Address by Director of Markets Supervision Gareth Murphy at the BitFin 2014: Digital Money and the Future of Finance Conference

Good afternoon ladies and gentleman. I am delighted to have the opportunity to address you today and to offer a regulatory perspective on virtual currencies. ¹

I was going to entitle this speech 'The Regulatory Challenges of Virtual Currencies'. After having listened to the earlier speakers and by the time that I have finished speaking you might agree with me that a better title might be: 'Where two worlds collide!'

At the outset, I think that it is important for me to state my belief that developments in mobile and information technology are very likely to change the landscape of financial services in the coming years. (And indeed, there have been a number of reports written on this subject recently).²  

Most of the regulatory reform agenda in financial services of the last six years has been a response to the crisis of 2008. This has taught us that we all have a stake in ensuring that severe financial crises ‒ wherever they might come from ‒ are less likely in the future. Technology-driven innovations in payments, savings and distribution typify some of the new challenges that financial authorities are likely to face in the coming years.

My remarks today:

• will cover seven issues which I think financial authorities should be concerned about,
• will outline the spectrum of regulatory engagement, and
• will mention some of the challenges which virtual currencies pose to policy-makers and regulators when it comes to framing regulatory engagement.

Which financial authorities?

Before delving into these issues, I should say that I am viewing the challenges posed by virtual currencies through the eyes of a broad number of interdependent public sector bodies at, a national and European level, which have some form of statutory role as stewards of the economy. By this, I mean central banks, financial regulators (or national competent authorities), ministries of finance (and other government ministries), fiscal authorities and statistical authorities.

Thought experiment

To frame my remarks today, I have conducted a simple thought experiment:

imagine a world in which a virtual currency develops to the point where a substantial amount of the goods and services produced and consumed in the economy are paid for in that virtual currency.

In effect, economic activity is the aggregate of domestic transactions in the 'euro-denominated economy' and the 'virtual currency economy'.

Unlike legal tender, the virtual currency is not produced by a statutory authority with all of the support which this entails. And governance around the production and supply of the virtual currency may be quite opaque and well outside of established norms of monetary and exchange rate policy.

Multi-currency economies are not unusual. For example, the US dollar is accepted in many economies alongside the local legal tender. Also, there are a number of regional currencies in existence in parts of France and Switzerland which aim to encourage transactions in local goods and services.³ 

But unlike these examples, rapid advances in information and mobile technology suggest that such a virtual currency could evolve. The factors behind this might include:

• the ease with which transactions can occur between counter-parties located anywhere in the world;
• the relatively low cost of effecting payment and transmitting funds;
• the fact that many large technology companies are household names that are recognisable and trusted; and
• the possibility of engaging a large market with a broad demographic span, particularly in terms of age, which is open to new innovations.⁴

So what are the issues that financial authorities are likely to be concerned about?

1. Economic Statistics

The starting point for all economic stewardship is the measurement of activity. Most countries have at least one official statistics agency charged with this responsibility. More widespread use of a virtual currency would mean that statistical agencies would have to gather data on activity in virtual currencies. Otherwise, measures of economic activity would not be complete. We should not underestimate the range of purposes for which national accounting measures are used in the stewardship of economies. In that regard, the completeness and integrity of these statistics is vital.⁵

2. Monetary and Exchange Rate Policy

Likewise when it comes to (a) measuring monetary aggregates, (b) calibrating monetary policy or (c) setting the price of credit, such a multi-currency world poses significant conceptual and operational issues for monetary authorities. Central banks, of necessity, have monopolised the exercise of these functions. Virtual currencies pose new challenges to central banks’ control over these important functions.

Similarly, exchange rate policy takes on a whole new dimension of complexity. The existence of a ‘euro-denominated economy’ and a ‘virtual currency economy’ raises the prospect of an internal balance of payments between two sub-economies where suppliers may prefer one currency over another as a means of payment (for different goods and services). And the exchange rate with the virtual currency would have to be closely monitored.

3. Tax Leakage

In the same way that monetary and exchange rate policy is likely to be complicated by the increased use of a virtual currency, so too, the country’s fiscal authorities need to consider the possibility of tax leakage to the virtual economy. There is a substantial threat to the country's finances if more and more transactions for goods and services in the national economy disappear from the tax net.

4. Payment Systems and Settlement Infrastructure

Another important task which most central banks perform is maintaining the integrity of the payments and settlement infrastructure. A failure of this, so-called, ‘financial plumbing’ (which we tend to take for granted when we cash a cheque or make an interbank transfer) would have a severe impact on consumer confidence and economic activity. Whatever infrastructure is used to support economic activity, irrespective of the denomination of that activity, central banks will have legitimate concerns that this infrastructure is reliable, resilient and robust.

5. Consumer protection

This leads us neatly into the issue of consumer protection.

Consumers expect currencies to be a predictable and stable store of value ‒ free from surprises, if you wish. When consumers lose confidence in currencies, the related uncertainty leads to a drop in economic activity. This may also lead to a potential waste of resources as consumers attempt to protect the value of their purchasing power by acquiring assets that have a stable consumption value. Financial regulators are always attentive to innovations in financial services and are mindful of the risks that consumers may rely on products or technologies that they do not fully understand.

In this regard, I thought the previous presentation⁶ was very instructive of the security risks of virtual currencies.

6. Anti-money laundering

In recent years, financial authorities have stepped up their efforts to prevent the proceeds of crime from being used to purchase goods and services in the real economy. Preventing such monies from entering the regulated financial services system is one way to achieve this. However, it is well-documented ⁷ that virtual currencies could provide an alternative channel whereby the proceeds of crime could be used to purchase goods and services. In this case, the application of current anti-money laundering (AML) regulations will be tested.

7. Impact on Regulated Financial Service Providers

Lastly, as a virtual currency starts to permeate economic activity, regulated financial service providers such as banks, insurance companies and asset managers may find themselves having to adapt to this new environment in order to maintain market share. This is likely to have a profound operational impact on these firms and their regulatory risk profile.

That was a whistle-stop tour of the types of issues that virtual currencies raise. I hope that this provides some useful insights regarding the challenges that policy-makers are faced with.

The Spectrum of Regulatory Engagement

To motivate further discussion on these issues, it is helpful to view the regulatory challenges posed by virtual currencies through the prism of a structured framework of regulatory engagement that has seven discrete steps ranging across:

1. data collection (or monitoring),
2. analysis,
3. policy formation,
4. regulation,
5. supervision,
6. enforcement and
7. resolution.

This so-called ‘spectrum of regulatory engagement’ ⁸ is characterised by a sequence of steps with ever-increasing levels of engagement and intrusion.

The first step is fundamental. Data is the lifeblood of any rational discipline ‒ regulation included. It supports the next step which involves analysing the issues of concern to regulatory authorities. Based on this analysis, it may be appropriate to consider whether certain policies need to be formulated. At this point various social, political and regulatory perspectives are brought to bear. Beyond policy-formation, the next step is the writing of legally enforceable regulations (or a rule-book, if you wish). After that, a supervisory framework to monitor compliance with the regulations must be designed and resourced. Where regulatory breaches are uncovered, enforcement action may follow. Enforcement is a distinct activity with its own resources and with internal processes which must conform with local laws on procedural fairness. Lastly, resolution is the most intrusive form of regulatory engagement. Here, financial authorities exercise, typically, far-reaching powers and step into the workings of a firm or a market so as to mitigate the effects of failure on the wider economy.

Applying this framework to virtual currencies illustrates many of the challenges for policy-makers and regulators.

Data Collection

Where do we start with the collection of data? Many parties who are transacting are simply anonymous (or pseudonymous ⁹) and are therefore off the radar. It is therefore very difficult to do any counter-party analysis (i.e. “to whom/from who” analysis), for example. In addition, the platforms which facilitate exchange and settlement are largely outside the current population of regulated financial service providers (though they may economic links with regulated entities).

Not surprisingly, the measurement of virtual currency activity on a legally-mandated basis would be a significant regulatory intervention. Choices would have to be made in relation to who should be legally obliged to report to financial authorities. That would potentially bring a whole new set of parties into the regulated net. However, in my view, this is a necessary element of any disciplined and proportionate regulatory engagement.

Analysis

As I mentioned earlier, the next step beyond gathering data is making sense of it. This analytical body of work very much depends on the policy questions of interest. There are a large number of issues which one may wish to explore such as:

1. who is transacting (to address AML concerns)?
2. how safe is the payments infrastructure?
3. how much economic activity is denominated in virtual currencies?
4. to what extent is the 'virtual currency economy' connected with the 'euro-denominated economy'?
5. how do we distinguish between transactional activity and speculative/investment activity?

And from a monetary policy perspective, there is also the fundamental question of understanding the supply of the virtual currency and its impact as a form of money.

Policy

Earlier, I enumerated seven reasons why policy-makers should be interested in virtual currencies. I will not reprise them at this stage.

However, in thinking about these policy issues, it is important to highlight the fundamental question which many policy-makers are asking which is "should anyone else be allowed to create money other than a central bank?" For the reasons I outlined earlier touching on monetary and fiscal policy, there is potentially an issue of sovereignty at stake here. Clearly rivals to the national legal tender pose challenges to central banks in terms of how to influence the price of credit for the whole economy. The implications for fiscal authorities are similar.

Regulation

As I said at the outset, technology will drive financial services in the coming decades. This presents new ‘perimeter problems’ for regulatory authorities because they have to think about new issues outside of their natural space which is, typically, framed within the context of existing regulations which apply to existing activity. Clearly, some of the current regulations such as the E-Money Directive, MiFID, Payment Services Directive, Anti-Money Laundering Directive and ECB Statistical Regulations may apply at present.

But we should not presume that current regulations are future-proof. It is possible that further innovations will mean that these regulations may no longer apply. This suggests that new regulations may ultimately be needed which are based on new legal concepts with a clear scope which must stand the test of time.

Supervisory framework

As I mentioned earlier the next step beyond writing the rulebook is the supervision of compliance with the rulebook. That requires resources. In particular, given the nature of this technology-driven innovation, specialist supervisory skills would be required. Like many employers, supervisory authorities are competing in a tight market for scarce talent with strong technology skills. However, supervisory authorities have the additional handicap of operating in a public sector pay environment.

Also, these days, successful supervision requires a substantial degree of international coordination and cooperation in order to avoid regulatory arbitrage.

Enforcement

A credible and proportionate threat of enforcement must exist to encourage a culture of good behaviour in financial services. The manpower challenges for delivering effective supervision apply similarly for creating an effective enforcement deterrent. But successful enforcement outcomes also depend on the quality of the regulations and the quality of the cases being presented by supervisors. (So effective enforcement depends on a sound rule book and good supervision).

Resolution

Effective resolution relies on all of these aforementioned steps as well as potentially significant powers of intervention and the appetite to use them.

I should add, that where there is theft of a virtual currency ¹⁰, it is for police authorities (such as the Gardaí in this jurisdiction) to investigate and pursue this criminal matter, in the first instance, though regulators may pursue further sanctions after the issue of the theft has been dealt with.

Conclusion

In conclusion, there are three key messages I would like to leave you with:

• Virtual currencies present a wide range of issues for financial authorities to consider.
• In my view, these issues are unique and will most likely require bespoke regulatory responses.
• Lastly, unlike the previous financial crisis when a culture of indifference by parts of the financial services industry towards regulation prevailed, I would urge this industry to work actively to address the concerns of financial authorities rather than 'playing cat and mouse' and eventually, and inevitably, being drawn into the regulatory net.

The challenge for you is to decide is which side of the regulatory tent you are on.

Thank you.

References

Bryans, D. (2014), “Bitcoin and Money Laundering: Mining for an Effective Solution,” Indiana Law Journal: Vol. 89, Issue 1, Article 13.

Coyle, D. (2014), “GDP: A Brief but Affectionate History,” Princeton.

Deutsche Bank Research (2012), “The future of (mobile) payments,” Current Issues Report, DB Research.

ECB (2012), “Virtual Currency Schemes,” European Central Bank, October 2012.

Gross, M.B., Hogarth, J.M., and M. D. Schmeiser (2012), "Use of financial services by the unbanked and underbanked and the potential for mobile financial services adoption," Federal Reserve Bulletin, Board of Governors of the Federal Reserve System (U.S.), Issue Sept.

Jack, W. and T. Suri. (2011),"Mobile Money: The Economics of M-PESA," NBER Working Papers 16721, National Bureau of Economic Research, Inc.

McLannahan, B. (2014), “Bitcoin exchange Mt Gox files for bankruptcy protection,” Financial Times, 28 February 2014. Available at: http://www.ft.com/intl/cms/s/0/6636e0e8-a06e-11e3-a72c-00144feab7de.html  

Moloney, K., and G. Murphy (2013), “The Spectrum of Regulatory Engagement,” Law and Financial Markets Review 7(3).

PwC (2014), “Asset Management 2020, A Brave New World”.

Sablik, T. (2013), "Digital Currency: New Private Currencies Like Bitcoin Offer Potential – and Puzzles," Econ Focus, Federal Reserve Bank of Richmond, Issue 3, pages 18-20.

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¹ The views I am expressing are my own and do not necessarily reflect those of my colleagues at the Central Bank of Ireland. I would like to thank Kitty Moloney, Neill Killeen and James O'Sullivan for their assistance.

² See, for example, PwC (2014), Gross et al. (2012) and Deutsche Bank Research (2012).

³ In addition, air-miles and a number of store credits exist which can be classified as (uni-directional) virtual currencies. See ECB (2012).

⁴ The success of M-PESA in Kenya shows the potential for this technology to reach a large market. See Jack and Suri (2011).

⁵ See Coyle (2014).

⁶ Delivered by Alan Reiner, from Armory, a virtual currency security specialist.

⁷ See ECB (2012) and Sablik (2013).

⁸ See Moloney and Murphy (2013).

⁹ See Bryans (2014).

¹⁰ See McLannahan (2014).