. The only thing mandatory data collection would ensure is that honest individuals must go through more hurdles and lose even more privacy in the world of Big Data and growing government surveillance.

Level-headed approach

RegulationsBut is all potential regulation bad? Of course not, there are many steps that can be taken to create more confidence within the mainstream population without severely hampering innovation or the privacy of users.

Somewhere to watch if you are looking for sensible rules in the bitcoin industry seems to be New York, where Ben Lawsky has been noticed for his level-headed approach in bitcoin talks.

One sensible requirement would be to set a standard for security in public businesses that wish to store or facilitate bitcoin conversions or escrow. Another will be to make it illegal for such a business to move, invest, or otherwise use customer funds (essentially fractional reserve banking) without explicitly stating this to customers, who have the right to take their own risks with their investments.

Requiring bitcoin companies to have a good reserve of bitcoin and publicly publish their balance sheets would offer customers some peace of mind.

Naturally all companies operating would be liable for their customers funds, if lost, which would be paid to either them personally, if personal information is recorded, or to an existing offline wallet linked to their account. All of this would help increase legitimacy, confidence, and consumer protection in the industry without negatively affecting innovation, and would also end the “Wild West” era of cryptocurrencies.

Antiquated thinking

While some will argue that all of these standards and services would probably evolve organically from a free market anyway, it at the very least gives regulatory agencies something to do that isn’t just a knee-jerk reaction, with no positive benefits for legitimate businesses and customers.

Currently, most legislators continue to think of bitcoin in antiquated terms, and that’s the problem.

Bitcoin promises to create a whole new paradigm in the game of finance – the biggest technological innovation in the field in many years.

The entire cryptocurrency ecosystem, both legal and otherwise, is evolving so quickly that government regulations can’t even keep up, let alone plan. Legislators are now preparing to make rules for circumstances that have no precedent, that can be hard to understand in their current form, and that will likely not exist tomorrow.

Bitcoin requires a whole new way of thinking, and a much more flexible approach from governments, to allow it to develop legally within the free market and to bestow its benefits on the world’s citizens.

Wallnetwork and regulations images via Shutterstock

Ben LawskyRussiaUSA

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