Why Know-Your-Customer Rules Won’t Work With Bitcoin

Ariel Deschapell
Apr 13, 2014 at 12:56 UTC
Updated Apr 14, 2014 at 11:01 UTC

Know Your Customer rules exemplify why moulding bitcoin into the current regulatory framework won’t work, argues Ariel Deschapell.

Square peg round hole

Regulation is a persistently hot topic in the cryptocurrency world, with a growing number in favour of government getting involved to further legitimize bitcoin.

This includes Circle CEO Jeremy Allaire who recently remarked:

“Bitcoin needs greater levels of governance around it. I do not believe this industry will grow without collaboration from governments around the world.”

Allaire stressed that a middle ground must be found between privacy and the needs of governments and authorities.

This sentiment is reflected by a majority of new industry entrants who want to see bitcoin mature quickly into a legitimate industry in the eyes of banks, Wall Street, and the mainstream in general. It also stands in stark contrasts to the very libertarian spirit still held by many in the community.

Proponents of greater regulatory oversight, such as Allaire, can easily claim to be the practical ones in this debate, recognizing the fact that to achieve its full potential, bitcoin must be incorporated into the existing regulatory hierarchy. While there is little doubt bitcoin can’t continue its Wild West free for all, it’s a little more complicated than that.

Impossible task

Eric Holder, US Attorney GeneralEric Holder, US Attorney General

It’s obvious governments aren’t going to simply stop trying to regulate cryptocurrency anytime soon. With this in mind, it becomes tempting to simply advocate that the industry ‘grow up’ and conform to the traditional financial regulatory institutions instead of fighting them.

But however seemingly practical this attitude is, it is anything but. Know Your Customer (KYC) rules are a clear example of why moulding bitcoin into the current framework is a fools’ errand at best, and is bound to create highly controversial issues.

US Attorney General Eric Holder has been the latest major figure in the regulatory world to comment on bitcoin:

“As virtual currency systems develop, it will be imperative to law enforcement interests that those systems comply with applicable anti-money laundering statutes and know-your-customer controls.”

Unfortunately it’s not quite that simple. Bitcoin as a whole is a decentralized system that doesn’t require any third parties to interact with, and can’t be controlled or directly regulated by any central authority.

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The only thing that any government would have jurisdiction over are exchanges and other services located within its borders, to which the KYC rules would apply.

KYC rules require money-related services to be able to identify all their customers, and self report ‘suspicious activity’ that can be signs of anything from money laundering to terrorist financing.

In the traditional financial sector, this makes money laundering much more difficult (although nowhere near impossible). This is because, in order to interact with the modern financial system and transmit money electronically, you need to use a third-party service such as a bank, which are easy points of regulation.

Regulation trade-off

However, with bitcoin it’s an entirely different story.

No one needs a third-party service to own, spend, or send bitcoins anywhere in the world. All that is needed is an open-source wallet, of which there are plenty available to download.

Individuals who are intent on using bitcoin for illegal and malicious uses can easily avoid regulated exchanges and services that require KYC compliance.

In a world where bitcoin is a widely accepted means of payment, forced regulatory compliance to KYC and similar measures does effectively nothing to negate money laundering. It will only serve to increase the cost of running a bitcoin-related company.

As this cost increases those most affected will be fledgling startups who don’t have the extensive legal departments that banks and larger companies possess. This will always hamper innovation, and inevitably push it overseas. So is the trade-off worth it?

For the traditional financial sector it may very well be, depending on who you ask. With bitcoin, however, the picture is far clearer. Every individual is fast becoming able to to move money all over the planet cheaply and without any institutional oversight.

Like any other tool ever invented, bitcoin can be used with both beneficial and malicious motives, and no central authority can do anything about this if they tried. There’s no going back. The real problem is whether governments will accept this new reality and plan appropriately, or continue to fight it.

Regulatory bodies can’t fit bitcoin into current regulatory framework. The two are simply not compatible, and that has nothing to do with any libertarian sentiments in the community. It’s fact.

The degree of oversight government now has in the traditional payments arena is impossible to replicate with bitcoin, as creating appropriate rules for the bitcoin industry would mean starting from the ground up.

Change of thinking

Think differentRegulators need to extensively educate themselves, and realize regulating this growing new ecosystem requires a totally new approach. They need to discuss and learn what is possible, what isn’t, what they ultimately want to achieve, and then analyze the costs and benefits of all resulting legislative ideas for society as a whole.

Despite a more compromising attitude from several industry leaders and many in the community, drafting any sensible legislation will be no easy task. I previously wrote that bitcoin is changing everything, and that includes the governments historically iron-clad control of the financial system.

Any massive adjustments to that level of control due to bitcoin aren’t going to take place without controversy. Any systematically sensible approach will require a major change in the way regulators like US Attorney General Eric Holder think of the role of government.

It will cause us not only to rethink what government should monitor, but what it even has the ability to monitor. Will it have any justification to continue to collect private financial data and enforce KYC rules when it only hurts innovation and when the effect on money laundering will be nonexistent?

This is especially important in light of public opinion becoming increasingly wary of large government agencies like the NSA, which are already doing plenty to mine data on entire populations.

Regardless of the desire of industry leaders to speed the regulatory process along, it will probably be a long uphill political battle to create legislation that actually makes sense and thus actually benefits the bitcoin ecosystem as a whole. Certainly trying to fit bitcoin into existing rules won’t be doing it, or anyone, any real favours.

No one should be surprised if cryptocurrency gradually became a larger and more prominent subject in political campaigns as mainstream usage continues to grow, and its effects on the economy and governments regulatory ability start to be felt.

Asking the right questions

The question is, how are politicians and regulators going to react? Will they continue to waste time and effort on the hopeless task of asserting the same amount of control they have in the traditional financial sector? Such an attitude won’t help bitcoin as a whole regardless of the short term ‘legitimacy’ it gains from it.

Or will governments willingly adjust to a new way of thinking, and thus help push a massive technological innovation that will have immeasurable benefits for the world economy?

The important question isn’t whether bitcoin needs regulation – it’s what kind? And why? That’s the honest and extensive discussion that should be occurring.

This debate carries massive consequences and will undoubtedly be dragged out into the national and public level. The importance and implications of the questions brought up by cryptocurrency demand nothing less.

How exactly all of this unfolds, we will only be able to tell with time. The only thing that is certain is that regardless of the political dilemmas it provokes, the world needs an open-minded approach from governments toward bitcoin, because the world needs bitcoin.

Square peg and think different images via Shutterstock

Ariel Deschapell is a freelance opinion and news writer for CoinDesk: his opinions do not necessarily reflect those of CoinDesk.