Bringing Commodities Regulation to Bitcoin

Mark Wetjen | The Wall Street Journal

More than 5,000 people across the globe recently logged on for the webcast of a Commodity Futures Trading Commission (CFTC) public meeting — not a significant number by Internet cat-video standards, but by far the largest online audience that one of our meetings had ever attracted. Viewers in Guangzhou, China, outnumbered those in Washington, D.C.

What drew them? The CFTC’s Global Market Advisory Committee on Oct. 9 was discussing virtual currencies, Bitcoin in particular. The viewers’ comments sent a clear message to federal regulators: Take notice and plan for the expansion of the technology that underpins virtual currencies, because Bitcoin — or something like it — has the potential to act as a disruptive innovation, including in derivatives markets.

Marc Andreessen, a venture capitalist who knows a thing or two about disruptive technologies, last month told Bloomberg Markets magazine: “If [Bitcoin] works, we can re-implement the entire financial system as a distributed system as opposed to a centralized system. We can reinvent the entire thing.”

That sort of revolution may be a long way off, but Bitcoin — which exists only as a complex mathematical formula “mined” by computers — merits serious regulatory consideration. The virtual currency is important to the Commodity Futures Trading Commission because a number of merchants who now accept Bitcoin as payment for goods and services have expressed the need to hedge exposures to fluctuations in its value. (Businesses accepting Bitcoin include Overstock.com, Dell and Dish Network, and eBay is moving toward integrating it into its PayPal system.) The CFTC was recently presentend with a swap contract on Bitcoin that has been listed for trading by one registered trading platform.

There are several other trading platforms already registered, or soon to be registered, that intend to list Bitcoin derivatives contracts. In some respects, they will rely on information provided by a global network of markets where the virtual currency is traded.

The definition of “commodity” under the CFTC’s authorizing statute could be read to include Bitcoin, in which case the CFTC would have authority to bring enforcement actions against anyone who attempts to manipulate the virtual currency. The CFTC certainly has a responsibility to ensure the greatest extent the integrity of the derivatives markets, including those for Bitcoin swaps and other virtual currencies.

With a market capitalization of around $4.4 billion, Bitcoin represents a tiny fraction of the U.S. financial system. But as Jerry Brito, director of the think tank Coin Center, said at our public meeting, Bitcoin has the potential to provide tremendous benefits to the under-banked and un-banked, particularly in emerging markets where the traditional financial services often are not available. Bitcoin is likely to be an especially powerful resource for people who rely on mobile-payment systems on their smartphones.

Bitcoin or similar technologies can be used as platforms for financial innovation in the digital transfer of currency, securities, contracts and sensitive information. Such innovation could play a fascinating role in the derivatives markets as well as financial services more broadly, as Mr. Andreessen suspects.

To realize these benefits, though, federal regulators and the industry must address the challenges that Bitcoin has faced in its brief existence. There are a number of high-profile examples, including the failure of the Bitcoin exchange Mt. Gox, the money-laundering scandal involving Liberty Reserve, and the revelations concerning illegal activities facilitated by the Silk Road market.

These challenges have shaken the public’s confidence in Bitcoin; the value of one Bitcoin dropped last week to $323 from a high of $650 in July.

Rarely can derivatives regulators anticipate a new market’s potential benefits while devising an appropriate regulatory framework. But virtual currencies such as Bitcoin, and other competing protocols and related technologies, represent such an opportunity.

Regulators should work quickly to understand how these technologies work and how they affect specific regulatory jurisdictions, with the ultimate goal of creating a regulatory framework should the public begin adopting or using these technologies in greater numbers. Creating a flexible and rational regulatory framework also is the best way for regulators to respond to previous incidents such as Mt. Gox, Liberty Reserve or Silk Road — serious innovators will choose to work within such a regime in the U.S. rather than avoid it, which in turn will build more confidence in consumers currently leery of embracing the new technology, or something like it. That will lay the groundwork for future innovation in virtual currencies.

Read the full article in The Wall Street Journal here.