BITCOIN, a new form of private money, is designed to remove the government’s ability to create inflation by printing money. Bitcoin was designed to nurture a new unregulated monetary system without the involvement of governments, banks or other regulated financial institutions.
Ironically, bitcoin and other cryptocurrencies are unlikely to gain mainstream status without the right mix of government regulation and oversight. Too much regulation and cryptocurrencies will succumb to compliance costs. Too little regulation and the cryptocurrency market will fail to achieve the integrity it needs to attract mainstream institutions and investors.
The supply of bitcoin is tightly controlled by open source software to ensure that the cryptocurrency’s value can never be debased. The blockchain distributed ledger technology, which makes bitcoin and other cryptocurrencies possible, underpins a transnational payment system that needs neither banks nor governments to operate.
The integrity of the blockchain payment system depends on the actions of independent “miners” who compete to solve the next blockchain cryptologic puzzle. The solution to the puzzle creates a permanent record of bitcoin transactions, and the winning “miner” earns bitcoin as a reward.
Unfortunately, the blockchain is not tamper proof. A single “miner” with too much computing power can manipulate the timing of transactions on the blockchain and potentially counterfeit the cryptocurrency.
This risk is greater than initially believed, and no government monitors the computing power of individual mining firms to ensure the integrity of the blockchain payment mechanism.
While the blockchain records payments of cryptocurrency between two virtual wallets, bitcoin and other cryptocurrencies must have additional functionality to be viable substitutes for national currencies. For example, cryptocurrencies must be easily and safely exchanged for national currencies.
At present, more than 50 cryptocurrency exchanges around the globe facilitate the exchange of cryptocurrency for national currency. These exchanges are private, unregulated intermediaries that match customer purchase and sales orders for cryptocurrency-national currency pairs.
Cryptocurrencies exchanges provide a critical service. But even though the integrity of these exchanges are critical for the long-term viability of cryptocurrencies, the bitcoin blockchain technology does not protect investors against theft or fraud when their cryptocurrency balances and transactions are entrusted to these intermediaries.
To use a cryptocurrency exchange, a currency owner must transfer virtual currency to the exchange, or provide the exchange with national currency to purchase cryptocurrency. Either way, the customer’s cryptocurrency is held in the exchange’s virtual wallet.
Unlike regulated exchanges, there is no law or regulation requiring that the balances of customers be segregated from exchange balances. If the exchange goes bankrupt from fraud or mismanagement, or the exchange’s virtual wallet gets hacked, customer cryptocurrency balances can be lost.
Unlike U.S.-regulated securities firms, there is no Securities Investor Protection Corp. insurance to protect customers.
In the short time cryptocurrency exchanges have existed, they have been hacked repeatedly and several have experienced bankruptcy.
Other risks include “flash crashes,” the potential for front running (where insiders enrich themselves through their knowledge of a pending transaction), the unknown impacts of algorithmic trading, and other information asymmetries that may disadvantage mainstream investors trading on cryptocurrency exchanges.
The anonymity of cryptocurrency transactions also creates risk. Cryptocurrencies are traded between virtual wallets that contain no identifying information about their human owner. The anonymity of these transactions attracts those who profit from illegal activities, including criminals, terrorists and tax evaders.
One recent study estimates that nearly 24 million bitcoin market participants and nearly half of all bitcoin transactions can be linked to illegal activities.
The link between cryptocurrency and criminal activity is a major problem for regulated financial institutions. These institutions are subject to anti-money-laundering laws that expose the institutions to fines and other sanctions should they accept funds linked to illegal activity.
Currently, the risk of processing funds related to illicit activities limits the participation of mainstream financial institutions in cryptocurrency markets.
This list of issues meriting regulatory oversight is surely incomplete, but the overriding message is that cryptocurrency markets are subject to the same market manipulation, fraud and criminal activities that impeded the development of mainstream financial markets.
Regulations to protect investors were a necessary part of the evolutionary process that allowed traditional financial markets to gain investor confidence and grow.
Consumers, investors and regulated financial institutions will be deterred from embracing cryptocurrencies as long as the integrity of their trades are a concern, the security of their legitimate investment balances are at risk, and cryptocurrency transactions are dominated by those who value anonymity above all else.
Paul Kupiec is a resident scholar at the American Enterprise Institute, where he studies systemic risk and banking and financial market regulation. He wrote this for InsideSources.com.