Panel: Blockchain Tech Undergirding Bitcoin Holds Great Promise, But Regulators Face Challenges

Chris Gaetano
Published Date:
Oct 27, 2016

Speakers at the FAE's Anti-Money Laundering Conference on Oct. 27 said that blockchain, the technology that drives Bitcoin and other virtual currencies, holds great potential for virtually all industries. But with this potential comes new risks that challenge regulators faced with navigating new territory opened up by this technology. 

A blockchain is a distributed database spread out over multiple nodes that maintains its own integrity through a consensus-based confirmation process between them. The chain is composed of discrete timestamped "blocks" of data that are linked to the previous block in order to provide a continuously-updated history of every change that has ever been made to that database, often called a ledger.

In order to add a new block to the ledger, and thus update the information in the database, all of the nodes must check the new block against all the previous transactions associated with it, with each node having a full history of all transactions on the chain. Once all the nodes agree that this newest block lines up with what one would expect with all the previous ones, then it's added as the latest entry in the chain and the transaction is deemed valid. Any new transaction after this would, in turn, create a new block which would, as before, be compared to all other transactions, including the block that was previously created. 

This means that even if someone were to figure out how to tamper with the data in one or even several nodes, the altered information would be unable to be entered into the ledger because it wouldn't fit what's in the rest of the nodes, and the change would be rejected. 

"Once something is there, you can never go back and change that information. You can add to it, but you can never change that initial piece," said Dana Syracuse, former  Associate General Counsel at New York Department of Financial Services and one of the speakers. 

He said that this new technology has many applications outside just virtual currency. Already, he said, it's being applied to payment and remittance systems, private stock trading, and "smart" contracts. Within only a few years, he said, we could also see blockchain technology applied to a wide variety of other things that may not even necessarily be connected to the financial industry, such as health records. 

"We want to convey the fact that these blockchain applications really span all industries and you see... the disruptive effect it will have not only on financial services and records management, but across all areas in which we live," said Syracuse. 

Another application that he said he found particularly interesting was identity management: things like passports, digital identities, birth certificates and residency. The problem with the current system, he said, is that it's insecure and forces users to expose more information than is necessary. He asked his audience to think of giving their ID to a bouncer before getting into a bar. 

"You have your address, your personal information, height, weight, eye color—but all they need is your name, face and birthday," he said. 

Blockchain, however, allows for what he said was an irrefutable identity verification. This means that someone doesn't need to share as much information, because whatever is shared is more certain to be their actual information due to it being linked to a blockchain. This, he said, means that people would be able to share only the information that is necessary. For example, he said, people might be able to open a bank account and give only the information the bank would need to do so. 

He said that companies both big and small are realizing the potential of this new technology and are investing serious technology in new applications. So are the regulators. The IRS, the Commodities Futures Trading Commission, the Securities and Exchange Commission, the Financial Crimes Enforcement Network, the Consumer Financial Protection Bureau and various state governments, including New York, have all taken an interest in virtual currencies and the blockchain technology on which they are premised. Companies, he said, would be best advised to consider the legal implications of whatever it is they're trying to build "to make sure you don't get too far out and building something that may have regulatory issues later on." 

Yet these same regulators haven't come to a clear consensus on how blockchain and its underlying applications should be regulated. For instance, the IRS considers virtual currencies property, the CFTC considers them a commodity, the SEC considers them a security, while FinCEN says it's a medium of exchange that operates like a currency. One area of agreement, said Syracuse, seems to be that the underlying blockchain technology itself should not be regulated, with the focus instead being on specific activities. But then, this brings other questions, such as the degree to which new regulatory frameworks are needed for these applications, or whether existing rules can be changed to incorporate them. 

This was a question that New York state faced when crafting its own regulation on virtual currencies. Syracuse, who helped develop these regulations when he was in the state government, said New York felt the need to examine virtual currencies in the first place because of its place as a world finance center. Regulators, he said, looked at existing money transmission law, but felt that it wouldn't be adequate. 

"We looked at the existing money transfer law, but it only governs the transmission of money, and it was important to us that we not regulate Bitcoin itself as the individual use, but those acting as financial intermediaries in this ecosystem for providing these new services or products," he said. 

He added, too, that unlike other states, the Department of Financial Services lacked the legal mechanism for altering the money transmitting law to account for virtual currencies. 

The final BitLicense regulation was approved last year and introduced a number of measures for those who act as financial intermediaries for virtual currencies, including registration requirements, disclosures, and cybersecurity mandates. Matthew Levine, the executive deputy superintendent for enforcement with the New York State Department of Financial Services, said that there are currently about two dozen pending applications for a BitLicense. There have also been two entities that the department has forced to cease activity. 

Levine emphasized how new not only this particular regulation is, but the entire area that it's regulating. Given this, he said that "we're only beginning to look at this area from an enforcement perspective in the virtual currency arena." He said that the department is only beginning the examination process, and that so far they are doing things similarly to how they do examinations at banks and insurance companies. 

"In a way it's kind of exciting, but we're not exactly sure what we're going to find. It's challenging for everyone," he said. 

Enforcement of this new regulation, at least in the beginning stages, will be more about setting a tone and creating expectations, "rather than simply doing enforcement for enforcement's sake." While he described the current record as meager, given that "there hasn't been a lot to do," he said that as the department's exams come back, there will be more information available. 

Blockchain also represents challenges in terms of criminal enforcement as well. Syracuse noted that, because of the difficulty in identifying people behind individual transaction on a blockchain, it makes it easier to allow for things like obfuscating transactions and moving vast quantities of money around the world anonymously. However, he also noted that while it's very difficult to identify a specific person, it's possible to monitor what he called "nefarious transactions," and companies that specialize in this are working with law enforcement to provide a measure of transparency.

Levine added that another area that might prove difficult for regulators is the speed at which transactions can be cleared using blockchain. Today, he said, it could take a few days for a trade to clear. This, he said, gives regulators time to examine the transaction and possible seize assets before they move. With a transaction settling in only 10 minutes, however, things become much more difficult for the regulators. 

Syracuse said that entities looking to take advantage of block chain should not only follow current laws and regulations where applicable, but to follow certain best practices. 

"What are the best practices when a company is building the technology? You need to be able to read the appropriate alerts, testing to make sure the technology functions as intended, you personnel with the skill set to understand them... and there needs to be a trend away from 'compliance silos'—by that I mean you have people at all levels of the agency that will understand all levels of the technology. And the bridge between anti-money laundering and cybersecurity isn't that great, I would encourage those two segments to work together. Very often you see information as a result of a cyber breach later used in a money laundering matter," he said. 

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