EU Regulation of Bitcoin and Virtual Currencies

Bitcoin and other virtual currencies are becoming increasingly important. They are not money but are used by a growing number of users as a means of payment and investment. However, central banks and supervisory authorities have risks.and see a need for regulation. Challenges in the EU include consumer protection and the fight against money laundering and terrorist financing. The EU institutions are currently revising the Money Laundering Directive to include virtual currencies for the first time. The regulation of virtual currencies is also on the agenda of the finance ministers and central bank heads of the G20 countries.

Since the creation of the Bitcoin network, the Internet for virtual currencies (VC) and block-chain technology has grown rapidly. In the public system, the fastest participants with the appropriate knowledge and computer resources can generate a digital representation of value by solving complex kryptografischen problems with computers decentrally, and quasi incidentally, transactions of other participants using the Bitcoin blockchain verifizieren. Every day, “miners” create new units with very high power consumption (“excavated” as in a gold mine). The units are stored in an eWallet, the digital wallet of the owner. Users can use Exchanger to buy and sell Bitcoin. Users have succeeded in exchanging Bitcoins for goods and services, i.e. “paying” with Bitcoins. Numerous imitator systems with similar concepts followed.

The blockchain technology behind the Bitcoin system uses a kind of accounting journal/transaction collection (distributed ledger) to validate and prove the totality of the generated units and the transactions carried out in a way that is virtually impossible to falsify. The information is stored redundantly and distributed. The idea of Distributed Ledger Technology (DLT) can also be transferred to other areas such as digital central bank money, securities settlement, and credit briefings.

Fiat currencies, virtual currencies, and cryptocurrencies

In general, money is made with the help of the three money functions definiert: Calculation unit, exchange, and payment mean, store of value. Money occurs in the following forms: Cash: Banknotes and coins which serve as legal tender; book money or girl money: deposits with state- or internationally recognized banks which can be used with instruments of cashless payment transactions for payment; electronic money (e-money): digital representation of a legal tender which is electronically stored as credit on a chip card or hard disk and used for payment. Cash, known as fiat money, is issued by a central bank in a controlled amount and is based on the general principle of the currency as a means of payment. The value of Fiat money is based on the experience, presumption or confidence that it can be used to purchase goods and services. Currently, all economies function with a fiat currency.

To describe Bitcoin and similar systems in general, many authors use the terms digital currency, virtual currency, cryptocurrency, token, etc. not quite clear. Therefore, this article clarifies and systematizes the terms on the basis of the publications of authorities and renowned organizations. The European Banking Authority (EBA) definiert has a virtual currency as follows:6 digital representation of value; is not issued by a central bank or public authority, is not need/necessarily linked to a fiat currency; is used by natural and legal persons for payment; can be transferred, stored and traded electronically; is not legal tender; can be part of a centralised or decentralised system; can be convertible or non convertible against national currencies; does not include any right to reimbursement in fiat money.

Differentiation within the virtual currencies follows from the properties of convertibility and centralization. Cryptocurrencies are a subset of virtual currencies. However, neither the EBA, nor the European Commission, nor the European Parliament uses the term “cryptocurrency”, but always the (generic) term “virtual currency”. The European Central Bank (ECB) speaks of a “virtual currency system with the bidirectional flow”, i.e. it is fully convertible to legally regulated currencies. The Financial Action Task Force (FATF) equates the terms cryptocurrency and de-central (convertible) virtual currency. According to finition by experts of the International Monetary Fund (IMF) in a working paper of 2016, a cryptographic currency is a digital representation of value that is not a legal tender (virtual currency), that can be exchanged for money, goods, services (convertible virtual currency), that has not been issued by a central issuer (decentralized convertible virtual currency), and that is validated by cryptography,

Does VC fulfill the three money functions? A report by experts at the Bank of England in 2014 states that Bitcoin only fulfills the function of a computing unit. The question is therefore answered in the negative. The IMF experts come to the conclusion that Bitcoin, for example, is used partly as a means of payment and as a store of value, but not at all as a unit of account. Selected retailers who accept Bitcoin as a means of payment would immediately calculate their prices in accepted VC at the current exchange rate of the fiat currency.

Object of speculation

The suitability for speculation with an object assumes its general ability to store value. Are VC like Bitcoin only “hot air in bags”? The board member of the Deutsche Bundesbank, Thiele, is very critical of them: “They are fictitious and multiply according to a fictitious scheme in virtual systems, some of which can be changed or created at the discretion of a small group. VC has no material value and, unlike commodity money, can neither be used nor consumed, but only transferred.

Photo by takahiro taguchi on UnsplashClassification at the national level

VC do not fit to the existing framework conditions for money, payment transactions and fiat currencies. As long as they do not affect the interfaces with the traditional monetary system, VC is not yet subject to any regulations for payment transactions in most countries. So far, VC is neither money nor foreign currencies nor commodities, and only a few nation states classify them as value therapy. It is therefore difficult for authorities to develop or even apply consistent regulation in the context of existing structures. VC has so far evaded systematic monitoring. This will not remain so for long, given the degree to which they have become widespread. In March 2018, the Securities and Exchange Commission (SEC) in the USA published a statement in which it spoke of “digital assets” which, in its view, fulfill the Definition requirements of securities and would thus be subject to its supervision.

In a 2015 report, the ECB provides an overview of the heterogeneous treatment of VC at the national level in the EU. There are no laws on spezifische in any EU Member State. Many countries have only issued public warnings. In Germany, Bitcoin is currently neither considered as electronic money, nor as a type (cash in foreign currency), nor as foreign currency (book money in foreign currency). The Federal Financial Supervisory Authority (BaFin) classifies Bitcoin as a financial instrument in the form of “units of account” in accordance with §1 (11) sentence 1 no. 7 of the German Banking Act (KWG). Units of account are comparable to foreign currencies but are not legal tender. Bitcoin and other VC are regarded as “private means of payment”, which is quite appropriate for the currently voluntary circle of users.

Vehicles for criminal activities

A significant weakness of convertible virtual currencies is their vulnerability to criminal activity, including drug trafficking, cybercrime, money laundering, and financing of terrorism, through the pseudonymous classification of owners in blockchains. Prominent evidence of criminal machinations are:

• Money laundering with Liberty Dollars through the money transfer weisungsfirma Liberty Reserve (2006 to 2013);
• Illegal trafficking in drugs, weapons including through the hidden website Silk Road (2011–2013) with Bitcoin as a means of payment;
• Internet crime such as data theft of bank accounts and credit cards organized by an international network around the platform Western Express International (2013).

The lack of data security of the blockchain frontends (exchangers and eWallets) makes them vulnerable to hacker attacks and theft by VC with finanziellem Damage, especially for users. The Japanese Bitcoin-Exchanger Mt. Gox, formerly market leader, was the victim of various attacks between 2011 and 2014. At least 650000 Bitcoin was stolen by users. In February 2014, the website offline went offline and the operator had to file for bankruptcy. The case still employs the judiciary and injured users as creditors in insolvency proceedings.

The investigation work to combat money laundering (Anti-Money Laundering, AML) and Countering the Financing of Terrorism (CFT) is made more difficult by the characteristics of VC:

1. Pseudonyms of VC owners: VC has more scope for anonymity than electronic payment transactions. The owners of the VC as well as senders and receivers of transmission from VC remain hidden because of the digital keys used. In the Bitcoin network, there are addresses of the owners, but these are not linked to a clear name.
2. Decentralized architecture: With decentralized virtual currencies, there is no central server. This makes cyber attacks considerably more difficult, but even authorities — unlike banks — cannot take a central office or unit for a criminal investigation or confiscation into duty.
3. Global reach: Users have worldwide access to VC systems, and public blockchains are distributed independently via the Internet. Transactions are crossing borders imperceptibly. Customer and transaction data befinden is distributed across numerous jurisdictions, making it difficult for national authorities to access it completely.

Regulatory approaches and regulated market participants

The question arises as to how strict a regulatory approach should be for VC. The spectrum ranges from public warnings/reports to the regulation of certain market participants to prohibitions. There is a need for an internationally agreed approach. The Bank for International Settlements (BIS) distinguishes between five categories of regulatory approaches. For example, the EBA’s public warnings belong to the “information and moral appeals” category. The SEC’s communication on the monitoring of issuers is to be regarded as an “interpretation of existing rules”. Various measures in China belong to the category “prohibition”.

In its 2014 opinion on VC, EBA made a broad recommendation aimed at regulating certain market participants. The EBA believes that the comprehensive regulation of VC in the EU, similar to the financial system, would require a signifikante governance structure and significant monitoring resources. The development of a comprehensive regulatory framework would take a long time. Therefore, only the urgent risks should be regulated first identifiziert and in the short term. Risks should be limited at the interface between the VC system and the regulated financial sector, i.e. where users exchange VCs in fiat currency. The following building blocks are possible:

• Regulated institutions such as banks and companies from the payment traffic sector should be prevented from interacting with the VC network (shielding).
• The legal framework for combating money laundering and Terrorismusfinanzierung should be extended to Exchangers and eWallet providers.

Photo by Vlad Busuioc on UnsplashCombating money laundering and financing of terrorism

Financial integrity is a high priority among VC’s areas of governance. The Financial Action Task Force (FATF), an international organization consisting of supervisory and investigative authorities, plays a central role in the development of standards for combating money laundering and Terrorismusfinanzierung. The committee adopted 40 general recommendations in February 2012. The FATF recommendations form global standards but are formulated in general terms. Therefore, the Financial Action Task Force 2014 has published a document with Definitionen and Risks on VC and 2015 a guidance document for a risk-based approach to VC in which selected recommendations (see Table 6) are specified.

• FATF Recommendation 1 addresses the risks of convertible VC. Decentralized systems can be regarded as considerably riskier because of the users’ difficulties at Identifizierung and therefore require improved due diligence (risk assessment carried out with “due care”). Governments are free to regulate Exchangers or even prohibit all activities.
• FATF Recommendation 14 concerns the registration or approval of natural or legal persons offering services in connection with the exchange of VC and Fiat currencies.
• FATF Recommendation 16 extends the concept of an electronic money transfer — de- finiert as a transaction from one financial institution to another by electronic means so that a sen- who can make an amount of money available to a recipient — to convertible VC. If an exchanger is used to transfer a convertible VC, which is interpreted as an electronic money transfer, the sender and recipient should become identified.

Money Laundering Directive

In the EU, various rules on money, payments and combating money laundering have been harmonized by EU directives. In Germany, the directives are implemented by amending various laws, including the Banking Act (KWG), the Payment Services Supervision Act (ZAG) and the Act on the Tracking of Profits from Serious Offences (Money Laundering Act — GwG). VC have not yet been taken into account at the EU level.

The Fourth Money Laundering Directive of 2015 (4AMLD) was revised to explicitly include the risks of VC. The following stages of the EU legislative process were passed through:

• The announcement by the Commission on 2.2.2016;
• Parliament resolution of 26.5.2016 on VC;
• The first draft law of the Commission of 5.7.2016;
• The decision in the first reading in the European Parliament on 19.4.2018 and adoption by the Council on 14.5.2018.

Adoption of the Directive is expected in the near future. EU Member States will have 18 months from the date of publication in the EU Official Journal to transpose the Directive into national law. With regard to VC, the new version of the Directive (informally abbreviated as 5AMLD) contains the following points:

• Definitions are introduced for VC, Exchanger (“providers engaged in exchange services between virtual currencies and fiat currencies”) and eWallet provider (“custodian wallet provider”).
• Exchangers and eWallet providers are to store the identity of the users and their wallet addresses in a central database or create possibilities for recording the users’ self-declaration.
• The EU Member States will be responsible for licensing the Exchangers and eWallet providers.

G20 meeting of finance ministers and central bank governors

In a joint letter dated 7 February 2018, the French and German finance ministers and central bank governors asked the Argentine finance minister, as host of the G20 meeting of finance ministers and central bank governors in Buenos Aires, to put the regulation of VC (“crypto-assets” or “tokens”) on the agenda. At the first meeting from 19 March to 20 March 2018, however, there was no consensus for a concrete agreement. In the communiqué, the international bodies Financial Stability Board (FSB) — in coordination with other organizations — and FATF da- were mandated to reach a consensus at the second meeting in Buenos Aires on 21.7. to 22.7.2018 to report on their work on “crypto-assets”.

Point 9 of the communiqué mentioned the usual problem areas (including consumer protection, tax evasion, money laundering and financing of terrorism), but did not yet identify any acute threats to financial stability. The G20 Group verpflichtet is committed to implementing the FATF standards as far as they concern “crypto-assets” and urges the Financial Action Task Force to promote a global implementation of the standards. In addition, competent international organizations should continue to monitor crypto-assets.

Depending on the development of the discussions, the heads of state and government will discuss the following issues within the framework of the joint final declaration at the G20 summit meeting on Position 30.11. to 1.12.2018 in Buenos Aires. Irrespective of an agreement at the G20 level, further steps towards the regulation of Bitcoin and other VC at supranational (EU) and national level can be expected.

EU Regulation of Bitcoin and Virtual Currencies was originally published in Hacker Noon on Medium, where people are continuing the conversation by highlighting and responding to this story.