Digital currencies such as bitcoin may have sprung from fantasies of a stateless virtual realm, but that libertarian vision increasingly is running up against real-world policy-makers, who are starting to grapple with just how these innovations fit within the established financial system.
Despite digital currencies’ relatively marginal appeal, wild volatility and some high-profile frauds, the dream that virtual money can be free of centralized authority is far from dead. Although there are serious concerns about the security and credibility of existing digital currencies, the underlying premise of a digital method of exchange that is more cost-effective and efficient than traditional paper accounting remains appealing.
And, given that the concept probably is not going away, traditional policy-makers and regulators are turning their attention to digital currencies.
For almost a year, Canada’s federal Standing Senate Committee on Banking, Trade and Commerce has been holding hearings into the digital currency phenomenon, and considering whether there should be some form of regulation in this emerging area. In mid-March, several representatives from the Ontario Securities Commission and Quebec’s Autorité des marchés financiers (AMF) appeared before the committee.
The regulators testified that, at this point, their involvement with these technologies is limited. Although warnings have been issued to investors, the regulators do not appear to have jurisdiction over digital currencies, which don’t meet the existing legal definition of “securities.”
With digital currency technology in its infancy, defining just what these currencies are is the first challenge for policy-makers. The Bank of Canada refers to bitcoin and similar crypto-currencies as “decentralized e-money.” However, other entities consider digital currency a commodity. The Canada Revenue Agency (CRA), for example, indicates that in situations in which digital currencies are traded like a commodity rather than used as a method of payment, the resulting gains or losses could be considered taxable income or capital. And although these vehicles don’t meet securities regulators’ definition of a security, the CRA points to its interpretation of securities transactions for guidance in how transactions involving digital currencies should be treated for tax purposes.
For now, perhaps the biggest issue for policy-makers is the potential for virtual currencies to be used for financial crimes, particularly money laundering.
The AMF, which has broad responsibilities as an integrated financial regulator in Quebec, isn’t looking to regulate virtual currencies as securities at this point. Earlier this year, the AMF declared that companies operating virtual currency trading platforms and ATMs must be licensed under Quebec’s laws governing so-called “money service” businesses. This category includes firms that provide money transfer or exchange services, such as remittances and foreign exchange. By capturing these firms under the AMF’s licensing rules, the people behind these businesses are subject to background checks; and the regulatory regime imposes certain client-verification and record-keeping obligations on these firms.
Last year’s federal budget proposed changes to anti-money laundering legislation to capture dealers in virtual currencies as money service businesses. The changes would require these dealers to report to the Financial Transactions and Reports Analysis Centre of Canada.
The legislative amendments to make those changes were adopted last summer, but the Department of Finance Canada still is in the process of developing the regulations that are needed to enact the legislative provisions. Those regulations are expected to define the types of virtual currency businesses that will be covered by the law and will set the specific obligations to be imposed on these firms.
For now, preventing the use of virtual currencies in crime appears to be policy-makers’ top priority, but more significant issues for securities regulators may yet appear as the virtual currency phenomenon evolves. In other parts of the world, investment products and derivatives that utilize virtual currency as an underlying asset have appeared.
So far, these innovations are focused primarily on devising ways to hedge exposure to the notoriously volatile bitcoin. In the U.S., the Commodity Futures Trading Commission (CFTC) approved the first regulated bitcoin derivative last year, and the CFTC also is considering an application from a firm seeking registration as a “swap execution facility” and a derivatives clearinghouse in order to trade and clear options on bitcoin.
Elsewhere, there are offshore hedge funds that hold bitcoins. As well, a preliminary prospectus has been filed in the U.S. for an exchange-traded fund – the Winklevoss Bitcoin Trust – that seeks a listing on Nasdaq and would hold bitcoins in its portfolio.
Although such products haven’t appeared in Canada, there is at least one publicly traded company that operates a bitcoin exchange, as well as a firm that recently announced a reverse takeover and plans to seek public listing.
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