Virtual Currencies and the European Banking Authority

July 9, 2014

On 4 July, the European Banking Authority issued an opinion recommending that EU national financial regulators ‘discourage’ their financial institutions from buying, holding or selling virtual currencies. This extraordinary step is based on over 70 risks that the EBA says it has identified and ‘tentatively’ ranked, which require ‘a comprehensive regulatory approach’ and ‘a substantial body of regulation’ before regulated institutions should be allowed to engage with virtual currencies. No attempt has been made to assess the level of support that financial institutions may already be providing to virtual currencies, the adverse consequences of ‘shielding’ regulated financial services from virtual currencies in the way envisaged, or to explain how this will help responsible innovation, competition and growth, either in virtual currencies or the protected regulated sector.  The EBA merely states: 

‘Other things being equal, this immediate response will allow VC schemes to innovate and develop outside of the financial services sector…. The immediate response would also still allow financial institutions to maintain, for example, a current account relationship with businesses active in the field of VCs.’

There are many flaws and ironies in the EBA’s approach, which seriously undermines the EU’s potential as a place to launch innovative financial services at exactly the time when the EU needs them most.  No one expects the authorities to sit on their hands when confronted with innovation, but they do expect them to engage with the participants in new markets constructively, and consult publicly, before taking deliberately disruptive action. 

Regulation: the EU’s Condition Precedent for Organic Life 

The EBA’s requirement for comprehensive regulation as the price of institutional support for virtual currencies emphasises the (flawed) belief amongst Europe’s technocrats that ‘vigorous regulation’ is a pre-condition for creating consumer trust in innovative services, as Paul Nemitz asserted in his recent speech to the SCL Technology Futures Forum. But as I pointed out elsewhere, this belief is not borne out by the growth of the Internet or the mass adoption of many services that run on it. Comprehensive regulation may be helpful in building trust in new goods and services as they become more widely adopted, but it cannot create trust out of thin air, any more than Parliament can launch start-ups. The law can really only follow commerce. This principle lies at the heart of the common law system in the UK and Ireland, but is at odds with civil law on the continent (on which EU law is based), which rests on the principle that an activity is only lawful if the state legislates for it. The authorities need to strike the right balance between supporting innovation and snuffing it out if the EU is to produce innovative digital services on the scale of the United States (another common law system).

Regulators can support the development of innovative services by putting in place some of the more essential building blocks, clearing legacy obstacles and fostering the evolution of comprehensive regulation. E-signatures legislation was an early example. Other examples of this approach in the context of virtual currencies are the statement issued by HM Revenue and Customs earlier this year clarifying their tax treatment; and the recent report of the international Financial Action Taskforce (FATF) on its project to establish key definitions, develop a risk matrix, promote fuller understanding of market participants, and to ‘stimulate a discussion’ on implementing risk-based anti-money laundering regulation. However, the EBA’s approach to virtual currencies does no such thing. If it were keen to support innovation then (to the extent that it feels the need to act now) the EBA should be opening up a forum for market participants, regulators and policy-makers to discuss how to adapt the existing regulatory framework to accommodate virtual currencies, rather than simply shutting them out.  

All of which suggests, of course, that the EBA would rather avoid playing a role in the development of virtual currencies at all. 

Overstating the Risks, Dismissing the Benefits 

Putting philosophy to one side, there is a lot of duplication and overlap amongst the 70-odd risks the EBA has identified (on p 22). Indeed these are later consolidated into a list of only 20 (on p 38). The EBA also concedes that some of these risks ‘are similar, if not identical, to risks arising from conventional financial services or products, such as payment services or investment products’, and its suggested regulatory controls are very familiar.  

The problem (as is always the case when legislating too early) is that the EBA’s risk evaluation is based on scant data:  

‘[65.]… the phenomenon of VCs being assessed has not existed for a sufficient amount of time for there to be quantitative evidence available of the existing risks, nor is this of the quality required for a robust ranking. 

66. Instead, the ranking is based on a tentative and preliminary assessment of factors such as the probability of a risk to materialise, the severity of the impact should the risk materialise, and an assessment of the anecdotal evidence available, such as bankruptcies of specific exchanges, cases of VC theft, etc .’ 

In fairness, the EBA has listed many benefits of virtual currencies, some of which are very significant when compared to existing financial services and fiat currencies (with the Euro perhaps being the most vulnerable). But the EBA’s dismissive assertion that the benefits of virtual currencies matter less in the context of the EU or the Eurozone are unconvincing, especially where that claim is based on references to legislative measures that are yet to take effect.  

Siege Mentality

Ironically, amongst the ‘risks to regulatory authorities’ are concerns that regulating virtual currencies more leniently than fiat currencies will create an unequal playing field that may in turn lead service providers to exit fiat currency markets in favour of virtual currency markets.  

It therefore seems strange to leave such attractive virtual currency markets to develop freely outside the financial regulatory sphere. It is as if the EBA learned nothing from the financial authorities’ failure to understand and respond to developments in the shadow banking sector throughout the past decade. 

In addition, shielding regulated financial institutions from virtual currencies risks leaving them ‘trapped’ in providing services that are liable to be outpaced by developments in ‘shadow’ markets that do not ignore user demand.  Yet we have already seen that ‘shielding’ our banks and investment firms from the forces of innovation and competition only breeds institutions that are weak and unable to adapt. 

Similarly, the EBA lists as one of the key risks the fact that virtual currencies are (currently) borderless yet fails to see that a more restrictive approach in the EU will simply encourage entrepreneurs to start businesses elsewhere, leaving EU markets lagging.  It is ironic that the EU is desperate to see evidence of cross-border commercial activity, yet keen to ‘shield’ its institutions from the opportunity to participate in the development of genuinely borderless financial services. 

An Overly Complex, Inflexible Regulatory Regime 

The EBA’s opinion begs the question: if so many risks and recommended controls are the same as for conventional financial services, why doesn’t the EBA recommend public consultation on adapting the existing regulatory system to deal with them?  

Just as the next iteration of the Payment Services Directive (‘PSD2’) opens up the potential for regulating major ‘limited network’ payment schemes (e.g. gift vouchers), that directive could conceivably be adapted to deliver such things as centralised governance for virtual currency schemes, customer due diligence, fitness and propriety requirements for service providers’ management, capital requirements and segregation of customer funds.  

Presumably the EBA prefers a standalone regime dealing with the same issues because the European Commission has already taken five years to develop PSD2 and it wishes to avoid further delay to bring it up to date.  But that merely highlights the undue complexity and lack of flexibility in the current regime –which is undermined by the ability for the EBA to make vague requests to national authorities to ‘discourage’ participation by financial institutions in certain markets without public consultation. 

As submitted in the context of the Parliamentary Commission on Banking Standards, the current financial regulatory regime has created an exclusive, officially-endorsed marketing environment in which small sets of incumbent product providers and intermediaries are able to charge higher fees, make higher margins and reward staff more generously than would be the case if they were exposed to external innovation and competition.  Regulations prescribe limited and exclusive types of financial products, providers, intermediaries and authorised activities that are not aligned with customer activities and requirements. Artificial markets are encouraged to grow around these products, participants and activities by the state guarantee of bank liabilities, tax and investment rules and management incentives amongst the protected incumbents. All this is compounded by the division into silos of policy officials and regulatory authorities who are only empowered to focus on conduct and competition within artificial markets, rather than on how the regulatory framework and related incentives impact competition and innovation both within and outside the regulatory sphere.

Somehow, this regime has to be made more flexible, adaptable and accommodating of innovation, new entrants and the possibility of failure of financial services. 

Legitimate Expectations? 

As the EBA points out, there are already many virtual currencies in use. Volumes appear to be low and evidence about them is largely anecdotal, but the number of currencies and their volumes appear to be increasing. Venture capital is entering the sector, and it is possible that financial institutions are already engaging in the activity that the EBA now seeks to ‘discourage’. In such circumstances, market participants should have a legitimate expectation that they may continue their lawful activities, unless they are rendered unlawful by established legislative process. If the rule of law is to be important at all, their activities should not be vulnerable to a nudge and a wink from unelected officials. It will not help the flow of capital into the development of innovative EU financial services if the authorities can informally require regulated institutions to withdraw their lawful support on a whim.   

Simon Deane-Johns is a consultant solicitor with Keystone Law and Chair of the SCL Media Board.