The Future of Payments

Crypto-Assets: What Are They and Why Do We Care? 66 BANKING PERSPECTIVES QUARTER 4 2018 T THE MIGRATION OF ASSETS – from land, commodities, and specie through paper records to electronic records – has been driven in large part by a desire to reduce transaction costs and increase the speed of transactions and hence the liquidity of assets and the markets for those assets. As electronic transactions evolved, one goal of that evolution has been to create unique electronic assets that cannot be counterfeited or duplicated. The ability to create a unique electronic asset allows it to be transferred and traded without (or with minimal) concern that the asset is not real and not a copy. Distributed ledger technology using blockchains appears to have met this goal. This technology has also triggered the creation of electronic assets that appear to have value in their own right, if only because people will deliver other assets in exchange for them. The term “cryptocurrencies” was coined and has been applied to assets that meet this description, such as bitcoin and a range of other electronic assets that have more conventional value characteristics. For financial institutions, especially banks, the creation of a new financial asset raises a host of legal and practical questions, including: What is the asset – an electronic representation or claim on some other asset or merely a unique set of digital characters? What is the asset for regulatory purposes – a loan, security, commodity, or something else? What law governs the ownership and transactions in the asset – private contract, statutory commercial law such as the Uniform Commercial Code (UCC), common law, or some combination of these? Is the asset an asset that is useful and permissible for a bank or other financial institutions to acquire? Even if a financial institution cannot acquire, or has no interest in acquiring, the asset, is it something that customers will want to acquire or hold, and how will that affect the financial institution’s dealings with those customers? Is there a role for financial institutions in clearing or settling transactions in the asset? How does the asset affect the creditworthiness of the financial institution’s customers? Will the financial institutions take it as collateral, or will they consider it a risky investment? These questions often can, and should, take a long time to sort out because premature decisions can stifle innovation, competition, productivity, and economic growth. Despite the risks of early characterizations, in our highly regulated world of financial services, one of the first questions that comes up is whether or not the asset is a security. Questions as to whether transactions in the assets can be used for money laundering, terrorist financing, or other illegal purposes and whether trading in the asset will trigger commodity regulations, which often follow shortly behind. As we discuss in the rest of this article, the answer to the security question for assets labeled as cryptocurrencies so far depends on the character of the particular asset, but other regulatory issues have arisen (most notably, in New York), and transactions in cryptocurrencies have been found to be subject to the Commodity Exchange Act (CEA). It is too early to try to address these issues comprehensively, but the following discussion is intended to help financial institutions start to think about them. BLOCKCHAIN AND CRYPTOCURRENCY Blockchain is the backbone technology that – along with numerous other use cases – currently is best known for powering all cryptocurrencies. Although there is no standardized definition for blockchain technology, it can be described as a distributed system of ledgers containing immutable time-stamped and connected blocks of data, which is operated generally in a decentralized manner; through pre-defined consensus mechanisms in lieu of a central authority; and by employing cryptography in order to prevent the ability to edit or tamper with the information recorded on the blockchain.