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Cryptocurrencies – Potential Obstacles and Policy Issues

Cryptocurrencies – Potential Obstacles and Policy Issues

Put simply, cryptocurrency is digital money that operates independently of a bank and can be used in ways similar to cash around the world. However, the digital nature of these new currencies adds some benefits that appeal to consumers and have led to their increasing popularity.

Potential Benefits

Traditional monetary and electronic payment systems involve a number of intermediaries such as government central banks and private financial institutions. To carry out transactions, these institutions operate and maintain extensive electronic networks and other infrastructure, employ workers, and require time to finalize transactions. To meet costs and earn profits, users of the systems are charged fees. Cryptocurrencies aim to provide a payment system that is more efficient, faster, and less costly. In addition, the anonymity of transactions (because of the use of (pseudonyms) offers greater privacy that could be valued by some users.

Potential Obstacles

It is not clear if cryptocurrencies will be able to deliver these hoped-for efficiencies because they currently face certain limitations. For money to be effective, it must serve as a medium of exchange widely accepted across the economy and act as a “store of value.” Unlike the U.S. dollar or other government-backed currencies, cryptocurrencies are not legal tender, meaning creditors are not legally required to accept them to settle debts.

In addition, consumers may be hesitant to place their trust in a decentralized computer network of anonymous participants that many do not completely understand. These characteristics may impede the widespread adoption of cryptocurrencies. Furthermore, the values of many cryptocurrencies have recently been highly volatile, potentially making them a poor store of value.

In addition, even if a cryptocurrency is able to achieve widespread acceptance and a stable value, the system is not costless. The fast processing of payments requires performing computations, which are extremely difficult and require investment in computers and servers and the consumption of electricity.

Policy Issues

Cryptocurrency transactions involve money transfers, exchanges, and investment products. Policymakers have created an existing regulatory framework to address risks related to these activities. Because these currencies are new and evolving, it is not yet clear how effective the tools and authorities available to regulators are when applied to cryptocurrencies.

Some observers argue that certain regulations restrict the adoption and use of beneficial cryptocurrencies and should be relaxed. In contrast, others argue that current regulation provides inadequate protections against potential risks and that regulation should be strengthened.

Crime

The anonymous and decentralized nature of cryptocurrency transactions could provide an additional means to launder money, evade taxes, fund terrorists, or bypass financial sanctions the U.S. government has imposed on other countries.

The Department of the Treasury’s Financial Crimes Enforcement Network (FinCEN) has issued guidance explaining how regulations designed to curtail these activities apply to the use of virtual currencies. FinCEN has indicated that exchangers (people engaged in the business of exchanging virtual currency for real currency, funds, or other virtual currency) and administrators (people engaged in the business putting virtual currency into circulation and who have the authority to withdrawal currencies from circulation) qualify as money services businesses (MSBs) subject to federal regulation. Among other things, MSBs must register with and report suspicious transactions to FinCEN and maintain anti-money laundering compliance programs.

Taxes

The Internal Revenue Service (IRS) has issued guidance stating that virtual currencies should be treated as property (as opposed to currency). This means that users owe taxes on any realized gains whenever they dispose of virtual currency, including when they use it to purchase goods and services. The guidance further indicates that when an employee is paid in virtual currency, it will be taxed as wages.

Consumer Protection

Because consumers are not necessarily familiar with cryptocurrencies, they could be (a) charged excessive fees when using or exchanging the currencies; (b) deceived about their true value; or (c) unaware of the risks of loss of value or electronic theft. Cryptocurrency exchanges may be required to obtain money transmitter licenses from the states in which they operate, and to abide by any consumer protection requirements imposed on money transmitters by state law.

Investor Protection

Cryptocurrencies have or may become the underlying asset in certain financial products— including:

  • Initial coin offerings (ICOs), wherein cryptocurrencies are sold to raise capital
  • Exchange traded funds (ETFs), wherein a fund invests in a portfolio of cryptocurrencies;
  • Futures contracts, wherein parties agree to buy, sell, or trade cryptocurrencies at a future date.

In the above cases, questions about investor protections have been raised. Some observers are concerned these products create the opportunity for investors to take on risks they do not understand or to become victims of fraud. The Securities and Exchange Commission (SEC) has indicated that depending on their specific features, ICOs may result in offerings of “securities” subject to federal regulation. The SEC also regulates the majority of ETFs, and has sought public comment on proposals related to Bitcoin-based ETFs. The Commodities Futures Trading Commission regulates derivatives contracts in virtual currencies, and exchanges on which such contracts trade. Both agencies have issued statements outlining their general approach to the regulation of virtual currency products.

For background information on cryptocurrencies, please see our blog titled Cryptocurrencies – A 21st Century Financial Innovation.”

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