THE DEPARTMENT OF THE TREASURY Potential Risks and Benefits of Decentralized Virtual Currency Anne Shere Wallwork, Senior Counselor for Strategic Policy, Office of Terrorist Financing and Financial Crimes U.S. Department of the Treasury Unclassified The overall classification of this briefing is: Unclassified

THE DEPARTMENT OF THE TREASURY What is Virtual Currency (VC)? Digital representation of value that may function as 1.A medium of exchange; 2.A unit of account; and/or 3.A store of value But does not have legal tender status in any jurisdiction. 2

THE DEPARTMENT OF THE TREASURY What Virtual Currency is NOT Fiat Currency A.k.a. “rea currency,” “real money,” or “national currency” The coin and paper money of a country designated as its legal tender, which circulates and is customarily used and accepted as a medium of exchange in the issuing country E-Money A digital representation of fiat currency used to transfer electronically the value denominated in fiat currency 3

THE DEPARTMENT OF THE TREASURY VC: Subset of Digital Currency Digital currency: a digital representation of either VC (non- fiat) or e-money (fiat) “Digital currency” is often used interchangeably with the term “virtual currency” 4

THE DEPARTMENT OF THE TREASURY Types of VC CentralizedDecentralized ConvertibleAdministrator, exchangers, users; third-party ledger; can exchange for fiat currency Exchangers, users (no administrator); no trusted third- party ledger; can exchange for fiat currency; growing infrastructure (third-party wallet provider, payments processors, ATMs) NonconvertibleAdministrator, exchangers, users; third-party ledger; cannot exchange for fiat currency Does not exist 5

THE DEPARTMENT OF THE TREASURY Convertible vs. Nonconvertible Convertible VC Equivalent value in real currency Can exchange back-and- forth for real currency Examples: Bitcoin WebMoney Second Life Linden Dollars e-Gold (defunct) Liberty Reserve (defunct) Nonconvertible VC Intended to be specific to particular virtual domain or world (e.g., massively multiplayer online role- playing game (MMORPG) or Amazon.com) Cannot exchange for fiat currency under the rules governing its use Examples: Project Entropia Dollars Q Coins World of Warcraft Gold 6

THE DEPARTMENT OF THE TREASURY Centralized vs. Decentralized Centralized VCs Single administrating authority (administrator) or third-party controls system Issues currency Establishes rules for its use Maintains central payment ledger Has authority to redeem currency Examples: PerfectMoney, WebMoney (“WM units”), World of Warcraft Gold (WoW gold), Second Life “Linden dollars,” e-Gold (defunct), Liberty Reserve (defunct) Decentralized VCs A.k.a. crypto-currencies Distributed, open-source, math-based, peer-to-peer VCs No central administrator No central ledger No central monitoring or oversight May be single currency (e.g., Bitcoin, LiteCoin) or multi-currency (e.g., Ripple, Stellar) 7

THE DEPARTMENT OF THE TREASURY Potential Benefits of Decentralized Convertible VC Payments: faster, cheaper, more secure Potential to improve payments efficiency Decentralized convertible VC may... Reduce transaction costs for payments and funds transfers Increase transaction speed with near real-time settlement Facilitate cross-border payments for international trade Improve privacy and security for PII Support financial inclusion 8

THE DEPARTMENT OF THE TREASURY Use Cases Payments Remittances, other cross-border transfers, micropayments Direct, real-time, bank-to-bank transfers Settlement FX exchange Replace correspondent banking with direct cross-border transfer and settlement Financial Inclusion Lower fees Emerging economies lacking traditional infrastructure Trading Clear securities Register and transfer real estate deeds, vehicle titles, etc. 9

THE DEPARTMENT OF THE TREASURY Beyond Payments: Potential Use of Blockchain Technology Blockchain: the underlying technology of Bitcoin Public and decentralized online ledger that verifies transactions in decentralized, convertible digital currencies (e.g., Bitcoin) Indelible record Network of computer users rather than centralized authority that verifies transaction authenticity Potential to adapt blockchain to process, record, and verify a wide range of financial transactions in more efficient and cost- effective manner Settlement Trading 10

THE DEPARTMENT OF THE TREASURY Potential Risks of VC Payments Risk Drivers for Decentralized Convertible VC Anonymity Global reach Segmentation Challenges in tracing VC flows and freezing or seizing illicit proceeds held in the form of VC Lack of regulation Risk Drivers for Centralized VC Same risks as decentralized convertible VC plus... May be established for the purpose of money laundering (ML) and other illicit financial activities (e.g., Liberty Reserve) 11

THE DEPARTMENT OF THE TREASURY U.S. Federal Regulation AML/CFT Convertible VC entities engaged in certain activities regulated under Bank Secrecy Act (BSA) as money transmitters Register with FinCEN Subject to BSA customer identification/verification, recordkeeping, transaction monitoring, and suspicious activity reporting requirements Other federal regulatory action Commodity Futures Trading Commission (CFTC) alerts regarding consumer protection SEC Advisory Committee regarding risks and pending registration decisions 12

THE DEPARTMENT OF THE TREASURY State Regulation Focus on licensing, safety and soundness, and consumer protection Conference of State Bank Supervisors (CSBS) Statement of principles Draft model of regulatory framework Licensing requirements: credentialing of business entity owners, directors, and key personnel; banking arrangements Financial strength and stability: net worth or capital requirements, permissible investments, bond requirements, policies, procedures for disaster recovery, and emergency preparedness plans Consumer protection Cyber security: CS program, policies, procedures; consumer notification and reporting requirements for CS events; third-party CS audit) AML/CFT Books, records, and supervision New York: VC business licensing (“BitLicense”) regulation pending California Texas, Kansas, Vermont: money transmitters 13

THE DEPARTMENT OF THE TREASURY Regulation in Other Countries Governments around the world just beginning to grapple with VC regulatory challenges Some taking action, at least with respect to AML/CFT Example: UK, Canada, Singapore planning to impose AML/CFT requirements on VC exchangers Many countries hesitating to take immediate steps because... Effective AML/CFT action requires more thorough understanding of the challenges and international regulatory framework specific to VC Countries believe they do not need to regulate VC under international AML/CFT standards because they consider VC property, not currency Financial Action Task Force (FATF) Guidance June 2014: key definitions and potential AML/CFT risks Anticipated guidance on applying risk-based approach to VC 14