IMF describes ‘Virtual Currency schemes,’ including Bitcoin, to the World Economic Forum

Christine Lagarde recently presented “Virtual Currencies and Beyond: Initial Considerations,” at the World Economic Forum in Davos, Switzerland. The invitation-only annual meeting brings together chief executive officers from its 1,000 member companies, as well as selected politicians, representatives from academia, NGOs, religious leaders, and the media.

Lagarde, whose five-year term as IMF Managing Director expires in July, presented the staff paper during the panel “Transformation of Finance.” The document provides an overview of virtual currencies, how they work and how they fit into monetary systems, both domestically and internationally.

“Virtual currencies and their underlying technologies can provide faster and cheaper financial services, and can become a powerful tool for deepening financial inclusion in the developing world.”

• Christine Lagarde, IMF Managing Director

The IMF oversees the international monetary system, and monitors the economic and financial policies of its 188 member countries. As part of this process, the IMF highlights possible risks to stability and advises on needed policy adjustments. In stark contrast to a report by the UK Government Chief Scientific Adviser, released the day before, the IMF has focused on regulatory and policy challenges.

The document is a first attempt by IMF staff to describe the principal features of VC schemes and their implications for regulation and policy. The concept of Virtual Currencies (VCs) is broadly defined to include; simple IOUs from issuers, such as Internet or mobile coupons and airline miles; VCs backed by the combination of existing tangible assets, such as gold, or national currencies and the creditworthiness of the issuer; and, “cryptocurrencies such as Bitcoin.”

The three broad groups posses some key attributes, states the paper, “digital representations of value, issued by private developers and denominated in their own unit of account.” But, with the fast evolving nature of the industry, there is a qualifier, “a universal definition has yet to emerge and could quickly change as the VC ecosystem continues to transform.”

There is also a distinction made between VCs and digital currencies, such as e-money, which are now defined as digital payment mechanisms for fiat currency. VCs, on the other hand, are not denominated in fiat currency and have their own unit of account.

While the report states that there is no generally accepted legal definition of currency or money, VCs also fall outside of the “legal concept” of currency or money, which is “associated with the power of the sovereign to establish a legal framework providing for central issuance of banknotes and coins.” The legal concept of money is also, “based on the power of the state to regulate the monetary system.”

Nearly the entire second half of the report, 33 chapters, focus on regulation and policy challenges: “VCs are a relatively novel phenomenon and have emerged in the absence of effective regulation. This has contributed to their potential benefits, such as low transaction fees and processing time, but has left unaddressed the risks that VCs pose.”

Somewhat ironically, the first issue raised in this section is “a definitional challenge to regulators.” As VCs combine properties of currencies, commodities, and payments systems, “their classification as one or the other will often have implications for their legal and regulatory treatment.”

“VCs are difficult to regulate as they cut across the responsibilities of different agencies at the national level, and operate on a global scale. Many are opaque and operate outside of the conventional financial system, making it difficult to monitor their operations.”

• Virtual Currencies And Beyond

Cryptocurrencies are outlined as posing particularly difficult challenges, as their decentralized nature does not fit easily within traditional regulatory models. “The question then becomes who to regulate – for example, the individual VC users or other parties within the system.”

Decentralized VC schemes present further problems when law enforcement is involved. They may not have a counterparty, or central authority, for investigative purposes, “it is difficult to envisage how regulators could take enforcement actions, including the freezing of assets and the seizure and confiscation of illicit assets.”

National authorities, states the report, have mostly targeted VC market participants and financial institutions that interact with them, “it is generally accepted that VC users will have to ‘cash out’ at some point— that is, convert their VCs into fiat currency. Recognizing these features of the current market, regulators have targeted ‘gatekeepers’.”

“If the use of VCs becomes so widespread that there is no longer a need for participants to ‘cash out’ (that is, convert the VC into fiat currency), it may be necessary to extend regulation to other VC network participants such as wallet service providers and payment processors that operate entirely within the system.”

• Virtual Currencies And Beyond

Aside from VCs, the report provides some in depth information on distributed ledgers. While modern payment systems are generally centralized, computing technology has enabled decentralized settlement systems, built on distributed ledgers distributed across individual nodes in the payment system: “This distributed ledger concept underpins decentralized VCs—for example the blockchain technology behind Bitcoin.”

Distributed ledger technologies have the potential to change finance, by reducing costs and allowing for wider financial inclusion, states the report. They could be applied to any area that requires fast, accurate, and secure record keeping. Some of the examples provided include land and credit registries, payment and settlement infrastructure for transactions in existing currencies, securities, and other assets. “In particular, it is possible to design distributed ledgers for transactions denominated in fiat currencies, instead of in VCs.”

“Virtual currencies’ technologies hold promise of greater financial inclusion and lower remittances costs.”

• Christine Lagarde, IMF Managing Director

One of the emerging uses of this technology is international transfers, “especially remittances.” While the IMF regards the banking industry as well integrated, the costs of sending international remittances are “notoriously high.”

According to the World Bank, remittances to developing countries are expected to rise to an estimated US$453 billion this year. Global flows of remittances are expected to reach US$610 billion, and then rising to US$635 billion in 2017. While remittance costs varied significantly by region and corridor, the World Bank estimates the global average cost of sending $200 to be about 7.7 percent in the second quarter of 2015. Transferring money through banks is the most expensive, costing an average of 11 percent, whereas money transfer operators (MTOs) charge approximately 6.6 percent and post offices 5.1 percent on average.

The report contrasts the 7.7 percent global remittance cost with bitcoin’s “1 percent,” and exemplifies the Philippines and Kenya for already using blockchain-based money transfer services via bitcoin, which is converted back into fiat currency for withdrawal by recipients through either their mobile phones or a bank account.

The IMF also mentions that distributed ledgers can shorten the time required to settle securities transactions, which can take up to three days for most securities, including stocks, corporate bonds, municipal securities, and mutual funds shares. “Not only is this time-consuming, but trading parties also face settlement and counterparty risks.”

“Some firms have launched blockchain-based security exchange platforms. Given that the industry is rapidly evolving, it is hard to gauge the full potential impact of these developments. But progress has already been made in several areas.”

• Virtual Currencies And Beyond

The way forward, according to the document, includes some broad conclusions, “the contours of the future landscape are difficult to predict.” While VCs offer many potential benefits, including rapidly increasing speed and efficiency in making payments and transfers, and deepening financial inclusion, “the distributed ledger technology underlying some VC schemes offers benefits that go well beyond VCs themselves.”

At the same time, the report states that VCs pose many risks and threats to “financial integrity, consumer protection, tax evasion, exchange control enforcement, and effective financial regulation.” While risks to the conduct of monetary policy are deemed unlikely at this stage,  “given VC’s very small scale,” the possible risks to financial stability may eventually emerge as new technologies come into more widespread use.

“A great deal of work remains to be done to put in place effective frameworks to regulate VCs in a manner that guards against the risks while not stifling financial and technological innovation.”

• Virtual Currencies And Beyond