Cryptonomy's Response to HM Treasury Call for Information

Cryptonomy’s Response to HM Treasury Call for Information.

Submitted 30.11.14 – PDF version

About

Cryptonomy Ltd is pleased to respond to the HM Treasury digital currencies call for information.

Cryptonomy Ltd is a digital currency consultancy based at the business incubation centre at the University of Sussex in Brighton. We advise on the emerging field of digital currencies and are also building a number of interesting technologies for clients. We are currently developing the world’s first decentralised exchange able to atomically swap digital currency pairs directly between blockchains and also digital currency for fiat.

Question 1

What are the benefits of digital currencies? How significant are these benefits? How do these benefits fall to different groups e.g. consumers, businesses, government, the wider economy? How do these benefits vary according to different digital currencies?

Digital currencies change the mode of financial transfers from a ‘pull’ based model to a ‘push’ model where only the owner of the digital currency can authorise its transfer.

Security is simplified and decentralised. Put simply there is no central point on which to focus an attack and the parts of the network that are public cannot be attacked either. This is in contrast to current centralised finical systems where a user’s credit card number can be stolen or website shop compromised allowing attackers to steal thousands of individual credit card numbers and bill their holders.

Digital currencies provide a step change in security, reducing the risks of fraud along with all the associated costs to consumers and business: customer’s money cannot be taken fraudulently from accounts and without a central point of attack the network is inherently more secure, providing a cost saving to the UK in fraud and crime.

Bookkeeping, accounting and tax calculations can now be automated, significantly reducing the UK’s costs associated with these activities. Furthermore a corporation’s finances become transparent removing the incentives for tax avoidance through clearer bookkeeping practices.

For those working in the UK supporting families abroad, remittance costs are reduced when using digital currency in place of traditional alternatives such as Western Union[1]. This retains more money within the UK economy and increases the welfare of those and their dependents abroad.

Consumers – spending digital currencies at a till in a shop is typically less button press than a credit or debit card for chip and PIN payments. The payment is also cryptographically secured unlike many contactless credit and debit cards[2] which can trade security for convenience. With digital currencies there is no trade-off between convenience and security.
N.B. Contrary to popular belief Bitcoin payments are instant and suitable for shop style transactions; as long as the recipient is attached to the internet via a connection they trust.
Businesses – payments can be automated and managed more easily. The costs of using a centralised payment provider such as Visa, MasterCard or PayPal are reduced and the risk of transaction reversal is removed entirely. In some instances retailers are offering a discount to customers paying in bitcoin[3] due to these reduced costs and risks. International payment becomes instant and virtually free, unlike international bank transfers which take weeks and have proportionally large fees.
Government – can now automatically calculate taxes due, creating a significant cost saving to both HMRC and the person or company who would previously have to manually calculate their tax. It also makes the process of tracking and spotting tax evaders and criminals far easier than with conventional bank accounts and cash.
Wider Economy – if digital currency use becomes widespread it has the potential to do for money and finance what the internet did for workflow. Digital currency use will significantly reduce the costs and time spent dealing with all financial actives from paying bills and taxes to accounting and bookkeeping representing a significant cost saving to the UK economy and reduced friction of money flow.

Broadly there are four types of digital currency which have emerged over the last eight years. These break down into the following groups:

Proof of Work based Blockchains – these use a register called a ‘blockchain’ to track the allocation and ownership of digital currency balances where blocks of data which update this register at regular intervals are ‘mined’ by the first party to solve a complex maths problem. Many people try to mine this next block as finding it nets the miner a reward in that blockchain’s digital currency. It also provides strong security to prevent transaction reversibility. The benefits for Proof of Work based cryptocurrencies are all as outlined above in this section. Examples of these include:
- Bitcoin (Nakamoto, S. 2008).
- Litecoin (Lee C. 2011).
Proof of Stake based Blockchains – Similar to Proof of Work, this method uses a blockchain to track the allocation and ownership of digital currency balances, the difference is blocks are mined by using the proof of a user’s currency holdings as the value to allow them to mine a block. This reduces the amount of energy required to maintain the network as compared to Proof of Work which is computationally intensive. There are a number of different implementations of these systems, with some less well tested than others and some still in the experimental stages of development. Therefore dependent on the specific implementation some of these provide advantages in the total energy use and potentially some improvements to network scalability. Examples of these include:
- Peercoin (King, Nadal 2011).
- NXT (Nxt community 2013).
Coloured coin based consensus systems – This method works by ‘piggybacking’ rules onto an existing blockchain (Proof or Work or Proof of Stake) by ‘colouring’ the coins within that blockchain to allow them to be tracked. These coloured coins either represent a type of assets such as British Pounds (GBP), Euros (EUR), US Dollars (USD) or a legal document of entitlement. Coloured coins systems generally tend to be more an approach at providing trading and tracking tools on top of a digital currency rather than being a new currency themselves. We would therefore conclude although these meet HM Treasury’s definition for a digital currency, as per this call’s definition, these currently provide a low level of benefit for use as an actual currency. Examples of these include:
- ‘Coloured Coins’ (Rosenfeld 2012).
- Counterparty (Counterparty community 2013).
- Mastercoin (Willett 2012).
Consensus Based Distributed Ledger Systems – These designs use a distributed ledger held by a number of central nodes called ‘gateways’. Rather than being a decentralised digital currency these systems are more a distributed system for tracking debt and converting mixed asset types such as USD, GBP, EUR and bitcoins and sometimes more esoteric stores of value such as physical gold and silver, allowing users to convert one into another on the distributed ledger platform. Although many of these implementations use their own tokens which are provided more as a conversion intermediary to track ownership and debt settlement. Many of these designs are overseen by a central authority or private company who has a controlling interest in the system and issues its tokens to users. We would therefore conclude although these meet HM Treasury’s definition for a digital currency they could also be considered a ‘virtual currency’ so may be out of scope for consideration. We would also argue that such tokens provide a low level of benefit for use as an actual currency. Examples of these include:
- Ripple (Ripple Labs 2013).
- Stellar (Stellar Development Foundation 2014).
- Hyperledger (Hyperledger community 2014).

In summary:

Digital currencies use a decentralised model of operation; this massively improves their security over traditional centralised banking models of operation.
The costs of transfers are far lower than traditional methods.
Transactions and global transfers are now instant.
Taxation and bookkeeping processes can now be automated.
There are many types of ‘digital currencies’ but most of the interest is focused on blockchain based digital currencies such as Bitcoin which is the most popular and provides the greatest innovation so far.

Question 2

Should the government intervene to support the development and usage of digital currencies and related businesses and technologies in the UK, or maintain the status quo? If the government were to intervene, what action should it take?

Any form of intervention would exert centralised control and therein risks damaging all of the benefits that a system of decentralised currency would bring.

Digital currencies themselves are still evolving, therefore the right kind of intervention that will foster innovation and growth whilst protecting users will be a complex, nuanced, balancing act, many aspects of which are still not clear.

At this stage we are able to highlight some areas that merit attention and some areas around digital currencies where intervention and legislation could be useful:

Clarification – Many of the entrepreneurs in the digital currencies space are keen to seek clarification on their use within a country. Guidance issued about Bitcoin and other cryptocurrencies by HRMC has proven very useful in clarifying this space for them in UK law (HMRC 2014). Further clarification along these lines will prove useful in creating certainty and draw digital currency users to the UK .
Education – In line with clarification, if the UK government is able to provide education and information about digital currencies it would encourage userbase growth for those business providing services within the UK.
Support – If the government provided a system where tax payers could register their digital currency payment addresses with HMRC for tax purposes (these addresses will likely appear on their business websites, tills and shop premises already) it will make business accounting automatic and more transparent. Lists of addresses could potentially be publically searchable, with publically posted business accounts listing digital currency address and takings for the year.

In summary:

Beneficial intervention, if required, will be a nuanced balancing act and should not be rushed.
To foster a healthy digital currency market within the UK clarification, education and support from government are needed.

Question 3

If the government were to regulate digital currencies, which types of digital currency should be covered? Should it create a bespoke regulatory regime, or regulate through an existing national, European or international regime? For each option: what are the advantages and disadvantages? What are the possible unintended consequences (for instance, creating a barrier to entry due to compliance costs)?

Firstly we would like to clarify that country to popular belief; digital currencies such as Bitcoin are not unregulated. Digital currency decentralised networks contain rules and algorithms which regulate both the digital network and the financial aspects of digital currencies. For example, it is possible to say with a high level of certainty what the rate of generation of bitcoins on the Bitcoin network will be, and therefore what the number of bitcoins issued into circulation will be on a certain date. This level of certainty is currently not possible with financial systems whose levels of currency can vary enormously from one quarter to another through the change in a central bank’s interest rates or a government quantitative easing program.

Any form of regulation would exert centralised control and therein risks damaging all of the benefits that a system of decentralised currency would bring. This risks driving digital currency business from the UK. We would therefore not recommend regulation, but strong clarification with a government level support framework.

In-line with the previous question’s response the UK government already recognises cryptocurrencies such as bitcoin as a taxable medium like money (HMRC 2014). In addition, it could consider creating a list of supported digital currencies on its online tax returns portal; this would facilitate compliance and automation rather than requiring additional regulation.

As previously mentioned we believe only Proof of Work and Proof of Stake blockchain based digital currencies are currently usable as actual money. Other digital currencies presently do not provide an effective means of money transmission, although this space is still evolving.

Of the Proof of Work and Proof of Stake cryptocurrencies only a small set are of sufficient market capitalisation to merit additional support from government in this way. For example at current prices Bitcoin has a market cap of £3.2 billion GPB across 13.5 million ‘coins’ and Litecoin, the next most popular blockchain based digital currency’s market cap is £76.5 million at 34 million ‘coins'[4]. The valuation trails off rapidly after that. If support rather than regulation is provided it would be best to do this on the basis of popularity and size, with other digital currencies included through existing regulation but not supported directly in the tax returns portal.

With regards to national, European or international regulation, fostering an environment in which local and international business can flourish is key to creating a strong UK economy. Compliance, rather than regulation would help achieve this whilst remaining compatible with legal requirements outside of the UK.

In summary:

Regulation would damage the benefits digital currencies bring.
We recommend providing support to facilitate compliance instead.
Facilitating compliance will keep the UK compatible with national, European or international regulation whilst fostering UK digital currency market growth and innovation in a beneficial way.

Question 4

Are there currently barriers to digital currency businesses setting up in the UK? If so, what are they?

Cryptonomy is currently aware of two areas which are damaging the UK’s market growth digital currencies.

The first is where digital currencies are passed outside of the built-in security provided by digital currencies: and control is handed over to a trusted third party institution or service provider. This poses risks of theft and loss on the part of the institution.

Some form of compliance is required on the part of these institutions to ensure against losses, this could take the form of insurance and security. Again any decisions on regulation in this area needs to be considered carefully and cannot be rushed.

Proving security to the users of these institutions within the UK will provide them with confidence to use the service, create growth and innovation in this space and drawing international businesses to the UK.

The second is resistance from the incumbent financial service providers: banks are currently hitting businesses where it hurts by closing the bank accounts of any business they find are using digital currencies such as Bitcoin. Even the mention of ‘Bitcoin’ to some banks is enough to have all your bank accounts closed[5].

This is potentially dangerous as it prevents the banks within the UK from innovating their services and passing these benefits to customers. Simultaneously it is also benefiting competition outside the UK threatening the country’s market position.

In summary:

Third party service providers handling users’ digital currency currently are not required to prove consumer protection. This is damaging confidence and causes damages if theft or losses occur.
UK banks are hostile to digital currencies and anyone who uses them, closing and refusing business accounts. This is preventing innovation in this market sector and damaging the UK’s ability to compete in the global market.

Question 5

What are the potential benefits of this distributed ledger technology? How significant are these benefits?

The key innovation for blockchain based digital currencies is the blockchain: this distributed ledger allows consensus on a decentralised network. This was a previously unsolved problem in computer science until 2008. Effectively this is a decentralised database of ownership. Ownership is cryptographically enforced so there is never any debate over who is in possession of what: ownership is absolute.

In the future it is likely that these distributed ledgers can be modified to decentralise other services such as eBay, Facebook, etc. removing their control from a central authority and placing it into the hands of its users (such research is MetaLair’s main business focus).

Currently blockchain implementations store large amounts of financial data, such as a user’s current balance and who sent what to whom and at what time. From this, large amounts of information can be harvested and many financial processes now automated.

For example, this could automate the process of bookkeeping and tax returns as well as allowing governments to monitor for crime and money laundering.

The current Bitcoin blockchain is also being used as a store of information such as writing permanent messages (Goodspeed, T., 2011) and registering legal contracts and property ownership with some of this being augmented with the aforementioned Coloured Coins systems (Q1). One couple registered the date of their marriage on the Bitcoin blockchain[6].

In future such systems could be extend to enable smart property, for example a car would only start if it’s owner instructed it to, where the owner was listed on the blockchain.

Other mediums such as company shares could be issued on blockchains rather than as paper certificates, which can still be traded in the usual way. This would enforce absolute ownership avoiding legal complications over ownerships which can sometimes occur with company shares.

The use of distributed ledgers and digital currencies is also causing a resurgence of innovation in the digital security space. Arguably this area is the most rapidly growing of the digital currencies technology space.

In summary:

Internet services such as eBay and Facebook may one day be decentralised using blockchain technology.
Currently blockchains allow the automation of finance and tax accounting systems.
The blockchains can be used to store data such as the date an event occurred or register property.
Smart property can be developed which only responds to its owner, as listed on the blockchain.

Question 6

What risks do digital currencies pose to users? How significant are these risks? How do these risks vary according to different digital currencies?

We believe the support and education about digital currencies rather than intervention and regulation by government to be key to managing risks.

Digital currencies are still a relatively new technology and many of the problems associated with the first wave of digital currencies are currently being worked on by developers and entrepreneurs; many have already been solved.

The most notable current outstanding risk to users is that of software based digital wallets. These software wallets provide a point of attack for each users of the system and should always be treated as insecure if kept on a device connected to the internet such as a desktop PC, tablet or smartphone. However there are a number of specialised hardware devices in development which mitigate this risk, with one already on the market[7]. These effectively create a ‘data diode’, which only allows one way flow of information, thereby preventing the theft of digital currencies. As the popularity of digital currencies develops so will these dedicated hardware wallets.

Hardware wallets will ultimately be compatible with all digital currencies: doing for digital curries what the iPod did for digital music.

Ultimately we believe the bigger risk will be in a lack of clarity and support of the use of digital currencies, which could cause other countries to gain significant market edge over the UK.

In summary:

Risks should be mitigated through support and education rather than intervention and regulation.
The greatest outstanding risk to users of digital currencies has recently been solved with the emergence of the first consumer digital hardware wallet, with more on the way.
The biggest risk to the UK will be in a lack of clarity and support slowing the UK’s growth in this market sector relative to other countries.

Question 7

Should the government intervene to address these risks, or maintain the status quo? What are the outcomes of taking no action? Would the market be able to address these risks itself?

Any form of intervention would exert centralised control and therein risks damaging all of the benefits that a system of decentralised currency would bring. We therefore believe that education and support are key to growth for this market sector.

As previously discussed we believe that intervention is required in two areas outside of the influence of digital currencies: third parties holding digital currencies for a user and the hostility of the banking sector to digital currency businesses.

Some of these service providers such as storage and exchanges are starting to offer insurance to compensate customers for any loss[8].

Enforced regulation in these areas would put the UK as one of the lead counties globally in which to trade and use digital currencies as it would increase consumer confidence and drawing businesses and investment.

In summary:

Regulation would damage the benefits digital currencies bring.
We recommend providing education support to facilitate compliance instead.
Some third party providers are beginning to provide insurance and security assurance of their own accord.

Question 8

One of the ways in which the government could take action to protect users is to regulate. Should the government regulate digital currencies to protect users? If so, should it create a bespoke regime, or regulate through an existing national, European or international regime?
For each option: what are the advantages and disadvantages? What are possible unintended consequences (for instance, creating a barrier to entry due to compliance costs)? What other means could the government use to mitigate user detriment apart from regulation?

Any form of regulation would exert centralised control and therein risks damaging all of the benefits that a system of decentralised currency would bring and would increase barriers to entry driving customers and businesses from the UK.

We therefore believe that education and support are key to growth for this market sector.

Regulation should be targeted at the areas outside of digital currencies such as third party institutions holding digital currency on users’ behalf and the currency hostility of the banking sector to digital currency users.

In summary:

Regulation would damage the benefits digital currencies bring raising barriers of entry and driving business from the UK.
We recommend providing education support to facilitate compliance instead.
Regulation needs to concentrate on services around digital currencies such as third parties holding digital currency for a user and banking hostility to digital currency users.

Question 9

What are the crime risks associated with digital currencies? How significant are these risks? How do these risks vary according to different digital currencies?

The crime risks associated with digital currencies are significantly lower than existing systems such as cash: indeed digital currencies contain mechanisms within them that can aid traditional law enforcement.

Digital currencies are not anonymous: all their distributed ledgers – such as Bitcoin’s blockchain – provide a publicly viewable listing of who owns what and who spent what to whom and when. All this data can be used to assist law enforcement processes.

Other mediums of exchange such as cash are far more useful to criminals as they provide total anonymity.

So far a number of cases have been put before the courts in various countries based on information stored in distributed ledgers[9].

In summary:

Digital currencies are not anonymous.
Law enforcement activities are aided by the use of digital currencies.
Other financial mediums are more efficient for criminal activities.

Question 10

Should the government intervene to address these risks, or maintain the status quo? What are the outcomes of taking no action?

Crime risks are currently mitigated by digital currencies, more so than with cash and other criminal accounting techniques: traditional law enforcement is aided by the distributed ledgers provided by digital currencies.

Any form of intervention would exert centralised control and therein risks damaging all of the benefits that a system of decentralised currency would bring.

Question 11

If the government were to take action to address the risks of financial crime, should it introduce regulation, or use other powers? If the government were to introduce regulation, should it create a bespoke regime, or regulate through an existing national, European or international regime? For each option: what are the advantages and disadvantages? What are possible unintended consequences (for instance, creating a barrier to entry due to compliance costs)?
What has been the impact of FinCEN’s decision in the USA on digital currencies?

Digital currencies contain mechanisms within them that can aid traditional law enforcement so are a less effective medium for crime than traditional approaches such as using cash and money laundering via fiat bank accounts.

In line with our recommendations, crime risks should be mitigated through education and support rather than intervention and regulation. Traditional law enforcement agencies can track the activities of suspected criminals via the distributed ledgers provided by digital currencies. Tracking can be as simple as retrospectively seeing how much cash went through a specific digital currency address to conducing a heuristic search of addresses to identify possible new suspect address and proactively prevent future crimes from occurring (Reid & Harrigan, 2012).

Any other approaches would create barriers to entry in the UK driving business from the country. A good example of restrictive regulation is FinCEN’s rulings in New York (NY Dept. Financial Services 2014) which many argue has slowed digital currency market growth[10].

If the UK creates an environment in which law enforcement correctly and effectively use the technologies available to, it will deter crime in the UK digital currency market, encourage beneficial growth and remain compatible with national, European or international regulation.

In summary:

Law enforcement activities are aided by the use of digital currencies.
Distributed ledgers allow for some sophisticated forensic techniques to spot and prevent crime.
Many believe that FinCEN’s ruling within the US is stifling innovation and market growth.
The approaches we recommend are compatible with preventing crime, fostering beneficial growth and compatible with national, European or international regulation.

Question 12

What difficulties could occur with digital currencies and financial sanctions?

Any form of intervention would exert centralised control and therein risks damaging all of the benefits that a system of decentralised currency would bring.

Financial sanctions in direct relation to the use of digital currencies run the risk of being seen to set a president and scare business from the UK.

As well as the aforementioned effects on market sector growth due to increasing barriers to entry this could have detrimental effects on the non-business users of the currency within the UK.

The proportion of low-income households without a bank accounts currency estimated to be around 5% in the UK by some NGOs (if post office card accounts are excluded this rises to 11%)[11]. Digital currencies such as Bitcoin provide a middle ground for handling a form of money with some of the advantages of both cash and a bank account.

If Bitcoin became commonplace in the UK it’s benefits would become available to such demographics and in some part help with their ‘catch 22’ position of not being able to secure a bank account due in part to their financial situation, such as no fixed residential address.

In summary:

Financial sanctions in relation to digital currencies could be seen as setting a president and scare business from the UK.
Digital currencies provide an opportunity to the estimated 5-11% of unbanked UK citizens.

Question 13

What risks do digital currencies pose to monetary and financial stability? How significant are these risks?

With all complex systems it’s difficult to comment on the long term outlook of a financial system and its stability accurately. But what we can draw on previous evidence to try and shape our analysis.

The vast majority of all previous fiat systems have never fared well in the long run, whereas systems backed by scarcity or a scarce resource often do[12].

Some digital currencies such as Bitcoin have scarcity built in with a maximum number of 21million ‘coins’ which will all have been completely generated by around 2140. This is enforced by Bitcoin’s built in algorithm and rules which regulate it on the network and mean the money supply is always know, stable and predictable. This is a sea change from the modern fiat economic climate. With time as Bitcoin’s use grows, its valuation and price relative to other currencies can only get more stable.

Having one or more digital currency alongside the British pound would likely shore up the economy should instability occur.

More countries outside the UK are adopting digital currencies for trade – an estimated 60,000 global companies rising to an estimated 100,000 by the end of 2014[13]. Not supporting the use of digital currencies and educating the public about them could cause the UK to loose pace with other countries effecting its economy detrimentally, such as damaging the UK’s ability to manage its import / export ratios effectively which would damage trade and growth.

Therefore we would conclude that the risks of financial instability may be greatest if digital currencies are not effectively integrating into the UK economy.

In summary:

All previous attempts at a fiat system have failed.
Digital currencies such as Bitcoin provide a functional alternative to gold backed currencies whilst providing the same level of longevity and stability.
We believe permitting the use of digital currencies alongside the British pound will strengthen the economy and prevent instabilities.
The risk of not integrating digital currencies with the UK economy will be far greater than intervening and trying to limit their uptake and adoption.

References

[1] – www.businessinsider.com
[2] – www.wreg.com
[3] – www.techtimes.com
[4] – www.coinmarketcap.com
[5] – www.metalair.org
[6] – www.bitcoinmagazine.com
[7] – www.bitcointrezor.com
[8] – www.coindesk.com
[9] – www.blog.kraken.com
[10] – www.altcoinpress.com
[11] – www.poverty.org.uk
[12] – www.dailyreckoning.com
[13] – www.uk.reuters.com

Bibliography

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(Lee C. 2011) Litecoin – a lite version of Bitcoin, Lee C., 2014.
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(Nxt community 2013) Whitepaper :Nxt, the Nxt community et. al, accessed 2014 (www.wiki.nxtcrypto.org).
(Rosenfeld 2012) Overview of Coloured Coins, Rosenfeld M., 2012.
(Counterparty community 2013) Counterparty, the Counterparty community et. al, accessed 2014 (www.github.com).
(Willett 2012) Mastercoin: The Second Bitcoin Whitepaper, Willett J. R., 2012 (www.bitcointalk.org).
(Ripple Labs 2013) Ripple Gateways, Ripple Labs, 2013.
(Stellar Development Foundation 2014) Stellar Website, accessed 2014 (www.stellar.org).
(Hyperledger community 2014) Hyperledger, the Hyperledger community et. al, 2014, (www.hyperledger.com).
(HMRC 2014) Revenue and Customs Brief 9 (2014): Bitcoin and other cryptocurrencies, accessed 2014, (www.gov.uk).
(Goodspeed, T., 2011) Can Bitcoin be used as a samizdat service? Goodspeed, T.; Imp. Kaminsky D., 2011 (www.blockchain.info).
(Reid & Harrigan, 2012) An Analysis of Anonymity in the Bitcoin System, Reid, F.; Harrigan, M., Security and Privacy in Social Networks, Springer, pp. 197–223, 2012 (doi:10.1007/978-1-4614-4139-7_10).
(NY Dept. Financial Services 2014) New York Codes, New York State, Department of Financial Services, Rules and Regulations, Title 23, Chapter 1, Part 200 Virtual Currencies.