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LegendaryActivity: 1256Merit: 1022 RECORD OF MEETING Federal Advisory Council and Board of Governors May 19, 2014, 06:49:21 PM #1

http://www.federalreserve.gov/aboutthefed/fac-20140513.pdf#page=10



Item 5: Bitcoin

Does Bitcoin pose a threat to the banking system, economic activity, or financial stability?



Concerns about Bitcoin can be summarized as follows:



1. Banking: disintermediation of traditional payment networks, promoting shadow transacting.

2. Economic activity: disruption of traditional channels of commerce with high potential for illicit use.

3. Financial stability: potential as a contagion of instability through volatility or lapse in network integrity.



Systemically, Bitcoins nascency makes it more curiosity than threat. Its greatest near-term hazards are its avoidance of consumer protection measures and illicit use, both of which support increased regulation. Medium - to long - term effects could be more pronounced as the network self - refines and adoption increases, requiring traditional payment processors to adapt and respond.



1. The Banking System



Bitcoin does not present a near - term threat to the banking system by way of disintermediation.



While it does have peer - to - peer utility, the network effect has prevented adoption from accelerating to the point where Bitcoin supplants traditional payment methods.

Bitcoin transactions correspond to only a fraction of todays global fund flows.



Various security concerns will continue to hinder adoption.



Lack of deposit insurance and other wallet protection magnifies exposure, as shown through the Mt. Gox theft and subsequent bankruptcy.



Unpredictability in Bitcoins value undermines its reliability as a regular medium of exchange.



Bitcoins longer - term impact could be more pronounced and require adaptation by payment processors.



Lower transaction fees, particularly for small transactions, are especially attractive to merchants.



While existing payment networks have a footprint advantage, it is largely confined to the developed world. Bitcoin enables cheap international remittance to the developing world and the developed worlds unbanked, expanding financial inclusion.



Consumers are likely to use Bitcoin if they perceive its benefits  namely faster settlement and geographic flexibility  to exceed those of its alternatives.



Should adoption accelerate, banking could participate increasingly in Bitcoin fund flows, especially as multicurrency accounts proliferate and reputational concerns subside.



One area of focus should be Bitcoins circumvention of currency controls, evidenced by Chinas high share of transactions and the use of Bitcoin to

transmit funds out of Cyprus post - bailout.



2. Economic Activity



Bitcoin does not present a threat to economic activity by disrupting traditional channels of commerce; rather, it could serve as a boon.



Its global transmissibility opens new markets to merchants and service providers.



Driving capital flows from the developed to the developing world should increase consumption.



Illicit applications are rampant but not endemic to Bitcoin; sovereign - issued currencies and other precious goods are similarly used.



Sizing estimates for the worlds black markets reach into the trillions of dollars. At this stage, the total value of Bitcoin is approximately $6 billion, a sum that is dwarfed by other forms of payment, whether illicit or not.



Furthermore, Bitcoins anonymity is overstated: it is better characterized as pseudonymous, with all transactions logged in a central and transparent block chain. Law enforcement has recently shown that it can trace the flow of specific Bitcoins, connecting user identification numbers to physical users.



3. Financial Stability



Bitcoins impact on financial stability is two - pronged: its intrinsic stability and its impact on systemic stability. In intrinsic stability, Bitcoin has room to improve.



Extreme price volatility is similar to other speculative forms of stored value, undermining Bitcoins credibility. This volatility is likely to diminish over time.



Susceptibility to theft increases uncertainty for users seeking alternatives to traditional institution - based deposits.



While Bitcoins protocol (its network infrastructure) has not been compromised, disruption to it could render the cryptocurrency worthless.



Bitcoin does not yet have the scale to act as a systemic contagion of instability.



Recent volatility shows that swings in value have not resulted in consequences beyond those felt by Bitcoin holders.



In an economy hypothetically dominated by Bitcoin, its finite number (21 million) would prevent the application of traditional monetary policy tools to provide support in a downturn or reduce growth during excessive expansion.



Should this medium of exchange be prohibited or regulated, and if so, what

considerations should be taken into account for its prohibition or regulation?

Regulation is advisable; considerations include protecting consumers, addressing illicit use, and avoiding Balkanization. Bitcoin advocates may argue that increased regulation minimizes one of its greatest advantages, namely decentralization. Recent events suggest that some flexibility should be sacrificed to address obvious problems.



1. Protecting Consumers



Bitcoins most obvious consumer flaw is its susceptibility to theft, which can be addressed in several ways:



Supervised risk management of Bitcoin exchanges, including requirements for business continuity planning



Regulatory oversight to ensure that exchanges invest in appropriate cyber and other security measures. This includes fully secure storage of Bitcoin wallets.



Additional consumer protections would be fraud prevention, a forum for transaction disputes, and disclosure of Bitcoins risks and costs.



2. Addressing Illicit Use



Illicit use, either as payment for unlawful goods and services or to fund illegal activity, remains a problem.



The same measures employed to minimize illicit applications of traditional currencies could be appropriately extended to Bitcoin.



Anti-money-laundering procedures, including modified Know Your Customer policies, would ensure that organizations trafficking in Bitcoin are not facilitating

criminal use.



Transaction and suspicious activity reports would enable ongoing monitoring and pattern recognition.



As with any regulation, transparency will be key.



3. Avoiding Balkanization



Consistency across geographic areas is necessary to preempt regulatory arbitrage, as is consistency with regulations governing existing payment networks.



Recent guidance from regulators indicates growing awareness of the need for oversight:



The Internal Revenue Service has characterized Bitcoin as property rather than currency for tax purposes, effectively making each transaction a taxable event and increasing recordkeeping requirements.



The Financial Crimes Enforcement Network (FinCEN) guidance obligates certain Bitcoin participants to register as money service businesses, subjecting them to greater reporting and recordkeeping requirements.



Additional efforts to address consumer protection and general network safety will hopefully follow. Concerns about Bitcoin can be summarized as follows:1. Banking: disintermediation of traditional payment networks, promoting shadow transacting.2. Economic activity: disruption of traditional channels of commerce with high potential for illicit use.3. Financial stability: potential as a contagion of instability through volatility or lapse in network integrity.Systemically, Bitcoins nascency makes it more curiosity than threat. Its greatest near-term hazards are its avoidance of consumer protection measures and illicit use, both of which support increased regulation. Medium - to long - term effects could be more pronounced as the network self - refines and adoption increases, requiring traditional payment processors to adapt and respond.Bitcoin does not present a near - term threat to the banking system by way of disintermediation.While it does have peer - to - peer utility, the network effect has prevented adoption from accelerating to the point where Bitcoin supplants traditional payment methods.Bitcoin transactions correspond to only a fraction of todays global fund flows.Various security concerns will continue to hinder adoption.Lack of deposit insurance and other wallet protection magnifies exposure, as shown through the Mt. Gox theft and subsequent bankruptcy.Unpredictability in Bitcoins value undermines its reliability as a regular medium of exchange.Bitcoins longer - term impact could be more pronounced and require adaptation by payment processors.Lower transaction fees, particularly for small transactions, are especially attractive to merchants.While existing payment networks have a footprint advantage, it is largely confined to the developed world. Bitcoin enables cheap international remittance to the developing world and the developed worlds unbanked, expanding financial inclusion.Consumers are likely to use Bitcoin if they perceive its benefits  namely faster settlement and geographic flexibility  to exceed those of its alternatives.Should adoption accelerate, banking could participate increasingly in Bitcoin fund flows, especially as multicurrency accounts proliferate and reputational concerns subside.One area of focus should be Bitcoins circumvention of currency controls, evidenced by Chinas high share of transactions and the use of Bitcoin totransmit funds out of Cyprus post - bailout.Bitcoin does not present a threat to economic activity by disrupting traditional channels of commerce; rather, it could serve as a boon.Its global transmissibility opens new markets to merchants and service providers.Driving capital flows from the developed to the developing world should increase consumption.Illicit applications are rampant but not endemic to Bitcoin; sovereign - issued currencies and other precious goods are similarly used.Sizing estimates for the worlds black markets reach into the trillions of dollars. At this stage, the total value of Bitcoin is approximately $6 billion, a sum that is dwarfed by other forms of payment, whether illicit or not.Furthermore, Bitcoins anonymity is overstated: it is better characterized as pseudonymous, with all transactions logged in a central and transparent block chain. Law enforcement has recently shown that it can trace the flow of specific Bitcoins, connecting user identification numbers to physical users.Bitcoins impact on financial stability is two - pronged: its intrinsic stability and its impact on systemic stability. In intrinsic stability, Bitcoin has room to improve.Extreme price volatility is similar to other speculative forms of stored value, undermining Bitcoins credibility. This volatility is likely to diminish over time.Susceptibility to theft increases uncertainty for users seeking alternatives to traditional institution - based deposits.While Bitcoins protocol (its network infrastructure) has not been compromised, disruption to it could render the cryptocurrency worthless.Bitcoin does not yet have the scale to act as a systemic contagion of instability.Recent volatility shows that swings in value have not resulted in consequences beyond those felt by Bitcoin holders.In an economy hypothetically dominated by Bitcoin, its finite number (21 million) would prevent the application of traditional monetary policy tools to provide support in a downturn or reduce growth during excessive expansion.Regulation is advisable; considerations include protecting consumers, addressing illicit use, and avoiding Balkanization. Bitcoin advocates may argue that increased regulation minimizes one of its greatest advantages, namely decentralization. Recent events suggest that some flexibility should be sacrificed to address obvious problems.Bitcoins most obvious consumer flaw is its susceptibility to theft, which can be addressed in several ways:Supervised risk management of Bitcoin exchanges, including requirements for business continuity planningRegulatory oversight to ensure that exchanges invest in appropriate cyber and other security measures. This includes fully secure storage of Bitcoin wallets.Additional consumer protections would be fraud prevention, a forum for transaction disputes, and disclosure of Bitcoins risks and costs.Illicit use, either as payment for unlawful goods and services or to fund illegal activity, remains a problem.The same measures employed to minimize illicit applications of traditional currencies could be appropriately extended to Bitcoin.Anti-money-laundering procedures, including modified Know Your Customer policies, would ensure that organizations trafficking in Bitcoin are not facilitatingcriminal use.Transaction and suspicious activity reports would enable ongoing monitoring and pattern recognition.As with any regulation, transparency will be key.Consistency across geographic areas is necessary to preempt regulatory arbitrage, as is consistency with regulations governing existing payment networks.Recent guidance from regulators indicates growing awareness of the need for oversight:The Internal Revenue Service has characterized Bitcoin as property rather than currency for tax purposes, effectively making each transaction a taxable event and increasing recordkeeping requirements.The Financial Crimes Enforcement Network (FinCEN) guidance obligates certain Bitcoin participants to register as money service businesses, subjecting them to greater reporting and recordkeeping requirements.Additional efforts to address consumer protection and general network safety will hopefully follow.