18 May 2022

SUERF: How to regulate crypto currencies

The rapid growth in crypto currencies has gotten ahead of financial regulations. Regulators have limited choices: a complete ban, or historic methods of regulation that are a poor fit with crypto currencies.

This paper proposes a novel approach that leverages the technology used for blockchain-based currencies to enable oversight while continuing to enable legitimate transactions with minimal impact.

Many countries around the world are actively looking for ways to manage the rapid rise in crypto transactions. A large number of these transactions are funding criminal activities such as the recent wave of ransomware attacks. The U.S. Secretary of the Treasury, Janet Yellen, spoke on 7 April 2022, promoting the recent Executive Order from President Biden calling for “a coordinated and comprehensive government approach to digital asset policy.”2 A mechanism for regulators to distinguish legitimate transactions from criminal activity that works at the speed of blockchain transactions is urgently needed.

What is required to regulate crypto currencies? A key part of financial regulation is to know your customer “KYC”. All blockchain transactions are public, with a digital identity tied to each transaction. But these identities are not always linked to real identities in the relevant jurisdiction. A mechanism is required for the appropriate authorities in each jurisdiction to get access to the KYC information when required. With the transaction information and the real identity, the existing legal framework can be used to manage fraud and criminal activity.

Crypto currencies create a virtual world in which its virtual currency value lives; regulation is part of the real world. The challenge in regulating is to identify where these two worlds meet. The first interaction point is in the so called exchanges, where users can exchange between state issued money and crypto currency. Regulation can be applied to the commercial entities that operate exchanges. Such regulation could, for instance, include reporting on anomalous transactions similar to the anti-money-laundering (AML) requirements for banks.

The primary point of engagement between the virtual and real worlds is in each of the computing nodes that generates transactions and puts them on a blockchain. These computing nodes are real and operate off of a common code base, which differs for each blockchain. Operators of the blockchain nodes are called ’miners’, and miners are responsible for the code that they execute. Miners are where the mechanism for regulation must be implemented.

The code base for each blockchain is open source. Authorities can specify the change in this open source code required to add a KYC mechanism as a bridge between the virtual world and their jurisdiction. Miners using code that contains this extension can create blockchains that are legal for that jurisdiction. Miners that don’t will have the same legal status as criminals who engage in high-value transactions without proper reporting. Compliance with this implementation can be seen in the distributed ledger, which is publicly visible.

Miners operate in different locations simultaneously, together computing the next record to put on the blockchain. Blockchain code includes a mechanism to move miners to code updates so that new blocks must be created by with the updated version. In the spirit of the open source software development a regulator could work with existing developers or by commissioning a commercial software developer to register as contributor and have it implement the actual code for the specified change. Any registered developer in open source project can implement a code change and then propose the change for adoption. A proposed change is first balloted by the collective developers to be incorporated in the code base and subsequently presented for adoption in running code by the miners.

Since early in the twentieth century withholding tax has been a tool in managing financial affairs in many countries. Withholding a tax can also be the basis of regulating cryptos. In this case the withholding can be applied to each crypto transaction processed. For instance, with a 35% withholding, 65% of the transaction is transferred to the target account as usual and recorded in the next block added to the chain, in the same block the balance is recorded as a transfer into the crypto account for the regulatory authority in a specific jurisdiction. Withholding part of each transaction meets a key requirement for the per-miner code to implement regulatory oversight while allowing the mining process to continue to operate essentially as before. Legal niceties underpinning the withholding can be managed according to the best practices in each jurisdiction.

SUERF

© SUERF