Cryptonomy’s Response to HM Treasury Call for Information
Cryptonomy Ltd is pleased to respond to the HM Treasury digital currencies call for information. Submitted 30.11.14 – before Cryptonomy had re-branded from MetaLair
Cryptonomy Ltd is pleased to respond to the HM Treasury digital currencies call for information. Submitted 30.11.14 – before Cryptonomy had re-branded from MetaLair
Submitted 30.11.14 – PDF version
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.
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.
Broadly there are four types of digital currency which have emerged over the last eight years. These break down into the following groups:
In summary:
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:
In summary:
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:
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:
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:
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:
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:
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:
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:
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.
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:
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:
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:
[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
(Nakamoto, S. 2008) Bitcoin: A Peer-to-Peer Electronic Cash System, Nakamoto, S., 2008.
(Lee C. 2011) Litecoin – a lite version of Bitcoin, Lee C., 2014.
(King, Nadal 2011) PPCoin: Peer-to-Peer Crypto-Currency with Proof-of-Stake, King s., Nadal S., 2012.
(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).
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(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.
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