Virtual currencies in the Eurosystem: challenges ahead

In a recent in-depth study commissioned by the European Parliament ECON Committee, we explore the legal and regulatory challenges for the Eurosystem that arise from the startling growth of the market in so-called ‘virtual currencies’ (VCs). We draw a distinction between privately issued VCs―such as Bitcoin―and VCs issued by central banks, and consider the implications of VCs for monetary policy and monopoly of note issue, and the risks for the financial system at large that are relevant to central banks.

The term ‘VC’ should be used with caution, as it begs the question of digital tokens’ status as currency. We suggest alternative nomenclature such as ‘cryptoassets’; however, consistent with the ECON Committee’s brief, we use the term VC in our analysis.

After a survey of the contemporary VC market and a comparison of VCs with existing financial instruments, we provide a legal analysis of VC’s from the perspective of the Eurosystem, ie the European Central Bank (ECB) and national central banks (NCBs).

Although legal analyses of VCs often start with the question of whether a given VC token is properly regarded as a new type of (digital) commodity, a security, or a currency, a major theme of our analysis is that the definitions of these legal categories are not as clear as we sometimes think, and that VCs exacerbate this lack of clarity because they display hybrid features. We thus take the view that it is preferable to understand VCs according to their technical features and economic functions before taking the second step of legal qualification (e.g. as ‘securities’).

Our study is guided by the metaphor of ‘border problems’. The classical borders are (i) those between regulated and unregulated entities and activities and (ii) between national jurisdictions. VCs also present a third border, namely that between cyberspace and the ‘real’ world, which exacerbates the difficulty of enforcing laws and regulations on VCs. Privately-issued VCs are a species of financial hybrid that defies straightforward placement in established categories. Though initially a product of a libertarian political project antagonistic towards central banking, VCs harbour technological innovations which may be beneficial to the broader economy and monetary system. Most regulators have taken a ‘watch and wait’ approach to avoid stifling beneficial innovation. We recommend vigilance and coordinated action at the European level to prevent regulatory arbitrage by market participants and a ‘race to the bottom’ by national regulators.

Privately-issued VCs may pose a direct challenge to central banks in both their money creation and oversight roles. We do not assess this risk to be credible at the moment. However, this assessment can change as the evolving technical features of VCs could enable the kind of economic function that would compel their legal characterisation as ‘money’. We note that VCs pose a number of conceptual challenges that are less easily dismissed. These relate to the definition of ‘money’, of ‘securities’, and the relationship between these two concepts. Just as the law follows technological innovations (which make new forms of economic behaviour possible), regulation tends to follow crises, rather than avert them. Again, pro-active and co-ordinated activity at the European level seems to us to be highly desirable.

Privately issued VCs could create risks to the stability of the financial system if VC markets continue to grow at the current pace and continue to interact and entangle with the regulated financial system. This might occur through (i) regulated entities taking part in VC-based activities directly, (ii) unregulated entities offering mainstream financial services via VCs, (iii) regulated entities lending to investors exposed in the VC market, (iv) regulated entities structuring regulated financial products on underlying VC assets. [Under (ii), there is a chance that the VC-based shadow payments system could grow to systemically important size]. Further, the unregulated nature of VCs, and the dominance of quasi-anonymous VC schemes, raises challenges in terms of anti-money laundering,  countering the financing of terrorism, and tax evasion.

Moving on to central bank-issued virtual currencies (CBVCs), though the public interest motivations of a central bank clearly differ from those of a private issuer, central banks have to choose from a similar suite of technical features, which would inform the VC token’s economic function. We discuss a number of important design considerations in CBVCs―such as whether they are interest bearing―and the problems CBVCs could pose for the existing monetary system, in particular for commercial banks’ money-creation role. We briefly examine recent proposals in Estonia to launch an ‘Estcoin’ as a national VC pegged to the euro, which have been strongly criticised by ECB President Draghi as being contrary to the Eurosystem legal framework (a criticism with which we concur). The notion of an e-Euro and the distribution of competence within the Eurosystem is an interesting space to watch, as the design of the Eurosystem attenuates the link between political sovereignty and fiscal authority, on the one hand, and money creation, on the other, to an unprecedented extent.

Rosa María Lastra is the Sir John Lubbock Professor of Banking Law at the Centre for Commercial Law Studies (CCLS), Queen Mary University of London.

Jason Grant Allen is the Humboldtian Post-Doctoral Fellow at the Centre for British Studies, Humboldt Univeristät zu Berlin and a Visiting Fellow at the Centre for Law Markets and Regulation, University of New South Wales.

This policy contribution was prepared for the Committee on Economic and Monetary Affairs of the European Parliament (ECON) as an input for the Monetary Dialogue of 9 July 2018 between ECON and the President of the ECB. Copyright remains with the European Parliament at all times.