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Bitcoin Needs Smart and Safe Regulation | Commentary

By Lawrence Goodman The advent of virtual money — such as bitcoin — may be another ground-breaking chapter in the history of finance. Yet volatility and risks threaten to thwart its progress, making it entirely possible Congress will be dragged into dealing with the fallout of any crisis that may arise.  

Over many years, the American financial industry has been at the forefront of innovations that have opened the door to economic opportunity and wealth for average Americans. New ideas — such as discount brokerages, mutual funds, college savings plans and an array of credit options, to name just a few — have benefited many.  

But America’s financial sector has also been source of colossal failures and strife — as evidenced by the economic meltdown in 2008. The crisis was largely driven by a toxic mix of profligate monetary policy, ineffective regulatory oversight and an avalanche of exotic high risk mortgage securities packaged and sold by financial institutions.  

So, as with all innovations, bitcoin not only offers great promise. It carries tremendous risk, particularly if it is allowed to expand without the proper protections for consumers and investors.  

At least one state, New York, is moving to fill the regulatory void. But there is more than ample room for Congress to establish national standards to prevent the emergence of a hodgepodge of state and federal rules. In fact, the gaming of regulations across geography and institution types or “regulatory arbitrage” was at the core of deepening and lengthening the financial crisis. So, Congress and other officials can work now to avoid similar problems, as innovations surrounding bitcoin and virtual currencies accelerate.  

Created in 2009, bitcoin has the potential to alter the way people in the United States and around the world conduct even the most basic transactions. It allows people to send money instantaneously anywhere on the planet at any time.  

Bitcoin differs from other monetary exchanges in that it eliminates the need for financial intermediaries such as credit card companies, wire transfer agents and banks. It also allows users to open accounts and conduct transactions anonymously.  

And so it is not surprising that venture capitalists and other investors are pouring millions of dollars into virtual currency exchanges around the globe. They are convinced and willing to take a risk that huge profits will be found in this cutting-edge industry at the intersection of finance and technology.  

But as is true with virtually all new ventures, digital currency is a murky and high-risk industry, particularly since it operates outside the regulatory bounds guiding the rest of the financial sector.  

Indeed, the brief history of this fledgling industry already abounds with example of volatility, strife, and failure.  

Consider the plummeting value of bitcoin from an all-time high of nearly $1,200 a little over a year ago to roughly $220. Purchasers of bitcoin at the peak lost nearly 80 percent of its value. Perhaps even more startling, a Tokyo-based exchange known as Mt. Gox — one the largest exchange of its kind — crashed last year after it lost nearly $500 million in a hacking attack that left customers, investors and the entire industry stunned.  

More recently, Coinbase, Inc., a new exchange for virtual currency, entered the market with more than  $100 million dollars in backings from venture capitalists, banks and, most notably, the New York Stock Exchange. But no sooner did it enter than it stumbled.  

Within days of its launch, financial regulators in both New York and California appeared to distance themselves from the company after the new entity claimed to be the first regulated bitcoin exchange in the United States.  

Shortly, thereafter, a top official with New York’s Department of Financial Services said that company was operating in the state without license. Similarly, California’s Department of Business issued a consumer alert — noting that the company was neither licensed nor regulated by the state.  

Coinbase has also drawn scrutiny over the fact that it has apparently touted the ability of virtual currency to evade international sanctions imposed on rogue nations. These assertions served to further alarm longtime critics of virtual currency, who contend that it may enable individuals and groups to engage in illicit activity under the cover of anonymity.  

It is against this tumultuous backdrop that there is a growing awareness of the need for regulations that provide greater transparency to this industry, hold exchanges like Mt. Gox accountable, and establish protections for consumers and investors.  

To its credit, the New York Department of Financial Services is working to meet this challenge with its proposed BitLicense. To be sure, the path will be nonlinear and complex. This was certainly the case after the initial draft of BitLicense was greeted with a loud Bronx cheer. Yet, the authorities seem to have incorporated feedback from over 3,500 comments into its latest BitLicense proposal. This is an important — yet still incomplete — step in the right direction.  

As we have learned from the recent crisis, poorly regulated financial institutions accentuated the depth of the economic fallout and pain suffered by many. So, regulatory authorities must proceed diligently — yet cautiously — to safeguard industry and consumers.  

For instance, new exchanges in the virtual currency space would benefit from adequate capital backstops, regulatory examinations and stress tests, protective processes against cyber breaches and anti-money laundering procedures.  

But as with any regulatory framework, there is a danger of bureaucratic overreach. And so it is essential that we create a forward-looking and largely hands-off regulatory environment that does not stifle the entrepreneurial energies that drive this new and exciting industry.  

In short, we need to ensure the path is clear for innovation that is smart and safe. Congressional leaders and key officials throughout government would be wise to take this issue seriously.  

Lawrence Goodman is president of the Center for Financial Stability.

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