## _sdn1603

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---

### Executive summary — key findings
- New technologies (encryption, network computing) are driving transformational change in how goods, services and assets are exchanged.
- Virtual currencies (VCs) are private sector systems that often facilitate peer-to-peer exchange bypassing traditional central clearinghouses.
- VCs and distributed ledger technologies (notably blockchains) are rapidly evolving; the future landscape is difficult to predict.
- Potential benefits:
  - Greater speed and efficiency in making payments and transfers—particularly across borders.
  - Potential to promote financial inclusion by offering secure and lower-cost payment options.
  - Distributed ledger technology offers a decentralized means of keeping track of transactions that could benefit financial market infrastructures (for example, stock exchanges, central securities depositories, securities settlement systems, trade repositories).
- Principal risks and concerns:
  - VCs can be misused for money laundering, terrorist financing, tax evasion, and fraud.
  - Risks to the conduct of monetary policy seem less likely at this stage given the very small scale of VCs, but risks to financial stability may eventually emerge as usage widens.
  - Many VCs are opaque and operate outside the conventional financial system, complicating monitoring and regulation.
- Regulatory and policy response is at an early stage; national approaches observed include clarifying applicability of existing legislation to VCs, issuing consumer warnings, imposing licensing requirements on certain VC market participants, prohibiting financial institutions from dealing in VCs, completely banning the use of VCs, and prosecuting violators.
- International coordination: international bodies are playing an important role in identifying risks and responses; international standards and best practices could guide national responses and promote harmonization.

### What are Virtual Currencies? — definitions, taxonomy, and operational models
- Core definition:
  - "VCs are digital representations of value, issued by private developers and denominated in their own unit of account."
  - VCs can be obtained, stored, accessed, and transacted electronically and used when transacting parties agree to use them.
- Range of VCs covered:
  - From simple IOUs (Internet/mobile coupons, airline miles), VCs backed by assets such as gold, to “cryptocurrencies” such as Bitcoin.
- Distinction from e-money:
  - VCs have their own unit of account and are not denominated in fiat currency.
- Convertibility:
  - Non-convertible VCs (closed schemes): operate exclusively within a self-contained virtual environment.
  - Convertible VCs (open schemes): allow exchange with fiat currency (or other VCs) and payments for goods and services in the real economy; convertible VCs may be subject to illiquid markets, limiting de facto convertibility.
- Operational models and decentralization:
  - VC schemes can be centralized, decentralized, or hybrid (example: Ripple).
  - Decentralized (cryptocurrency) features:
    - No central issuing authority; participants (often “miners”) validate transactions and may be rewarded with newly minted currency.
    - Cryptocurrencies do not represent a liability on anyone.
    - Most cryptocurrencies are “pseudo-anonymous”: transactions publicly recorded, users identified by VC “addresses”.
    - Supply rules vary; most (including Bitcoin) have limits, new systems may not.

### How VCs are obtained, stored, and provided for — ancillary services
- Acquisition:
  - Purchased/exchanged via VC exchanges or directly with another VC holder.
  - Obtained in payment for goods or services.
  - Obtained by mining in decentralized systems.
- Storage:
  - Stored in VC “wallets” (wallet software or intermediaries).
  - Cryptographic keys: public keys (akin to account numbers) and private keys (akin to passwords/signatures); loss of a private key results in loss of access.
  - Wallets: online (“hot storage”) or offline (“cold storage”); cold storage offers greater protection against hacking/theft.
- Ancillary providers:
  - Payment facilitators convert VC payments into fiat and may bear exchange rate risk.
  - Some providers offer anonymizing services that further obfuscate traceability.

### Are virtual currencies money? — legal and economic perspectives
- Legal findings:
  - VCs fall short of the legal concept of currency or money.
  - Currency in the strict legal sense is associated with sovereign power, legal tender status, and central issuance of banknotes and coins.
  - Money as a legal concept is broader (banknotes, coins, assets readily convertible into such), but generally denominated in sovereign-issued currency.
- Economic functions assessment:
  - Store of value:
    - High price volatility limits reliability as a store of value.
    - VCs are not liabilities of a state and most are not liabilities of private entities.
  - Medium of exchange:
    - Small size and limited acceptance network restrict use as a medium of exchange.
    - Current total market value of VCs is about US$7 billion.
    - U.S. currency in circulation is US$1.4 trillion; U.S. money supply (M2) is about US$12 trillion.
    - Bitcoin accounts for about 90 percent of decentralized VC market value (coinmarketcap.com, January 11, 2016) and had a small daily transaction volume of about US$70 million in 2015 (blockchain.info).
  - Unit of account:
    - Little evidence VCs are used as an independent unit of account; prices are typically quoted in fiat currency and converted to VC at point-in-time exchange rates.
- Monetary context:
  - Current VC systems exhibit only “high-powered money” characteristics; there is no known financial institution providing inside money in VCs.

### Distributed ledgers and blockchain mechanics, design, and uses
- Concept and mechanics:
  - Distributed ledgers maintain multiple copies of the ledger across network nodes; validation achieved using consensus mechanisms (often blockchain technologies).
  - Bitcoin-like illustrative mechanics: multiple copies of transaction records, miners solving cryptographic puzzles (“proof-of-work”), mining rewards, and vulnerability to a “51 percent attack.”
- Design approaches:
  - Fully public systems: open participation, typically pseudonymous, secured by economic incentives (examples include Bitcoin, Ethereum).
  - Fully private systems: permissions assigned by a central entity, do not need embedded currency.
  - Hybrid/consortium systems: consensus validation by pre-selected organizations; identity and KYC/KYB can be required.
- Emerging uses and potential benefits:
  - Applications beyond VCs: land and credit registries, payment and settlement infrastructure for transactions denominated in fiat currencies, securities settlement, and back-office improvements.
  - Remittances: global average cost of sending small remittances (e.g., US$200) is 7.7 percent (2015); estimated cost with Bitcoin is about 1 percent (Goldman Sachs, 2014).
  - Securities settlement: current settlement times up to T+3 (most securities), many FX settlements T+2, U.S. Treasury bonds at least T+1; distributed ledgers could shorten settlement times and reduce risks.
  - Smart contracts:
    - Defined as computerized protocols that execute contract terms; can be self-executing/self-enforcing.
    - Potential benefits: speed, efficiency, reduced verification/enforcement costs.
    - Risks: unclear legal status, consumer protection issues, potential to amplify systemic risk, technical challenges (integration of external events); “No viable smart contract systems have yet emerged.”

### Risks: financial integrity, consumer protection, taxation, exchange controls
- Financial integrity (AML/CFT):
  - Key vulnerabilities: anonymity and cross-border reach raise concerns for money laundering, terrorist financing, and sanctions evasion.
  - Preventive measures: customer due diligence (CDD), transaction monitoring, record keeping, suspicious transaction reporting.
  - FATF stance:
    - FATF finds most ML/TF risks concentrated at intersections between VCs and the regulated fiat system and calls for regulation of VC exchanges and other “gatekeepers” as covered entities required to implement preventive measures.
    - FATF has not advocated regulating parties who use VCs to purchase goods or services.
  - Enforcement challenges: decentralized schemes complicate freezing/seizing and jurisdictional enforcement.
- Consumer protection:
  - Vulnerabilities from regulatory uncertainty and lack of transparency.
  - Risks include system disruptions, hacks (example: Mt. Gox), scams, and irreversibility of transactions.
  - Policy responses: user/investor awareness, clarifying legislation, issuing consumer warnings, enforcing existing laws against violators.
- Taxation:
  - VCs create risks for tax evasion; treatment varies by jurisdiction (property vs currency).
  - Tax recording: tax record keeping requirements for VCs will be substantial and may reduce attractiveness for everyday use.
  - Example: U.S. IRS requires conversion to dollar-value to be “made in a reasonable manner consistently applied”; backup withholding applies to payments in excess of $600 to non-exempt persons.
  - VAT/sales tax treatment varies; further analysis and international consistency needed.
- Exchange controls:
  - VCs may be used to circumvent exchange and capital controls by enabling cross-border transfers outside traditional systems.
  - Reports exist of such use in China, Venezuela, Cyprus, and Greece.

### Financial stability, systemic risk, and resolution challenges
- Current scale and risks:
  - VCs do not currently pose systemic risks owing to small scale and limited linkages to the financial system.
  - VC market values and transaction volumes are marginal compared to major payment platforms; regulated financial institutions generally do not engage in VC activities.
- Risks to holders and infrastructures:
  - VC infrastructures have suffered disruptions; user exposures include operational, credit, liquidity, and legal risks.
  - Absence of a lender-of-last-resort (LOLR) and deposit insurance increases run risks.
- Potential systemic threats if scale increases:
  - Large-scale VC use and greater interconnectedness could give rise to systemic financial risks, including erosion of bank revenue from payments and consequences for FMIs.
  - Cryptographic risks (for example, advances in quantum computing) could threaten security assumptions.
  - Tail-risk scenario: some VC schemes or blockchains could become too big or too interconnected to fail and be difficult to resolve due to strong encryption, decentralized governance, and cross-jurisdictional nature.
- Regulatory responses to date:
  - Early-stage; countries have limited exposures by prohibiting financial institutions’ VC activities or introducing licensing for VC businesses (for example, New York Department of Financial Services licensing).
- Policy questions:
  - Whether VC intermediaries replicate bank-like functions and should be regulated as banks.
  - Whether VCs in VC-wallets should be considered deposits protected by deposit insurance schemes.
  - Who should oversee VC markets and FMIs using blockchain technology internationally.

### Monetary policy implications
- Current implications:
  - VCs do not currently have significant implications for monetary policy given small scale.
  - Many existing cryptocurrencies have rigid supply rules limiting inflationary risk but creating deflationary bias.
- Deflationary risks:
  - Nearly fixed supply of many cryptocurrencies could result in structural deflation as money demand grows with the economy.
  - Modern flexible-money regimes have advantages in smoothing business cycles.
  - VCs could in principle be designed to allow supply expansion (for example, in line with transaction volumes).
- Monetary policy effectiveness and LOLR:
  - High VC adoption could diminish monetary policy effectiveness and central banks’ capacity to act as LOLR.
  - Decentralized VC schemes are unlikely to substitute for public liquidity provision in crises.
- Adoption patterns:
  - VCs may be more attractive where monetary policy credibility is low, but high VC volatility limits appeal compared with dollarization.

### Regulatory responses, principles, and international cooperation
- Regulatory approaches observed:
  - Bans in some jurisdictions; clarifying existing laws, consumer warnings, licensing requirements in others.
  - Two practical regulatory focus areas:
    - (i) Regulating VC market participants that interface with the fiat economy (gatekeepers such as VC exchanges).
    - (ii) Restricting regulated entities (for example, banks) from interacting with VCs.
- Effectiveness and adaptability:
  - Regulating gatekeepers aligns with current market structures, but peer-to-peer evolution could reduce effectiveness; regulation should be flexible and adaptable.
- Guiding principles for national authorities:
  - Responses should be commensurate to risks without stifling innovation; targeted approaches (for example, regulating intermediaries) may be preferred to outright bans.
  - Design approaches mindful of novel VC business models (focus on gatekeepers when no central authority exists).
  - Address market conduct (AML/CFT, fraud) and financial soundness of VC intermediaries; prudential requirements may be warranted for intermediaries whose failure could affect consumer protection or payments stability.
  - Consider degree of integration between conventional financial system and VC market and options to prohibit, limit, or allow full integration.
- International actions recommended:
  - International bodies should strengthen understanding of VCs, study their evolution and effects on banking and payments, and identify effective regulatory responses mindful of country circumstances.
  - FATF guidance on AML/CFT applicability to VC schemes is an example; consideration could be given to tailored principles at other standard-setting bodies.
  - Development of international standards may promote harmonization and cooperation on information sharing and cross-border investigations/prosecutions.

### Selected key statistics and facts (preserved exactly as in source)
- Current total market value of VCs is about US$7 billion.
- U.S. currency in circulation is US$1.4 trillion.
- U.S. money supply (M2) is about US$12 trillion.
- Bitcoin accounts for about 90 percent of decentralized VC market value (coinmarketcap.com, January 11, 2016).
- Bitcoin had a small daily transaction volume of about US$70 million in 2015 (blockchain.info).
- Global average cost of sending small remittances (for example US$200) is 7.7 percent (2015).
- The cost with Bitcoin is estimated to be about 1 percent (Goldman Sachs, 2014).
- Settlement times cited: many securities up to T+3; many foreign exchange settlements T+2; U.S. Treasury bonds at least T+1.
- Tax reporting example: backup withholding applicable to payments made in Bitcoin in excess of $600 to a non-exempt person in the U.S.

*Source: _sdn1603 — Virtual Currencies and Beyond, International Monetary Fund (excerpt).*

### EXECUTIVE SUMMARY ___________________________________________________________________________ 5

### _sdn1603 - EXECUTIVE SUMMARY ___________________________________________________________________________ 5

### Executive summary — key findings

- New technologies—supported by advances in encryption and network computing—are driving transformational change in the global economy, including in how goods, services and assets are exchanged.
- An important development is the emergence of virtual currencies (VCs), private sector systems that often facilitate peer-to-peer exchange bypassing traditional central clearinghouses.
- VCs and associated technologies (notably distributed ledgers based on blockchains) are rapidly evolving and the future landscape is difficult to predict.
- Potential benefits of VCs and distributed ledger technology:
  - Greater speed and efficiency in making payments and transfers—particularly across borders.
  - Potential to promote financial inclusion by offering secure and lower-cost payment options.
  - Distributed ledger technology offers a decentralized means of keeping track of transactions that could benefit financial market infrastructures (for example, stock exchanges, central securities depositories, securities settlement systems, trade repositories).
- Principal risks and concerns:
  - VCs can be misused for money laundering, terrorist financing, tax evasion, and fraud.
  - Risks to the conduct of monetary policy seem less likely at this stage given the very small scale of VCs, but risks to financial stability may eventually emerge as usage widens.
  - Many VCs are opaque and operate outside the conventional financial system, complicating monitoring and regulation.
- Regulatory and policy response is at an early stage:
  - National approaches observed include clarifying applicability of existing legislation to VCs, issuing consumer warnings, imposing licensing requirements on certain VC market participants, prohibiting financial institutions from dealing in VCs, completely banning the use of VCs, and prosecuting violators.
  - Authorities face a trade-off: address risks forcefully while avoiding overregulation that could stifle innovation.
- International coordination:
  - International bodies are playing an important role in identifying risks and possible responses and should continue to do so.
  - As experience grows, international standards and best practices could guide national regulatory responses and promote harmonization, including frameworks for cross-country cooperation on information sharing and cross-border investigations and prosecutions.

### Introduction — overview and framing

- Paragraph 1–2: New technologies (Internet-based commerce, mobile tech, encryption, network computing) have enabled innovative business models and payment solutions (examples cited: Uber, Airbnb, PayPal, M-Pesa).
- Paragraph 2: VCs question the paradigm of state-supported fiat currencies and the dominant role of central banks and conventional financial institutions; some VC schemes use distributed ledger technologies that enable peer-to-peer transactions without a central registry.
- Paragraph 3: VC schemes and distributed ledger technologies can:
  - Strengthen financial efficiency by facilitating peer-to-peer exchange while reducing transaction times and costs, especially across borders.
  - Deepen financial inclusion in the longer term.
  - Provide fast, accurate and secure record keeping with implications beyond payments.
  - Require technological and regulatory progress to realize potential benefits.
- Paragraph 4: Risks include misuse for illicit activity and potential longer-term challenges to parts of the established financial system when distributed ledger technologies diffuse beyond VCs.
- Paragraph 5: Policy responses must balance addressing immediate risks (financial integrity, consumer/investor protection, tax evasion) and avoiding undue constraints on innovation; VCs cut across multiple regulators and cross borders, raising risk of regulatory arbitrage and need for effective coordination.
- Paragraphs 6–7: Paper scope — explains what VCs are and how they work, examines distributed ledger features and uses, discusses policy/regulatory implications, and notes the VC landscape is new and rapidly changing, so the paper is a first step.

### What are Virtual Currencies? — definitions and taxonomy

- Core definition:
  - "VCs are digital representations of value, issued by private developers and denominated in their own unit of account."2
  - VCs can be obtained, stored, accessed, and transacted electronically and used when transacting parties agree to use them.
- Range of VCs covered:
  - From simple IOUs (Internet/mobile coupons, airline miles), VCs backed by assets such as gold,3 to “cryptocurrencies” such as Bitcoin.
- Distinction from other digital currencies:
  - VCs fall within digital currencies but differ from e-money, which is denominated in fiat currency; VCs have their own unit of account and are not denominated in fiat currency.
- VC schemes comprise two key elements:
  - (i) the digital representation of value or “currency” that can be transferred between parties; and
  - (ii) the underlying payment and settlement mechanisms, including the distributed ledger system.
- Convertibility:
  - Non-convertible VCs (closed schemes) operate exclusively within a self-contained virtual environment, with restricted exchange into fiat or use outside the virtual domain.
  - Convertible VCs (open schemes) allow exchange with fiat currency (or other VCs) and payments for goods and services in the real economy.4
  - Note: convertible VCs may be subject to illiquid markets, limiting de facto convertibility.5
- Operational models:
  - VC schemes can be centralized, decentralized, or hybrid. Core operational areas:
    - (i) issuance and redeemability of the VC;
    - (ii) mechanisms to implement and enforce internal rules on use and circulation; and
    - (iii) payment and settlement process.
  - Each area may be managed centrally by a trusted private party or in a decentralized manner; hybrid schemes mix functions (example given: Ripple).6
- Decentralized (cryptocurrency) features:
  - No central issuing authority; internal protocols allow participants to verify transactions.
  - Participants (often “miners”) are rewarded in newly minted currency for validating transactions (“mining”), introducing new VCs and enabling decentralized operation.
  - Cryptocurrencies do not represent a liability on anyone, unlike fiat currency.
  - Systems may have limited or unlimited issuance; most (including Bitcoin) have limits, but new systems may not.
  - Most cryptocurrencies are “pseudo-anonymous”: transactions are publicly recorded, users identified by VC “addresses” not readily traced to real-world identity—more transparent than cash but more anonymous than other online payments.
  - Cryptocurrencies derive value solely from the expectation that others will value and use them, unlike fiat currencies backed by central bank/government creditworthiness or privately issued currencies historically backed by issuer credibility and commodity reserves.

### How VCs are obtained and ancillary services

- Convertible VCs can be:
  - Purchased or exchanged with fiat currency or other VCs via a VC exchange or trade platform,7 or directly with another VC holder.
  - Obtained in payment for goods or services.
  - Obtained by participating in transaction validation (mining) in decentralized systems.
- Storage:
  - VCs are typically stored in a “VC wallet,” either directly via wallet software or through intermediaries (VC wallet service providers).8
  - Cryptocurrencies use cryptographic keys: public keys (akin to account numbers) and private keys (akin to passwords/signatures). Loss of a private key results in loss of access to the wallet’s contents. Wallets can be online (“hot storage”) or offline (“cold storage”); cold storage offers greater protection against hacking/theft.
- Ancillary providers:
  - Payment facilitators convert VC payments into fiat currency for merchants and may bear exchange rate risk.
  - Some service providers offer additional anonymizing services that further obfuscate transaction traceability.

### Are virtual currencies money? — questions raised

- Key questions to consider:
  - Do VCs satisfy legal definitions of money and fulfill economic roles of money (store of value, medium of exchange, unit of account)?
  - How do VCs compare to historically privately-issued monies?
  - If VCs become widely used, could or should they substitute for national currencies?
- Monetary context:
  - “Money” can mean different things: high-powered money (central bank liability, outside money) versus money supply (which includes base money and inside money created by banks and bank-like institutions).
  - In current VC systems there is no known financial institution providing inside money in VCs; the VC monetary system consists only of high-powered money.9

*Source: _sdn1603 - EXECUTIVE SUMMARY ___________________________________________________________________________ 5*

### 17.      Theory and history offer some guide-posts for considering these questions (Box 1):

### 17.      Theory and history offer some guide-posts for considering these questions (Box 1):

### Theory: public vs private provision of money
- High inflation in the 1970s after the end of the Bretton Woods System renewed skepticism over granting central banks monopoly power to issue nonconvertible fiat currency.
- Friedman and Schwartz (1986) and Fischer (1986) reject Hayek’s proposal to denationalize money (1976).
- Ongoing theoretical work contemplates laissez-faire monetary regimes and the feasibility/optimality of privately issued money under monopoly or competition.
- Competitive market efficiency is cited for private provision (White, 1984; Selgin, 1988), but:
  - Competitive equilibrium may not be optimal when the market is incomplete or there is asymmetric information that can cause moral hazard (Mas-Colell, Winston, and Green, 1995).
  - Such imperfections are typical in financial markets; systemic shocks may hit the entire system and are not fully insurable.
- Many researchers argue public provision of money can improve welfare:
  - Weiss (1980): central bank money and active monetary policy facilitate inter-temporal smoothing in overlapping generations frameworks.
  - Diamond and Dybvig (1983) and Bryant (1980): public liquidity and deposit insurance manage bank runs.
  - Allen and Gale (2000), Freixas, Parigi, Rochet (2000), Holmstrom and Tirole (1998), Tirole (2008): private provision of liquidity can be insufficient in systemic shocks; contagion risk is a concern.
- Welfare implications may be less clear when moral hazard costs from a lender-of-last-resort (LOLR) are incorporated.

### History: empirical guide-posts and the origins of central bank powers
- Historical record is mixed on inflation performance across private and public systems.
- Examples exist where multiple private banks provided currency without high inflation; many central banks began as private banks and lacked legal tender or monopoly status initially.
- U.S. Greenback era: government-issued nonconvertible “Greenbacks” coexisted with private bank notes traded at par; private notes were printed by government, backed 111 percent by government bonds held on deposit at the Treasury, and aggregate issuance was capped (later abolished).
- Without regulatory systems, privately-provided nonconvertible fiat money often was oversupplied in history (examples: French private bank nonconvertible notes with legal tender status; late-19th century Japan private notes leading to inflation when convertibility to gold was suspended).
- Public systems also experienced excess inflation: medieval seignorage (debasement), macro policy mismanagement in emerging/developing economies, and high inflation in major advanced economies in the 1970s after the end of Bretton Woods.
- Discussions followed on returning to rules-based frameworks (including the gold standard) to tie central banks’ hands (Friedman and Schwartz, 1986).

Box Table: The Origins of Central Bank Powers (selected structure as presented)
- Country / Date founded / Monopoly over note issue / Notes made legal tender / State ownership
  - France: 1800 / 1848 / 1878 / 1945
  - Germany: 1875 / 1875 / 1909 / 1948
  - Japan: 1882 / 1884 / 1885 / NA
  - Italy: 1893 / 1893 / 1893 / NA
  - United Kingdom (England): 1694 / 1844 / 1833 / 1946
  - United States: 1913 / 1913 / 1933 / NA
  - Canada: 1934 / 1935 / 1935 / 1938
- Source cited: Redish (1993).

- Historical emergence of central banks often linked to need for a creditworthy LOLR and to manage bank runs (Goodhart, 1988; Redish, 1993; Gorton and Huang, 2006).
  - Example: 1907 U.S. crisis—J.P. Morgan’s private intervention contributed to establishment of the Federal Reserve Board in 1913.
  - Bank of England: began as a private bank and evolved to legal tender status and monopoly issuance as credibility to provide liquidity grew.
- The global financial crisis reinforced the need for a credible LOLR.

### Comparison of Virtual Currencies (VCs) with existing and historical currencies (high-level findings informed by Table 1)
- Bitcoin used as a representative VC; compared to a home currency (USD), a foreign currency (Euro), commodity bullion, commodity currency (coin), gold standard, and U.S. Greenback Era (1861–78).
- Economic demand factors and functions:
  - Intrinsic value: Bitcoin — None; USD — None; Euro — None; Commodity (bullion) — Yes; Commodity currency (coin) — Yes; Gold standard — None; U.S. Greenback Era — None.
  - Claim to issuers: Bitcoin — No; USD — Yes; Euro — Yes; Commodity (bullion) — No; Commodity currency (coin) — No; Gold standard — Yes; U.S. Greenback Era — Yes.
  - Legal tender: Bitcoin — No; USD — Yes; Euro — No (in the U.S.); Commodity/coin — na/mixed; Gold standard — Yes (no) to public note (private).
  - Used as medium of exchange: Bitcoin — Small, but rising especially in online retail; USD — Yes; Euro — Limited (in the U.S.) possibly more for cross-border trade; Commodity/coin/gold/greenbacks — Yes.
  - Used as unit of account: Bitcoin — No; USD — Yes; Euro — No (in the U.S.); Commodity/coin/gold/greenbacks — Yes (all notes shared “dollar” unit for Greenback Era).
  - Used as store of value: Bitcoin — Yes, subject to very high exchange rate risk and sudden confidence shock; USD — Yes, subject to inflation risk; Euro — Yes, subject to foreign exchange risk; Commodity/coin/gold/greenbacks — various risks (commodity price risk/cycle; dilution of coin quality; devaluation risk; inflation risk).
- Supply structures and rules:
  - Bitcoin: decentralized supply; private supply source; supply quantity — Inflexible; supply rule — Computer program; supply rule change possible? — Yes with agreement of majority miners; cost of production — High (electricity consumption for computation).
  - USD and Euro: monopoly supply; public supply source (USD home currency), foreign public (Euro as foreign); supply quantity — Flexible; supply rule — Rule-based (inflation target); supply rule change possible — Yes; cost of production — Low.
  - Commodity bullion and coins: decentralized or mixed supply sources (mining); supply quantity — Inflexible; cost of production — Very high (mining) for bullion; Medium for coins.
  - Gold standard and U.S. Greenback Era: mixed characteristics; supply quantity — Flexible for Greenback Era; reserve-based rules historically.
- Macro-financial stability risks:
  - Risk of hyperinflation due to over-supply?
    - Bitcoin: No for individual VCs.
    - USD (home): Possible (with policy mismanagement).
    - Euro (foreign): ... (ellipsis appears in source).
    - Commodity (bullion): Limited.
    - Commodity currency (coin): Possible (by diluting coin quality).
    - Gold standard: Possible (by ending convertibility).
    - U.S. Greenback Era: Possible (if losing credibility to resume convertibility).
  - Risk of long-term hyperdeflation:
    - Bitcoin: High.
    - USD (home): Low.
    - Euro (foreign): ... (ellipsis).
    - Commodity/coin/gold: High or Low depending on regime; U.S. Greenback Era — Low.
  - Base money quantity changes to temporary shocks?
    - Bitcoin: No (limited even with rule changes).
    - USD: Yes.
    - Euro: No (to US money demand shocks).
    - Commodity/coin/gold: No/No/Somewhat (by changing reserve ratio subject to total holding of gold).
    - U.S. Greenback Era: Yes.
  - Can the issuer be lender of last resort with outside money?
    - Bitcoin: No.
    - USD: Yes.
    - Euro: Yes.
    - Commodity/coin: No.
    - Gold standard: No.
    - U.S. Greenback Era: Yes to some extent for credible issuer; Yes for public, harder for private (due to reserve requirement).

### Legal perspectives (key findings)
- VCs fall short of the legal concept of currency or money.
- Legal concept of currency:
  - Associated with sovereign power to establish central issuance of banknotes and coins.
  - Currency refers to the unit of account and the medium of exchange denominated by reference to that unit of account, prescribed by law.
  - In the strict sense, currency refers to banknotes and coins issued by a central authority with exclusive right to do so.
  - Currencies are given legal tender status under the state’s legal framework, generally entitling the debtor to discharge monetary obligations via mandatory acceptance within the jurisdiction.
  - Value and credibility of sovereign currency are linked to the state's ability to support that currency.
- Legal concept of money:
  - Broader than currency; includes banknotes, coins, and assets/instruments readily convertible into such banknotes and coins (for example, demand deposits).
  - Money can be created by private parties (e.g., banks) as well as central banks, but must generally be denominated in a sovereign-issued currency and intended as a generally accepted medium of exchange within that state (Procter 2012).
- Legal tender definition varies by jurisdiction (examples noted for euro area recommendation in 2010 specifying three elements for legal tender).

### Economic perspectives: how VCs currently measure up to money’s functions
- VCs do not completely fulfill the three economic roles associated with money:
  - Store of value:
    - High price volatility of VCs limits their ability to serve as a reliable store of value.
    - VCs are not liabilities of a state and most are not liabilities of private entities.
    - Prices have been highly unstable with volatility typically much higher than national currency pairs; prices and volatility appear unrelated to economic or financial factors, making them hard to hedge or forecast (Yermack, 2013).
  - Medium of exchange:
    - Small size and limited acceptance network restrict use as a medium of exchange.
    - Without legal tender status, a VC is accepted only by mutual agreement between parties.
    - Current total market value of VCs is about US$7 billion.
    - By contrast: U.S. currency in circulation is US$1.4 trillion; U.S. money supply (M2) is about US$12 trillion.
    - Bitcoin accounts for about 90 percent of decentralized VC market value (source cited: coinmarketcap.com, January 11, 2016) and had a small daily transaction volume of about US$70 million in 2015 (source cited: blockchain.info).
    - Given high exchange rate risk, most retailers immediately convert Bitcoin payments into fiat currencies.
  - Unit of account:
    - Little evidence VCs are used as an independent unit of account; they typically represent value in fiat currency via the VC exchange rate.
    - Retailers quote prices in fiat currency; price in VC based on exchange rate at a point in time.

### Distributed ledgers: payment clearing and settlement context (introductory note)
- Exchange requires accounting; modern payment systems are generally centralized.
- Typical structure:
  - Central bank clears and settles payment requests from member financial institutions by moving money from one account on its central ledger to another.
  - Member financial institutions adjust positions of their individual members/account holders on their own internal ledgers.
  - Central bank validates transactions in its central ledger to safeguard against double-spending or counterfeiting.
  - System stability depends on trust in the central bank as an honest broker and its ability to safeguard the central ledger from tampering or failure.

*Source: _sdn1603, “Virtual Currencies and Beyond,” International Monetary Fund.*

### 22.      Computing technology has made possible decentralized settlement systems built on

### 22.      Computing technology has made possible decentralized settlement systems built on distributed ledgers distributed across individual nodes in the payment system.

### Distributed ledger systems: concept and mechanics
- Distributed ledger systems maintain multiple copies of the central ledger across a financial system network rather than a single master ledger kept by a trusted central counter-party.
- Validation of the network’s distributed ledgers—and hence individual transactions—is achieved using technologies derived from computing and cryptography, most often derived from the so-called blockchain technology.
- Consensus across members of the network is used to establish the validity of the ledger.
- In decentralized VCs, the distributed ledger provides a complete history of transactions associated with particular units of a decentralized VC, offering a secure permanent record that cannot be manipulated by a single entity and does not require a central registry.
- Example mechanics (illustrative, Bitcoin-like blockchain):
  - Copies of transaction records (ledgers) are kept in multiple computers in the network and visible to anyone.
  - Transactions are settled by a multitude of individual nodes (miners), providing computing resources to the network.
  - Miners solve a cryptographic puzzle as part of validation and must show proof of doing this work to the network (called a “proof-of-work” system), which is costly (computing and energy resources).
  - Only the miner who finds the solution faster than any others receives newly minted Bitcoins as reward.
  - Trust is created by making tampering attempts prohibitively expensive; a tampering miner would need to compete against other miners.
  - This mechanism could break down, for example, if a person or group takes up 51 percent of the network (mining share), called a “51 percent attack.”

### Design approaches to distributed ledgers (Box 2)
- Fully public systems:
  - Decentralized ledgers open to all Internet users.
  - Anyone can read, submit transactions, and participate in verification and validation.
  - Secured by economic incentives and cryptographic verification (e.g., proof of work or proof of stake).
  - Participants typically pseudonymous; issuance of an embedded currency provides incentives.
  - Examples include, Bitcoin, Ethereum, and other cryptocurrencies.
- Fully private systems:
  - Permissions assigned by a central entity.
  - Applications include database management and auditing internal to a single company.
  - Do not need an embedded currency because the central entity can assign computers to verify transactions.
- Hybrid or consortium systems:
  - Consensus validation controlled by pre-selected individuals or organizations (for example, a consortium of financial institutions).
  - Right to read the blockchain may be public or restricted.
  - Considered partially decentralized; identity of users can be required to conform to know your business (“KYB”) or know your customer (“KYC”) procedures.
  - Whether an embedded currency is needed depends on the degree of trust and decentralization.

### Emerging uses and potential benefits
- Distributed ledger technology is emerging across mainstream finance, including money transfer startups, consortium efforts among global banks, and blockchain-based security exchange platforms.
- Potential applications beyond VCs include land and credit registries, and payment and settlement infrastructure for transactions in existing currencies, securities, and other assets; distributed ledgers can be designed for transactions denominated in fiat currencies.
- Remittances:
  - As of 2015, the global average cost of sending small remittances (for example US$200) is 7.7 percent, down from just below 10 percent in 2008.
  - The cost with Bitcoin is estimated to be about 1 percent (Goldman Sachs, 2014).
  - Blockchain-based remittance systems have emerged in some economies (examples cited include the Philippines and Kenya).
- Securities settlement and back-office:
  - Current settlement times: up to three days since trade date (T+3) for most securities; many foreign exchange settlements continue to require two days (T+2); U.S. Treasury bonds require at least one day (T+1).
  - Distributed ledger technology could shorten settlement times and reduce settlement and counterparty risks.
  - Examples of industry activity: Goldman Sachs applied for a patent on a blockchain-based settlement system (SETLCoin) in late 2015; NASDAQ and a blockchain startup launched Linq for privately-held companies to facilitate issuance and transfer records.
  - Blockchain-issued bonds and equities have been launched by some firms with regulatory approval.
- Broader industry effects:
  - Distributed ledger modalities, together with other financial technology developments, could cause structural shifts in the financial industry.
  - Growth of blockchain-based financial services by non-bank startups and exploration by e-commerce firms coexist with large global bank investments.
  - Historical precedent: large technological changes have led to adjustments in market shares and increased emphasis on technology skills within traditional financial intermediaries.

### Smart contracts (Box 3)
- Definition and functionality:
  - First defined as “a computerized protocol that executes the terms of a contract” (Szabo, 1994).
  - A smart contract encodes the terms of a traditional contract into a computer program and executes them automatically; with blockchain they can in principle be self-executing and self-enforcing without intermediaries.
  - Can encapsulate complex terms and conditions, including contingencies on external events such as prices or volatility.
- Potential benefits:
  - Increased speed, efficiency, and trust in contract execution.
  - Could overcome moral hazard problems (for example, strategic default) and reduce verification and enforcement costs.
- Risks and unresolved issues:
  - Legal status is unclear and could raise serious consumer protection issues.
  - Widespread use could increase risks to financial stability by automatically propagating adverse events through the financial system, with self-reinforcing feedback loops (similar to automated high-speed trading risks).
  - Complexity may make it hard for consumers to understand what they agree to; regulators and courts may struggle to keep pace.
  - Technical difficulties remain, including reliably observing and integrating external events; “No viable smart contract systems have yet emerged.”
  - Platforms seeking application include Ethereum and Codius.

### Regulatory and policy challenges
- General context:
  - VCs emerged in the absence of effective regulation, contributing to benefits like low fees and processing time but leaving risks unaddressed.
  - Risks span a continuum: immediate concerns about financial integrity (AML/CFT), consumer protection, tax evasion, and capital movement regulation; less immediate but important concerns about financial stability and implications for monetary policy.
  - Blockchain technology used in closed systems administered by regulated financial institutions raises fewer policy concerns a priori.
- Specific regulatory challenges:
  - Definitional challenge:
    - VCs combine properties of currencies, commodities, and payments systems; classification affects legal and regulatory treatment and which national agencies should regulate them.
    - Different competent authorities may classify VCs differently (example: IRS classified VCs as “property” for federal taxation; FinCEN classified VCs as “value” for AML/CFT obligations).
    - Some jurisdictions avoid formal classification and focus on the nature or type of transaction.
    - Disparity of treatment within and among jurisdictions may hamper coordination and lead to inconsistencies.
  - Monitoring difficulties:
    - The opaque nature of many VC schemes makes it difficult to gather information, including statistical data, or to monitor their operation.
  - Transnational reach:
    - Cross-border reach complicates asserting jurisdiction over VC transactions, market participants, or schemes and makes enforcement challenging in a virtual environment.
  - Cryptocurrencies and decentralization:
    - Decentralized cryptocurrencies eliminate central intermediaries who would normally be focal points of regulation.
    - Raises the question of whom to regulate—the individual VC users or other parties within the system.

*Source: Excerpt from IMF chapter on distributed ledgers and virtual currencies.*

### 33.      Different regulatory responses have emerged to address the risks posed by this new

### 33.      Different regulatory responses have emerged to address the risks posed by this new

### Regulatory responses and objectives
- Policymakers face a balance between addressing risks and vulnerabilities posed by VCs while not stifling innovation.
- Responses have varied greatly among jurisdictions (see Annex).
- Some countries have decided to ban the use of VCs.31
- Other countries have addressed immediate risks (financial integrity, tax evasion, consumer protection) by:
  - amending or clarifying interpretations of existing laws and regulations,32
  - issuing consumer warnings.
- A number of jurisdictions have yet to adopt a formal position on VCs.

### Who to regulate: gatekeepers and regulated entities
- National authorities have mostly targeted VC market participants and financial institutions that interact with them.
- Issuance and transfer of VCs between users are less likely to pass through an intermediary, but interfaces between VCs and the broader economy—payments for goods and services and exchanges with fiat currency—often go through a VC exchange or other VC service provider.33
- Recognizing that VC users will have to “cash out” at some point, regulators have targeted “gatekeepers.”
  - Two practical approaches:
    - (i) Regulating VC market participants that provide an interface with the broader economy (for example, VC exchanges).
    - (ii) Restricting the ability of regulated entities (for example, banks) to interact with VCs and VC market participants.34

### Effectiveness, market evolution, and regulatory scope
- The effectiveness of emerging regulatory initiatives will depend on how the VC market evolves.
- Regulating VC “gatekeepers” aligns with current market characteristics, but:
  - If use becomes more peer-to-peer, regulating gatekeepers may not be sufficient.
  - Some regulators are regulating a broader range of VC market participants (for example, VC wallet service providers) that operate entirely within the system.
- Regulation must be flexible and adaptable to evolving circumstances.

### International regulatory cooperation and standards
- International efforts have focused on achieving consensus on benefits and risks of VCs and identifying areas for future cooperation.
- International bodies providing forums, reports, guidance, and manuals include:
  - Financial Action Task Force (FATF)—AML/CFT standard-setter,
  - United Nations Office on Drugs and Crime (UNODC),
  - Committee on Payments and Market Infrastructures (CPMI),
  - OECD, European Banking Authority (EBA), Commonwealth Secretariat.
- More could be done internationally to facilitate appropriate policy responses:
  - Developing international standards and best practices could provide guidance on regulatory responses in different fields and promote harmonization across jurisdictions.35
  - Standards could set frameworks for cooperation on sharing information and investigation and prosecution of cross-border offenses.

### Financial Integrity: AML/CFT (Sections 39–44)
- Key vulnerabilities:
  - Anonymity and cross-border reach of VCs raise concerns for money laundering (ML), terrorist financing (TF), and evasion of sanctions.36
  - Traceability is limited due to user anonymity37 and anonymizing service providers.
  - Vulnerabilities have been exploited in practice (e.g., Bitcoin used in “Silk Road”).
- Preventive AML/CFT measures that can help:
  - Customer due diligence (CDD),
  - Transaction monitoring,
  - Record keeping,
  - Obligations to report suspicious transactions.
- Two-fold challenge in applying AML/CFT to VCs:
  - (i) Whether VC operations (exchanges of VCs for fiat, transactions in VCs) should fall within AML/CFT regimes.
  - (ii) If so, who should bear these obligations.
- FATF guidance and stance:
  - FATF determined most significant ML/TF risks are concentrated at intersections between VCs and the regulated fiat currency financial system.38
  - FATF called for regulation of VC exchanges and other network participants that operate as “gatekeepers” with the regulated fiat system (including central authority within a centralized system if it performs currency exchange functions).
  - As “covered entities,” these would be required to implement preventive measures and report suspicious transactions.
  - FATF has not advocated regulating parties that use VCs as a means of exchange to purchase goods or services.
- Potential need to extend regulation:
  - If VCs become so widespread that participants need not “cash out,” it may be necessary to extend regulation to other VC network participants (wallet service providers, payment processors) that operate entirely within the system.
  - FATF standard would effectively require jurisdictions to consider additional mitigating measures if ML/TF risks cannot be contained by imposing AML/CFT controls on “gatekeepers” alone.
- Enforcement challenges:
  - Enforcement will remain challenging, especially in decentralized VC schemes where law enforcement may lack a counterparty for investigative actions and to implement freezing and seizing orders on funds held in VCs.39
- Jurisdictional approaches:
  - Consistent with FATF, some jurisdictions (for example, U.S., Germany, U.K., Canada) clarified applicability of AML/CFT obligations to certain virtual currency businesses—finding VC administrators and exchanges fall within covered entities, while users usually do not.
  - Other jurisdictions (for example, Italy) issued advisories or warnings to financial sectors on ML/TF risks posed by VC businesses as customers.
  - Some (for example, China) barred interaction between VC businesses and the formal financial sector.

### Consumer protection (Sections 45–46)
- Regulatory uncertainty and lack of transparency create significant consumer protection vulnerabilities:
  - Risks related to VC systems:
    - Disruptions to VC systems can result in losses for holders; disruptions can be market-related or technology-related (e.g., a disruption in the VC protocol could paralyze the system).
  - Risks related to VC intermediaries and service providers:40
    - VC exchange platforms, VC wallet providers, payment processors, brokers—many are largely unregulated, leaving customers vulnerable.
  - Risks related to scams:
    - Opaque industry, lack of regulatory safeguards, complexity of technology make VC holders vulnerable to scams (stealing VCs via hacking, fraud, misrepresentations; fraudulent investment schemes/Ponzi schemes).
    - Notable examples: VC exchanges and digital wallet providers have been hacked, resulting in thefts of Bitcoins held for users.41
  - Risks related to irreversibility of transactions:
    - Errors cannot be reversed; users cannot reclaim payment for erroneous transactions given decentralized VCs lack a central intermediary and clarity regarding the counterpart.42
    - Decentralized schemes place transaction failure risks on users, unlike centralized payment systems where a central authority would assume the risk.
- Policy responses:
  - Increasing awareness of users and investors about these risks.
  - Clarifying scope of relevant legislation.
  - Most countries have issued statements highlighting consumer risks.43
  - Jurisdictions are clarifying how existing consumer protection legislation (including securities legislation) applies to VCs or amending legislation where appropriate.
  - National authorities have taken enforcement actions against VC businesses violating relevant legislation.44

### Taxation (Sections 47–50)
- VCs have high potential for tax evasion, particularly cryptocurrencies where participants need not disclose identity and transactions are peer-to-peer and cross-border.
- Key tax issues:
  - Whether VCs should be treated as (non-monetary) property or as a form of currency.45
    - If treated as property, use of VC to purchase goods or services or for investment would result in recognition of gains or losses—the character depending on jurisdictional rules (capital asset definitions, holding periods, classification as speculation).
    - If treated as currency, most jurisdictions would require recognition of foreign exchange gains or losses.
  - Tax treatment of newly-created VCs obtained through mining (as opposed to acquiring existing VCs).
  - VAT and sales tax treatment of transactions involving VCs; country practices have varied significantly.46
- Need for further action:
  - Further analysis and discussions are required, including legal and regulatory changes where needed.
  - Greater international consistency should be promoted.

*Source: IMF — Virtual Currencies and Beyond (excerpt).*

### 51.      Tax record keeping requirements for VCs will be substantial and may reduce the

### _sdn1603 - 51.      Tax record keeping requirements for VCs will be substantial and may reduce the

### Tax record keeping and fiscal reporting
- Tax record keeping requirements for VCs will be substantial and may reduce the attractiveness of VCs in everyday use.
- In many jurisdictions, such as the U.S., it will be necessary to calculate and report gains and losses on each use or disposition of Bitcoins.
- Use of a Bitcoin “agency” can facilitate this record keeping (at a price), but the taxpayer would still be responsible for accuracy.
- Multiple exchanges (for example for Bitcoin) with different prices further complicate record keeping.
- U.S. IRS guidance so far prescribes only that the conversion to dollar-value must be “made in a reasonable manner consistently applied.”
- In the U.S., backup withholding will be applicable to payments made in Bitcoin, with payments in excess of $600 to a non-exempt person to be reported to both the IRS and the receiving person.
- Note from source footnote: the use of Bitcoins would result in the application of two GSTs—one on the goods and services supplied in exchange, and one on the use of the Bitcoins themselves. In the U.S., New York has declared that transactions using Bitcoins will be treated as a barter transaction subject to sales tax.

### E. Exchange Controls and Capital Flow Management
- VCs may be used to circumvent exchange and capital controls by effectively conducting cross-border transfers of fiat currency while bypassing traditional payment systems.
- The applicability of national exchange control regimes to VCs is often unclear, making VC schemes an avenue for evasion of capital controls, especially when schemes combine speed, low transaction costs, and anonymity.
- The ease of acquiring VCs on the internet makes them attractive where costs and regulatory burdens of traditional payment systems are high.
- Reports exist of VC schemes being used to circumvent exchange and capital controls in China, Venezuela, Cyprus, and Greece.
- Market participants can purchase VCs on the Internet and use them to conduct Internet-based foreign exchange transactions or make capital transfers that would otherwise be prohibited.
- Conversion of VCs can be done via peer-to-peer exchange floors or through marketplaces matching sellers and buyers through complimentary purchases.

### F. Financial Stability
Findings on current risks and scale
- As of now, VCs do not pose systemic risks to financial stability, owing to their small scale and limited linkages to the financial system.
- VCs have relatively limited market values and transaction volumes, marginal compared to major credit card payments platforms, and do not yet amount to a systemically important payment network.
- Regulated financial institutions generally do not engage in VC-related activities, and VC-denominated derivatives are still at the trial stage.

Risks to individual holders and infrastructure
- VCs may pose non-negligible financial risks to individual VC holders and users.
- VC market infrastructures have suffered disruptions with some frequency, most notably the bankruptcy of the main Bitcoin exchange platform (Mt. Gox).
- No contagion to the wider financial system has thus far been observed.
- VC holders seem to engage in speculative hoarding, with potential for runs triggered by loss of confidence in the VC or a third-party service provider (for example, a VC exchange).
- Runs are likely to be exacerbated by the absence of a LOLR function.
- VCs and related IT systems are vulnerable to security breaches.
- VC users face payment system-like risks such as operational risk, credit risk, liquidity risk, and legal risk.
- Credit and liquidity risks may occur for user funds held with third-party institutions that provide support for the use of VCs (for example, VC wallet service providers or exchange platforms) if there are no guarantees that these institutions can meet obligations or provide liquidity when needed.
- Operational risk could occur if there is no sound operational procedure or business continuity plan.
- Legal risk arises from legal uncertainty regarding VCs.

Potential systemic threats if scale increases
- Large-scale use of VCs and greater interconnectedness with other parts of the financial sector could in due course give rise to systemic financial risks.
- One significant source of risks may be the erosion of bank revenue from payments services.
- Widespread use of distributed ledger technology (for example, the blockchain) could have consequences for a wide range of markets and financial market infrastructures, including stock exchanges, central securities depositories, securities settlement systems, or trade repositories.
- Cryptographic risks: like most systems relying on cryptography, VCs and blockchains are vulnerable to cryptographic risks (for example, advances in technology such as quantum computers or new algorithms).
- Most potential channels of transmission are at this stage not clearly understood and somewhat hypothetical; regulators and supervisors should closely analyze and monitor developments.

Tail-risk and resolution challenges
- Under a tail-risk scenario, some VC schemes or blockchains could become too big or too interconnected to fail and could be difficult to resolve.
- Difficulty would arise from the use of strong encryption, decentralized governance, and the cross-jurisdictional nature of VC networks.
- Monitoring rising systemic risks would be challenging given anonymity of exposures and lack of a governing regulatory framework.

Regulatory responses to date
- Regulatory responses to financial stability concerns are at early stages.
- Countries have generally limited financial institutions’ exposures to VCs by prohibiting them from engaging in VC businesses.
- Some U.S. states have introduced prudential regulatory frameworks for entities conducting "VC businesses” based on money transmitter rules.
- Example actions cited: New York Department of Financial Services licensing and Connecticut amendments requiring licenses for businesses engaged in transmission of VCs; Conference of State Bank Supervisors developed a model regulatory framework.

Policy questions for authorities
- National-level questions include:
  - Whether some VC intermediaries replicate the functions of a bank and should be regulated like a bank.
  - Whether VCs in VC-wallets should be considered as deposits protected by deposit insurance schemes.
- International-level question:
  - Given the cross-border nature of VC networks, who should oversee VC markets and FMIs using blockchain technology in payment, settlement, and other activities?
- International cooperation and agreed regulatory principles would be beneficial, but the appropriate framework remains to be defined.

### G. Monetary Policy
Current implications and concerns
- VCs do not currently have significant implications for monetary policy, but would raise concerns if they become more widely used.
- VCs with rigid supply rules—the characteristics of many existing cryptocurrencies including Bitcoin—in principle have limited inflationary risk unlike many privately provided monies of the past.
- Current VC systems lack critical features that stable monetary regimes typically provide, including:
  - Guarding against structural “deflation”;
  - Flexibility to respond to temporary shocks to money demand and smooth the business cycle;
  - Capacity to function as a LOLR.

Deflationary risks
- Nearly fixed supply of VCs—particularly many cryptocurrencies—could result in structural deflation in the same way as the gold standard.
- Money demand typically grows with the economy; a nearly fixed money supply with growing money demand leads to structural deflation.
- Modern monetary regimes with flexible money supply have an advantage over VCs in this regard.
- In principle, VCs could be designed to allow expansion in money supply (for example, in line with transaction volumes) to overcome deflationary bias.

Monetary policy effectiveness and LOLR function
- In an economy with high share of VCs, the ability of monetary policy to manage the business cycle could be diminished, similar to challenges faced by heavily dollarized countries.
- The current generation of VCs does not allow expansion of money supply in response to negative demand shocks, which would tend to exacerbate recessions and could lead to deflationary spirals (historical parallel: Great Depression under the gold standard).
- VCs will also not easily replace the LOLR function of central banks; decentralized VC schemes are unlikely to generate the liquidity response needed during a financial crisis.
- Experience and economic theory suggest a public agency is needed to solve externalities and coordination failures in crisis contexts.

Adoption patterns and confidence
- Absent regulatory measures and other interventions, VCs will likely be more widely adopted in countries with less credible monetary policy.
- Network externalities create a tendency toward one dominant currency (the fiat currency) and confer incumbency advantages that VCs could not easily overcome.
- VC appeal may be greater where confidence in monetary policy is low; however, VC value volatility is so high that dollarization may be a more attractive option in such settings.

### The Way Forward (conclusions and principles)
Broad conclusions (section 65)
- VCs are rapidly evolving and the future landscape is difficult to predict.
- VCs offer potential benefits, including rapidly increasing speed and efficiency in making payments and transfers, and deepening financial inclusion; distributed ledger technology offers benefits beyond VCs.
- VCs pose many risks and threats to financial integrity, consumer protection, tax evasion, exchange control enforcement, and effective financial regulation.
- While risks to monetary policy seem unlikely at this stage given VC’s very small scale, risks to financial stability may eventually emerge as new technologies spread.
- Development of effective regulatory responses is at an early stage; progress exists in areas such as AML/CFT, but much work remains to put in place effective frameworks that guard against risks while not stifling innovation.

Guiding principles for national authorities (section 66)
- Regulatory responses should be commensurate to the risks without stifling innovation; outright bans may be unduly blunt while targeted approaches (for example, regulating VC intermediaries) may be preferred.
- Regulatory responses should adapt to changes in the VC landscape; regulators should remain flexible.
- Regulators should design approaches that take into account novel VC business models. In the absence of a central authority in some cryptocurrency schemes, focus may need to shift to other VC market participants (for example, gatekeepers such as VC exchanges and VC wallet providers).
- Regulation may need to address market conduct issues (for example, AML/CFT, fraud) and financial soundness of VC intermediaries; failure of an intermediary can affect consumer protection and payments system stability and may warrant prudential requirements.
- Regulators should consider the degree of integration between the conventional financial system and the VC market and whether to:
  - Prohibit any interaction between financial institutions and the VC market;
  - Allow a certain degree of integration; or
  - Allow full integration.

International actions recommended (section 67)
- International bodies have a role in strengthening understanding of VCs; several international bodies have already issued reports and served as fora for discussion (for example, FATF, CPMI, European Commission, ECB, World Bank).
- More international work is needed to study VC evolution and potential effects on traditional banking and payments systems, to understand risks, and to identify effective regulatory responses taking into account country circumstances.

*International Monetary Fund — extract from the chapter sections 51–67 of the IMF staff paper contained in the supplied content.*

### 68.      In the longer term and as experience is gained, consideration could be given to

### _sdn1603 - 68.      In the longer term and as experience is gained, consideration could be given to

### Standards and international cooperation
- Some international standard-setting bodies have begun providing guidance on the applicability of existing standards to VC schemes; FATF has issued guidance to member jurisdictions on the manner in which national AML/CFT frameworks should be applied to VC schemes under the FATF standard.
- Consideration could be given to exploring similar initiatives at other international standard-setting bodies.
- Beyond clarifying the applicability of existing standards, the development of new principles tailored to the specific features of VC schemes may eventually become necessary.
- Establishing international standards that take into account the specific features of VC schemes may:
  - promote harmonization in regulation across jurisdictions, and
  - facilitate cooperation and coordination across countries over issues such as the sharing of information and the investigation and prosecution of cross-border offenses.

### Ongoing monitoring, analysis, and research priorities
- An important ongoing process will involve monitoring and analyzing how VCs are evolving and the policy challenges they pose.
- Further work is necessary in particular on the following areas:
  - How VC schemes and their underlying distributed ledger technologies will change existing business models in the financial sector, and what types of risk may arise from these developments.
  - Whether the application of distributed ledger technologies in the mainstream financial system will evolve in a manner that gives rise to new specific risks that require a regulatory response.
  - What potential implications VC schemes may have for the IMF now and in the future.

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### Annex—Policy responses by selected countries (overview)
- Jurisdictions have taken different approaches towards mitigating the potential risks of VCs and regulating VC-related activities.
- The Annex presents a matrix of responses by selected jurisdictions illustrating divergence in approaches across policy areas including:
  - AML/CFT: warning and regulating (existing and new)
  - Tax Treatment
  - Consumer Warnings and Advisories
  - Licensing/Registration of VC Intermediaries
  - Financial Sector Warnings, and Bans
  - Bans on the Issuance/Use
- Examples from the Annex include:
  - Argentina: Warning on the ML/TF risks; Consumer Warning; Warning on reporting entities.
  - Bolivia: Yes (Ban).
  - Canada: Amending existing regulations; Clarified tax treatment; Consumer Advisory.
  - China: Ban.
  - France: Application of existing regulations; Clarified tax treatment; Consumer Warning.
  - Germany: Application of existing regulations.
  - Italy: Consumer Warning; Warning.
  - Japan: Plan to introduce new regulations; Consumer Warning; Plan to introduce new regulations.
  - Russia: Application of existing regulations; Consumer Warning; Yes–draft law (on bans).
  - Singapore: Plan to introduce new regulations; Clarified tax treatment; Consumer warning.
  - South Africa: Consumer Warning.
  - U.K.: Application of existing regulations; Clarified tax treatment.
  - U.S.: Application of existing regulations (Federal); Clarified tax treatment (Federal); Consumer Warning; State licensing regimes (for example, NY BitLicense).
- Footnote: The information gathered in the Annex includes readily available information from public sources and does not necessarily reflect all actions taken by any given jurisdiction.

*Source: Excerpt from VIRTUAL CURRENCIES AND BEYOND, INTERNATIONAL MONETARY FUND.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/sdn/2016/_sdn1603.pdf_