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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 cryptocurrencies 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 1
What 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


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

Businesses could experience


o 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.

o Digital currencies transact on an infrastructure that is less expensive, faster


and arguably more secure than traditional payment systems.

Government could experience


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

Wider Economy
o 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.
o 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 2
Should 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 3
If 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 4
Are 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 5
What 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.
2.
3.
4.
5.
6.
7.
8.
9.

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


It can be extended beyond currency use.
It holds an irrefutable record of all transactions.
It authenticates all transactions.
It has no need for a central authority, if desired.
It provides instantaneous value transfer.
It supports a completely distributed architecture.
It cannot be subverted by any single entity.
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 7
Should 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 AntiMoney 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 of FinCENs 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.