This is part 6 of a seven parts series by Dr Ken Alabi, who has a Doctorate in Engineering from Stony Brook, a masters in Computer Aided Engineering from the University of Strathclyde, and is an IT professional, programmer, and a published researcher with over twenty publications in various fields of technology.
Needless to say, all statements and views expressed below are solely those of the author. You might wish to read the introduction, part 1, part 2, part 3, part 4 and part 5 of the series before continuing.
This is part of a series looking at issues that need to be solved in the next few months and years for digital currencies to grow to a reasonable size compared to the tiny segment of the global economic system that they currently occupy.
At the start, the development of cryptographically enabled digital currencies was based on a decentralized model as well as a repudiation of the non deterministic and opaque minting practices of fiat currency. Early adopters also gravitated to this new currency to avoid some of the rules and regulations binding financial transactions denominated in fiat currencies. For digital currencies, there are no rules on how much you can withdraw or transfer, or who must be notified when you transfer certain amounts, etc. On the other hand, there are also no protections, no refunds, and no insurance or guarantee of funds.
Initial coin offerings based on digital currencies also followed this same unregulated environment, setting up new ways of raising funds in a decentralized manner in which their contributors had much less leverage compared to say venture capital investors.
This state of operations is perfectly fine to most early adopters. And it is possibly admissible as long as digital currencies are limited to a small proportion of the overall world economy. Since we are looking at an ideal digital currency poised for mass adoption, we have to consider factors that will allow mass adoption; and clear regulations are a factor. The rationale for this is examined in this segment of the series.
Imagine an Unregulated Digital Currency in Widespread Use
Let’s imagine an unregulated digital currency that comes to majority use in a nation state. Going by the fact that digital currencies are pseudonymous, and some are completely anonymous, it can be expected that tax receipts to the state will drop precipitously. And the facts bear that out. In 2015 according to the IRS, in spite of the value of a bitcoin going from $13 to about $1,100 over the prior two years, only 802 people paid any taxes to the government on those gains. Since voluntary taxation does not work, no nation state can survive an unregulated digital currency that occupies any significant share of the economy. If digital currency use continues to increase, and wages, and payments for goods and services begin to significantly be denominated in those currencies; nations and states would either be defunded and collapse, or find ways to regulate and tax them as comprehensively as is done for fiat currencies.
The choice that exists to those who advocate complete freedom from regulations for digital currencies is to also come up with a new way of organizing societies. In that new world, we would have new ways of maintaining communities and providing infrastructure such as roads, law enforcement, and other services that we currently organize around nations, states, and local governments and states enabled by taxes. Or we would need to regulate digital currencies in a way that their use could be taxed as effectively as with centralized fiat currencies.
Must we go back to Regulations like we have for Fiat Currencies?
So let’s set the table clearly before the mind walls come up. The arbitrarily minting of monetary value without clear preset rules is not what is being advocated here. The first segment of this series advocates for a decentralized, mathematical, and deterministic way, without the extreme deflation and volatility that exists currently. However, most people are not seeking to eliminate the nation-state, which would result without regulations to tax economic gains; or to create a free for all system with no protections or rules.
So regulations are for two purposes. The first is so that the society can be financed through taxes. The second would be to protect people from those who would take advantage of others within the system.
So why should we need to protect anyone? Decentralization itself has a lot of built in protections. This is correct and reduces the need for much regulations. However, there remains aspects of the new economy that is centralized. An ICO such as Confido, to mention a recent one, should not be able to simply take people’s money and disappear if the current reports hold. Exchanges should not be able to take people’s money and lose it as we saw with Mt Gox and several since. Same for upcoming side chains and digital currency to fiat debit card networks. Those should probably be required to insure deposits they hold on behalf of their users. Or at least not trade with them (some form of Glass-Steagall for exchanges and centralized side-chains.) Also, individuals who meet with others and sell bitcoins should not find themselves in trouble for unwittingly running a money service business (MSB) without a license, because of unclear rules. Same for many who may find that they have violated tax laws for not declaring digital currencies they sold. Clear rules and regulations will help digital currencies in the long run, and those who use them.
How Can Anonymous and Pseudonymous Digital Currencies be Effectively Regulated
The next question then is how do you effectively regulate and tax an anonymous decentralized digital currency. The answer based on the current technology is that it can not be accomplished directly on chain. As described in Segment three of this series, the evolution of digital currency adoption will transition through three stages:
This is the first five or so years of digital currencies where it was used by only few early adopters. At between 0 to 0.1% of all global transaction value, the use of digital currencies did not yet rise to a prominent enough level for any regulatory action to be necessary. In fact, there were still doubts as to their long term viability. Regulators and law enforcement simply focused on going after individual and exceptional cases of abuse and fraud and did not bother to define a broad comprehensive framework covering the technology.
This is the current stage we are currently in, and would probably continue for the next half decade or so. The use of digital currencies during this stage is expected to rise from between 0.1% to about 20% of all global transactions. Governments and financial institutions are coming to terms with the technology, its potential, and the fact that is here to stay. Financial institutions are even developing their own versions of the technology (Quorom, Hyperledger), and some governments are considering the same as well. Regulators are coming to terms with the fact that broad and clear regulations may be necessary, and that simply prosecuting abuse cases after they occur will not suffice. Many are also beginning to realize that they may be unable to tax its use in the same manner as they did for fiat currencies. They are also realizing that digital currencies tend to be global and do not belong to any particular state. On realizing that it is stripping the state of its revenues, and it potential for abuse, some have approached the issue by outright ban of access to it (China, Morocco). Some others are in the process of developing regulations guiding its use; much of which can best be described as currently in experimental and trial stages.
During this stage, fiat currencies remain the mainstay of most economies and represent the conduit to which value flows to digital currencies. There is also still no technological path to on-chain based regulation, especially as more currencies implement even more anonymous transactions. Attempting to utilize chain analysis to decipher who owns and who transferred what, on-chain, as the IRS is currently experimenting with, will prove to be extremely expensive and likely not work as volumes increase. The most effective regulations will be through the conduits from fiat to cryptocurrencies. This will be via exchanges, centralized hubs of side chains networks, fiat to digital currency debit card networks described in Segment 3, digital currency merchant payment services networks, and regulation of businesses that generate payrolls using digital currencies.
We already see attempts to compel Coinbase, a digital currency exchange, to reveal its user information to enable the government to effectively monitor and tax users via that conduit. The current litigation trying to compel access to the information is symptomatic of an ad-hoc process that would not exist if there was legislation or clear rules in place before hand.
During this stage, the laws and regulations would not change much; but would mostly be existing rules layered to apply similarly to digital currencies as much as possible. Side chains and exchanges will be required to obtain licenses, for instance, the MSB licenses some digital currency debit cards currently need to serve in the United States. Sales taxes would be required of digital currency payment merchant gateways, and businesses that make payroll using digital currencies would be required to make the same deductions as they do with fiat currencies. However, gains through methods such as direct payments for services, gifts, inheritance, and estates that take place solely on-chain will remain hard to track.
Enforcement will still remain difficult for on-chain transactions following the second stage. It may be expected that blockchains of the future may implement on-chain tools that would easily support regulations while maintaining user privacy and security. One such innovation would be fingerprint encoded private keys. The private key for such blockchains would have two features. The first would serve its current purpose where it unlocks the account for the owner to access its value and transfer it as desired. The second would be to allow its owner to authorize a regulator in the state they choose to be citizens of or reside in to receive summary details of their accounts; only when absolutely necessary, such as during an audit. That authorized release would search the blockchain for accounts bearing that fingerprint signature in its primary key to prevent evasion by concealment of accounts. An earlier segment already highlighted other advantages of a fingerprint derived primary key including completely solving the issue of key loss and the accompanying loss of funds.
ICOs do need Regulations
This brings us to ICOs or initial coin offerings; a new way by which businesses related to blockchains and digital currencies are raising money to finance their ideas. There have been some abuses of this mechanism recently as mentioned earlier, and there are some estimates that over 90% of current ICOs would fail and thus squander contributor funds. Maybe ICOs will eventually self regulate, in that digital currency adopters would demand that ICOs implement the promises behind their proposals within the smart contract, and subject releases of funds to deliverables; or they get automatically returned. Either that or tailored regulations would eventually be introduced defining how groups and individuals can make use of this powerful new tool to bring good ideas to fruition.
On this, we are also at the early stages. But the shift in the power relationship between fund contributors (who used to be investors and venture capitalists with some rights and say in the business) and entrepreneurs in the current set up is probably not sustainable. Unconnected and loose group of contributors is great for entrepreneurs; very decentralized; but it totally gives the contributor side no power in the relationship, in exchange for their funds. Such arrangement is prone to abuse and will continue to experience a high level of the same until some changes are brought to bear.
Banning of Digital Currencies will Likely not Work
Finally, let’s take a look at nation states that have outlawed access to digital currencies as a regulatory step. Currently, the biggest country in this group is China. This ban will likely fail. Firstly, technologically the ban is about as hard to sustain as banning access to the Internet, or specific sites. Some will continue to find access to it so you end up just creating inequities. But the more important reason for its eventual failure is that the state that unilaterally bans digital currencies will lose by costing its own citizens access to a source of jobs and economic growth in the next few years. (In fact, just like with the Internet innovation that spurred significant economic growth, you already see proposed legislation to protect the new innovation inherent in blockchains technology; such as the proposal to exempt from taxes purchases less than $600 in the US.)
The current gains in digital currency values and technologies will accrue to those in nations that admit them within their economy. Look at it this way: if any country that bans acquiring digital currency do not also ban the dollar for example, and the value of a digital currency appreciates with respect to the dollar, then they really haven’t banned the value of the digital currency. And currency is basically its value if it can be exchanged. Others who have it will exchange it to dollars and do business with citizens of those countries where it is banned with the leveraged value of their digital currency. The holders of the digital currency will benefit, and those banned from holding it will lose from being barred.
You can already see the cracks in the Chinese ban of digital currency access through exchanges, because miners were exempted and are allowed to keep acquiring digital currencies through mining. The state rightly did not wish to cost its own miners and its economy value by stopping the miners. That is an inherent admission of value that makes preventing access to other citizens questionable.
Perhaps the plan is to create a national or local version of digital currencies. If the replacement is not as decentralized or is subject to the same opaque minting practices of fiat currencies, it will be harder to justify its existence in lieu of the nation’s fiat currency. And if there is no replacement, or the national replacement fails, expect to see a slow return to access to digital currencies in most of the nation states that have currently banned its access.
The views here are provided freely and could be freely used in whole or part, hopefully with a kind reference to the article. It is not intended as investment advice and should not be used in that capacity.