HMT Call for Information on Digital Money

Citi

December 3rd 2014

Introduction

This response is provided by Citis Treasury and Trade Services (TTS) Technology & Innovation Team. TTS processes nearly 2 Billion transactions yearly, moves more than USD 3 Trillion in daily transaction flows and is a Banking license holder in 97 countries including 78 emerging countries

Citi aspires to the be Worlds Digital Bank and employs a network of innovation labs that is currently investigating the scope and potential of Digital Money as an innovation complementary to global financial services.

Due to the potential benefits, we believe that the adoption of Digital Money is inevitable.

While we believe that the use of Digital Money is certain, the future of specific crypto-currencies such as Bitcoin is less clear.

Ultimately, Bitcoins benefits will be realized through the application of the underlying distributed ledger technology (i.e., blockchain) to provide an extensible decentralised, trustworthy, and generic transaction store.

Companies are currently developing applications utilizing Bitcoins underlying technical innovations to increase transparency and efficiency, benefitting consumers, merchants, governments and regulators alike.

Using such technology, there is a clear opportunity to reduce the cost of moving and handling money, increase consumer spending, and introduce greater liquidity to the market.

The digital ledger of transactions can be used to enable the digitization of components of the current Financial System. The implementation of which would establish an extensible, decentralized, trustworthy, and immutable generic transaction store that enables encoding of business logic, laws, and other rules.

However, we believe that Governments and the Financial Industry incumbents are not currently leveraging the benefits of emerging technologies and risk similar challenges to that of the Post Office during the shift to digital forms of communication.

The greatest benefits of digital currencies can be realised through the government issuing a digital form of legal tender. This currency would be less expensive, more efficient, and provide greater transparency than current physical legal tender or electronic methods.

Question 1What are the benefits of digital currencies?

We believe, the benefits are realised through the application of the underlying technology to provide an extensible decentralised, trustworthy and generic transaction store to solve a wide variety of problems. Using such technology there is an opportunity to reduce costs of handling cash, increase spending, and to move money to the formal economy as a result of the adoption of digital currency.

How significant are these benefits?

We believe there could be very significant benefits in two areas:

1) Making transactions more efficient in some segments of the financial system where barriers to entry or regulation produce artificially wide spreads.

2) Using the blockchain technology to make and keep track of financial and nonfinancial asset transactions in a permanent accounting record.

How do these benefits fall to different groups e.g. consumers, businesses, government, the wider economy?

Consumers could experience

Lower transaction costs

Digital currency that can be used with a wide range of technology options is capable of reaching unbanked and underbanked citizens.

Businesses could experience

By facilitating real-time payments, and enabling business logic at the transaction level, Digital Money could allow businesses to benefit from enhanced back-office functionality (including cash management capabilities) and lower overhead costs.

Digital currencies transact on an infrastructure that is less expensive, faster and arguably more secure than traditional payment systems.

Government could experience

Greater transparency at the transaction level by providing an immutable record of accounting, and ability to embed automated tax collection at the transaction level, enabling governments to decrease overhead and increase efficiency.

Possibly realise benefits from financial inclusion, increasing the efficiency of government disbursements and addressing fraud and overpayments.

Wider Economy

By reducing the cost of moving and handling money, digital currency increases consumer spending potential and introduces greater liquidity to the market by increasing the velocity of money.

Potential digitization of components of the existing Financial System.

How do these benefits vary according to different digital currencies?

Digital Money implementation has characteristics which vary greatly, for the most part in terms of their blockchain implementation. Secondly, these currencies include payment networks with characteristics which vary significantly, such as the level of distribution involved and how consensus is arrived at.

As with any currency, Digital Money's intrinsic value is in its utility. Due to the current lack of retail traction and regulatory ambiguity, the full potential benefit of digital currency has not been realized. A potential use case promoting the greatest benefits of digital currencies is realized through state issue of legal digital tender. This currency would be cheaper, more efficient, and provide greater transparency than current physical legal tender or electronic methods of commerce.

Question 2Should the government intervene to support the development and usage of digital currencies and related businesses and technologies in the UK, or maintain the status quo?

Intervention would help address the current level of uncertainty.

If the government were to intervene, what action should it take?

In our opinion, the absence of clear regulatory guidelines creates uncertainty in this space, and prevents legitimate players from entering the space. Resolving this uncertainty will allow Banks to make decisions on how to approach digital currencies.

Another option would be for the government to provide state-backed digital money for the benefit of, citizens, businesses, the government and the wider economy.

Question 3If the government were to regulate digital currencies, which types of digital currency should be covered?

All digital currencies, as each presents risks and opportunities to citizens, businesses, the government and the wider economy.

Should it create a bespoke regulatory regime, or regulate through an existing national, European or international regime?

In our opinion, due to its inherent ability to easily cross borders and jurisdictional controls, Digital Money requires an international framework to regulate effectively. National level regulations and protections are also required. Bespoke regulatory regimes may create onerous ongoing obligations that inhibit growth. A pro-innovation approach that balances innovation with regulatory requirements (Anti-Fraud, AML, Cyber Security and Privacy & Information Security) is attractive. The regulation of Digital Money is best served by leveraging existing regulatory regimes.

For each option: what are the advantages and disadvantages?

The overall advantage would be that regulation can grant legitimacy to a digital currency and help pave the way for greater adoption by both consumers and businesses alike.

The more bespoke the regulatory obligation the more onerous the reporting.

Broader-scope regulatory initiatives more accurately capture the boarder-less nature of Digital Money and provide more meaningful analytics.

What are the possible unintended consequences (for instance, creating a barrier to entry due to compliance costs)?

By virtue of its function, regulation creates a barrier to entry. The actual cost of this function should be kept to a minimum, but is required for a transparent system.

Regulation has consequences on the motivations to hold digital currency. If its usefulness is negated by overtly strict regulation it is unlikely that it will be used or driven underground. Excessive compliance costs may negate the benefit of using such currencies and/or drive its use underground.

Question 4Are there currently barriers to digital currency businesses setting up in the UK?

We believe so

If so, what are they?

In our opinion, the absence of clear regulatory guidelines creates uncertainty in this space, and prevents legitimate players from entering the space. Resolving this uncertainty will allow Banks to make decisions on how to approach digital currencies. This could address the greatest barrier to entry that currently exits.

Question 5What are the potential benefits of this distributed ledger technology?

Block chain technology has a number of properties which change how we look at a wide variety of financial and non-financial transactions.

1. It can and has been used as a secure digital currency.

2. It can be extended beyond currency use.

3. It holds an irrefutable record of all transactions.

4. It authenticates all transactions.

5. It has no need for a central authority, if desired.

6. It provides instantaneous value transfer.

7. It supports a completely distributed architecture.

8. It cannot be subverted by any single entity.

9. It can be encoded with business logic, laws and other rules.

How significant are these benefits?

The benefits are profoundly significant when you look at the Blockchain as new Information Technology that was previously thought impossible before its invention within the Bitcoin solution.

Securing digital assets has been a difficult problem for decades and to date all proposed or implemented solutions have been mediocre at best. With this invention suddenly it is possible to send money across the Internet in a totally secure manner, to parties you do not know and be 100% sure it will get there, will not be compromised, and will not be copied.

Fundamentally all data in all computer systems can be changed at any time, it is one of the great strengthens of data, however it is also one of the greatest weaknesses especially if securing a digital asset or a digital representation of a real world occurrence.

Bitcoin and Blockchain have managed to solve this problem with one of the most challenging assets to secure and secure in a digital form money.

By extension many other digital assets or digital representation of physical assets can benefit from this invention.

Question 6

What risks do digital currencies pose to users?

There are many risks, including the following non-exhaustive list:

1. A digital currency user can suffer a loss if an exchange is fraudulent, fails or is hacked.

2. Price volatility.

3. A digital currency user holding digital currencies may unexpectedly become liable to tax requirements.

4. A digital currency user could find themselves in violation of applicable laws and regulations.

5. A digital currency user could lose digital currency units through digital wallet theft or hacking. Various companies now provide solutions to store digital wallets (usually a software application for holding, storing and transferring bitcoins or other virtual currency) in an offline mode, referred to as cold storage that specifically protects against theft and hacking.

6. A digital currency user's identity could be stolen when providing identification credentials to access digital currencies.

7. An individual involved in market participation using digital money could suffer losses due to unexpected application of law that renders contracts illegal/unenforceable.

8. An individual involved in market participation using digital money could suffer losses due to delays in the recovery of digital currency units or the freezing of positions.

9. An individual involved in market participation using digital money could suffer losses due to counterparties/intermediaries failing to meet contractual settlement obligations.

10. An individual involved in market participation using digital money could suffer losses of digital currency units held in custody by others.

11. Users have no guarantee that digital currencies are accepted by merchants as a means of payment on a permanent basis.

12. When used as a means of payment the user may not able to convert digital currencies into fiat currency, or not at a reasonable price.

13. When used as a means of payment the user may be unable to access digital currencies after losing passwords/keys to their wallet.

How significant are these risks?

We believe that the risks are very significant. In the US, the Consumer Financial Protection Bureau has issued advisory warnings, noting that digital currencies are not backed by the government, have volatile exchanges rates and are targeted by hackers and scammers. Also Bitcoin-based deposits are not federally insured.

How do these risks vary according to different digital currencies?

These risks vary between digital currencies at many levels including, protocols, cryptography, key management, linkability of pseudonyms. They have characteristics which vary greatly, for the most part in terms of their block chain implementation.

Secondly, these currencies include payment networks with characteristics which vary significantly, such as the level of distribution involved and how consensus is arrived at.

Question 7Should the government intervene to address these risks, or maintain the status quo?

We believe that intervention should be considered

What are the outcomes of taking no action?

1. Lessened capability in reaching the unbanked and under-banked.

2. Continued barriers to financial inclusion.

3. Continued risks in fraud and overpayments.

4. Continued high cost of transactions.

Would the market be able to address these risks itself?

We do not believe the market can addresses the risks itself.

Question 8

Should the government regulate digital currencies to protect users?

The area would benefit from a review .

If so, should it create a bespoke regime, or regulate through an existing national, European or international regime?

The government could work with national and international bodies, agencies and government departments in order to formulate and harmonise regulations. For example, the US government has applied current regulatory rules to bitcoin exchanges. One such exchange was shut down due to money laundering and conspiracy allegations by its founder. Furthermore to mitigate against anonymous transactions that can be used to thwart AML measures, governments can impose regulations, such as the Know Your Customer (KYC) principle, on the intermediaries who offer services in exchange for bitcoins.

In the EU, the European Banking Authority (EBA) argue that digital currency pose a risk through manipulation or design the algorithm, protocol and transaction ledger might be manipulated or might not be designed in good faith''. The EBA and a number of countries worldwide such as Brazil, Argentina, and India, have issued warnings to the public about the risks associated with digital currencies.

The consumer could also be protected and with a rise in the number of transactions using digital currency, the US consumer regulator will now solicit related consumer complaints. Eventually violations against consumer law can be enacted upon within a legal framework.

For each option: what are the advantages and disadvantages?

One of the key defining features of Digital currencies systems is that can be accessed globally to make payments and transfer funds across borders. Encouraging bespoke regimes may result in future difficulties for law enforcement and control. In investigating and prosecuting crimes that involve digital currencies they may have to rely upon cooperation from international partners who may operate under different regulatory and legal regimes. A collective regime will allow the technology to retain the advantage of cross border reach. Due to the current absence of regulatory action worldwide, an international regime would be difficult to establish today.

What are possible unintended consequences (for instance, creating a barrier to entry due to compliance costs)?

Regulation has consequences on the motivations to hold digital currency. If its usefulness is negated by overtly strict regulation it is unlikely that it will be used or go underground. Excessive compliance costs may negate the benefit of using such currencies.

What other means could the government use to mitigate user detriment apart from regulation?

There are many measures that a government could take. For example tightening of consumer protection laws will help improve confidence and drive usage of using digital currencies in commerce.

Question 9

What are the crime risks associated with digital currencies?

Digital currencies have facilitated crimes such as Anti-money laundering, terrorist financing and fraud. The storing and moving of illicit funds that are untraceable has given new tools to criminals. Digital money systems can be used globally to make payments and transfer funds across borders. Hacking and theft of digital currency is an issue and needs to be tackled. Law enforcement agencies investigating and prosecuting crimes that involve digital currencies may have to rely upon cooperation from international partners who may operate under different regulatory and legal regimes.

Most of these points are true for physical and electronic money.

How significant are these risks?

These risks are significant. They can cause loss to national governments in terms of revenue. Increased criminal activity and security threats will also need to be tackled by the government. Fraud and theft concerns may dampen consumer uptake of digital currencies.

How do these risks vary according to different digital currencies?

There are many digital currencies offering different levels of encryption to protect from theft. Bitcoin being the most popular,has suffered high profile attacks on exchanges and wallets. Darkcoin, on the other hand, was created to solve the inherent privacy problem of Bitcoin. Darkcoin, an altcoin, uses DarkSend, a decentralised peer to peer CoinJoin based cryptographic currency which provides protocol extensions to merge transactions together into larger anonymous transactions. This provides greater anonymity for those transacting in Darkcoin.

Question 10

Should the government intervene to address these risks, or maintain the status quo?

Yes, the government should consider intervention.

What are the outcomes of taking no action?

A first step should be to provide immediate guidance to regarding existing digital currencies. There are clearly benefits for businesses and consumers in using these currencies. The existing cannot be controlled unless a better, safer alternative emerges unless governments and banks are at the centre of this technological shift beyond paper and credit cards, it will continue to support financial crime. To be a key participant may mean that banks and governments need to work together to develop digital currencies that supercede the existing physical and electronic solutions.

Question 11

If the government were to take action to address the risks of financial crime, should it introduce regulation, or use other powers?

The introduction of regulation should be considered. A pro-innovation approach that balances innovation with regulatory requirements (Anti-Fraud, AML, Cyber Security and Privacy & Information Security) is required. The regulation of Digital Money is best served by leveraging existing regulatory regimes like the European Commissions Anti-Money Laundering Directive, and USAs Financial Crimes Enforcement Network.

If the government were to introduce regulation, should it create a bespoke regime, or regulate through an existing national, European or international regime?

The government could work with national and international bodies, agencies and government departments in order to formulate and harmonise regulations.

For each option: what are the advantages and disadvantages?

Encouraging bespoke regimes may result in future difficulties for law enforcement and control. When investigating and prosecuting crimes that involve digital currencies they may have to rely upon cooperation from international partners who may operate under different regulatory and legal regimes. A collective regime will allow the technology to retain the advantage of cross border reach. Due to the current absence of regulatory action worldwide, an international regime would be difficult to establish today.

The more bespoke the regulatory obligation the more onerous the reporting.

Broader-scope regulatory initiatives more accurately capture the borderless nature of Digital Money and provide more meaningful analytics.

What are possible unintended consequences (for instance, creating a barrier to entry due to compliance costs)?

Regulation has consequences on the motivations to hold digital currency. If its usefulness is negated by overtly strict regulation it is unlikely that it will be used or it will move underground. Excessive compliance costs may negate the benefit of using such currencies.

By virtue of its function, regulation creates a barrier to entry. The actual cost of this function should be kept to a minimum, but is required for an honest system.

What has been the impact ofFinCENs decision in the USA on digital currencies?

Despite the FinCEN rulings on what constitutes a Money Transmitter with respect to digital currency, many exchange services still emerge. The Bit license proposal in New York, will also create additional barriers to the smaller start-up service provider in this space. Additionally, Banks and Governments should be fostering this innovation in collaboration with the very same people within these regulation frameworks.

Question 12

What difficulties could occur with digital currencies and financial sanctions?

Although digital currencies are somewhat anonymous new currencies such as Darkcoin are being developed to provide increased anonymity for transacting. With the vast array of digital currency choices available those on sanction lists have at their disposal a multitude of ways of sending and receiving currency.

The greatest difficulty in complying with financial sanctions regulations is the absence of a robust (international) Digital Money framework for KYC and AML. The decision by a Government to issue its own Digital Money would resolve the majority of national AML, KYC, and Sanctions concerns. Clearly this creates possible privacy concerns on the side of the citizen, but could be offset by the additional value Digital Money provides.

Question 13

What risks do digital currencies pose to monetary and financial stability?

Digital currencies, despite price instability are managing to act as a store of value, albeit poorly. In cases where individuals choose to use digital currency in place of fiat currency for purchase of goods or remittance, information used to predict economic events is impacted. Estimates on the velocity of money or monetary aggregates will lose accuracy as adoption of digital currency increases. Digital currency examples today are purposely built with their own formula for rate of creation and scarcity. This is intended to sidestep monetary policy mechanisms such as interest rate control and fractional reserve banking rules. The risks include:

Price Volatility

Low Liquidity

Transaction Cost fluctuation

Loss of seignorage if digital currency originates from a non-governmental source.

Reduced visibility of financial activity

Reduced control over Money Supply

Reduced control over Interest Rates

How significant are these risks?

Highly significant. The threat to the effectiveness of monetary policy is currently low, but there is little to prevent it occurring if digital currency adoption becomes mainstream.