This brief discusses money in its general definition and describes new types of money arising in the modern era of digitalization, such as electronic money, cryptocurrencies, Central Bank Digital Currencies (CBDC), etc. It provides an overview of some of the legislative approaches trying to deal with new types of money and outlines the benefits and shortcomings arising from allowing for financial operations with digital currency. It also stresses the necessity of a new integrated approach in national and international regulation of cryptocurrencies.
Cryptocurrencies have existed for more than 10 years. During this period the interest towards this type of digital money has seen its ups and downs. However, by now, they have become part of modern financial markets. Today, more and more central banks consider the possibility of introducing national digital cash and try to create easy-to-understand and clear regulation for new payment methods. We can observe the rapid transformation of the traditional monetary system. At the same time, there is no clear understanding of how the new monetary system should look like. An essential step towards this understanding is developing a clearer systematization and definition of money, financial funds, cryptocurrencies, fiat money in the traditional and the modern sense. Explaining these concepts is necessary to facilitate effective regulation, the development and supervision of financial markets. Indeed, during rapid financial markets transformation, well-developed regulation is necessary to avoid excessive financial risks and speed up financial sector development.
The Place of Money in the Modern Financial System
Financial resources play an extremely important role in the economy: Monetary systems are like the blood circulation for the body. While there is a common understanding of what money is in the traditional sense, this concept does not take into account the recent development of the financial sector, the penetration of IT technologies, the entry of new non-financial institutions into the financial sector as well as the creation of new products at the intersection of finance and IT. As argued above, a clear and encompassing definition of money, reflecting these developments, is necessary for regulatory purposes both at the national and international level.
Typically, money is defined through its functions, such as a measure of value, means of circulation, means of payment and savings. For example, the Large Economic Dictionary suggests that “Money is the universal equivalent, a special product, used to form expressions of the value of all other goods. Money functions as a medium of exchange and of payments, as a measurement of value, wealth accumulation and world money” (Borisov, 2003). As can be seen, one of the most important characteristics of money is its universality. Money can be exchanged against different goods and services almost without any limitations. At the same time, Tarasov mentioned that money is “legal payment funds, usually consisting of banknotes and coins that are constantly circulating as a medium of exchange in accordance with government rule” (Tarasov, 2012). There are other definitions of money, but they usually describe traditional money.
Along with traditional fiat money, there are other payment methods and electronic money is the most common of them. According to the Belarusian legislation, electronic money is “units of value stored in electronic form, issued in exchange against cash and monetary funds and accepted as a means of payment […]”
Electronic money cannot be described as traditional cash or money on bank accounts. It is not included in the money supply and can be issued only by commercial banks. At the same time, electronic money can perform the same functions as traditional fiat money. Whether or not electronic money can be considered full-fledged money is essentially a legal issue.
Another very important question is dedicated to cryptocurrencies. Cryptocurrencies are usually issued based on blockchain technology (distributed ledger) and can be created (“mined”) by anybody. Hence, electronic money is representative of traditional money, but cryptocurrencies are not.
Taking into account the penetration of information technologies into finance as well as the appearance of electronic money and cryptocurrencies, we can define money as the universal equivalent (measure) of value constituting a legal means of circulation, payment and savings on certain territories within a particular jurisdiction, with a legal status guaranteed by the government (Luzgina, 2018). In this definition, the emphasis is placed on the legitimacy of money because in some countries, operations with digital currencies can be legally interpreted as operations with securities, equity etc., rather than money in the legal sense.
Belarus was one of the first countries that legalized operations with crypto assets. But this does not mean that cryptocurrencies have become the equivalent of national or foreign currencies. According to the Belarusian legislation, people can mine cryptocurrencies, exchange them against Belarusian rubles, foreign currencies, buy, sell and exchange against other tokens (Decree #8, 2018). There is no official permission to use crypto money as a measure of value, means of circulation or payment method. In other words, people cannot use bitcoins for purchasing goods and services. At the same time, cryptocurrencies can be used as traditional financial assets.
It is necessary to emphasize here that the digitalization of the financial sector is an ongoing process. It is very hard to be the leader in the sphere. Despite Belarus being an early mover in the legalization of crypto assets and notwithstanding the existence of a strong IT sector and attractive crypto assets regulation, Belarus is only the 59th among 65 countries in the Fintech Index 2020. Based on the experience of other countries, sustained progress in this area can be achieved by government support, the existence of a well-developed ecosystem and access to financing (Global FinTech Index 2020).
Belarus is not the only country in the world that has limitations on cryptocurrencies’ circulation as fiat money; restrictions differ depending on the jurisdiction. Many central banks consider cryptocurrencies as disruptive technologies with high risks. Regulatory bodies usually cannot control operations with crypto money. That is why cryptocurrencies can be attractive for payments in the grey economy. Moreover, exchange rate fluctuations of cryptocurrencies are very unpredictable. Owners of cryptocurrencies can become very rich as well as very poor within a short period of time.
Central banks can implement limitations to avoid or decrease risks. For example, operations with cryptocurrencies are prohibited in Bangladesh and strongly restricted in India. There are central banks (including the central banks of Malaysia and Austria) that take a neutral position with regards to crypto operations but inform the society about possible risks, including risks of high fluctuations (Luzgina, 2018). At the same time, Japan permits the circulation of cryptocurrencies as a means of payment within its current regulation. That is, the Japanese authorities legalized these digital assets and, supposedly, can keep risks under control.
It is important to understand that these, and other, differences in the approach to crypto assets regulation create barriers for international payments and investment transactions. At the same time, a unification of regulation would contribute to transparency and mitigate the risk of cybercrimes.
Central Bank Digital Currencies: Main Aspects
There is an intense political and academic debate about the future of crypto markets. At the same time, more and more countries begin to think about the introduction of Central Bank Digital Currency (CBDC). Countries like Ukraine, China, Sweden, Canada, Thailand and some others have announced their plans of issuing CBDC. CBDC can be compared with digital cash; it can reduce operational costs and make all money transactions more transparent. But there are some uncertainties: The technology is new and may cause confusion and even disapproval among the population who prefers to use only cash.
One of the most interesting examples of the introduction of CBDC is the case of Uruguay. In 2017-2018, this country realized a pilot project of CBDC (the e-peso). A limited amount of digital currency was issued and only 10,000 citizens joined the project. There was a limited list of stores and businesses that were allowed to work with digital currency and all transactions on the base of mobile phones were done only between registered users. This project has demonstrated several advantages of e-peso circulation. First, the system could work without Internet and provided anonymity but at the same time controllability of all operations. Second, security was the main concern: The person could get access to his/her digital resources even if he/she forgot the password of the digital wallet or lost the mobile phone, but non-authorized access was effectively avoided. Finally, the last but not the least advantage of the system was the exclusion of double charge or falsification during payment transactions. The project lasted half a year and finished successfully. However, transition to the digital currency did not follow.
As of now, many countries only consider or are going to realize pilot studies in this area. The only country that is going to implement CBDC in the foreseeable future is China. The cautious position of many central banks is understandable because CBDC is an analogue of digital cash. The population distrusts such forms of money. Another challenge is that senior citizens often prefer cash for payments and other financial transactions.
Tokens vs. Cryptocurrencies
Bitcoin and other cryptocurrencies present only one kind of digital tokens. According to the Belarussian legislation, a token is an entry in the register of transaction blocks (blockchain), or another distributed information system certified that the owner of a digital sign (token) has rights to civil law objects and (or) presents cryptocurrency. All cryptocurrencies are tokens but not all tokens can be defined as cryptocurrencies. Tokens are issued for multiple purposes. Governments in many countries try to identify all types of operations with tokens for the creation of clear regulation. For example, the Central Bank of Lithuania highlights the differences between issuing tokens in the framework of ICO (Initial Coin Offering) and STO (Security Token Offering). According to the Lithuanian regulation, ICO usually provides for presenting discount programs or using tokens as payment instruments. At the same time, STO includes the issuance of tokens that have features of bonds or other traditional financial instruments and is subject to regulation. In other countries, central banks do not highlight STO and operations regulation with tokens depends on the characteristics and specifics of each project.
Many countries have developed unique principles and rules of tokens regulation. But there are no unified approaches at the international level which makes it difficult for conscientious market participants to work with financial crypto assets over different jurisdictions. Moreover, there are uncertainties and risks that have to be investigated more in detail. Authorities in many countries are afraid of cybercrimes and increasing money laundering operations.
At the same time, many advantages are apparent. For example, in Belarus, crypto platforms get more popular, because they offer attractive financial instruments for the population and companies. On such platforms, companies can attract necessary resources and citizens invest in financial tools with regulated risks.
Figure 1 – Structure of digital, electronic money, tokens and financial means (Luzgina, 2018)
Comment: Fiat electronic money is an electronic analogue of fiat currency. In this case, if we put 100 euros in an electronic wallet, we should see 100 electronic euros after the transaction. At the same time, non-fiat electronic money differs from fiat currency. For example, we can exchange Belarusian ruble against electronic money – V-coin, which is issued by Belgazprombank in cooperation with the mobile operator – A1.
The above discussion results in a number of policy-relevant implications:
- The legal definition of money, financial funds and electronic money should be updated taking into account innovative forms of financial instruments development and the appearance of new financial market participants.
- Old rules and regulatory approaches hinder market development and unregulated space can create additional risks and uncertainties.
- The transition from cash to CBDC is possible but has limitations.
- A unified regulation for cryptocurrencies and other tokens should be developed at the international level for decreasing risks and further developing financial markets.
Financial market transformation is happening very rapidly. The penetration of information technologies in the financial sector created a huge number of new innovative products and simplified financial operations. All these changes have affected the payment system. The creation of electronic and digital currencies makes it necessary to reconsider the future of the traditional monetary system. But even the current regulation has to become more flexible and take into account the rapid growth of new types of financial market participants and products. The development of financial technologies creates additional risks, such as money laundering, money theft or uncontrolled financial operations which go beyond the borders drawn by national jurisdictions very often. Many central banks treat payments with cryptocurrencies and ICO with caution. At the same time, the process cannot be stopped because alternative methods of financial transactions are often more attractive compared with traditional financial services. But the low level of financial and digital literacy among the population combined with outdated legislation can slow down innovative processes in the financial sphere and augment the risks.
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- Tarasov V.I. (2012), “Money, credit, banks”, Minsk: BSU. p. 375.
- “On Digital Economy Development”. Decree No.8 dated December 21, 2017.
- Luzgina A. “Money and monetary funds as economic categories and their relationship with cryptocurrencies”, Bank Bulleting Journal, October 2018. pp.26-35.
- “Japan to provide G20 with the solution for Crypto Regulation”, News Bitcoin.com. Accessed February 28, 2020.
- Central Banks worldwide testing their digital currencies“, News Bitcoin.com. Accessed February 20, 2020.
- Banco Central del Uruguay, 2018. “Uruguayan e-Peso on the context on financial inclusion“, Accessed January 15, 2020.
- “Bank of Lithuania Issues Guidelines for Regulating STO”, (2019). Crowdfund Insider, Accessed February 10, 2020.
- Borisov A.B, (2003). Large Economic Dictionary. Knizhni Mir. p. 895.
- “The Global FinTech Index 2020”, (2019). Accessed March 10, 2020.
- Ting Peng “Turning a crisis into an opportunity, China gets one step closer to CBDC”. Accessed March 25, 2020.
Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.
Using novel approaches that exploit the blockchain to identify illegal activity, we estimate that around $76 billion of illegal activity per year is financed through payments in bitcoin (46% of bitcoin transactions). This staggering number is close to the scale of the US and European markets for illegal drugs and suggest that cryptocurrencies are transforming the black markets by enabling “black e-commerce.”
Cryptocurrencies have grown rapidly in price, popularity, and mainstream adoption. The total market capitalization of bitcoin alone exceeds $150 billion as of July 2018, with a further $150 billion in over 1,800 other cryptocurrencies. The numerous online cryptocurrency exchanges and markets have a daily dollar volume of around $50 billion. Over 170 ‘cryptofunds’ have emerged (hedge funds that invest solely in cryptocurrencies), attracting around $2.3 billion in assets under management. Recently, bitcoin futures contracts have commenced trading on the major US derivatives exchanges (CME and CBOE), catering to institutional demand for trading and hedging bitcoin. What was once a fringe asset is quickly maturing.
The rapid growth in cryptocurrencies and the anonymity that they provide users has created considerable regulatory challenges, including the use of cryptocurrencies in illegal trade (drugs, hacks and thefts, illegal pornography, even murder-for-hire), potential to fund terrorism, launder money, and avoid capital controls. There is little doubt that by providing a digital and anonymous payment mechanism, cryptocurrencies such as bitcoin have facilitated the growth of ‘darknet’ online marketplaces in which illegal goods and services are traded. The recent FBI seizure of over $4 million of bitcoin from one such marketplace, the ‘Silk Road’, provides some idea of the scale of the problem faced by regulators.
In a recent research paper (Foley, Karlsen, and Putnins, 2018), which is forthcoming in the Review of Financial Studies, we quantify the amount of illegal activity that involves the largest cryptocurrency, bitcoin. As a starting point, we exploit several recent seizures of bitcoin by law enforcement agencies (including the US FBI’s seizure of the Silk Road marketplace) to construct a sample of known illegal activity. We also identify the bitcoin addresses of major illegal darknet marketplaces. The public nature of the blockchain allows us to work backwards from the law enforcement agency bitcoin seizures and the darknet marketplaces through the network of transactions to identify those bitcoin users that were involved in buying and selling illegal goods and services online. We then apply two econometric methods to the sample of known illegal activity to estimate the full scale of illegal activity. The first exploits the trade networks of users to identify two distinct ‘communities’ in the data—the legal and illegal communities. The second exploits certain characteristics that distinguish between legal and illegal bitcoin users, for example, the extent to which individual bitcoin users take actions to conceal their identity and trading records, which is a predictor of involvement in illegal activity.
We find that illegal activity accounts for a substantial proportion of the users and trading activity in bitcoin. For example, approximately one-quarter of all users (26%) and close to one-half of bitcoin transactions (46%) are associated with illegal activity. The estimated 27 million bitcoin market participants that use bitcoin primarily for illegal purposes (as at April 2017) annually conduct around 37 million transactions, with a value of around $76 billion, and collectively hold around $7 billion worth of bitcoin.
To give these numbers some context, the total market for illegal drugs in the US (Kilmer et al, 2014) and Europe (EMCDDA, 2013) is estimated to be around $100 billion and €24 billion annually. Such comparisons provide a sense that the scale of the illegal activity involving bitcoin is not only meaningful as a proportion of bitcoin activity, but also in absolute dollar terms. The scale of illegal activity suggests that cryptocurrencies are transforming the way black markets operate by enabling ‘black market e-commerce’. In effect, cryptocurrencies are facilitating a transformation of the black market much like PayPal and other online payment mechanisms revolutionized the retail industry through online shopping.
In recent years (since 2015), the proportion of bitcoin activity associated with illegal trade has declined. There are two reasons for this trend. The first is an increase in mainstream and speculative interest in bitcoin (rapid growth in the number of legal users), causing the proportion of illegal bitcoin activity to decline, despite the fact that the absolute amount of such activity has continued to increase. The second factor is the emergence of alternative cryptocurrencies that are more opaque and better at concealing a user’s activity (e.g., Dash, Monero, and ZCash). Despite these two factors affecting the use of bitcoin in illegal activity, as well as numerous darknet marketplace seizures by law enforcement agencies, the amount of illegal activity involving bitcoin at the end of our sample in April 2017 remains close to its all-time high.
In shedding light on the dark side of cryptocurrencies, we hope this research will reduce some of the regulatory uncertainty about the negative consequences and risks of this innovation, facilitating more informed policy decisions that assess both the costs and benefits. In turn, we hope this contributes to these technologies reaching their potential. Our work also contributes to understanding the intrinsic value of bitcoin, highlighting that a significant component of its value as a payment system derives from its use in facilitating illegal trade. This has ethical implications for bitcoin as an investment. Third, the techniques developed in the paper this brief is based on can be used in cryptocurrency surveillance in a number of ways, including monitoring trends in illegal activity, its response to regulatory interventions, and how its characteristics change through time. The methods can also be used to identify key bitcoin users (e.g., ‘hubs’ in the illegal trade network) which, when combined with other sources of information, can be linked to specific individuals.
- EMCDDA, 2013. “EU drug markets report: a strategic analysis.” Lisbon, January 2013.
- Foley, Sean; Jonathan R. Karlsen; and Talis J. Putnins, 2018. “Sex, Drugs, and Bitcoin: How Much Illegal Activity Is Financed Through Cryptocurrencies?” (October 21, 2018), forthcoming in the Review of Financial Studies.
- Kilmer, Beau; Susan S. Sohler Everingham; Jonathan P. Caulkins; Greg Midgette; Rosalie Liccardo Pacula; Peter H. Reuter; Rachel M. Burns; Bing Han; and Russell Lundberg, 2014. “What America’s Users Spend on Illegal Drugs: 2000–2010.” Santa Monica, CA: RAND Corporation, 2014.
Acknowledgment: This Policy Brief is based on a recent research paper (Foley, Karlsen, and Putnins, 2018), which is forthcoming in the Review of Financial Studies, published by Oxford University Press and the Society for Financial Studies.
Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.