People involved in FinTech live in a world of “what if?”, “how about?” and “why not?”. They gaze into an unknown future filled with unlimited possibilities for a more efficient and inclusive global financial system. But that future may also pose potentially devastating risks that are beyond the control of policy-makers. Nowhere is this dichotomy more clear than in the world of cryptocurrencies. It is therefore important to understand: (i) the principal features of cryptocurrencies; (ii) their potential benefits and risks; and (iii) their implications for regulators.

The International Monetary Fund (IMF) has a great interest in the role of technological change in the financial system, and in the emergence of cryptocurrencies. These issues fall squarely within the IMF’s mandate to promote the stability and effective operation of the international monetary system. IMF staff has a very active program of research and outreach in this area. Last year, we published our first paper on Virtual Currencies and Beyond; Initial Considerations. We recently established a high level advisory group of external experts to advise us in our ongoing work. They were featured in a very well-received panel on FinTech and the Transformation of Financial Services that took place during the IMF/World Bank Spring Meetings this past April in Washington DC.

What are Cryptocurrencies?

Cryptocurrencies are digital representations of value, issued by private developers, and denominated in their own unit of account. Some cryptocurrencies like Bitcoin are convertible into fiat currency but they do not meet the legal definition of a currency. There is no central authority administering a cryptocurrency system, and there is no trusted intermediary like a bank involved in a transaction. Rather, the issuance, holding and transfer of cryptocurrencies are governed by the blockchain and protocols underlying the system. Transactions are conducted on a peer-to-peer basis, and are verified by the system’s participants themselves. Cryptocurrencies are “pseudo-anonymous”: the blockchain will show a complete transaction history and the addresses of the participants in a transaction, but not their actual identities.

Benefits and Risks of Cryptocurrencies

Cryptocurrencies offer many potential benefits for the financial system. They can provide a cheap and quick way to transfer small amounts of currency across national borders. For many developing countries with inefficient and expensive banking systems, this has enormous potential to promote financial inclusion.

But they also pose risks. Some of these are remote – for example, that a cryptocurrency scheme may become such an important part of a country’s financial system that it would complicate the conduct of monetary policy or pose risks to financial stability. But others are more immediate. Cryptocurrencies present opportunities for fraud, tax evasion, and the circumvention of exchange and capital controls. And they may be used to facilitate money laundering (ML) and terrorist financing (TF) by disguising the illicit origin or destination of funds. This is of particular concern to the IMF, given our active involvement in the international community’s efforts to combat money laundering and terrorist financing.

How to Regulate Cryptocurrencies?

In designing a regulatory response to these risks, what should that response be? Developing a response is challenging. Cryptocurrencies combine properties of currencies, commodities, and payments systems and may fall within the jurisdiction of several different regulators in a country. Given their pseudo-anonymous nature, the use of cryptocurrencies is difficult to monitor. And their transnational reach may require close cooperation between regulators across multiple jurisdictions.

In these early days, national regulators have taken many different approaches. A few have banned the use of cryptocurrencies entirely. Some have prohibited their banks from dealing in them. Some have issued consumer warnings. And some have done nothing at all. But regulation has generally focused on particular uses of cryptocurrencies and on the conduct of service providers in the cryptocurrency space. National authorities have used general legislation to address uses of cryptocurrency for illegal purposes (e.g., prosecution for fraud under criminal law). But they have also enacted new rules specific to cryptocurrencies or clarified the applicability of existing rules to include cryptocurrencies.

Regulatory approaches have, in some cases, had to adapt to new business models that exist within the cryptocurrency space. An important example of this approach is in the area of anti-money laundering and combating the financing of terrorism (AML/CFT) where countries have historically required regulated financial institutions like banks and money transmitters to enforce AML/CFT rules by engaging in customer due diligence (CDD) and know your customer (KYC) procedures. The problem with the cryptocurrency world is that these institutions are generally not present. Regulators have, therefore, had to find new types of service providers within the cryptocurrency space to perform these functions. Following guidance from the Financial Action Task Force (FATF), many countries have imposed these KYC/CDD requirements on virtual currency exchanges through which market participants buy or sell cryptocurrencies for fiat currencies.

Jurisdictions are also imposing licensing requirements on these new types of service providers. Most have treated virtual currency exchanges as “money transmitters” subject to the relevant licensing regime. But a few jurisdictions have established separate licensing regimes for virtual currency service providers. New York’s “BitLicense” framework sets out a comprehensive licensing regime for a broad range of virtual currency service providers, including exchanges, wallet services, dealers, and administrators.

Moving forward, what should be the guiding principles for the regulation of cryptocurrencies? Regulation should be proportionate to the risks it is seeking to address: wherever possible, it should not stifle innovation. Regulation should strike an appropriate balance between transparency and privacy – for example, in determining to what degree the authorities should have access to the identities of cryptocurrency users. National authorities will need to decide how much to rely on state-imposed regulation or self-regulation by the industry. And the transnational element will be essential: national regulators will need to cooperate closely with their foreign counterparts, while international bodies, over time, can promote greater harmonization in regulatory approaches. Finally, it is important to recognize that regulation has an important role to play in instilling trust in the financial system. While cryptocurrencies arguably reduce the need for trusted intermediaries like banks, they will not eliminate the need for trust in the system. In fostering trust, effective regulation can help.

Ross Leckow is Deputy General Counsel at the International Monetary Fund. This post is part of an online symposium entitled “Blockchain: The Future of Finance and Capital Markets?” You can read all the posts here.