Summary

The European Banking Authority, the EBA, has called on national supervisory authorities to discourage banks and credit institutions from buying, holding or selling virtual currencies, of which the best-known example (not mentioned by name in the EBA opinion) is Bitcoin.  It calls for regulation of market participants at the interface between conventional and virtual currencies. Over the longer-term, the EBA is calling for a ‘substantial body’ of regulation to be applied to virtual currency market participants, including the creation of ‘scheme governing authorities’ accountable for the integrity of a virtual currency scheme and the imposition of capital requirements.  In the short term, the EBA is calling for national authorities to ‘shield regulated financial services from virtual currencies’.

EBA opinion

The EBA this month issued an opinion on ‘virtual currencies’, which it defines as a ‘digital representation of value that is neither issued by a central bank or a public authority, nor necessarily attached to a fiat currency, but is accepted by natural or legal persons as a means of payment and can be transferred stored or traded electronically’.  The best known example is Bitcoin.

The EBA issued a public warning in December 2013 to make consumers aware that virtual currencies are unregulated, meaning that risks are not mitigated through regulation.  This opinion goes further, acknowledging a number of benefits (whilst downplaying their significance within the EU), but focussing on more than 70 risks that it claims to have identified.

The three benefits to virtual currencies that are acknowledged by the EBA are reduced transaction costs, faster transaction speed and financial inclusion, by which is meant the ability of users in less developed financial markets to engage in financial transactions at reasonable cost.  Virtual currency transactions are said typically to incur 1-2% transaction fees, whereas for conventional banking transactions the equivalent is 3-4% and transactions outside the banking system may carry as much as 8-9% transaction penalty.  The EBA points out that part of the reason for the lower virtual currency transaction costs lies in their lack of regulation, indicating that under an appropriate regulatory regime this advantage would be reduced.  The EBA is confident that current EU regulatory initiatives, in particular its promotion of the Single European Payments Area (“SEPA”) (covering 34 countries), which requires accounts to be credited by the next business day, will also reduce the disparity in speed of processing between virtual and traditional banking.  The potential, outside the EU, of virtual currencies to aid those disadvantaged by the expense of transactions in countries without extensive financial institution networks is recognised, though; there are similarities to telephony, where mobile technology has allowed lesser developed countries largely to leapfrog the fixed-line telephony stage of development.

The focus of the EBA opinion, however, is on the many perceived risks of virtual currencies, which it divides into risks to users, to non-user market participants, to financial integrity, such as money laundering and other financial crime, to existing payment systems and to regulatory authorities.  These risks derive both from characteristics inherent in virtual currencies, such as the theoretical ability of anyone with a sufficient share of computational power to alter the functionality of the virtual currency and the anonymity of transactions, and from market characteristics such as the high volatility in exchange rates that have been seen to date.  The EBA’s conclusion is that if the virtual currency market is isolated from the traditional financial services market, this will mitigate risk to those using traditional financial services whilst leaving virtual currency schemes free to innovate and develop outside the financial services sector, including developing solutions allowing their effective regulation.

Comment

One of the prime motivating factors behind the development of Bitcoin and other virtual currencies was to remove control of financial transactions from central governments, banks and large corporations.  The EBA and other similar proposals envisage an undermining of these principles in favour of consumer protection and regulation.

The total number of virtual currency transactions is still extremely small compared to transactions utilising conventional currencies (estimates vary but daily volumes worth around £40m have been suggested), and the chances of any systemic risk affecting markets therefore appear small.  That, however, provides no comfort to virtual currency investors who have seen their money disappear in collapses such as that of the Mt. Gox trading exchange in March 2014.

A number of countries have either banned the use of virtual currencies altogether or imposed restrictions with an equivalent effect, including Russia and China.  The approach in other markets, such as USA, UK or Germany has been more measured, with concern over abuses such as the use of virtual currency by criminals, but acceptance that virtual currencies have a role to play; the focus there has been more on the classification of virtual currency transactions for tax purposes.  There is a growing reluctance to risk that a potentially lucrative market will be forced into other jurisdictions. 

There are suggestions of possible further liberalisation down the line.  The Bank of Russia’s Deputy Chairman, Georgy Luntovsky, said on 3 July 2014 of Bitcoin that ‘one can’t ignore this instrument, maybe this is the future’.  One of the most positive recent statements came in June 2014 from Switzerland’s Federal Council, which reported that no new regulation was necessary and that virtual currencies such as Bitcoin could one day be awarded legal status as money, provided only that volatility reduced.

Opinions on the way in which virtual currencies should be regulated differ widely.  A view quite different to that of the EBA can be found at the Institute of Economic Affairs, whose Director General, Mark Littlewood, said on 17 June 2014 that governments should embrace private monies, both to enhance individual freedom and because fierce demand for private money would drive innovation, creating a ‘tidal wave of new and superior forms of exchange’.

Conclusion

Debate must move on from the phase of asking whether virtual currencies can survive at all or are destined to rank alongside Dutch tulips and the South Sea Company as no more than a temporary, speculative bubble.  Major challenges remain, some of virtual currencies’ present advantages over conventional currencies may be reduced through, for example, the SEPA rules, and it may not be the present leaders that last the course, but virtual currencies appear set to enter the mainstream as a small but significant element of the currency market.  The degree of regulation that is applied to control virtual currency participants remains a key question and the EBA report sets an important marker of that regulator’s views that Governments and national regulators in Europe will no doubt take into account.

Click here for the EBA Opinion on 'Virtual Currencies'