Regulating Bitcoin?

RBI wakes up to the virtual currency

Recent activity suggests that Indian regulatory authorities have belatedly become aware of the potential dangers presented by virtual currencies like the Bitcoin. In December, the Reserve Bank of India issued an advisory outlining the dangers of trading in virtual currencies. The Enforcement Directorate has raided a couple of websites dealing in Bitcoin. The Income-Tax Department is seeking to create a structure for levying tax on virtual currencies. Regulatory interest is overdue since the Bitcoin is now almost as valuable as gold. But virtual currencies continue to exist in a grey area not addressed by regulations. The central bank has not banned virtual currencies; it has only warned about dangers attached to their use. The I-T Department is puzzled about how it could tax trading in such assets. Indeed, central banks and global monetary authorities are divided in their opinions about the regulation of these instruments. The Chinese central bank has banned its member banks from accepting Bitcoin. The US, on the other hand, is contemplating regularising Bitcoin usage.

A successful currency must generate trust. In the case of fiat currencies, the trust comes from regulation and oversight by monetary authorities, like central banks. Or, as in earlier eras, the currency may itself be backed by precious metal. Bitcoin doesn't conform to any such systems. Each coin is just a unique digital code. It is backed by nothing. Transactions are managed by an open peer-to-peer network, regulated by nobody. The money supply depends on the solution of mathematical problems with coins being created at a predetermined rate as problems are solved. Ownership is anonymous. Consider a situation where somebody exchanges a computer code (also known as Bitcoin) for a real asset (a car) or a service (a haircut). How does one regulate or tax such transactions? At the same time, one of the drawbacks of such a virtual currency is that a standard model of fractional reserve banking is very cumbersome, or outright impossible to implement. The basis for the trust is cryptographic integrity. Users can check the authenticity and transaction history of a Bitcoin, without knowing the identity of the owner. A real world analogy would be that of a shopkeeper who could check the authenticity of every currency note presented by anonymous customers, hidden behind impenetrable veils. Bitcoin already fuels a growing range of transactions ranging from the exotic to the mundane. As an experiment, a journalist lived for a week in San Francisco, using only Bitcoin, to pay for groceries and transport. It is possible to buy Lamborghini cars, hamburgers and coffee with it and it may soon be possible to contribute to American political campaigns in Bitcoin.

One reason for the popularity is the proliferation of 24x7 currency exchanges where Bitcoin can be exchanged for dollars and euros. This allows vendors to rapidly offset a Bitcoin trade. It also fuels speculation. Another reason for the popularity is the sheer anonymity. This makes Bitcoin popular in money-laundering operations and encourages its use in criminal transactions. Drug deals amounting to several billion dollars were Bitcoin-denominated on the online black market, Silk Road.

The RBI has reason to be worried by the proliferation of Bitcoin usage. However, it has also been right to proceed cautiously and attempt to understand how it works before trying to regulate. The virtual currency has already gained enough momentum to make simple bans unworkable. The elegant cryptological underpinnings could also well find use in the design of more conventional financial assets. The virtual currency is believed to have been launched as a libertarian experiment. It may have done the world a service by forcing bankers to re-examine the basic principles and processes of the monetary system.