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This article first appeared in The Edge Malaysia Weekly on September 25, 2017 - October 1, 2017

THE father of the mass-consumer automobile, Henry Ford, once said, “If I had asked people what they wanted, they would have said faster horses.”

In today’s fast-paced world however, there is no shortage of enterprising people looking for the next proverbial automobile that will revolutionise the world. And one thing that futurists are watching closely is the emergence of cryptocurrencies like Bitcoin and Ethereum.

With an estimated collective market capitalisation of US$133.23 billion and a 24-hour turnover of US$3 billion (on Sept 21), cryptocurrencies have ceased to be non-trivial. Today, central banks are faced with a major dilemma — how should cryptocurrencies be regulated, and should it be allowed into a country at all?

After all, central banks are the custodians of fiat currency — the proverbial horses, if you may, in keeping with the analogy. Cryptocurrencies are a direct competitor to conventional currency, and something that is beyond the reach of central banks’ control.

But if cryptocurrencies are to fiat money what mass-produced cars are to horses, then bitcoin is arguably the Ford Model T — groundbreaking, but merely the first step into a new regime.

To be clear, Bitcoin is a massive first step. It is difficult to play down a coin that makes up nearly half of all cryptocurrencies in circulation and boasts a US$64.4 billion market capitalisation. That is larger than the three biggest companies on Bursa Malaysia combined — Malayan Banking Bhd, Tenaga Nasional Bhd and Public Bank Bhd.

Furthermore, Bitcoin has a daily trading turnover of between US$1 billion and US$2 billion, no small sum to scoff at.

At the same time, Bitcoin is far from perfect. Sceptics are quick to point out its many structural and technical shortcomings.

“Some of the technical flaws, including scalability, can be solved as technology progresses. However, fluctuation in value may be a big hurdle for Bitcoin use in daily payments,” notes Makoto Shibata, principal analyst and head of the global innovation team under The Bank of Tokyo-Mitsubishi UFJ Ltd’s digital transformation division.

On the other hand, Bitcoin’s defenders argue that the blockchain technology is still in its infancy. If it can follow Moore’s law, that improvements in digital technology grow exponentially, then it can quickly overcome these shortfalls.

That said, the future of cryptocurrency may not necessarily be Bitcoin. Like how Facebook doomed all its social media predecessors to obscurity, a new and better rival could usurp Bitcoin.

It is for this reason that regulators are hesitant to slam the door shut on cryptocurrencies for fear of being left behind. Nor will they be hasty in opening the floodgates either. Regulators are simply hedging their bets and playing wait-and-see.


Regulating the unregulatable

It is interesting to ponder what a regulator-endorsed cryptocurrency ecosystem might look like. To be sure, there are still many structural and technological pitfalls to be ironed out.

But just because seatbelts and indicators have not been invented yet, it does not mean people should be stopped from building cars altogether.

Bank Negara Malaysia last week indicated that guidelines for cryptocurrencies were being drafted and should be ready by the end of the year. It is not clear what tack the central bank will take, and when contacted, it declined to comment.

Broadly speaking, there are two areas that need to be addressed. Firstly, there is the pressing matter of regulating (or less likely, outlawing), the ongoing trading activity in cryptocurrencies.

A quick search online will reveal dozens of ways for Malaysians to access exchanges to buy and trade in Bitcoin. Once the actual Bitcoin is purchased, there is little that regulators can do to monitor the flow of funds.

Thus, Bank Negara is expected to tighten controls on intermediaries that facilitate and bridge the cash-to-cryptocurrency gap. The key motive will be to apply capital controls and prevent the use of cryptocurrencies for money laundering and other illicit purposes.

The second matter for the central bank to consider is the potential value of blockchain, distributed ledger technology and cryptocurrencies — as a technology and the possible applications in financial markets that may not even be conceived yet.

It is conceptual. But the returns could be huge.

What if regulators could catalyse further development of blockchain-related technologies in Malaysia within a robust framework? Could it spur the development of a completely new area in financial services?

A similar comparison would be how Malaysia, as a relatively small country in the global financial landscape, managed to pioneer and develop Islamic banking and finance.

Interestingly, it is not difficult to find industry players that are more than open to the idea of regulation.

“We are pro-regulation. In fact, we believe cryptocurrencies should be regulated sooner rather than later. Otherwise, we could end up in a similar position that China faced,” explains Kelvyn Chuah, the co-founder of SINERGY Technologies (M) Sdn Bhd, a Penang-based cryptocurrency start-up.

He is referring to the clampdown by Chinese authorities on cryptocurrency trading as well as initial coin offerings this year. It is a controversial topic in the cryptocurrency community, but the impact of the crackdown speaks for itself.

Overnight, Bitcoin trading activity in China came to a standstill.

Analytics site bitcoinity shows that renminbi used to account for over 90% of Bitcoin trading prior to the clampdown. Today, China accounts for less than 8% of the global Bitcoin trading activity. The heavy-handed and reactionary approach created uncertainty and has driven trading activity away from China.

“Don’t get us wrong. We think that China did the right thing. They had to tighten controls. But they did it a little too late and it has been highly disruptive for the market, setting it back,” says Chuah.

In the fallout, traders have since fled to more stable regulatory environments like Japan.

It is not to say that Japan has allowed cryptocurrency trading to run rampant. In fact, come Oct 1, any Bitcoin or “alternative coin” exchange or money transfer business that wants to operate in Japan must come under the regulatory supervision of Japan’s Financial Services Agency and be subject to annual audits.

It is not an outright endorsement, but definitions of what denotes a virtual currency have managed to wrangle the anarchical spirit of cryptocurrency out of the shadows and under regulators’ scrutiny.

Specifically, a 2016 amendment to Japan’s Payment Services Act (Article 2-5) allowed cryptocurrencies like Bitcoin to fall under the definition of virtual currency — a means of payment that is not a legal currency.

The amendment places relatively arduous compliance requirements on an industry that supposedly prefers to self-regulate. But more importantly, it also opens the door to more equity investment in the sector — from banks, for example — by widening the permissible scope of financial holding companies’ operations.

Today, about 10% of all Bitcoin transactions are done in yen.

It is worth noting that Japan is by no means the only jurisdiction that has been relatively friendly to cryptocurrency operators.

The US, of course, hosts the highest number of Bitcoin users and reportedly, the largest number of Bitcoin automated teller machines as well. Other cryptocurrency-friendly countries include those that already have low reliance on physical cash, like Estonia, Denmark, Sweden, the Netherlands and Finland.

Closer to home, countries like South Korea and the Philippines have moved to introduce regulations on cryptocurrencies this year.

Against this backdrop, the development of regulations is expected to continue to evolve and develop, along with cryptocurrencies, which are also works in progress.

“No country has the monopoly on a final solution,” says Chuah when asked about the ideal regulatory environment.


The regulatory low-hanging fruit

Looking ahead, what sort of hypothetical framework could Malaysian regulators possibly put together that will allow cryptocurrencies to develop as an industry?

To be clear, cryptocurrencies will run into a gamut of problems as they hope to comply with many of the existing principles regulators like Bank Negara and the Securities Commission apply to the financial services and securities markets.

Some will have workable solutions while others may need more time to figure out.

Take, the KYC (know your customer) requirements for cryptocurrency trading, for example. Many consider this to be a low-hanging fruit as far as regulatory hurdles go.

“There are plenty of proposals and solutions out there in the market for KYC compliance. Countries like Luxembourg has already implemented some of this. To prove you are a resident and you are who you say you are, you have to submit a picture of yourself with your passport as well as bank statements and bills,” explains Chuah.

“In Japan, they have got even more innovative. A postcard will be sent to you with a code in it that you will submit online to prove that you are physically at the address you claim to be at.”

These approaches are not airtight, but it draws from solutions that online banks have developed to meet KYC requirements in recent years. Typically, these are considered to meet less stringent forms of KYC checks compared with in-person KYC at a physical bank branch. The compromise is usually a restriction on the amount of funds such accounts can transfer.

In short, it is not difficult for regulators to identify who is putting money into Bitcoin.

The next issue that arises is that of capital controls and anti-money laundering (AML). It is said to be the main reason Chinese authorities put the brakes on cryptocurrency exchanges in China.

However, Shibata says KYC, AML and other compliance requirements are not particularly difficult to implement.

As long as proper KYC protocols are already in place, conventional checks and balances that financial institutions rely on can by used by cryptocurrency exchanges.

“The money that gets deposited in a cryptocurrency wallet needs to come from a bank. These transactions can be monitored, and if there is something fishy, the bank can stop the transaction,” explains Chuah.

“It is the same with cash, anyway. Once you withdraw it from the ATM, you can do whatever you like with it and the government won’t know.”

However, Shibata concedes that the impact of capital controls or applied market practices on cryptocurrency is not very clear, “and even regulators in many jurisdictions have different views on the significance of cryptocurrency controls on market stability”.


Unresolved questions for regulators

The deeper problems that regulators will have to overcome are less administrative.

Can a central bank allow more than one currency to circulate within the country? Especially one that it does not control?

It is all good and well if cryptocurrencies merely behave as an intermediary for remittances. But if they start to take root as a second form of currency in a country, it can have far-reaching implications.

“For the time being, the macro impact of virtual currencies has been constrained by the fact that most people are buying them as a store of value, rather than as a medium of exchange,” notes BCA Research, an independent investment research house.

But what if virtual currencies start to become more pervasive in a society?

Over time, the public may begin to regard virtual currencies as legitimate substitutes for traditional currencies. There are two possible outcomes. Either people spend the money or deposit them in commercial banks.

“The first outcome would obviously be inflationary, but so would the second, if rising deposit inflows cause banks to increase lending,” notes BCA Research.

“The merits of doing so would depend on the state of the business cycle. When inflation is low, as it is today in most parts of the world, central banks would gladly welcome anything that boosts spending and liquidity. Indeed, in some ways, the issuance of private currencies could have similar effects to helicopter drops of money. However, if inflation were to accelerate too rapidly, central banks would have to begin withdrawing their own currencies from circulation, or push for the withdrawal of private currencies,” says the report.

Of course, central banks would loath it if private virtual currencies begin to displace conventional fiat money. After all, central banks issue money as a form of revenue — also known as seigniorage revenue.

For example, when the US Treasury issues a US$100 bill, it gains the ability to buy US$100 worth of goods and services with it, but the cost is close to zero. In the US, this seigniorage revenue averaged US$70 billion a year over the past decade.

Obviously, no country would want to part with this revenue, notes BCA. Instead, governments are more likely to introduce their own competitors to Bitcoin (see “Pondering a central bank cryptocurrency” on Page 87).

“The blockchain technology that Bitcoin is built on is ingenious but completely within the public domain. Central banks are already thinking about how to issue their own virtual currencies,” notes the report.

Therein lies the conundrum for cryptocurrency advocates. As long as a cryptocurrency remains relatively small scale, it poses no problems to regulators. But small-scale coins are not attractive. But as a cryptocurrency grows in scale and begins competing with conventional fiat money, regulators have a strong incentive to hinder or ban it as it competes directly with fiat money.

Of course, such a scenario is probably a long way off.

“At this point, it is less likely that cryptocurrency will replace fiat currency for daily payments,” says Shibata, noting that price volatility is the biggest hindrance.

It is at this point that the analogy of the car seems to be a poor one. The challenge of assembling a cryptocurrency within a regulated environment extends beyond tangible mechanical and engineering problems.

Yet, even as central bankers study blockchain technology and fret its implications, they are confronted with an unsettling fact: Somehow, despite all odds, cryptocurrencies are alive and well in no-man’s land. And it does not look like it is going away anytime soon.


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