Into the Black: The Tragic but Inevitable Regulation of Cryptocurrencies

Edward Mears, Vol. 36 Associate Editor

[Ed. note: Compare Chris Sungwon Lee’s article of October 2015 here.] Introduction On February 4th, 2015, Ross Ulbricht, known online as ‘Dread Pirate Roberts,’ was convicted of seven felonies for his involvement with the Silk Road, a so-called “dark-market” that existed on what is commonly known as the Deep Web – a network of unindexed websites that provide a nearly impenetrable shield of anonymity.[1]  On the Silk Road, Ulbricht and others bought and sold millions of dollars worth of illicit drugs financed with a cryptocurrency known as BitCoin.[2]  At their core, BitCoin and other cryptocurrencies are early pioneers in the frontier of virtual decentralized currency, which do without the ‘trusted’ middlemen such as banks or credit card companies that most people rely upon for their day-to-day currency transactions.[3]  By removing third parties from transactions, these cryptocurrencies provide a level of anonymity that is nearly impossible to find in traditional currency markets. How BitCoin Works While the identity of the inventor(s) of BitCoin remain somewhat unclear, the payment system emerged in 2008 and attracted a very niche market of clientele, primarily consisting of users involved in the online sale of illegal goods such as controlled substances.[4]  In recent years, BitCoin has become more ubiquitous and is now used for many legitimate every-day transactions all over the globe.[5] In most traditional currency markets, purchases and exchanges of currency are validated by trusted sources such as banks and credit card companies, which vouch for the reliability of the transaction, providing a sense of trust.  BitCoin, however, does not rely on these institutions.  Instead, BitCoin outsources the validation component to all users by disseminating a virtual ledger attached to every transaction.[6]  Every person who transacts on the BitCoin market has a copy of this master ledger.  This ledger is compared against the ledgers of others with whom that user transacts to validate the authenticity and integrity of the ledger as transactions are added and verified by all users.[7]  These transactions are encrypted, allowing them to be recorded in the virtual ledger, but the true identities of the parties are not disclosed.  This anonymous crowdsourcing of the validation process is one of the novel mechanisms to emerge from the cryptocurrency boom, and while this model provides a very private way to engage in transactions with others, the model poses a threat to traditional financial institutions have many governments and regulatory bodies nervous about the future of cryptocurrencies.[8] Calls for Regulation BitCoin and other cryptocurrencies are prone to pronounced volatility.  Victims of BitCoin fraud have no legal recourse, as anti-fraud mechanisms are non-existent for cryptocurrencies.  These concerns have congealed into calls for governmental regulation and some states have already moved to regulate cryptocurrency. [9]  While predicated on alleviating the above stated concerns, the move to regulate is also likely necessitated on the foresight that at some point in the near future, cryptocurrencies will rival traditional currencies.[10] Due to BitCoin’s decentralized nature, proponents of cryptocurrency regulation have quickly realized it is very difficult for governments to effectively regulate BitCoin; most attempts have proven futile. [11]  The anonymity that BitCoin and other cryptocurrencies provide is precisely the reason why users currently gravitate to these currencies.  Should a dependable form of regulation insert itself into the cryptocurrency market, many of its users will likely migrate in search of the next anonymous haven to conduct illicit transactions.  Despite the threat of pushing out a significant number of cryptocurrencies, the rapid adoption of cryptocurrencies in legitimate online marketplaces, as well as well-placed concerns over privacy after the disclosure of the NSA’s mass surveillance program by Edward Snowden, have brought largely benign cryptocurrency adopters into the fold.[12] Regulation efforts have emerged all over the world.  For example, Russia has proposed a blanket ban on cryptocurrencies and would impose steep penalties for transgressions.[13]  In the wake of the bankruptcy of the Mt. Gox[14] BitCoin exchange, Japan’s government has focused its sights on pending regulation of cryptocurrencies, while trying to maintain an atmosphere conducive of innovation in the cryptocurrency field.[15]  The timeline for the implementation of these regulations in Japan is unclear, as Japan is currently embracing a “wait-and-see” approach.  In the United States, New York has taken the lead in BitCoin regulation, and has proposed a slew of regulations that are targeted at providing more security and protection from virtual theft.[16]  The New York regulations realize that anonymity is important for most users of BitCoin, and the proposed regulations would maintain that aspect of the cryptocurrency.  However, the new regulations would likely include governmental oversight of the virtual ledger to ensure the validity of transactions.[17] If successful, these regulations will likely bring more stability to the BitCoin market and could harness the staggering volatility that has plagued the currency in recent years.  Should the New York experiment prove successful, larger regulatory schemes may gain traction as governments attempt to legitimize these complex currencies. What the Future Holds The success or failure of the New York regulation will likely be the bellwether for the future of cryptocurrency regulation.  It remains to be seen whether the proposed New York regulation, when implemented, will initiate a migration of BitCoin users to other forms of unregulated currency looking to escape the restrictions of regulation and preserve their online anonymity.  If BitCoin is able to survive this migration, the new regulatory scheme in New York should provide the stability and security required to compete with cash and credit cards as a payment method.  This stability and security will move cryptocurrencies into the mainstream, but at the unfortunate expense of the original adopters who prized such innovations for the anonymity and privacy that will likely disappear as states continue to push to regulate.

[1] Benjamin Weiser, Man Behind Silk Road Website Is Convicted on All Counts, N.Y. Times (Feb. 4, 2015), http://www.nytimes.com/2015/02/05/nyregion/man-behind-silk-road-website-is-convicted-on-all-counts.html.