Bitcoin Regulation: How Not to Blockade Innovation

In just the past few years, digital currency technologies, especially Bitcoin, have progressed from an obscure white paper by a mysterious inventor into a global phenomenon. Today, the Bitcoin network processes over 100,000 daily transactions for millions of users all around the world. At its core, the Bitcoin Protocol is a distributed, open-source software that allows its users to transmit, validate, and record the transfer of bitcoin (the digital currency) and other encrypted information without centralized coordination. Sound confusing? It’s actually not unlike a technology we all use every day–email–which is an open network that can allow anyone to send messages from one email server to another at any time and anywhere in the world with little intermediation.

The global, instant, and open email network quickly changed forever how businesses worked and how people communicated. But what if email were regulated in the early 90s as it was taking off? What if emerging service providers were forced to restrict user messages or close their networks so users could only email other users of the same service? We’d be living in a different world — less communication, less productivity, and less innovation.

Bitcoin today is similar to email in the the early 90s. It’s just taking off, with a few million regular users, and it carries enormous potential to make the world smaller and more connected: it enables the instant transfer of value across borders, true global marketplaces, new business models, microtransactions, and more. But Bitcoin faces the immediate risk of regulation that could stamp out innovation and ultimately defeat the utility of the technology. It’s important that regulators in the US appreciate how regulation can be appropriately focused in order to not suppress a technology that top leaders in finance, technology, and business have said could be as transformative as the Internet itself.

So the question is: how can the United States set regulation that best combats criminal use of digital currency without blocking innovation?

Because Bitcoin is not centrally managed, there is no single accountable entity, and no switch that can be flipped off. This makes it difficult to control, and more difficult to regulate. But where the technology is itself elusive to authorities, certain of its users may not be. Many Bitcoin businesses–services that facilitate the purchase, sale, or use of bitcoin–are well-within arm’s reach of government agents. And they are the key to a well-precedented regulatory tactic: where the Internet may proliferate and scatter targeted activity across national borders, governments can police readily accessible intermediaries that play an indirect role. Targeted enforcement against secondary actors can achieve sweeping results that may otherwise require heavy-handed and costly global campaigns against primary actors.

The history of the Internet is replete with such examples: Internet tobacco sales, online gambling, and unauthorized use of copyrighted material have all been successfully curbed by pressuring intermediaries; financial services providers, like card networks, banks, and other payment processors must block certain payment transactions or face criminal liability; social media websites are subject to takedown orders and liability for user-posted content; Internet service providers and/or domain hosts can be forced to shutdown and/or restrict access to certain websites involving illicit activity.

The US government’s targeted first cut at Bitcoin regulation follows from the same playbook. Virtual currency exchange businesses (“exchangers”) who allow customers to exchange virtual currency for sovereign currency or vice versa, must register as money services businesses and implement anti-money-laundering (“AML”) policies to detect, report, and block illicit use. This approach is proving to be a reasonably effective means to combat money laundering because most users ultimately wish to spend fiat currency, not bitcoin, and they need to cash out via exchangers to do so. A relatively few professional exchangers will continue to mediate most exchange transactions so long as users continue to prefer to settle the fiat side of the transaction directly via conventional means (like bank-to-bank transfers or through card networks), rather than through unwieldy and inconvenient face-to-face cash transactions. Moreover, most of these exchangers recognize the risks of money laundering, cooperate with law enforcement, and work hard to establish effective AML programs.

Which gets us back to the Bitcoin Protocol. What about bitcoin transfers that do not involve an exchange for fiat currency–i.e. transactions for which the Bitcoin network serves as the sole payment rail between the parties?

The truly open nature of the network constitutes a paradigm shift in payments technology. Conventionally, an electronic payment between two parties involves banks, payment processors, settlement networks, and other intermediaries, all of whom must be trusted to reliably and securely retain and transmit personal information of parties to the transaction. Not so for Bitcoin.

The Bitcoin Protocol is designed to allow open, unrestricted use and to encourage innovation without permission. It is easy to access, easy to install, easy to operate, and easy for developers to augment with new applications. Anyone with an Internet-connected device anywhere in the world can plug directly into the Bitcoin Protocol and can transfer and store bitcoin without the intermediation of a bitcoin company or a legacy payment system. In other words, it’s trivially easy to cut the intermediaries out of a bitcoin transfer because bitcoin is like cash–you can spend it yourself without help from a third party. Two important observations follow.

First, the typical enforcement tactic is ineffective as it relates to bitcoin transfers. In truth, restricting peer-to-peer bitcoin transfers across the Bitcoin network would require an onerous, oppressive, and laborious enforcement campaign, akin to restricting the transmittal of emails via privately-hosted servers. Circumstances will undoubtedly warrant special efforts against certain bad actors, but authorities must realize that there is no real nexus for top-down control over the Protocol, and therefore no panacea to the enforcement challenge.

Some regulators have suggested that providers of hosted bitcoin wallets–a software interface that makes it easier to use bitcoin, much like an email client makes it easier to use email–should impose AML controls on customers’ bitcoin activity, including requirements to verify identity information, limit transfer volumes, or block bitocin transfers in certain circumstances. Although it’s technically possible for businesses to impose controls against their own customers–in effect, building a walled garden inside the Bitcoin network–the benefits to AML authorities are illusory. Illicit actors can neatly sidestep hosted-wallet AML procedures as easily as they can switch Internet browsers. Alternatives beyond sight and easy reach of law enforcement, such as desktop wallets and haven jurisdictions, are just a few clicks away.

And that gets us to the final point: bad Bitcoin policy isn’t just ineffective, it hurts the industry. To be sure, the industry wishes to cooperate in AML efforts; but the imposition of Bitcoin controls upon select wallet services will disrupt a population vastly comprised of good-faith users and will entail technically-challenging solutions, widespread confusion, and legal uncertainty. And even worse, tightened but sporadically-implemented controls within the Bitcoin network will erode its greatest virtue: its universally free and open access. Like the Internet, the enormous untapped potential of Bitcoin is best realized when entrepreneurs all around the world can freely develop, use, and improve the technology without the burden of heavy protocol regulation and corresponding legal risk.

If allowed to thrive freely, the future of this technology in the U.S. is as bright as the Internet. As with email, the power of an open network is not known in its early days. Open networks are ever-growing and can lead to the great companies, services, and apps of tomorrow. If the Bitcoin Protocol is yoked with regulation, however, entrepreneurs in the U.S. will struggle and much of the enormous growth potential and the industry will be stymied or pushed offshore.

One clap, two clap, three clap, forty?

By clapping more or less, you can signal to us which stories really stand out.