Bitcoin and other crypto-currencies (secret currencies) are getting a lot of airtime and being considered with seriousness, for example at HM Treasury, for inclusion in or coalescence with the traditional payments eco-system.
HM Treasury launched a Call for Information on Digital Currencies and is now digesting the results. The watchwords at HMT are echoed at the new UK Payment Systems Regulator:
- Access for new entrants
- Reduction of the market power of the vertically-integrated incumbents – the big banks
We have the FinTech market bubbling, with all manner of incubators and venture funds trying to get a piece of the action on two distinct sides of the fence, in the EU at any rate:
- Start-ups that will register as Payment Institutions, or eMoney Institutions, or even as ‘Challenger’ banks if they are large and diverse enough
- Bitcoin and crypto-currency companies that appear to be intent on steering around the regulatory regime
This has to be seen as part-and-parcel of the banking reforms based on Vickers Report and Changing Banking for Good, and as an accompaniment to Project Innovate at the Financial Conduct Authority. The FCA has issued its Feedback Statement FS14/2 on the Call For Inputs regarding Project Innovate, a call that was very poorly advertised and which will have delivered a misleading result: it was advertised only in those channels frequented by organisations who were a priori proponents of innovation.
As a result the Feedback statement contained discussion of topics which should have been off-limits. For example it is wrong for the FCA to even mention altering the regulatory entry barriers to the financial services industry for innovators. Those barriers have been erected, not least by the FCA itself, to protect the financial services eco-system and the consumer. Arguably new entrants should pass more stringent tests than proven operators. At the very least there should be no discussion of relaxing barriers in any way. It is irresponsible of the FCA to hold this out as a possibility.
Lastly there was a statement by the FCA (in 2.62.e on page 31 about Commercial viability and management) that “we do not intend to substitute our own judgement for that of the market”. This statement betokens a worrying misunderstanding of what the “market” consists of, and how enterprises can be launched into the financial services ecosystem based on aspiration and closed interests.
The “market” only comes into play after these new ventures have been launched and are in possession of customer funds. The actors that bring them to launch are a combination of:
- Venture capitalists
- IT companies who have a business unit dedicated to fostering Fintech start-ups and raising money for them, money that is then spent with the IT company to create the start-up’s IT and operational environment
Players in category (2) will have been paid out before the venture reaches the real market.
Players under category (1) are not interested in individual start-ups: the structure of the venture capital industry gives each VC an equal and small share in each start-up, and limited liability. The VC does, however, have unlimited upside if the start-up succeeds.
The FCA’s statements demonstrate a complacent misunderstanding of the structure, motivators, risks, and rewards of the equity investors in these start-ups. On the other hand there clearly were respondents to the Call who were concerned that the business plans of new entrants should be tested – during angel/incubator phase and regulatory approval phase – through many aspects but not for their commercial viability.
The ‘moral hazard’ and assumption that shareholders will ensure that the business has a good chance of succeeding before they invest are not in play here. Upon whom falls the collateral damage once these start-ups begin to fail at the normal rate of 97 in 100?
- The general public, if in the meantime any of these start-ups has received a banking licence or can otherwise call upon the public to reimburse their customers;
- The London financial market, as it is positioning itself as a major hub for new payment start-ups.
There is a lack of expert, independent and contrarian challenge to the business plans of these start-ups. This results in unviable businesses making it over the start line and becoming part of the financial services eco-system, introducing risk of collateral damage to the eco-system, customers and taxpayers.
These risks need to be managed comprehensively by the organisations responsible for payments and banking as a whole, and not allowed to fall between any regulatory or supervisory cracks.
Those sentiments are, however, running contrary to the current flow of official enthusiasm – for Financial Services innovation as a whole (Project Innovate), for new Payment Service Providers (Payments Systems Regulator) and for its subset Bitcoin and other crypto-currencies (Call for Information on Digital Currencies).
Since this Call for Information was launched, however, the prices of bitcoin have fallen as have volumes traded, and there are fresh concerns over the fate of funds deposited with exchange operator Bitstamp, which has suspended services over a possible compromise of its ‘hot wallet’.
The company, which initially took over the mantle of the world’s biggest USD Bitcoin exchange following the scandal-ridden demise of Mt Gox, has ceased all withdrawals and warned customers not to make any fresh deposits while it investigates the problems.
Notwithstanding the upswing of official interest in the UK in 2014, some important bodies did take a position in 2014, and a very negative one. Financial Action Taskforce – in its June 2014 paper on definitions and AML risks – and the European Banking Authority – in its July 2014 ‘Opinion on virtual currencies’ – have made their positions clear: crypto-currencies have no validity and are a channel for money laundering, illicit financing, and tax evasion.
Crypto-currency cannot be ‘money’ in the accepted sense. It is not a fiat currency issued by a national government and backed by the full faith and credit of its taxpayers. It cannot be legal tender as the designation thereof is another power reserved to national governments or associations of national governments (in the case of the euro).
It is ‘mined’ (i.e. manufactured) via computer algorithms and the difficulty of mining is supposed to limit supply, and where there is limited supply and significant demand, the price should go up. FATF and EBA have a very clear picture of where the demand is coming from.
The US Department of Justice has designated it as ‘goods’: if that treatment is replicated in the UK and the rest of the EU, then all exchanges involving bitcoins are sales by the giver, and subject to the VAT regime, including – for businesses – adding VAT to a bitcoin payment you are making, if you are VAT-registered. Since bitcoin is secret, do you even know who you are trading with, what VAT should be added, what you should put in your EU Sales List?
As regards accounting, should payments made with bitcoin be added to ‘Cost of Goods Sold’, and payments received added to ‘Sales’? In other words payments for sales and costs are themselves costs and sales i.e. a payment with bitcoin is a barter.
What about the valuation of bitcoin owned if it rises or falls? Are such profits taxable and any losses tax-deductible? Here we need the Inland Revenue to make a statement.
And what does an ‘owner’ of bitcoin own actually – shares, an account balance, an investment?
Who is behind a crypto-currency and what claim does the owner have on the sponsor or any assets that were purchased with the real money that the owner parted company with? What about transparency of pricing, certainty of delivery, and recourse to a lifeboat fund if a bitcoin ‘deposit’ goes bad or disappears?
It would appear that all of these characteristics are absent.
An “investor” is meant to have confidence that, because it is very difficult to “mine” bitcoin, the supply will remain limited and so the price will be supported. It is correspondingly difficult to have confidence in this line of argumentation when:
- Moore’s law on the increase on computing power pertains
- There are 6 billion people on the earth and a large fraction have access to a computer and to the internet
- The recent hacking of SONY around the film “The Interview” demonstrates the degree of ingenuity that exists to bypass any supposed controls
- If the alternative for so many of the world’s population is to work for very long hours in unpleasant conditions and for very low wages, is it not credible that many will either switch full-time or else expend extra hours to manufacturing their own money?
There are further monetary policy ramifications for authorities. If there is any easy link between the bitcoin world and the fiat currency world, such that the creation of ‘money’ in the crypto-world creates money in the real world too, how does that affect any attempts by central banks to manage money supply? Is it a sort of private and uncontrolled Quantitative Easing? What could be the ramifications for prices of assets, pensions and investments and so on?
Secondly, if economic activity does start to be conducted using bitcoin out in the ether, and such inconveniences as Online Pay-As-You-Earn filings and EU Sales Lists can be circumvented, that can leave a hole in national revenue accounts, at a time when demand for public services is rising and tax revenues and living standards are under pressure. FATF and EBA certainly see bitcoin as a large home for the black economy.
An Isle of Man-registered company is even proposing to offer physical bitcoins to UK persons that are “securely” numbered bits of brass or of silver, depending upon the denomination you buy, and they come in a velvet case. The silver ones will have an intrinsic value – their weight in silver. The brass ones are intrinsically valueless and would only ever have a value if they represented a claim on an asset or a legal person. Of course the item has a “value” at the start: the price the punter has paid out for it in real money.
The sponsor of this particular offering lays great emphasis on the measures to guarantee authenticity, non-repudiation, and avoidance of loss of the claim itself, but much less emphasis on what happens to the money paid in.
These tokens are very different from the £5 commemorative coins that are issued for royal wedding and anniversaries by the Bank of England, because they are legal tender for their face value. In a sense the issuance of physical bitcoin is an instance of a company launching a rival physical currency to that of the Bank of England in the UK. That might class as forgery or at least as an attempt to undermine the currency (literally – mining bitcoin = undermining fiat currency).
The sponsor of these tokens proposes to offer them as an “investment” to UK residents: surely the Financial Services Authority would have something to say about that.
What assets are the proceeds invested in such that the value of a partial claim on the asset portfolio might result in the price of the bitcoin rising? What is the pricing mechanism? What is the credit rating? Where is the liquidity? Where is the ombudsman? Are we looking at a form of Green Shield Stamps? What is the Capital Gains Tax treatment?
The precious piece is the statement that this company “need(s) to perform an analysis of what local regulations apply in each country we hope to sell in first, so are focussed on launching in the UK for the time being”.
So there are no local regulations here in the UK? Of course there are but up to now none of the owners of the different areas of regulation has stepped up to the plate and claimed ownership of this topic for themselves.
There is a certain head of steam building around crypto-currencies and a corresponding dearth of education – a potentially dangerous combination for those who have money from which they might become parted, for example those liberated under the new private pensions freedoms.
Buyer Beware should not be the response here. We have regulators coming out of our ears: The Pensions Regulator, the Financial Conduct Authority, The Financial Services Authority, The Prudential Regulation Authority, The Payment Systems Regulator, HM Customs, Inland Revenue, The Bank of England, HM Treasury, The Financial Ombudsman and no doubt several more. They need to very quickly get together and decide whose bailiwick bitcoin and crypto-currencies fall within and what the regulatory regime will be, and block market access to those companies that do not comply.
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