The brave new world of Bitcoin
Market trends Given the convenience of established currency and payment systems, what is driving the ever-growing interest in Bitcoin and other virtual currencies?
Bitcoin was developed to some extent as a response to the global financial crisis when the risks of relying on trusted financial counterparties and intermediaries became apparent. The original white paper by Satoshi Nakamoto is a good starting point to understand some of the potential attractions of virtual currencies (“Bitcoin: A Peer-to-Peer Electronic Cash System”).
Many support the fact that virtual currencies are not controlled by the government or banks. The global financial crisis, and perhaps even more so the response to it (including bailouts of private companies using public funds and the significant inflation of many assets, since that does not benefit all) has led to a counter-cultural drive to disassociate from central government and traditional financial institution means of control. Consequently, trust in public institutions is at a multi-generational low.
Virtual currency is an asset held largely outside of the existing financial system. In the event of fiat currency crashes or hyperinflation, many holders perceive it to be a safer store of value.
The use of virtual currencies is attractive for sending and receiving money internationally can be done quickly, with ease and minimal cost in transaction fees and exchange rate costs.
Virtual currencies can be used by the unbanked and the underbanked to exchange value.
The phenomenal rise in price of Bitcoin, Ether and other virtual currencies has given rise to speculative interest that attracts new people to the currencies and underlying technologies.
One of the initial attractions of virtual currencies was the perceived anonymity in respect of the value held and transferred. However, criminal and terrorist organisations are beginning to realise that an immutable public ledger showing all transactions between participants is not the best means of avoiding detection (even if the wallets are not directly linked to their personal data).
More recently, there has been a large amount of interest in the use of virtual currencies as a form of largely unregulated crowdfunding (often referred to as Initial Coin Offerings), whereby blockchain-based tokens are issued in exchange for cryptocurrencies (often Ethereum) to develop new products, platforms, currencies and technologies.
Regulation Has your jurisdiction taken steps to regulate virtual currencies? What is their current status?
There is no legislation that directly regulates virtual currencies in Gibraltar and the issue does not fit neatly into the existing financial regulatory regimes, such as those regarding financial instruments, securities, payment services, electronic money and anti-money laundering.
However, Gibraltar has recently announced that it intends to pioneer a regulatory regime to ensure certain Distributed Ledger Technology (DLT) operators regulated by the Gibraltar Financial Services Commission (GFSC).
Gibraltar is taking a lead in cryptocurrency and sees the crypto economy (which is much wider than virtual currency-related activities) as an area where it can be competitive as a small jurisdiction with a strong track-record in regulated e-commerce (ie, e-gaming, e-money and payments, and other electronically supplied financial services) and a reputation for attracting quality operators over quantity.
The GFSC has set up an Innovate and Create team to encourage innovation by supporting those businesses looking to develop and introduce innovative ideas for financial products or services into the market.
It is focusing on scalable and carefully-considered financial technology opportunities and working through the requirements that will be applicable to DLT operators from January 2018.
In the proposed Gibraltar DLT regime consultation (Proposals for a DLT Regulatory Framework) the government stated that the:
“HM Government of Gibraltar [has been considering proposals] for a new regulatory framework for firms engaging in activities that use Distributed Ledger Technology (DLT) for the transmission or storage of value belonging to others. The proposed framework will facilitate a progressive, well-regulated and safe environment for firms using DLT to grow, whilst also ensuring that this new regulatory environment protects both consumers and the good reputation of the jurisdiction. ..” (Ministry of Commerce.)
“The primary driver for the DLT framework is to encourage Gibraltar's economic development while providing safeguards for consumers and protecting the jurisdiction's reputation and integrity. The DLT framework is designed to be both good for Gibraltar and safely so. It recognises Gibraltar's status within the EU while considering the likely impact of Brexit and related outcome scenarios…”
The new regime is still in development and is intended to evolve from the ground up, whereby the applicable requirements for DLT operators will be based on a review of their ability to conform with the nine key DLT principles. The regime can therefore develop and solidify based on an objectives-based approach to practical problem solving in the DLT sector. In addition, the regime is not intended to require authorisation for activities that are already subject to existing financial services authorisation requirements. There is likely to be a number of important distinctions, such as whether DLT is being used only for an enterprise’s own purposes (eg, the issuance of a proprietary form of cryptocurrency to clients) or if the enterprise is storing or transmitting other cryptocurrencies or DLT related value (whether mainstream cryptocurrencies or proprietary blockchain based tokens issued by third parties). However, as this is a new regime the boundaries and practical requirements are yet to be determined, it is crucial to engage with the GFSC on a case by case basis.
As with most countries, Gibraltar does not have a specific regulatory regime applicable to the sale of tokens as a form of crowdfunding. However, it is building up a body of knowledge and experience in this new area and is already a European leader with Switzerland. Whether by regulation or cross-party industry agreement on a self-regulatory basis, it is expected that Gibraltar will take a lead in managing the risks and setting the standards that should be applied in this fast-growing sector. Most jurisdictions (including the United States) expect a detailed case by case assessment of whether any such crowdfunding may constitute the offer of securities (including whether they constitute a form of investment fund).
Gibraltar will apply anti-money laundering regulations to virtual currency exchanges and custodians and other authorised DLT operators. This is also in line with the proposed changes to the EU Fourth Anti-money Laundering Directive.
Further, Gibraltar is a participant of the various international frameworks for financial data sharing (i.e., the Foreign Account Tax Compliance Act, Common Reporting Standards and Tax Information Exchange agreements) and for crime prevention (ie, EU Fourth Anti-money Laundering Directive, MONEYVAL and the Organisation for Economic Cooperation and Development White List). This means that Gibraltar is not an attractive place for criminals seeking to avoid detection and relying on the use of cryptocurrencies and technologies. Gibraltar is also a very small and close-knit community which makes it difficult to misuse the jurisdiction for criminal purposes.
Gibraltar financial institutions largely support the crypto economy drive. However, there remains a dependence on UK banks for sterling settlement, which represents a strategic risk given the existing approach of major UK banks in this sector.
Different EU member state authorities have thus far taken different approaches to the regulation of virtual currencies. Is this due to the different legal frameworks of the member states or (mainly) by institutional practices of the respective authorities?
There is no harmonised approach at EU level to the regulation of virtual currencies or the use of blockchain technologies in areas that overlap with more traditional financial services and this permits member states, and the authorities in each, to take their own view on the sector and technologies. The European Union is seeking to bring virtual currency exchanges and custodians within the scope of the EU-wide anti-money laundering and counter-terrorist financing regime by making them ‘obliged entities’. This has been partly driven by concerns about terrorist financing and money laundering (eg, due to a number of European terrorist atrocities, such as in in Paris and Brussels). This may be the first step on a long road to seeking a more widespread agreement on the extent to which virtual currencies should be considered a regulated financial instrument or payment mechanism.
How likely is it that the regulation of virtual currencies will be harmonized at EU level? Could a consistent regulatory approach be reached through institutional guidelines for the competent authorities in the member states?
Other than in respect of laws to combat anti-money laundering and counter-terrorist financing risks, it seems unlikely that the various diverse member states will reach an agreement on the way and circumstances in which operators in the virtual currency sectors should be authorised for financial services purposes. Virtual currencies represent a significant opportunity and challenge to governments, central banks and the existing financial services frameworks. Existing market participants (particularly banks) may not be incentivised to support the normalisation of virtual currencies in law. Given the unhealthy symbiosis between the government, central banks and commercial banks in the most recent financial crisis (and potentially even more in effect today) it is difficult to see how political opinion could be harmonised until after the next (and likely much bigger) financial crisis, when the existing architecture and influence of a small number of banks and financial institutions may be depreciated. The Bank of England’s review of the Real-Time Gross Settlement and desire to open the sterling settlement system to other market participants represents a healthy attempt to deconcentrate systemic risks from a small number of financial institutions, as well as fostering innovation.
There are also wider issues in respect of taxation, payment protection, cybercrime, accounting, data protection and distance selling that require serious consideration.
Taxation How are transactions using virtual currencies as the medium of exchange taxed in your jurisdiction?
Gibraltar does not have a value added tax or capital gains tax regime. The major issue is therefore whether the currencies constitute taxable income for businesses or individuals. There is not yet any local guidance on this matter, but it would seem appropriate that they would be treated the same as foreign currency transactions.
The receipt of virtual currencies in respect of a sale of crypto-tokens could either constitute an asset exchange or an income item, depending on:
- the nature and structure of the issuer and the issue;
- the point at which the token is usable; and
- who will accept the token in exchange for services.
Inflation If virtual currencies were to become a mainstream payment system, how might this affect the ability to control inflation in your jurisdiction?
Pursuant to the Currency Notes Act of 2011 the Government of Gibraltar issues its own currency, and has an obligation to exchange each printed note with its sterling reserves at par (ie, one to one) relying on a Note Security Fund which backs the local currency. Although Gibraltar notes are denominated in pounds sterling, they are not legal tender in the United Kingdom. UK coins and notes are accepted in Gibraltar and, in many cases, so are Euros.
Despite this, the central bank rate used for commercial lending purposes is set by the United Kingdom. Inflation in Gibraltar is therefore driven partly by UK monetary policy in addition to local economic and fiscal activity. Gibraltar also sets its own taxes and controls its own budget.
The orthodox understanding of inflation mechanics and the position apparently taken by most modern central banks, is that inflation can be controlled largely through the central bank interest rate (the rate payable by the central bank on reserves of commercial banks and lenders) and interest rate expectations set by the central bank in its communications. Money supply, lending and asset value can also be moderated directly through central bank intervention as seen in the recent period of quantitative easing.
In the United Kingdom, the total money supply (M4) is estimated to be approximately £2.3 trillion. The higher priced variant of Bitcoin (XBT) is the largest virtual currency within the sector and represents over 70% of the entire sector by value. It has a total supply of 21 million and there are approximately 16.5 million in circulation. The price per XBT is approximately £3,000 (giving a notional value of £49.5 billion when priced in sterling).
Due to the limited value of virtual currencies in circulation, it is not regarded as a major issue. However, if use of virtual currency continues to grow at the existing rate and large volumes and values of virtual currency are used instead of fiat currency, the ability of central banks to influence inflation with monetary policy could be seriously affected. Interestingly, central banks are now considering implementing their own virtual fiat currencies using blockchain technology.
The longer term implications of the widespread use of decentralised payment mechanisms on sovereign states with their own currencies is a complex issue.
The encouragement of a transparent and careful (and in some cases regulated) use of virtual currencies should mitigate some of the risks that may arise in respect of virtual currencies and local monetary policy.
Fraud and money-laundering What are the potential risks of virtual currencies in terms of fraud? How would these be addressed in your jurisdiction? Have any specific instances emerged in which virtual currencies have been used for money-laundering or other fraudulent purposes?
As virtual currencies can be held and spent outside of the existing financial services frameworks (at least to some extent) it means that information on the payer and payee and the amounts held or transferred may not be easily available to the authorities. In addition, wallets to hold virtual currencies can be decentralised smart wallets (ie, not controlled by an exchange or custodian). This can make investigating and tackling fraud difficult where criminals hack wallets or use virtual currencies to accept payments in respect of extortion and ransomware attacks.
However, there is a danger that the above factors are mistakenly described as making virtual currencies anonymous. There are a number of tools available to find relations between wallets and transactions on the relevant blockchains – these tools can assist authorities when looking for criminal activities and syndicates. Further, virtual currency transactions are taking place on an immutable public ledger. This means that it also represents an opportunity for law enforcement agencies not easily available for other monetary transactions (eg, cash and physical commodities).
With the advent of the DLT regime it is clear that virtual currency exchanges and operators will be within scope for anti-money laundering and counter-terrorist financing purposes from January 2018.
Some work has been done by public policy think tanks in respect of educating police authorities regarding the use and seizure of virtual currencies involving criminal activity. See, for example, “Innovation and the Application of Knowledge for More Effective Policing”, N8 Policing Research Partnership Catalyst Project.
Virtual currencies have been used in a number of high-profile fraud and criminal cases. The notorious Silk Road marketplace (involving the use of virtual currencies to pay for illegal goods and services) and the collapse of Mt Gox due to serious implications of fraud have given rise to successful prosecutions in a number of countries (particularly the United States).
Given the push to encourage a crypto economy, the Gibraltar Financial Intelligence Unity is likely to become a centre of knowledge, and integral to the investigation of crime related to DLT, blockchain and virtual currencies.