The Opinions of the European banking Authorities on Virtual Currencies

The European Banking Authorities (EBA) report on virtual currencies, released 4th July, 2014 highlights the risks proposed by virtual currencies towards their users. The paper proses to ‘identify risks arising from financial activities and take mitigation action when required’. In this paper, we will critically examine 4 key points raised by the EBA and discuss their validity for and against.

The EBA raises risks in relation to their ‘probability to materialize and the severity of the impact should the risk materialize’. Although valid in its identification of risks, the paper does not identify the risk severity correctly for issues inherit to virtual currencies relating to ‘lack of liquidity’ and ‘unexpected exchange fluctuation’.

Point 72, identifies the risk of ‘significant or unexpected exchange rate fluctuations’ as being of high priority. It states that virtual currency markets are “relatively opaque” thus allowing for easy manipulation.

Although this is a valid argument, it fails to recognize existing manipulation of foreign exchange markets and large banking institutions in general. Secondly it misappropriates a lack of ‘clarity’ towards price discovery as a high risk variable, although investing in virtual currencies is a high risk investment due to this lack of ‘price discovery’, this is accounted for by normal market forces. Anyone who is investing in virtual currencies is doing so fully aware that its price is ‘opaque’ which is inherent in its risk/reward payoff; this risk is therefore not high, it is normal.

Point 72 also states that ‘Denial of Service attacks could prevent processing of transactions’ which is incorrect. In a specific instance where a transactions is ‘DDOS’ed’ it will not prevent the network from processing transactions, in-fact the decentralized nature of virtual currencies reduce the risk factor of DDOS attacks.

It is also stated that ‘decentralized virtual currencies have no ‘central authority’ to intervene and stabilize exchange rates’, although correct, this point does not reflect the reality of where the majority of issues stems from; central authority malpractice.

Considering examples like the recent guilty verdict given to five of the largest banks for rigging currency markets and prior cases like LIBOR this argument is hard to realize as adding risk when there are numerous examples of central authorities acting against the interests of the honest participants of the system. Historically the ‘central authority’ has been proven to be the greatest risk, decentralized virtual currencies remove this risk completely.

The second point which I want to highlight, 93, states a ‘user is not able to convert virtual currencies into fiat currencies, or not at a reasonable price’ is disagreeable. It states ‘illiquid markets, low market depth and non-fluid exchanges’ are factors preventing liquidity. Although correct, this is a matter of market forces behaving in a way which reflects normal market behaviour. To suggest that a lack of market depth and subsequent liquidity raises risk levels to high is incorrect, it’s impossible to add liquidity to a market forcibly; therefore this risk is inherent with a market of this size and is reflected by the trade volume and market capitalization. The lack of liquidity does not pose a high risk; it reflects its current size accurately.

This point covers the statement that ‘anyone can anonymously create and subsequently change the functioning of a virtual currency’, although correct this statement does not pose a risk as a virtual currency scheme which was newly created would have no users, network or subsequent exchange to operate within. Therefore newly created virtual currencies do not pose a ‘risk of exchange fluctuation and/or liquidity’ because they are inherently illiquid and valueless.

Point 82, which states ‘user suffers loss when exchange is hacked’ is poised as a high risk; this point is entirely valid. Stating that “an exchange may temporarily hold users’ virtual currency units but can be hacked’ and stating this as a high priority risk. To date, the majority of virtual currency losses have been attributed to poor security measures implicated by exchanges. Users who store virtual currency on exchanges need to recognize that they have no rights to those funds and that they are stored by entirely arbitrary measures. I believe this is one of the highest risks currently posed to virtual currencies as accurately categorized by the EBA.

Finally, the EBA states ‘user suffers loss through e-wallet theft, hacking or malfunctions’ which reflects the same issues as point 81. The security measures of ‘wallets’ are similar to ‘exchanges’ with the main issue being that there are no standard methods practices. The majority of users of virtual currency schemes are not educated enough on the risks posed by storing coins with a third party, therefore the EBA’s stance that these two risks are ‘high’ is accurate.

The EBA has outlined many risks affecting virtual currencies. They have accurately measured some risks they have also miss-states certain risks by trying to impose a centralized framework upon virtual currencies. The EBA needs to work on defining the inherent strengths in a virtual currency scheme and how they offset these highlighted risks in its future research.

Author Bio: Rupert Hackett works for Global Internet Ventures, an Australian based investment and consultancy group developing multiple Bitcoin companies. Rupert is studying the world’s first Masters in Digital Currencies and regularly blogs for BuyaBitcoin.