Thoughts on a Country Adopting a Bitcoin-Like Currency

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A few months ago, a Latin American advisory group asked me to comment on the Digital Sucre and the potential impact of a country adopting a digital or crypto currency as legal tender.  It never occurred to me that I should post the surface-scratching responses I came up with, until American Banker‘s Bailey Reutzel asked the question (here).  With the upcoming release of AuroraCoin in Iceland, and the adoption of a bitcoin clone by the Oglala Lakota Native American nation, this seems to be a good time to poke the discussion.  So here go my two cents in the hope that a few extra thoughts will be triggered.

In concept, is bitcoin more a currency or a payments system?

Bitcoin is both.  In addition, and most importantly and fundamentally, it’s also a protocol on top of which additionally functionality can be built.  The fact that Bitcoin (with a capital B) is multiple things at once is what creates most of the confusion about it.  Bitcoin is a sophisticated globally distributed asset register that, at this moment in time, is mostly being used to register value in USD or other fiat currencies.  Hence the fact that it’s mostly construed as a commodity, or a digital asset class with a corresponding value in fiat currency.  Now, given its novelty and the potential for growth in the value of Bitcoin as a payment protocol, there’s a considerable degree of speculation going on, and the value of bitcoin (with lowercase b) is behaving like a roller coaster.  Confusingly, bitcoin (with lowercase b) itself also has features of a fiat currency, because it can be used as a medium of exchange, although the jury is still out whether it’ll ever store value and serve as a unit of account with the stability that a currency theoretically needs.

Is it easier for a nation-state to establish crypto-currency value than an independent party doing the same?

I’m not sure I understand what you mean by ‘establishing crypto-currency value.’  The value of each unit of account, expressed in other currencies, is established by an open market.  Neither a nation nor an independent party are able to ‘establish the value’ of the bitcoin currency, at least for the time being.  If you mean establish a crypto-currency, period, nothing prevents a nation-state from creating and/or adopting a crypto-currency as its national currency.  How easy it would be is another question.  It seems to me that it would be harder for a state or government to establish and adopt a crypto-currency, given the high switching costs involved.  That is, it’s much simpler for an individual or group to start using Bitcoin as an alternative store of value and payment network than by an entire nation.

“Bitcoin is a sophisticated globally distributed asset register that, at this moment in time, is mostly being used to register value in USD or other fiat currencies.”

What regulatory measures must accompany a virtual currency for it to have legitimacy against money laundering and fraud?

The challenge with decentralized virtual currencies like Bitcoin is that they give each individual with the right device and an Internet connection the power to perform two functions that have traditionally been the realm of highly regulated and controlled intermediaries: store value and conduct transactions in any amount anywhere in the world without having to identify themselves or the recipients of their transactions.  This of course poses many challenges.  It’s relatively easy to regulate an institution to reduce anti-money laundering (AML) and fraud risks, but how do you regulate millions of individuals?  What would bring legitimacy and protection against money laundering and fraud is the adoption of high standards of customer identification and compliance with existing (or new) regulations by all of the participants in the ecosystem, whether exchanges, payments processors or digital storage providers.  That would reassure the public and the regulators that safeguards are in place against multiple real and perceived risks.  That, however, is bound to take some time.  In the meantime, the US government has established via a guidance that came out on March 18, 2013 that certain virtual currency industry participants –especially exchangers converting fiat currencies to virtual currencies in both directions– are money transmitters and therefore are governed by applicable federal reporting and record-keeping, AML and state consumer protection regulations.  With respect to fraud, some types of fraud are made impossible by the nature of the virtual currencies themselves, and others need to be mitigated by means of information security best practices.

What regulators or financial systems oppose existing digital currencies?

I have not heard of any regulator or industry incumbent openly oppose digital currencies [Note: I responded this questionnaire back in early September], but it is not hard to imagine what must be giving them pause.  Many federal and state regulators and law enforcement agencies have publicly expressed concern about the potential money laundering and terrorist financing risks posed by virtual currencies, and are conducting inquiries and investigations.  For example, earlier this year the state of California issued a (rather misguided) cease and desist letter order against the Bitcoin Foundation, the state of New York issued subpoenas commanding twenty-two industry players in the US to provide details about their business plans, ownership structure and risk management programs.  Also, the Senate Homeland Security Committee requested details of the Department of Homeland Security on how they were planning to address the risks of virtual currencies.  The Commodity Futures Trading Commission has also expressed interest in investigating whether bitcoins, inasmuch as they can be considered commodities, may fall under their regulatory purview.  Internationally, there have been mixed responses to Bitcoin, but none especially negative or opposing.  The closest to an opposing stance has been that of the Bank of Thailand, which was reported last July to have suspended bitcoin trading due to the lack of existing applicable laws and capital controls. [Note: Again, pardon the anachronisms!  For an up-to-date inventory of the regulatory sentiment on Bitcoin, check out my Crypto-Timeline or this service.]

In the case of Ecuador, the digital Sucre may become its new currency.  However, the Sucre as a paper currency is highly devalued.  What does this mean for Ecuador?

Adopting a digital currency will not automatically protect a currency from devaluation.  What makes Bitcoin anti-inflationary is the fact that the frequency of issuance of the units of account called bitcoins has been pre-determined within the software, as have been the total units that will ever be in circulation.  In other words, the bitcoin ‘monetary system’ is not based on the fractional reserve model, which is inherently inflationary.  If Ecuador adopts a digital manifestation of a currency issued under a fractional reserve scheme, it will just be that –an inflationary digital currency.  What would be interesting is to see what would happen if Ecuador or any state for that matter were to adopt bitcoin or any other non-inflationary, math-based currency as its national currency.

“If Ecuador adopts a digital manifestation of a currency issued under a fractional reserve scheme, it will just be that –an inflationary digital currency.”

Hypothetically, could a well-regulated digital Sucre improve Ecuador’s economy and that of its trade partners?

It depends on what you mean by ‘well-regulated’ and by ‘digital Sucre.’  I would venture to say that adopting a non-inflationary digital currency, that is, not a digital manifestation of an existing fractional reserve currency, could change the rules of the game and could be a contributing factor in stabilizing a failing economy.  However, it would be simplistic to think that the nature of the currency alone is what would improve a country’s economy.  There’s a multitude of interconnected micro and macro-economic factors at play in a modern economy.

What could Ecuador and the ALBA countries lose by adopting a crypto-currency?

This may sound facetious but what a country would lose by adopting a crypto-currency like Bitcoin, that is, one that is designed not to be inflationary, is the ability to manipulate the monetary policy to its advantage.  Fractional reserve systems allow governments to regulate key macro-economic indicators much like a valve allows for the release of pressure.  However, therein lies the problem –a few have the power to control the many, and if the system is not managed responsibly, the short- and long-term consequences to the majority of the people can be disastrous.  A crypto-currency like bitcoin disintermediates even central monetary authorities and hands the power to regulate the currency back to the market.  On the flip side, if a government centrally controls a digital currency, it wouldn’t be far-fetched to imagine that nation attaining 100% tax compliance or crypto-graphically ensuring the enforceability of all contracts.  A crypto-currency platform like Bitcoin is a powerful tool whose value goes beyond the merely economic.

Ecuador’s financial relationship with Iran places suspicion on its banking practices. With the digital Sucre, Iran could potentially access global finance through a single location. Could this undermine Ecuador’s economy or cause it to become robust – perhaps in illicit terms?

This is an interesting proposition –what would happen if two or more nations adopt the same crypto-currency and start creating a ‘parallel economic universe’?  Here we can see the potential power of crypto-currencies to challenge the U.S. as the most powerful nation in the world.  This would create geo-political tectonic shifts whose impact on the world is unfathomable.  Again, the reason why it’s possible today for the U.S. to enforce its many sanctions programs (Cuba, Iran, North Korea, etc.) is that financial intermediaries are relatively few.  If a nation adopted a digital currency that is only connected to the mainstream financial system at the seams, that is, at the currency translation points, nothing prevents that nation from transacting with whomever it wants within the digital currency universe.  Whether this would undermine or strengthen that nation’s economy is beyond my predictive power, but it’s not hard to imagine that the rules of the game as we know them today would change.  And yes, the potential for illicit movements of funds is there.  Every transaction that has ever happened gets recorded on Bitcoin’s public ledger, which makes it unattractive to individual financial criminals, but what if it’s the government that controls the public ledger?

“What a country would lose by adopting a crypto-currency like Bitcoin, that is, one that is designed not to be inflationary, is the ability to manipulate the monetary policy to its advantage.”

What could the US and Europe expect with the launch of an Ecuadoran/ALBA virtual currency, given the opposition this alliance has toward the US and the global financial entities?

I would imagine that any threat to the current power balance would not go unnoticed and unchallenged by the incumbents.

Do you foresee a Sucre of the future becoming a South American equivalent of what the Euro is for the EU?

I think the emergence of decentralized, cryptography and mathematics-based digital currencies is going to challenge every single paradigm in finance, payments, money and contract law.  I cannot foresee with clarity a Sucre becoming the Euro of South America, but I can foresee with clarity a world where the vertical will increasingly become horizontal, and the central will increasingly become peripheral, where personal responsibility and freedom may have a chance to thrive like never before in history.