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At the intersection of free banking, cryptography, and digital currency
Updated: 9 hours 45 min ago

Market-Based Reactions To New Bitcoin Regulation

Fri, 02/28/2014 - 09:30
By Jon Matonis
Sunday, February 23, 2014

Every action has a reaction, and the world of government regulation is no different. Recently, the regulatory chatter has picked up around Bitcoin and it appears to be focused on two major mandates as perceived by the financial regulators.

Number one is the attempt to apply invasive technology-specific money transmitter regulation to a technology that doesn’t seem to fit into any of their other regulatory boxes. Licenses are being crafted to ensure the same level of AML (Anti-Money Laundering) and KYC (Know Your Customer) guidelines for bitcoin companies as for other types of existing financial institutions.

Number two is protecting us “from ourselves” under the standard guise of consumer protection and fraudulent operators. In an interview on The Bitcoin Group, Andreas Antonopoulos describes a self-regulating method where the consumer protection holes can be solved by free market-enforced exchange solvency and implemented cryptography solutions.
New York-Style Licensing
Regarding technology-specific regulation at the state level, New York has put forth a bad idea with an unfortunate name, mostly because it sounds like an innovative Silicon Valley startup which it definitely is not.

It is, however, a grand attempt from a local regulator to overlay an inappropriate technology-specific regulation within the confines of the great state of New York.

Unfortunately, this will cause greater hardship for New Yorkers than it will for the bitcoin businesses that will most likely seek out other favorable jurisdictions. If New York wanted to drive new growth businesses away from the state, then this would be the way to do it. These antics are not predicted to be emulated.

Markets perceive regulation as ‘damage’ and route around it. This is true with Internet-related damage and it is equally true with Bitcoin-related damage.

For example, artificial damage to bitcoin’s semi-anonymous properties could be inflicted by tracking specific bitcoin addresses at the exchange endpoint level and beyond. Perhaps mandated by law in the near future, this type of regulatory action would be akin to to registering bank note serial numbers during a routine cash withdrawal.

Most people would reel in horror at the prospect of this because they naturally believe that they have a right to use their cash as they see fit without serial number tracking.
Surveillance techniques
Coin tracking and coin validation schemes are new types of surveillance techniques that Bitcoin’s public transaction ledger enables. Interestingly, either the free market or the law could spawn these invasive techniques as a business model.

In the case of an exchange seeking to bolster its compliance reputation, it might turn to an independent service provider that analyzes bitcoin address data and associated traffic patterns known to be involved in crimes.

Of course, the major underlying and still unresolved problem here is that subjective judgement must be exercised in data analysis of this type which could unduly harm the downstream owners of fungible bitcoin. That is, if anyone held title in bitcoin to begin with.

Markets provide solutions to these cases of bitcoin privacy ‘damage’ and this is where it becomes tricky for regulators. They are practically in a no-win situation because regulators must use their tools to regulate, but the more they do, the more they inadvertently encourage market-based responses.

Fortuitously, Bitcoin comes with built-in plausible deniability due to the many ‘mixing’ hops that can be traversed both on-block chain and off-block chain. Unless the user’s private key is seized, no one can prove with absolute certainty that a particular amount of bitcoin is owned by an individual without their consent. In financial privacy terms, this is referred to as “knowledge of balance” privacy and it is a key element of overall financial privacy.
Mixing servicesAs cited in ‘The Politics of Bitcoin Mixing Services’, mixing services for bitcoin may emerge as the next frontier in the battle for financial privacy. Coin mixing services for cryptocurrencies do not violate any laws and they merely attempt to re-balance natural deficiencies in the protocol.

According to CNBC, Ben Lawsky and New York’s Department of Financial Services are “still wrestling with whether to ban or restrict the use of ‘tumblers,’ which obscure the record and source of virtual currencies.” Lawsky said tumblers are a concern to law enforcement although they might have legitimate uses.

Is it even possible for New York to ban tumblers that exist on the global Internet? How will the cryptographic free market respond to encroaching regulation into the market for Bitcoin?

Zerocoin and CoinJoin represent two attempts to restore the balance in making digital cash as private as physical cash today. They operate in a decentralized manner without requiring trust in a third party.

Originating from Johns Hopkins University, the first Zerocoin plan was a proposed extension to the Bitcoin payment network that added anonymity to Bitcoin payments and used provably secure cryptographic techniques to ensure that Bitcoins cannot be traced.

After refusing to gain traction among the bitcoin user and developer communities, creators Matthew Green and Ian Miers decided to launch Zerocoin as its own independent cryptocurrency complete with separate block chain and reward incentive system. The Economist refers to Zerocoin as “washing virtual money”.

CoinJoin, first described by Gregory Maxwell as a method of increased coin privacy for the real world, is an urgently needed improvement, because:
“Bitcoin is often promoted as a tool for privacy but the only privacy that exists in Bitcoin comes from pseudonymous addresses which are fragile and easily compromised through reuse, ‘taint’ analysis, tracking payments, IP address monitoring nodes, web-spidering, and many other mechanisms. Once broken this privacy is difficult and sometimes costly to recover.”Involving no changes to the Bitcoin protocol but requiring specific wallet implementations, CoinJoin operates as a unique transaction style for Bitcoin users to dramatically improve their privacy.

Both efforts succeed where the original Bitcoin protocol stopped short. In direct response to increasing and potentially onerous regulations, Zerocoin and CoinJoin stand as pillars of financial privacy in a world where surveillance has run amok.

Ultimately, society can have hope that if privacy becomes disrespected, the market can and will provide cryptographic solutions to restore the balance. If Bitcoin is to succeed, that is the real challenge for the talented individuals and leading companies in the Bitcoin ecosystem.

The Evolution of the Bitcoin Clearing House

Mon, 02/24/2014 - 09:27
By Jon Matonis
Friday, February 14, 2014

We may be witnessing the final months of the large international bitcoin exchanges for retail purposes. On the road to maturity, the survivors are most likely to emerge as supra-regional bitcoin clearing houses.

Today’s global bitcoin exchange plays the mega-role of both retail and wholesale exchange, providing the platform for individual traders, corporate traders, and smaller bitcoin exchanges. Due to a dearth of functioning exchanges in many active bitcoin countries, traders are forced to look outside of their home jurisdiction for liquidity and they tend to go international.

In finance, a clearing house is an institution that provides clearing and settlement services for financial and commodities derivatives and securities transactions. The origin of cheque clearing for banks can be traced back to the 1770s.

With bitcoin, a clearing house can be thought of as a wholesale liquidity provider clearing transactions in an over-the-counter (OTC) market or a futures exchange.

By standing between two member clearing firms, a clearing house reduces the settlement risks by netting offsetting transactions between multiple counterparties and by providing independent valuation of trades and collateral accounts.

When bitcoin derivatives are inevitably introduced, margin deposits will be involved, requiring the clearing house to monitor the credit worthiness of member clearing firms and, ideally, to establish and maintain a guarantee fund that can be used to cover losses that exceed deposited collateral from a defaulting clearing firm.

The Russia-based ICBIT exchange offers a bitcoin derivatives market today.

As more and more trading for bitcoin occurs locally, the need for international bitcoin exchanges will diminish and the remaining exchanges will have to evolve in order to remain relevant. Initially, some may function in a dual capacity as both exchange and clearing house during the transition period.
Forces of changeTwo separate forces are at work driving this trend within the local bitcoin environment.

Local bitcoin exchanges catering to a country or region allow the easiest method for buying and selling bitcoin because, as local players, they understand the existing electronic payment networks and the dynamics of how best to integrate with their country’s banks. Also, since bitcoin is ultimately more frightening to central banks than it is to normal retail banks, the inevitable is starting to happen.

Banks are beginning to explore methods of incorporating bitcoin services directly into their proprietary online offerings. And why not? Banks have the proven expertise in currency trading, deposit holding, secure IT environments, and payments. They should exploit this advantage.

If retail bitcoin exchanges cannot provide greater privacy and service than banks, then why are they needed to sit between you and your bank? The answer is that they probably are not needed – at least not in the same way. As more bitcoin exchanges request the opening of commercial bank accounts, the banks are gradually realizing that bitcoin services may be a direct opportunity for themselves.
Losing the middlemen
Exemplified by the recent announcement from South Africa’s Standard Bank, a bitcoin pilot program tested by the bank eliminates the need for a retail bitcoin exchange in the middle of the transaction. Partially owned by China’s biggest bank, ICBC, Standard Bank is the largest bank operating in Africa.

Similarly, Germany’s Fidor Bank pioneered the integration of bitcoin as a competitive advantage for the bank when, in July 2013, they agreed to a large-scale partnership with the exchange in Munich. The agreement called for a “liability umbrella” for bitcoin trading and represented the first direct banking cooperation in the regulated EU bitcoin sector.

Shortly thereafter, Fidor Bank signed an exclusive arrangement with Payward Ltd, operator of the Kraken bitcoin exchange. Under the deal, Kraken became Fidor Bank’s exclusive digital currency trading platform throughout the European Union, with the exception of Germany where Fidor Bank already had the local partnership with

Turning the tables on owning the bitcoin customer relationship, Fidor Bank CEO Matthias Kröner said: “Digital currencies are emerging as serious and useful alternatives to government-issued currencies. With Kraken we can enable our customers to trade bitcoin and other digital currencies just as securely, easily and flexibly as they trade other foreign currencies today.”
Shifting rolesThese are still early days, but it could forecast the beginning of a trend where regional banks take on the role of building online platforms and interfacing with the millions of bitcoin customers.

In this scenario, the banks become local liquidity providers and bitcoin position takers. As the service offerings mature, banks will require a bitcoin trading desk, complete with portfolio-hedging strategies and multiple avenues for two-way liquidity.

Global bitcoin exchanges emerge as bitcoin clearing houses – less retail-oriented and more wholesale-oriented – providing deep liquidity and sophisticated offerings for the local market participants.

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