Friday, February 28, 2014

Market-Based Reactions To New Bitcoin Regulation

By Jon Matonis
Sunday, February 23, 2014

Every action has a reaction, and the world of government regulation is no different. Recently, the regulatory chatter has picked up around Bitcoin and it appears to be focused on two major mandates as perceived by the financial regulators.

Number one is the attempt to apply invasive technology-specific money transmitter regulation to a technology that doesn’t seem to fit into any of their other regulatory boxes. Licenses are being crafted to ensure the same level of AML (Anti-Money Laundering) and KYC (Know Your Customer) guidelines for bitcoin companies as for other types of existing financial institutions.

Number two is protecting us “from ourselves” under the standard guise of consumer protection and fraudulent operators. In an interview on The Bitcoin Group, Andreas Antonopoulos describes a self-regulating method where the consumer protection holes can be solved by free market-enforced exchange solvency and implemented cryptography solutions.

New York-Style Licensing

Regarding technology-specific regulation at the state level, New York has put forth a bad idea with an unfortunate name, mostly because it sounds like an innovative Silicon Valley startup which it definitely is not.

It is, however, a grand attempt from a local regulator to overlay an inappropriate technology-specific regulation within the confines of the great state of New York.

Unfortunately, this will cause greater hardship for New Yorkers than it will for the bitcoin businesses that will most likely seek out other favorable jurisdictions. If New York wanted to drive new growth businesses away from the state, then this would be the way to do it. These antics are not predicted to be emulated.

Markets perceive regulation as ‘damage’ and route around it. This is true with Internet-related damage and it is equally true with Bitcoin-related damage.

For example, artificial damage to bitcoin’s semi-anonymous properties could be inflicted by tracking specific bitcoin addresses at the exchange endpoint level and beyond. Perhaps mandated by law in the near future, this type of regulatory action would be akin to to registering bank note serial numbers during a routine cash withdrawal.

Most people would reel in horror at the prospect of this because they naturally believe that they have a right to use their cash as they see fit without serial number tracking.

Surveillance techniques

Coin tracking and coin validation schemes are new types of surveillance techniques that Bitcoin’s public transaction ledger enables. Interestingly, either the free market or the law could spawn these invasive techniques as a business model.

In the case of an exchange seeking to bolster its compliance reputation, it might turn to an independent service provider that analyzes bitcoin address data and associated traffic patterns known to be involved in crimes.

Of course, the major underlying and still unresolved problem here is that subjective judgement must be exercised in data analysis of this type which could unduly harm the downstream owners of fungible bitcoin. That is, if anyone held title in bitcoin to begin with.

Markets provide solutions to these cases of bitcoin privacy ‘damage’ and this is where it becomes tricky for regulators. They are practically in a no-win situation because regulators must use their tools to regulate, but the more they do, the more they inadvertently encourage market-based responses.

Fortuitously, Bitcoin comes with built-in plausible deniability due to the many ‘mixing’ hops that can be traversed both on-block chain and off-block chain. Unless the user’s private key is seized, no one can prove with absolute certainty that a particular amount of bitcoin is owned by an individual without their consent. In financial privacy terms, this is referred to as “knowledge of balance” privacy and it is a key element of overall financial privacy.

Mixing services

As cited in ‘The Politics of Bitcoin Mixing Services’, mixing services for bitcoin may emerge as the next frontier in the battle for financial privacy. Coin mixing services for cryptocurrencies do not violate any laws and they merely attempt to re-balance natural deficiencies in the protocol.

According to CNBC, Ben Lawsky and New York’s Department of Financial Services are “still wrestling with whether to ban or restrict the use of ‘tumblers,’ which obscure the record and source of virtual currencies.” Lawsky said tumblers are a concern to law enforcement although they might have legitimate uses.

Is it even possible for New York to ban tumblers that exist on the global Internet? How will the cryptographic free market respond to encroaching regulation into the market for Bitcoin?

Zerocoin and CoinJoin represent two attempts to restore the balance in making digital cash as private as physical cash today. They operate in a decentralized manner without requiring trust in a third party.

Originating from Johns Hopkins University, the first Zerocoin plan was a proposed extension to the Bitcoin payment network that added anonymity to Bitcoin payments and used provably secure cryptographic techniques to ensure that Bitcoins cannot be traced.

After refusing to gain traction among the bitcoin user and developer communities, creators Matthew Green and Ian Miers decided to launch Zerocoin as its own independent cryptocurrency complete with separate block chain and reward incentive system. The Economist refers to Zerocoin as “washing virtual money”.

CoinJoin, first described by Gregory Maxwell as a method of increased coin privacy for the real world, is an urgently needed improvement, because:
“Bitcoin is often promoted as a tool for privacy but the only privacy that exists in Bitcoin comes from pseudonymous addresses which are fragile and easily compromised through reuse, ‘taint’ analysis, tracking payments, IP address monitoring nodes, web-spidering, and many other mechanisms. Once broken this privacy is difficult and sometimes costly to recover.”
Involving no changes to the Bitcoin protocol but requiring specific wallet implementations, CoinJoin operates as a unique transaction style for Bitcoin users to dramatically improve their privacy.

Both efforts succeed where the original Bitcoin protocol stopped short. In direct response to increasing and potentially onerous regulations, Zerocoin and CoinJoin stand as pillars of financial privacy in a world where surveillance has run amok.

Ultimately, society can have hope that if privacy becomes disrespected, the market can and will provide cryptographic solutions to restore the balance. If Bitcoin is to succeed, that is the real challenge for the talented individuals and leading companies in the Bitcoin ecosystem.

Monday, February 24, 2014

The Evolution of the Bitcoin Clearing House

By Jon Matonis
Friday, February 14, 2014

We may be witnessing the final months of the large international bitcoin exchanges for retail purposes. On the road to maturity, the survivors are most likely to emerge as supra-regional bitcoin clearing houses.

Today’s global bitcoin exchange plays the mega-role of both retail and wholesale exchange, providing the platform for individual traders, corporate traders, and smaller bitcoin exchanges. Due to a dearth of functioning exchanges in many active bitcoin countries, traders are forced to look outside of their home jurisdiction for liquidity and they tend to go international.

In finance, a clearing house is an institution that provides clearing and settlement services for financial and commodities derivatives and securities transactions. The origin of cheque clearing for banks can be traced back to the 1770s.

With bitcoin, a clearing house can be thought of as a wholesale liquidity provider clearing transactions in an over-the-counter (OTC) market or a futures exchange.

By standing between two member clearing firms, a clearing house reduces the settlement risks by netting offsetting transactions between multiple counterparties and by providing independent valuation of trades and collateral accounts.

When bitcoin derivatives are inevitably introduced, margin deposits will be involved, requiring the clearing house to monitor the credit worthiness of member clearing firms and, ideally, to establish and maintain a guarantee fund that can be used to cover losses that exceed deposited collateral from a defaulting clearing firm.

The Russia-based ICBIT exchange offers a bitcoin derivatives market today.

As more and more trading for bitcoin occurs locally, the need for international bitcoin exchanges will diminish and the remaining exchanges will have to evolve in order to remain relevant. Initially, some may function in a dual capacity as both exchange and clearing house during the transition period.

Forces of change

Two separate forces are at work driving this trend within the local bitcoin environment.

Local bitcoin exchanges catering to a country or region allow the easiest method for buying and selling bitcoin because, as local players, they understand the existing electronic payment networks and the dynamics of how best to integrate with their country’s banks. Also, since bitcoin is ultimately more frightening to central banks than it is to normal retail banks, the inevitable is starting to happen.

Banks are beginning to explore methods of incorporating bitcoin services directly into their proprietary online offerings. And why not? Banks have the proven expertise in currency trading, deposit holding, secure IT environments, and payments. They should exploit this advantage.

If retail bitcoin exchanges cannot provide greater privacy and service than banks, then why are they needed to sit between you and your bank? The answer is that they probably are not needed – at least not in the same way. As more bitcoin exchanges request the opening of commercial bank accounts, the banks are gradually realizing that bitcoin services may be a direct opportunity for themselves.

Losing the middlemen

Exemplified by the recent announcement from South Africa’s Standard Bank, a bitcoin pilot program tested by the bank eliminates the need for a retail bitcoin exchange in the middle of the transaction. Partially owned by China’s biggest bank, ICBC, Standard Bank is the largest bank operating in Africa.

Similarly, Germany’s Fidor Bank pioneered the integration of bitcoin as a competitive advantage for the bank when, in July 2013, they agreed to a large-scale partnership with the exchange in Munich. The agreement called for a “liability umbrella” for bitcoin trading and represented the first direct banking cooperation in the regulated EU bitcoin sector.

Shortly thereafter, Fidor Bank signed an exclusive arrangement with Payward Ltd, operator of the Kraken bitcoin exchange. Under the deal, Kraken became Fidor Bank’s exclusive digital currency trading platform throughout the European Union, with the exception of Germany where Fidor Bank already had the local partnership with

Turning the tables on owning the bitcoin customer relationship, Fidor Bank CEO Matthias Kröner said: “Digital currencies are emerging as serious and useful alternatives to government-issued currencies. With Kraken we can enable our customers to trade bitcoin and other digital currencies just as securely, easily and flexibly as they trade other foreign currencies today.”

Shifting roles

These are still early days, but it could forecast the beginning of a trend where regional banks take on the role of building online platforms and interfacing with the millions of bitcoin customers.

In this scenario, the banks become local liquidity providers and bitcoin position takers. As the service offerings mature, banks will require a bitcoin trading desk, complete with portfolio-hedging strategies and multiple avenues for two-way liquidity.

Global bitcoin exchanges emerge as bitcoin clearing houses – less retail-oriented and more wholesale-oriented – providing deep liquidity and sophisticated offerings for the local market participants.

Friday, February 21, 2014

My Visit to the British Embassy in Warsaw

On February 12th, 2014, I presented "Is Bitcoin a Good Thing?" to the Financial Services Club at the British Embassy in Warsaw, Poland. It was my first time to Poland.

Prior to the event, I was interviewed by Chris Skinner and the audio was recorded.

Friday, February 7, 2014

Legal Online Gambling Is Next Major Bitcoin Market

By Jon Matonis
Thursday, January 30, 2014

The international online gambling industry is an estimated $30bn market, and growing. More importantly for Bitcoin, it’s a global market that depends on fast, irreversible payments.

Just like a ordinary casino chip in any land-based casino, digital bitcoin provides privacy, immediacy, and payment finality. Unlike most typical consumer purchases (where returns and chargebacks are usually legitimate), a wager is a one-way transaction. Of course, you may be dissatisfied with the outcome, but that does not justify a reimbursement. The online gambling industry has struggled with this fact for years.

Plagued by chargebacks and fraudulent transactions, specialized payment methods and payment companies have sprouted up around the online casino world to address the problem of payment finality.

iGaming and bitcoin

For the first time ever, the world’s largest and most comprehensive trade event in gaming, ICE Totally Gaming 2014, will feature a half-day seminar on bitcoin in the iGaming environment on 4h February. The London-based conference represents every gambling sector: betting, bingo, casino, lottery, mobile, online, and social gaming.

Organized by Gran Via’s Willem van Oort, the seminar features two extraordinary panels: ‘Regulatory Aspects’ and ‘Bitcoin’s Competitive Edge’. I will also be speaking on the evolution and future of bitcoin as a new monetary unit.

Moderated by iGaming attorney David Gzesh, the regulatory panel will assess the compliance challenges in dealing with bitcoin payment processing applications, including currency conversion, reduced transaction costs, payment finality, Know Your Customer rules, and coin management techniques.

Panelists include; Stuart Hoegner, managing director at Gaming Counsel PC; Steve Beauregard, CEO and founder of GoCoin; and Michael Ellen, director of licensing and strategy at Alderney Gambling Control Commission.

The second panel of the day focuses on the competitive advantages offered by bitcoin in the iGaming industry and will explore potential for new games, new jurisdictional regions, and unique investment opportunities on the horizon.

Stellar panelists include; Esteban van Goor, indirect tax lawyer at PwC; Ivan Montik, CEO and founder of Softswiss; Erik Voorhees, founder of SatoshiDice; Brock Pierce, managing director at Clearstone Global Gaming Fund; Jiten Melwani, founder of Bitgame Labs; and Gabriel Sukenik, director at Coinapult.

Into the mainstream

We are now witnessing the long-awaited arrival of mainstream online casinos and betting establishments into the bitcoin universe. This is the beginning of the second-generation bitcoin gambling sites – the first generation exemplified by sites like SatoshiDice, BitZino, and Seals With Clubs.

CoinDesk reported on Wednesday that Malta-registered casino Vera&John has become the first of the major licensed and regulated online casinos to accept bitcoin deposits. The gaming operator accepts inbound customer payments which are then processed and converted into euros via Panama-based Coinapult service.

Following a trend common among existing online poker sites like WinPoker, Vera&John will only permit wagering in national currency units. The strategy of utilizing bitcoin only as a customer payment transfer mechanism eliminates the exchange rate risk for the operator and the player.

Alternatively, if the player uses bitcoin for deposit, betting, and withdrawal, then the exchange rate risk stays with the player. Examples of that approach include CloudBet and CoinBet.

Sports betting site Cloudbet claims to have revolutionized the online betting experience by introducing the world’s most advanced bitcoin betting platform accessible from desktop and mobile devices. Users can browse an intuitive, elegant site to place immediate and discreet bets on any world event – at zero fees.

CloudBet currently deploys 100% offline cold storage for all bitcoin assets and the site has received excellent reviews.

In addition, Costa Rica-registered CoinBet offers casino gaming, poker, and sports betting all under a simple email registration with password. CoinBet claims to be the first legitimate, licensed entity to re-enter the real money online gambling space since Full Tilt Poker, PokerStars, and Absolute Poker all had their sites shut down by the US Department of Justice in April 2011. However, that particular claim may actually go to Costa Rica-registered Infiniti Poker.

Unlike other regulated gambling jurisdictions issuing licenses, Costa Rica does not require operators to obtain and verify the identity of its players. On the policy of accepting US players, John Bauer, senior vice president of gaming at CoinBet, proudly emphasized:
“Look, to take away a person’s fundamental right to spend their money on whatever they choose is wrong, unconstitutional, and without question, an un-American thing to do.”
He continued: “We are not here to engage in a legal debate, we are here to serve up the very first legitimate workaround to the complex online gambling laws in this US market. We are returning to Americans their freedom to choose and giving them their power back!”

Internet gambling in the US operates in a legal grey area. Other gaming operators in the near future may come to appreciate Bauer’s statement because the US jurisdiction has yet to see a clarifying test case in the matter of bitcoin-only wagering without conversion.