The State and Cryptocurrency

Expect state government agencies and legislators to move most quickly on providing regulatory clarity on FinTech regulation in the United States. U.S. federal regulatory agencies have initiated enforcement actions against some of the most egregious cryptocurrency investment practices and are watching the industry closely.

By and large, regulators strike a positive tone for the new technologies changing the character of money and how businesses and consumers use it while warning market participants to watch their steps. The following links provide a run-down of recent U.S. state and federal regulatory activity, as well as a look at how central banks around the world are considering digital currencies.

The State of the States

The Illinois Blockchain Task Force, an initiative including state legislators, agency staffers, and FinTech entrepreneurs, release its final report on the use of distributed-ledger technologies in government. Illinois seeks to present a progressive regulatory environment to blockchain and FinTech firms, and the comprehensive report covers use cases throughout state and county government, many of which the Illinois government agencies are investigating.

"Over the past year, the Illinois Blockchain Initiative has grown from a nascent project based at the Illinois Department of Technology into a program with two completed pilots and renewed momentum for the next stage of research," reports Sara Friedman of Government Network News, in an overview of the state’s blockchain pilots and initiatives.

I find the discussion on identity most interesting, especially considering continuing media coverage of identity breaches among private-sector companies:

Identity is not only foundational to nearly every government service but is the basis for trust and legitimacy in the public sector. It is the starting point of confidence in citizen’s interactions with government and is a critical enabler of service delivery, security, privacy, and public safety activities. How identity attributes are collected, used, managed, and secured is and will continue to be of critical interest to leaders in the public sector charged with protecting the rights of citizens, ensuring privacy, and ensuring national security and public safety.

The two poles of U.S. state regulatory scrutiny of FinTech are neatly summed up by these two headlines: Sex, money laundering and blockchain: 11 states look at FinTech. The article rounds up cryptocurrency and blockchain regulatory initiatives introduced in 11 states last month.

State regulators take first step to standardize licensing practices for FinTech payments. Seven states have agreed to a multi-state compact that standardizes key elements of the licensing process for money services businesses (MSB), reports the Conference of State Bank Supervisors (CSBS). If one state in the compact approves an MSB’s business, security, and compliance plans, the other states will accept the findings.

"This MSB licensing agreement will minimize the burden of regulatory licensing, use state resources more efficiently, and allow for broad participation by other states across the country," says John Ryan, CSBS CEO. Georgia, Illinois, Kansas, Massachusetts, Tennessee, Texas, and Washington are the initial participating states.

The move is related to a suit CSBS filed last April against the U.S. Office of the Comptroller of the Currency (OCC), saying it does not have the authority to grant bank charters to nonbanks. OCC introduced a limited charter application to FinTech firms, an initiative that is now in limbo after the recent change in OCC administrators and the state suit.

Another means that FinTech firms can use in some states to offer bank products are industrial loan company charters, a tactic that fell out of favor during the financial crisis. The nominee for head of the Federal Deposit Insurance Corp. (FDIC) "has spoken favorably about industrial loan company charters (paywall), raising hopes they can make a comeback," reports Lalita Clozel of The Wall Street Journal.

The U.S. Congress and Federal Regulators are Watching

The federal government has been a bit more circumspect of late, with languages that covers all the bases. Yes, these things are good, but they need to be regulated, too.

"Congress is reviewing the financial technology marketplace to ensure proper regulations are in place without restricting companies’ innovation," reports the Association of Credit and Collection Professionals. The House Subcommittee on Financial Institutions and Consumer Credit determined during the hearing that "modern developments in digital technology are changing the way many financial services are offered and delivered, and that Congress and regulators must continue to evaluate the state of the industry."

The scrutiny got a little more intense last week, as Bloomberg reports in Cryptocurrencies get word from SEC inspectors: we are watching:

Digital currencies just got name-checked by a group that many of their boosters would probably rather avoid: Securities and Exchange Commission inspectors.

For the first time ever, the SEC’s Office of Compliance Inspections and Examinations put cryptocurrencies and initial coin offerings on a list of focal points for scrutiny this year at the financial firms and advisers the agency oversees. The markets for such products "present a number of risks for retail investors," the office said.

U.S. Securities and Exchange Commission chair Jay Clayton, however, testimony on virtual currencies and Initial Coin Offerings (ICOs) was careful to keep all doors ajar, if not open:

To be clear, I am very optimistic that developments in financial technology will help facilitate capital formation, providing promising investment opportunities for institutional and Main Street investors alike. From a financial regulatory perspective, these developments may enable us to better monitor transactions, holdings and obligations (including credit exposures) and other activities and characteristics of our markets, thereby facilitating our regulatory mission, including, importantly, investor protection.

At the same time, regardless of the promise of this technology, those who invest their hard-earned money in opportunities that fall within the scope of the federal securities laws deserve the full protections afforded under those laws. This ever-present need comes into focus when enthusiasm for obtaining a profitable piece of a new technology "before it’s too late" is strong and broad. Fraudsters and other bad actors prey on this enthusiasm.

Mr. Clayton’s testimony and articles on cryptocurrency regulation going back to 2014 is available here.

The Central Bankers Weigh In

The chief of the Bank of International Settlements, often described as the world’s "central bank for central banks," says regulators may need to act. "Bitcoin has become a combination of a bubble, a Ponzi scheme, and an environmental disaster," says BIS general manager Agustin Carstens.

Two payments researchers from the Federal Reserve Bank of New York—writing in a Q&A blog post on behalf of the bank and not the U.S. central bank—addressed that question last week in more even handed but less certain terms. Digital currencies are a great idea, but they aren’t really solving the primary problem a currency solves: trust. National currencies do that just fine now.

Michael Lee: So are cryptocurrencies the future of money?

Antoine Martin: It will ultimately depend on how well they compete with other, already established payment methods: cash, checks, debit and credit cards, PayPal, and others. Cryptocurrencies arguably solve the problem of making payments in a trustless environment, but it is not obvious that this is a problem that needs solving, at least in the United States and other advanced economies. And solving that problem creates others. One is scalability; the process of picking random validators takes time, is expensive, and consumes tremendous amounts of energy.

Another issue lately is extreme volatility in the value of cryptocurrencies which makes them less useful as currencies. This volatility is an inherent feature by design. Since there is no central bank that adjusts the supply of bitcoin to accommodate changes in demand, bitcoin's value can swing sharply with demand. In a world where all things were priced in bitcoin, this would likely translate into massive swings in inflation and economic activity. In contrast, providing an "elastic" currency to promote financial and price stability is a goal shared by the Federal Reserve System, the European Central Bank, the Bank of Japan, and many other central banks.

Eric Lam gives a taste of what the world's central banks have been saying about cryptocurrencies. Very little of it is positive, aside from the British, Dutch, Scandinavians, and Turks.

For its part, the Bank of England won the initiative of the year in the Central Banking Awards 2018 for its FinTech Accelerator. "The UK central bank has embraced fintech service providers in a controlled manner to bolster its cyber-security and payments capabilities," writes CentralBank.com in an overview on the bank’s initiatives.

Meanwhile, Bloomberg’s editorial board doesn’t constrain itself with the linguistic hedges of a central banker and regulators. "Cryptocurrencies and the speculative mania surrounding them pose a financial risk," the editors write. "Not a moment too soon, America's biggest banks have moved to ban their customers from using credit cards to buy Bitcoin or other cryptocurrencies. Banks and regulators have been slow to guard against the dangers of the Bitcoin phenomenon—and central banks, in particular, need to move more forcefully."

The technology and goal of cryptocurrencies is not the problem, Bloomberg’s editors make clear. Dispensing with physical cash is not a problem as long as the digital currencies "have the government backing they need to function correctly as money."

That will take a while, much longer than market participants would like. To be fair, regulation generally always lags technology innovation, which does not really become the business and social norm until regulatory and governance structures change accordingly (Financial Capital: The Dynamics of Bubbles and Golden Ages).

But as the Bloomberg editors state, "Without that crucial ingredient, though, risk arises from the misapplication of cryptocurrency technology and the speculative mania surrounding it."