BitLicense and why buying Bitcoin in Australia can’t be regulated
Bitcoin regulation has been a hot topic ever since the New York Department of Financial Services (NYDFS) first released its initial “BitLicense” proposal last week. The proposal includes sweeping legislation that would affect virtually every corner of the Bitcoin ecosystem, regardless of location. While there are many obvious examples in the proposed regulations where the NYDFS is reaching in both authority and enforceability, it’s essential to return to the basics of why Bitcoin simply can’t be governed by traditional Australian regulations. As long as Bitcoin is approached with the old regulatory mindset, BitLicense and all other government regulatory actions will continue to be fundamentally flawed.It is impossible to truly know the motives behind regulators such as Benjamin Lawsky, the main architect of the BitLicense. At best, the proposal has good intentions but its authors fail to grasp blockchain technology and how it differs from traditional financial institutions. At worse, the regulators are deliberately trying their best to mold Bitcoin into something they can understand and control. While it is tempting to speculate, the focus should remain on the fact that even the stated goals of such regulation are hopelessly ineffective.
The proposal aims to accomplish two objectives: prevent money laundering and protect consumers. The former attempts to prevent the financing of criminal and terrorist organizations, while the latter ensures customer funds are protected either by full reserve, insurance, fraud protection, etc. While these goals seem noble, in the long run the proposed regulation may end up harming the very consumers it is designed to protect.
Know Your Customer (KYC) rules are a widespread requirement in finance that aims to prevent money laundering. These rules accomplish this by mandating that all financial business keep strict records of all customers and their personal information, reporting any activity that can be deemed as “suspicious” to authorities for further investigation. In the legacy financial system, while KYC is hardly foolproof in preventing money laundering as various major scandals have proven, it at least makes some theoretical degree of sense. Traditionally, to electronically move money, third parties are needed in the form of banks or other money transmitters such as Paypal. Such institutions are easy chokepoints to regulate; chokepoints that everyone must pass through to use modern financial infrastructure. Of course, this was true only until the creation of Bitcoin. With Bitcoin, money for the first time became totally digital, and could be moved electronically around the world in a peer-to-peer fashion without a facilitating third party.
The internet’s version of cash was born, and with it KYC immediately lost whatever value it had left in law enforcement. KYC relies on easily regulated chokepoints in order to be even somewhat effective. To avoid detection, nefarious actors can simply step around such institutions, which are only optional when using Bitcoin. While legitimate Bitcoin business and their customers are loaded with KYC regulations, those with illegal intentions would never use such a third party in the first place. They would simply acquire bitcoins via another means, either in cash, by mining, or through rapidly developing decentralized exchanges and other anonymous services. None of these avenues are even remotely possible to control or even limit, and they will only grow in sophistication if legitimate Bitcoin companies continue to get hammered with KYC requirements.
The end result is an industry running through all the hoops and costs that KYC compliance entails, while doing effectively nothing to actually stop money laundering. Not only does this hurt businesses with extra costs, but it forces the individuals ostensibly served by such regulation to forego all semblance of financial privacy for no effective law enforcement purpose. It is thus abundantly clear that any measure of KYC ultimately does much harm, while being virtually worthless in preventing any crime. Yet instead of acknowledging this fact, the BitLicense proposed in New York bizarrely creates even stricter KYC compliance rules than most traditional money transmitters have to follow. This means it can hardly be an oversight, and is either a very forceful attempt at denial or complete ignorance to the workings of the technology that they are trying to regulate.
Yet while preventing money laundering seems fated for failure, at first glance, a much more effective argument can be made for consumer protection. Indeed one need not look any further than the infamous collapse of Mt. Gox, and the lost of millions worth of bitcoins. With many other examples of defrauding and theft besides, it’s not hard to see why regulators would find it necessary to protect consumers from the dangers of a volatile and risky new market.
However, policy should not be created in reaction to an event without proving that it will actually help prevent it in the future. Unfortunately for regulators, the Bitcoin ecosystem is evolving so fast that this is already no longer the case. Far before any legislative proposal has been enacted to protect consumers, existing Bitcoin exchanges and companies have already taken very effective steps in doing so. Exchanges and services like Bitstamp and Coinbase have already run numerous and public third party audits, and other methods of proving they hold full reserves which are kept under tightly secured systems. This is due to simple market forces working in overdrive. In the vastly competitive and fast moving “wild west” of the Bitcoin ecosystem, companies had to quickly reinforce trust with users after the Mt. Gox debacle or lose them to more savvy competitors who did. Bitcoin is uniquely suited for this, because funds being purely digital entries on a totally public ledger meant it was easy to validate the truth of a company’s statements now that users were demanding it. There’s simply no fudging the numbers or not being able to prove the funds held. The effectiveness of all this is easily supported by the dramatic decline in frequency of security breaches in all services across the Bitcoin network in the last several months, and a decline in the scale of such attacks. This is the result of a rapid response from companies in a free market, which had no need to wait for a centralized bureaucratic institution to give any form of legal guidance.
The case can of course be made that individual bad apples can still act fraudulently within the ecosystem in the future. Yet this is true of any industry, including Finance, the most tightly regulated section of the economy. You simply need to look at examples such as Enron, WorldCom, and the 2008 financial crises to realize that isolated incidents will always occur regardless of the presence of regulations. Therefore, competition is clearly the most effective form of consumer protection in the long run, and it does so without adding additional complexity and costs to start ups or deterring experimentation and innovation.
That said, Bitlicense is not without its silver lining. Despite obviously skewing in favor of incumbent financial institutions, it will give Bitcoin more credibility among the New York financial sector, thereby creating a way for Wall Street money to flood into the cryptocurrency and away from the traditional financial infrastructure. While the world doesn’t need New York’s permission to innovate and invest in Bitcoin, “mainstream” institutions in Wall Street do. The amount of capital they will infuse in Bitcoin will no doubt greatly boost its legitimacy and rate of global adoption, and thanks to Bitlicense this may happen sooner rather than later.
Bitcoin regulation is ultimately always going to fail in its stated objectives, and force innovation to move to more accommodating locations. The reality is law enforcement and regulatory agencies have grown accustomed to the wealth of private financial information available to them under traditional regulations, and they are reluctant to cede this level of control. As Bitcoin continues to grow in use and adoption, however, regulators will not be able to ignore the economic impact of their actions. As a result, the end game is always the same; it is only a question of how we are going to get there.
Will regulators voluntarily recognize this inevitable paradigm shift sooner rather than later, and dial back the red tape to allow their local economies to fully benefit from Bitcoin? Or will they cling on to their old methodologies and worldview, forcing innovation away and creating demand for even more decentralized and anonymous systems that will simply act to further erode their authority? Benjamin Lawsky and the NYDFS seem to have their mind made up, but the question remains whether the rest of the world will follow suit.