In this CoinDesk 2016 in Review special feature, CoinDesk contributor Frederick Reese gives an overview of regulatory developments that shaped the year that was, and that look to be setting the stage for 2017.

At the PYMNTS’ Innovation Project 2013 conference, former US vice president Al Gore made waves by speaking out in favor of bitcoin and the potential of the distributed ledger technology that drives the cryptocurrency.

“I think the fact that within the bitcoin universe an algorithm replaces the functions of [the government] … is actually pretty cool,” Gore said. “I know that there are a lot of innovators that are out there that are trying to … come up with new models and I look forward to that.”

And 2016 saw governments on both the local and national levels come to the same conclusion as Gore for the first time.

From the Federal Reserve’s declaration of interest to Illinois’s embrace of distributed ledgers, this year saw US governments take big steps in evolving their thinking on financial tech.

While no major actions have yet been taken, the governments’ apparent interest in blockchain tech has been encouraging, experts have indicated.

“I have been in Washington now for many years and what I have observed is an unprecedented effort to catch up if not get ahead of the curve on blockchain technology,” Carol Van Cleef, FinTech specialist and partner at financial services law firm BakerHostetler, told CoinDesk.

Van Cleef added:

“It is impressive, the level of effort being made in many areas of the government to learn about blockchain technology – not just to better inform the regulators but to potentially change the way the government operates internally and fix what many find to be broken about the current system.”

In this end-of-the-year review, we’ll look into the ways government policy has changed toward blockchain in 2016 and explore what we might be able to expect in the new year.

New York’s struggles

The beginning of the year saw some of the more notable attempts to regulate cryptocurrencies suffer growing pains.

In particular, New York State’s ‘BitLicense’ – created in an attempt to provide clear guidelines on reporting obligations for cryptocurrency businesses in the state – seemed to prove the most problematic.

Once heralded as an advance for the industry, advocates of the law hoped that having clear expectations would remove the uncertainty of doing business in digital currencies in the state. However, opponents argued it created undue pressures on startups and violated the privacy tenets that are key to the technology’s success.

Nearly two years in, it seems like the opponents might have been right.

Due to the hurdles involved, by the deadline for license applications in 2015, only 22 companies had applied. Now it seems fewer are being approved.

By June 2016, the state has only assigned two BitLicenses, with the other 20 applicants still operating under the regulation’s “safe harbor” provisions.

Uncertain approaches

In the wake of struggles in New York, other US states seemed reluctant to begin enacting regulations for the industry.

California, for example, flirted with and scrapped its attempt to issue New York-like licenses.

Elsewhere, Connecticut’s Substitute House Bill 6800 made virtual currency an equivalent to money, but also made businesses that transfer it subject to different regulatory criteria than those that deal with national currencies.

This leaves many elements of regulation at the discretion of the state’s Department of Banking, such as the size of the surety bond that must be filed, allegedly to “address the current and prospective volatility of the market in such currency or currencies”.

Georgia signed into law HB 811 in April, giving state regulators the power to create rules for all virtual currency businesses. But, as it gives no definition in regards to the scope or intended target of this law – short of excluding “software” and “protocols” from the definition of “virtual currency” – the law is ambiguous.

New Hampshire – like other states on this list – also chose to make cryptocurrency dealers in the state money transmitters, subject to the same requirements and rules applicable to traditional money transmitters. This means that those choosing to sell or trade cryptocurrencies in the Granite State must apply for a state money transmitter’s license and pay a $100,000 bond.

This is similar to North Carolina’s HB 289, passed in June, which defines a money transmission to include “maintaining control of virtual currency on behalf of others” and set the required bond at $150,000.

New Hampshire did, however, exclude individuals using virtual currencies in private transactions from the licensing requirement and defined virtual currencies as cryptocurrencies that could be converted or redeemed for fiat.

Pennsylvania passed its long-delayed HB 850 in November, which defined money to include any form of virtual currency, but the bill was temporarily tabled due to a budget impasse.

Finally, Wyoming failed to pass HB 0026, which would have relieved virtual currencies from the state’s current money transmitter rules that require a reserve to be held equal to the amount of the company’s payment obligations.

This regulation has effectively kept exchanges and other cryptocurrency businesses out of the state.

Unleashing the blockchain

Although action on the state level may have been limited, 2016 saw regulators begin exploring and learning about the technology.

Both the Federal Reserve and the SEC, for example, have indicated a willingness to pursue distributed ledger products and have formed working groups to investigate integrations with the technology.

This interest in using blockchains as an alternative to the current system of interconnected, incompatible databases emerged from two relatively recent developments in blockchain technology: the use of smart contracts to automate business processes and the ability to conduct transactions between different blockchains.

Looking forward to 2017, Lewis Cohen, a partner in the intellectual property practice at Hogan Lovells, shared his thoughts on this issue, noting that interconnected blockchains offer regulators the potential to be involved directly in this new wave of innovation.

“The biggest surprise of 2017 may be the rise of ‘interconnecting’ blockchains,” Cohen said. “The inability to deliver this type of blockchain integration will otherwise prove to be a major pain point for the industry.”

Cross-blockchain technologies, such as Polkadot, IBM’s HyperLedger, Overstock’s tØ and Ripple, create the possibility of nodes from one blockchain conducting transactions with nodes from another blockchain – potentially those operated by regulators – in real time.

This, coupled with privacy-insuring technologies such as R3’s Corda, which allows a node to choose the information it wants decentralized while protecting the rest, allows for a new way to think about public ledgers.

The DAO’s wake

With bitcoin values likely to keep climbing in the short term and ethereum set to continue growing, it may be safe to say that the states will continue to consider legislation and regulations that will make the taxation and the tracking of this new form of wealth easier to manage.

However, the impetus for rule making for the future may shift towards engineering a proof-of-concept on how this technology can work in real-time governance situations, rather than experimenting with ways to track money transfers to and from fiat currencies.

“If 2016 was the year that the blockchain burst into public view, 2017 is the year that blockchain pilots and proofs-of-concept begin to permeate the mainstream of industry,” said Alan Cohn, co-author of the Steptoe Blockchain blog and former Department of Homeland Security assistant secretary.

As highlighted by The DAO, while blockchain tech can help to solve some of the administrative problems associated with large-scale data management, it creates new potential problems that must be closely monitored by regulators.

The 18th June hack on The DAO revealed that smart contracts can – if not implemented correctly – be used to drain value from the system, putting consumers at risk.

Finding solutions to mitigate the problems that may arise from a blockchain failure may be a priority in 2017. Unlike cryptocurrency networks, a loss on a data-bearing distributed ledger may not just result in loss of wealth.

Yet, the potential loss of personally identifiable information, the unauthorized access to critical data and the potential for violations of existing security laws all are areas that must be resolved should a public sector blockchain solution be pursued.

Standards as a hedge

2016 saw cryptographic transaction technology emerge from its adolescence and take its first steps as a mature mode of operations.

Accordingly, the government has reacted and has taken steps to both understand the technology and come up to speed with it regulation-wise.

Yet, there is still the question of incoming president Donald Trump.

With both cryptocurrency advocates and opponents named to his cabinet, it is unclear how the new administration will approach cryptocurrency and distributed ledger legislation.

Uncertainty, it seems, is now the biggest roadblock preventing further public experimentation with blockchains.

Mike Massaro, CEO of cross-border startup Flywire, for example, told CoinDesk that he believes regulatory uncertainty will be the largest roadblock against moving past proofs-of-concept forward, and that industry-led work on standards may have to take its place.

Massaro concluded:

“I expect there to be some real progress in this area.”

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