January 2016SDN/16/03I M F S T A F F D I S C U S S I O N N O T E Virtual Currencies and Beyond Initial Considerations Dong He, Karl Habermeier, Ross Leckow, Vikram Haksar, Yasmin Almeida, Mikari Kashima, Nadim Kyriakos-Saad, Hiroko Oura, Tahsin Saadi Sedik, Natalia Stetsenko, and Concepcion Verdugo-Yepes DISCLAIMER Staff Discussion Notes SDNs showcase policy-related analysis and research being developed by IMF staff members and are published to elicit comments and to encourage debate. The views expressed in Staff Discussion Notes are those of the authors and do not necessarily represent the views of the IMF, its cutive Board, or IMF management.VIRTUAL CURRENCIES AND BEYOND 2 INTERNATIONAL MONETARY FUND INTERNATIONAL MONETARY FUND Monetary and Capital Markets, Legal, and Strategy and Policy Review Departments Virtual Currencies and Beyond Initial Considerations Prepared by an IMF Staff Team1Authorized for distribution by Jos Vials, Ross Leckow, and Siddharth Tiwari DISCLAIMER Staff Discussion Notes SDNs showcase policy-related analysis and research being developed by IMF staff members and are published to elicit comments and to encourage debate. The views expressed in Staff Discussion Notes are those of the authors and do not necessarily represent the views of the IMF, its cutive Board, or IMF management. JEL Classification Numbers G00, G10, G18, G20, G23, G28, E42, E5 Keywords Virtual currencies, cryptocurrencies, payment technology, distributed ledger, blockchain, financial innovation, financial efficiency, financial inclusion, AML/CFT, consumer protection, tax evasion, exchange controls, capital flows management, financial regulation, financial stability, monetary policy, international cooperation Authors’ E-mail Address dheimf.org; khabermeierimf.org; rleckowimf.org; vhaksarimf.org; nkyriakossaadimf.org; tsaadisedikimf.org; yalmedidaimf.org; mkashimaimf.org; houraimf.org; nstetsenkoimf.org; cverdugoimf.org; 1The IMF staff team comprised Dong He, Karl Habermeier, Ross Leckow, Vikram Haksar, Yasmin Almeida, Mikari Kashima, Nadim Kyriakos-Saad, Hiroko Oura, Tahsin Saadi Sedik, Natalia Stetsenko, and Concepcion Verdugo-Yepes. s are also gratefully acknowledged from Victoria Perry, Federico Diaz- Kalan, Silvia Iorgova, Jonathan Pampolina, Nadia Rendak, Anna Strandquist, Herve Tourpe, and Christophe Waerzeggers. Sonia Echeverri, Rosemary Fielden, and Kajal Jagatsing provided valuable support. VIRTUAL CURRENCIES AND BEYOND INTERNATIONAL MONETARY FUND 3 CONTENTS CUTIVE SUMMARY ___________________________________________________________________________ 5INTRODUCTION __________________________________________________________________________________ 6A. Overview ________________________________________________________________________________________ 6B. What are Virtual Currencies ____________________________________________________________________ 7ARE VIRTUAL CURRENCIES MONEY __________________________________________________________ 10A. Perspectives from Theory and History _________________________________________________________ 11B. Legal Perspectives _____________________________________________________________________________ 16C. Economic Perspectives _______________________________________________________________________ 17DISTRIBUTED LEDGERS _________________________________________________________________________ 18A. What Are They and How Do They Work _____________________________________________________ 18B. Emerging Uses of Distributed Ledgers ________________________________________________________ 21REGULATORY AND POLICY CHALLENGES _____________________________________________________ 24A. Regulatory Challenges and Responses ________________________________________________________ 24B. Financial Integrity AML/CFT ___________________________________________________________________ 27C. Consumer Protection __________________________________________________________________________ 28D. Taxation _______________________________________________________________________________________ 30E. Exchange Controls and Capital Flow Management ____________________________________________ 31F. Financial Stability ______________________________________________________________________________ 31G. Monetary Policy _______________________________________________________________________________ 33THE WAY FORWARD ___________________________________________________________________________ 35SELECTED BIBLIOGRAPHY ______________________________________________________________________ 38BOXES 1. Public and Private Provision of Money History and Theory ___________________________________ 122. Design of Distributed Ledgers _________________________________________________________________ 213. Smart Contracts _______________________________________________________________________________ 23FIGURES 1. Taxonomy of Virtual Currencies _________________________________________________________________ 82. Volatility of Bitcoin Value ______________________________________________________________________ 183. Distributed Ledger System How Does It Differ from Centralized Payment System __________ 20VIRTUAL CURRENCIES AND BEYOND 4 INTERNATIONAL MONETARY FUND TABLE 1. Characteristics of Currencies A Comparison __________________________________________________ 14ANNEX 1. Policy Responses to Virtual CurrenciesSelected Countries __________________________________ 42VIRTUAL CURRENCIES AND BEYOND INTERNATIONAL MONETARY FUND 5 CUTIVE SUMMARY New technologiessupported by advances in encryption and network computingare driving transational change in the global economy, including in how goods, services and assets are exchanged. An important development in this process has been the emergence of virtual currencies VCs. VC schemes are private sector systems that, in many cases, facilitate peer-to-peer exchange bypassing traditional central clearinghouses. VCs and their associated technologies notably distributed ledgers based on blockchains are rapidly evolving, and the future landscape is difficult to predict. VCs offer many potential benefits, including greater speed and efficiency in making payments and transfersparticularly across borders––and ultimately promoting financial inclusion. The distributed ledger technology underlying some VC schemesan innovative decentralized means of keeping track of transactions in a large network––offers potential benefits that go far beyond VCs themselves. At the same time, VCs pose considerable risks as potential vehicles for money laundering, terrorist financing, tax evasion and fraud. While risks to the conduct of monetary policy seem less likely to arise at this stage given the very small scale of VCs, risks to financial stability may eventually emerge as the new technologies become more widely used. The development of effective regulatory responses to VCs is still at an early stage. VCs are difficult to regulate as they cut across the responsibilities of different agencies at the national level, and operate on a global scale. Many are opaque and operate outside of the conventional financial system, making it difficult to monitor their operations. Regulators have begun to address these challenges, with a variety of approaches across countries. Responses have included clarifying the applicability of existing legislation to VCs, issuing warnings to consumers, imposing licensing requirements on certain VC market participants, prohibiting financial institutions from dealing in VCs, completely banning the use of VCs, and prosecuting violators. These approaches represent an initial policy response to the challenges that VCs pose, but further development is needed. In particular, national authorities will need to calibrate regulation in a manner that appropriately addresses the risks without stifling innovation. More could be done at the international level to facilitate the process of developing and refining policies at the national level. International bodies are playing an important role in identifying and discussing the risks posed by VCs and possible regulatory responses, and they should continue to do so. As experience is gained, international standards and best practices could be considered to provide guidance on the most appropriate regulatory responses in different fields, thereby promoting harmonization across jurisdictions. Such standards could also set out frameworks for cross-country cooperation and coordination in areas such as ination sharing and the investigation and prosecution of cross-border offenses. VIRTUAL CURRENCIES AND BEYOND 6 INTERNATIONAL MONETARY FUND INTRODUCTION A. Overview 1. New technologies are driving transational changes in the global economy, including in how goods, services, and assets are exchanged. The development of monies and a variety of payments systems throughout history have helped make exchange more efficient and secure. The rapid spread of Internet-based commerce and mobile technology––supported by advances in encryption and network computing––has driven the development of several innovative technologies. Companies such as Uber and Airbnb have developed radical new business models. Secure online payments systems for example, PayPal and mobile payments and transfer solutions for example, M-Pesa are changing the ways in which payments for goods and services are made. 2. An important development in this process of transation has been the emergence of virtual currencies VCs. VCs, in principle, question the paradigm of state-supported fiat currencies and the dominant role that central banks and conventional financial institutions have played in the operation of the financial system. VCs are issued without the involvement or backing of a state. Some VC schemes make use of “distributed ledger” technologies that provide complete and secure transaction records without using a central registry. These technologies therefore allow for direct peer-to-peer transactions and eliminate the need for central clearinghouses. It is therefore not surprising that private sector interest in these new technologies has been growing, and that attention from regulators and policymakers has not been far behind. 3. VCs and their underlying distributed ledger technologies have the potential to generate benefits. VC schemes and distributed ledger technologies can strengthen financial efficiency by facilitating peer-to-peer exchange while reducing transaction times and costs, especially across borders. In the longer term, these technologies have the potential to deepen financial inclusion by offering secure and lower-cost payments options. Beyond payments systems, distributed ledger technologies have implications for a wide range of markets and financial market infrastructures as a fast, accurate and secure record keeping system, including for stock exchanges, central securities depositories, securities settlement systems or trade repositories. Technological and regulatory progress will be needed to realize these potential benefits. 4. However, these technologies also pose risks. VCs can be misused as vehicles for money laundering, terrorist financing, and tax evasion, and other s of illicit activity. While risks to the conduct of monetary policy seem less likely to arise, risks to financial stability may eventually emerge as the new technologies come into more wide-spread use. Although the growing use of distributed ledger technologies outside of the context of VCs pose far fewer risks, it may over time pose a serious challenge to parts of the business model of the established financial system. VCs and distributed ledger technologies will thus continue to attract the attention of policymakers and regulators at both the national and international levels. VIRTUAL CURRENCIES AND BEYOND INTERNATIONAL MONETARY FUND 7 5. Any policy response to VCs will need to strike an appropriate balance between forcefully addressing risks and abuses while avoiding overregulation that could stifle innovation. The initial focus should be on the most pressing concerns related to VCsincluding financial integrity, consumer/investor protection, and tax evasionwhile leaving less immediate risks for example, financial stability, monetary policy to a later stage. VCs combine many different properties of electronic payment systems, currencies, and commodities that span the responsibilities of several types of regulators at the national level. VCs operate in a virtual world that reaches across borders, increasing potential risks and creating opportunities for regulatory arbitrage. Effective policy coordination will therefore be required at the national and international levels. 6. This paper discusses the potential benefits and risks posed by VCs and how financial regulators could approach them. The paper begins by explaining what VCs are, and how they work. It then examines key features and related developments in distributed ledger technologies underlying decentralized VCs, along with their potential use for financial development and financial inclusion. The paper subsequently discusses the policy and regulatory implications of VCs generally and concludes with a brief discussion of areas for future analysis. 7. As a starting point, it is important to note that the VC landscape is still new and rapidly changing. It is therefore not possible to fully predict the future direction and importance of these evolving technologies or to identify specific longer-term policy responses. The paper is therefore intended as a first step and a plat for further research and analysis. Many of the questions it raises are left for future discussion. B. What are Virtual Currencies 8. VCs are digital representations of value, issued by private developers and denominated in their own unit of account.2VCs can be obtained, stored, accessed, and transacted electronically, and can be used for a variety of purposes, as long as the transacting parties agree to use them. The concept of VCs covers a wider array of “currencies,” ranging from simple IOUs of issuers such as Internet or mobile coupons and airline miles, VCs backed by assets such as gold,3and “cryptocurrencies” such as Bitcoin. 9. As digital representations of value, VCs fall within the broader category of digital currencies Figure 1. However, they differ from other digital currencies, such as e-money, which is a digital payment mechanism for and denominated in fiat currency. VCs, on the other hand, are not denominated in fiat currency and have their own unit of account. 2Given the fast evolving nature of the industry, a universal definition has yet to emerge and could quickly change as the VC ecosystem continues to trans. 3This type of VCs is backed by the combination of e