Need for a regulatory framework for Cryptocurrencies

Bitcoin, the cryptocurrency touted to be the greatest invention after the Internet, is at heart an unregulated currency, breaking free from controls of state, law and third party intermediaries. The public ledger that functions as the decentralized system for ownership and value transfers is the common denominator among all cryptocurrencies. While the technical idea of the operation is complex, the core idea is quite simple.

When an owner of a unit of cryptocurrency transfers the units to a recipient, the transfer is verified in a process called “mining” and the mining operation is done by a “miner”. A crowd of miners consult the ledger, verify the owner’s claim of ownership and document the transfer to the recipient, who is now logged on the ledger as the owner of the units of cryptocurrency. The verification process is a competitive one. The miners are required to solve a complex cryptographic problem. The first miner who succeeds wins the competition, logs the transaction on the ledger and is awarded a new batch of cryptocurrencies.

The new batch of cryptocurrencies is automatically generated by the software and functions both as the incentive for participating in the mining process and as a decentralized mechanism of generating new cryptocurrency units. Anyone can become a miner by downloading the necessary software; an open source software not controlled or owned by a central agency or organization.

Cryptocurrencies hold great potential. Cryptocurrencies win over traditional commerce by overriding the necessity for a third party validating mechanism and cutting costs by negating the requirement of this validating agency. However, cryptocurrencies are also suitable for harmful behaviour for two reasons. The only public feature about the public ledger is the documentation of ownerships and transfers. The owners themselves are not identified on the ledger, but rather by a set of letters and numbers representing their public key, the address of their cryptocurrency wallet. This public key in combination with a private key is the authorization process for logging into a cryptocurrency wallet and transacting through it. Anyone can freely create as many wallets as they may want without providing identifying information. This makes cryptocurrencies susceptible for transacting in illegal and banned products and services.

The second reason why cryptocurrencies are suited for criminal activity is the lack of regulation. Traditionally, third party intermediaries through activities such as “know your customer rules” have done regulation. However, with third party intermediaries being ruled out in cryptocurrencies, this process becomes excessively expensive. The combination of these two factors makes cryptocurrencies a perfect medium for criminal commerce.

Possible regulatory frameworks

Intermediaries as value adding agents to cryptocurrency transactions

Intermediaries aren’t always an interference to transactions. They are market created, not always government created constructs. They do not just serve as agents for buyers and sellers but add actual value to the financial market. Cryptocurrency markets too require an intermediary in the same way; exchange fiat currencies to cryptocurrencies, cryptocurrency-wallet service providers, and clearinghouses for cryptocurrency transactions.

For example, the US Treasury’s Financial Crimes Enforcement Network subjects certain cryptocurrency service providers to regulations as money transmitters. The IRS requires certain cryptocurrency service providers to provide information to them and their service recipients, and the New York State Department of Financial Services recently proposed rules that would require registration and licensing for certain cryptocurrency financial services providers.

Anonymity tax in cryptocurrency transactions

Tax collection system is presently based on individual self-reporting. The enforcement of such reporting requirements is largely dependent on the regulation of intermediaries. The intermediaries are required to provide the account holder with information necessary to complete the account holder’s tax return. However, many taxable transactions that are traditionally facilitated through financial institutions can theoretically rely on cryptocurrency protocols in order to avoid the use of a costly financial intermediary and, as such, defeat intermediary-based tax enforcement.

A consumer can use cryptocurrency the same way as cash but as per IRS taxation rules, cryptocurrency counts as property. However, the reporting of cryptocurrency transactions is upon the discretion of the cryptocurrency owner. That is because no intermediaries are involved in reporting or monitoring transactions.

However, a mechanism can be created to incentivize consumers to identify themselves to a merchant or an intermediary that provides cryptocurrency clearing services. In such cases, the merchant would function as a surrogate for the collection of the purchaser’s tax. Merchants that accept cryptocurrencies as payment would be required to collect a special cryptocurrency-transaction tax based on a percentage of the gross value of the transaction and remit the tax details to the IRS. This gross tax being waived if the consumer were identified by the merchant of record or intermediary. Thus, the consumer has the choice of declaring their identity and obtain tax exemption or pay the tax in return for anonymity.

If the consumer chooses to pay the tax in return for anonymity, the tax would serve as a proxy for functionally unreported income.

These are but baby steps, towards making cryptocurrencies, the greatest innovation in commerce, a regulated yet efficient means to transacting across the world.

Vishal Gupta
Chief Architect, Internet dollar.org
Co-founder Digital Assets and Block chain Foundation of India(DABFI)