The EBA, European Banking Authority, has been watching Virtual Currencies (VC) since September 2013. In December 2013, the EBA publicly highlighted various concerns due to the risks associated with unregulated virtual currencies. A few days ago on 4th July, 2014 the EBA went further and released an EBA Opinion on Virtual Currencies. In this publication the EBA say that the European authorities should discourage banking and related institutions from buying, holding or selling Virtual Currencies. In the meantime, Canada has introduced digital currency regulations, and the US state of California has also approved a bill that lifts the ban on the use of Bitcoin and other Virtual Currencies. So why has the EBA taken this stance?
This post shares and references the EBA identified risks associated with virtual currencies like Bitcoin. To read the full report, please refer to the EBA Opinion on Virtual Currencies.
What is a Virtual Currency?
The EBA definition of virtual currencies like Bitcoin, includes the following:
- The value of a virtual currency is represented digitally
- A virtual currency is decentralised, so it is neither issued nor controlled by a conventional central bank or public body
- Virtual currencies like Bitcoin, can be used as a payment method to purchase goods / services. Clearing system are not needed in this purchase transaction, and so the payment is typically processed much faster and at a much reduced fee
- A virtual currency can be transferred, stored and traded electronically
- Virtual currencies are not considered to be legal tender – as mentioned in the introduction though, this is changing when we consider virtual currencies like Bitcoin
- Some virtual currencies cannot be converted to conventional money, and exchanged back into virtual currency
I’ve mentioned Bitcoin a few times, and it is one of the leading virtual or digital currencies in the world. Bitcoin is a software based digital payment system which was introduced globally in 2009. Given the massive attention around Bitcoin I had to mention it here. But the intention of this post is to delve into the details of why the EBA thinks Europe should generally keep away from virtual currencies – Bitcoin is one such example. If you’re interested in reading up on Bitcoin, I recommend https://bitcoin.org/en/
The EBA Concerns:
1. Transaction Fees – One of the key benefits of virtual currencies like Bitcoin, is that the virtual currency transactions incur significantly lower fees. Now from a pure European perspective the EBA believes that the transaction cost differentials are not so great. This is because across the SEPA countries there is no longer a concept of a cross border payment, and with it the associated higher transaction fees. All SEPA payments and collections are treated as domestic. The SEPA transaction fee, at least for individuals, is either very low and in some cases free. This is turn reduces, sometimes removes, the transaction fee advantage of virtual currencies like Bitcoin.
2. Processing Times – The understanding is that virtual currency transactions are processed much faster than conventional currencies. Again, the EBA states that this advantage is reduced in the SEPA zone because many SEPA countries are introducing additional settlement cycles and in some cases are on the verge of implementing 24/7 real time payment services.
3. Financial Inclusion – the EBA states that in some regions financial services may not always be readily available to people. In such locations virtual currencies may fill the void and can potentially offer and enable financial inclusion. Here again, within the European Union the Payments Account Directive (April 2014) offers all EU citizens access to a low cost bank account. To take this a step further, the EBA would argue that an EU account is regulated and offers individual protection far beyond what virtual currencies like Bitcoin can offer. So the stated Virtual Currency advantage of enabling financial inclusion is significantly reduced within the EU
4. Because a virtual currency is not subject to regulatory requirements, if the exchange or virtual currency payment is subjected to fraudulent intervention, the individual suffers the financial loss – ouch!
5. Anyone can set themselves up as a virtual currency (VC) exchange. The established VC exchange may not be a registered entity subject to conventional rules and regulations. As such the exchange can make up their own rules and may not offer virtual currency to conventional currency conversion. In this instance, the individual may incur a loss.
6. Exchange rate fluctuations may result in the individual incurring losses in the value of their Virtual Currency. If this fluctuation was to occur with a conventional currency, the exchange rate would typically be stabilised / controlled by the central authority. This authority may not exist with virtual currencies like Bitcoin
7. Virtual Currency rules and regulations are unclear. Depending on the local/in country rules virtual currencies may be subject to tax rules and regulations. In this scenario the individual again may unexpectedly be liable to pay some kind of tax liability
8. Virtual currencies like Bitcoin can be mined, and in some cases users pool their PC’s to enable a greater mining capacity. Here the rules and regulations are unclear, so the mining pool owner may not fairly distribute the mined units. The process of mining, distribution and verification is exposed to errors, fraud and hacking. Here again the individual may lose out
9. During the mining, distribution and verification process ones computer could be hacked and its computing power may be used for someone else’s benefit.
10. Anyone can anonymously create/change a Virtual Currency scheme. Virtual Currency schemes and the functioning thereof can be falsely represented. Because the Virtual Currency transactions are irreversible, and in the absence of a legal contract coupled with the fact that there isn’t a complaints procedure means the individual could lose out.
11. The anonymity associated with virtual currencies concerns the EBA. The anonymous creation of a virtual currency scheme is not subject to independent rules and regulations. Once a majority of miners agree a change should be made, the changes could inadvertently introduce unexpected errors or worse still some miners may introduce changes with bad intentions.
12. The lack of a central body and the regulation they enforce means that users may not have all of the information (pro’s and con’s) about a Virtual Currency scheme
13. Individuals may unexpectedly find themselves violating local laws and regulations due to the fast changing pace of rules and regulations in the Virtual Currency space. Equally the VC scheme may itself change, here the changes may not be adequately communicated to the participants
14. Users may incur loses due to their e-wallet being hacked or targeted for theft. Equally the e-wallet software could malfunction as could the device holding the e-wallet. When this happen the users have no refund right, and directly incur the loss
15. Insufficient security at a Virtual Currency exchange may result in the exchange being hacked. Where an exchange is temporarily holding a users Virtual Currency units, the user incurs the loss. We have already said that the user has no refund right and that the transaction cannot be reversed so the individual loses out
16. Various user verification processes are in place with VC schemes. Some schemes require passport scans, finger prints – because there are no central rules/regulations/data protection measures in place – these very personal credentials maybe not be used for their intended purpose
17. If/ when Virtual Currency schemes are regulated, individuals may suddenly and unexpectedly find that their existing VC contracts are rendered illegal or unenforceable
18. Anonymity within Virtual Currencies is a key EBA concern. Individual may suffer losses due to delays in the recovery of VC units or the freezing of Virtual Currency positions
19. The anonymity of some participants may undermine the transaction credentials. This may result in unclear settlement expectations and/or the counterparty may simply not have sufficient funds with which to complete the transaction. This adds risk to the Virtual Currency scheme
20. In the absence of centrally regulation, market participants may incur losses because the VC scheme custodian is:
- Acts negligently or fraudulently
- Is unable to correctly oversee, record and retain transaction processing
- Has insufficient funds to pay creditors
21. Variations in the rules and requirements creates an imbalance in Virtual Currency schemes. For example, some participants may choose to remain anonymous, have better technological access, have better access to insider information. This creates an unfair playing field, where some may incur losses due to the inequality within the scheme
Risks associated with using Virtual Currencies as a Payment Method:
22. If a counterparty (who may choose to remain anonymous) within a Virtual Currency scheme fails to meet their payment (around which there maybe no legal contract) or settlement obligations, the individual may suffer a loss
23. VC cash machines are not subject to any regulation, licensing and there is no redress procedure. As a result if a user chooses, where possible, to exchange a Virtual Currency for a conventional currency at a VC cash machine, the individual may unexpectedly incur a loss.
24. Virtual Currencies are not legal tender. So a merchant can choose to accept or refuse Virtual Currencies as a method of payment as they see fit
25. When making a VC payment, if the users’ e-wallet is incorrectly debited, the user incurs a loss. Remember a VC transaction is irreversible and based on trust
26. It is not always possible and good value to exchange Virtual Currencies into conventional currencies.
27. If a user loses their e-wallet password / access key, they lose access to the e-wallet altogether. A key/ password cannot be re-issued, so once its gone its gone, you’re stumped!
28. Virtual Currency units on an exchange that is deemed to be a ‘going concern’ may not be accessible. An exchange may block any activity during this period, and in turn cause the individual some stress in the short term and potentially a loss in the long term.
29. If a Virtual Currency exchange goes out of business, the user may suffer a loss. Due to the lack of Virtual Currency regulation the process of bankruptcy proceedings is unclear. Either way, individuals are unlikely to be compensated for any losses.
Risks associated with using Virtual Currencies as an Investment:
30. Virtual Currency prices maybe manipulated by key players in the marketplace resulting in losses for smaller individuals
31. By their very nature investment products are typically complex. So investing in regulated investment products using unregulated Virtual Currencies results in a high risk investment.
32. An individual maybe misled by unreliable, perhaps even manipulated, exchange rate data
33. An individual may incur losses by investing in a fraudulent or Ponzi Virtual Currency scheme
34. There is inherent uncertainty around the unit price of many virtual currencies. This uncertainty combined with low market depth may result in price volatility in a short time period
35. Investors may not be able to sell Virtual Currencies when they want to.
Risks associated with non-user Market Participants:
36. The exchange maybe unable to fulfil payment obligations denominated in Virtual Currencies or Conventional Currencies
37. The exchange may not hold adequate records and implement sufficient controls resulting in a lack of order in its overall operation
38. Where an exchange offers refund policies, market participants may take advantage of this and use the policy to hedge currency exchange transactions. This may incur a loss for the exchange
39. If a merchant accepts Virtual Currency as a form of payment, there is no guarantee that the merchant will be reimbursed. There may not be a transaction verification process, and so it may be difficult to prove that a payment has/ or has not been made
40. Similar to individuals, a merchant cannot be entirely certain that they can spend their received Virtual Currency payment. VC acceptance is completely voluntary and usage may vary over time and between schemes
41. The Virtual Currency exchange rate versus a conventional currency varies significantly. As a result it is difficult for a merchant to know the actual value and buying power of any received virtual currency ‘funds’
42. As mentioned already, Virtual Currency e-wallets, exchanges, trade platforms are not regulated and don’t have a physical office that you can attend. If an individual is unhappy with a particular transaction, the individual may only be able to face and complain to the merchant and request some kind of compensation
43. E-Wallets are vulnerable to hacking and other security breaches. Some individuals may choose to hack an e-wallet provider, here the ability to cause large scale theft is considered to be high risk
44. Administrators of a Virtual Currency may fail to implement and maintain strong controls, security measures, governance and integrity.
45. E-wallet providers are not always subjected to rules and regulations. As a result if their e-wallet solution is compromised the e-wallet provider may seek compensation claims from its customers. The procedures around how this compensation claim can happen is unclear.
Risks – Financial Integrity:
46. Money laundering via Virtual Currency schemes is a huge concern to many authorities. The anonymity of Virtual Currency transactions enables criminals to easily launder their ‘earnings’ through the anonymous deposit and transfer via Virtual Currency schemes
47. Criminals can quickly deposit and transfer Virtual Currencies globally, and without trace and fear of being reversed
48. To enable a Virtual Currency transaction, the participant and potentially criminal only requires internet access. Very quickly criminals can use VCs to send the VC across the globe and to potentially fund further criminal activities in another country without being intercepted and traced
49. Some Virtual Currency participants may in turn be influenced / controlled by criminals, terrorists or related organisations. The risk and concern here is similar to the above, i.e. the ease at which VCs can be transferred globally
50. Criminals may use Virtual Currency transactions as a way to stay under the financial sector radar and trade in illegal commodities
51. Anonymity combined with the ease at which funds can be transferred globally makes it extremely difficult to trace criminals and in turn seize and confiscate any assets. The lack of an intermediary and the fact that no names are attached to some e-wallets further adds to the complexity of trying to track down the involved criminal parties
52. Criminals can use Virtual Currencies as a way to make internal and/or inter-organisational payments
53. Virtual currencies enable individuals to engage in criminal activities by avoiding the regulated financial system, and by making it easier to purchase illegal goods and services
54. Hacking Virtual Currency software, e-wallets and/or exchanges enables criminals to steal identities and incriminate the stolen identities in criminal activities
55. There are recurring themes in the EBA publication. The anonymity, global reach of Virtual Currency transactions and irrevocability are among these. Here the EBA state that by transferring VC’s to another jurisdiction, governments and other authorities / bodies are unable to seize assets or impose financial sanctions or embargos. Knowing this enables and facilitates criminal activity through the VC channel across different jurisdictions
56. Criminals may create a Virtual Currency scheme and use it for their own criminal purposes
57. Virtual Currencies enable tax evaders to obtain income denominated in Virtual Currencies, which side steps the conventional currency payment system and the prevailing rules and regulations
Risks – Conventional Currency Payment Systems and Payment Service Provider (PSP):
58. PSP’s that utilise both conventional currencies and offer Virtual Currency services may incur loses due to laws that deem Virtual Currency contracts to be illegal
59. Conventional currency PSP’s that provide Virtual Currency services may fail to meet their contractual obligations as payment system participants due to liquidity exposures in their Virtual Currency operations
60. PSP’s offering Virtual Currency services may suffer losses and reputational damage if their Virtual Currency services fail to meet their customer needs
61. If there is disruption in the financial markets due to Virtual Currencies, the whole regulated economy suffers
Risks – Regulatory Authority:
62. Significant reputation risk would result if a Regulator decides to regulate a Virtual Currency, but the adopted rules and regulations fail
63. If a Virtual Currency remains unregulated but in the absence of good communication a regulated institution starts dealing with a VC, any negative outcome would impact the reputation of the regulated institution
64. Broadly speaking a regulated conventional currency and a Virtual Currency are essentially fulfilling the same objective. The approach is the differentiator. So from a Regulator’s perspective allowing a VC scheme to operate without rules and regulations in a way undermines the Regulator’s overall objective of ensuring well functioning payment systems
Risks – Legal:
65. When a Regulator decides a regulatory approach for a given Virtual Currency, any existing contracts maybe rendered illegal. The impacted individuals may contest the legality of the contracts and take legal action against the Regulator
Risks – Competition Objective:
66. The Regulators needs to ensure that they apply equal rules and regulations to similar services offered in Virtual and Conventional Currencies. This is to ensure that the Regulator creates a level playing field in the market place
67. If inequalities exist in the marketplace between regulated VC and conventional currencies, we may see a shift towards the less regulated VC services.
A lack of regulation, central governance, combined with concerns around the ability to remain anonymous and change the operation of a virtual currency and/or scheme at short notice are recurring fears in the EBA publication. You could argue that without the willingness to regulate Virtual Currencies will always be at a disadvantage and will continue to be shrouded in mystery and generally misunderstood. On the other hand, you could argue that the decentralised nature, lack of restrictive regulation and indeed self regulation is actually the underlying strength and advantage of Virtual Currencies like Bitcoin. One thing is for certain, virtual currencies like Bitcoin are gaining in popularity and increasingly attracting global attention. How they evolve remains to be seen.
So there you have it. That’s the EBA’s view, what do YOU think about virtual currencies like Bitcoin?