BitCoin: prettier in a shiny regulated wrapper?

Sparked by an anonymous user in 2008, released as open software in 2009 and free from any controlling entity or incumbent ideas of value.[1] It is in this post-financial crisis, unstable economic era where the democratisation of the financial services sector is achieved through the digitisation of services and investment value seeking refuge in assets uncorrelated to the traditional economy,[2] that I and countless others have found an appreciation for BitCoin. I love BitCoin... theoretically, says Anita Raubenheimer, Marketing & Brand Manager at Webber Wentzel.

Would I invest in it? No.

As crucial as BitCoin may be to the growing global financial markets, and as much as it may revolutionise concepts relating to payment and economic freedom, it has been plagued by a volatile market value, reports of hacking and theft and its utilisation in the notorious "dark Web".[3]

In short, "I don't trust BitCoin" - this is the common narrative that keeps South Africans from being able to access the value of Bitcoin from both an economic and financial inclusion perspective.[4] This happens to be a narrative that the global BitCoin economy continuously seeks to change - and the development of an innovative financial product may just be the big break that the BitCoin narrative has been waiting for.

Winklevoss BitCoin Trust

In July 2013, the Winklevoss Bitcoin Trust (yes, those Winklevoss) filed the first Bitcoin exchange traded fund (ETF) with the SEC.[5] The Winklevoss BitCoin ETF is the first ETF to track BitCoin as its only asset, with the aim of reforming the manner in which BitCoin value is realised and traded[6] by enabling members of the public to trade in shares issued by the Winklevoss BitCoin Trust, which derive their value from the fluctuating BitCoin price.[7]

This product, and the idea that underpins it, has sparked a much needed conversation in the BitCoin economy. Namely, whether housing BitCoin in a financial product wrapper, such as an ETF, is the key to changing the current BitCoin narrative.

South African BitCoin narrative

The South African BitCoin narrative finds its origins in the 2014 position paper published by the South African Reserve Bank.[8] The position paper was prompted by the introduction of BitCoin into the national payments system and the regulatory challenges its posed.

Accordingly, while the position paper is contextualised by the needs and purposes of BitCoin in 2014, the assertions set out in the paper have managed to solidify three core principles in the South African BitCoin narrative, which has, in turn, informed the current integration of BitCoin in South Africa. These core principles are:

1. BitCoin is primarily a decentralised virtual currency and its use, accordingly, is purely to effect a payment system;
2. Banking and payment systems regulation does not recognise BitCoin as legal tender within South Africa, and accordingly, the utilisation of BitCoin operates in a regulatory lacuna; and
3. Should consumers choose to participate in the BitCoin market, such consumers will be exposed to risks of financial instability and potential security breaches without a regulatory environment to protect such investors or create a forum for recourse.

As result of the position taken by the South African Reserve Bank in the position paper, the BitCoin narrative is one that is only known by those who know it and the participants in the BitCoin economy are, accordingly, limited to those who are able to access informative material on BitCoin and have the resources to store and absorb any potential loss of BitCoin.

This narrative, however, is counter-intuitive to the financial inclusion objective that the BitCoin economy, an alternative to the institutional banking environment,[9] sought to advance in South Africa. Economic marginalisation of South Africans is, unfortunately, now again further entrenched through limiting South Africans' access to BitCoin as well as the purposes for which it may be used.

The key to changing this narrative is perhaps in recognising the way in which BitCoin interacts with regulation. Unlike other fintech disruptors which thrive on regulatory lacunas, BitCoin actually requires regulation to legitimise its use.[10] Implemented correctly, regulation, or the development of some form of a regulatory environment, can stimulate the demand for BitCoin by legitimising its use and disseminating information about its construct into the market. This increase in demand is essential to stabilising the volatile BitCoin economy and developing more stringent mechanisms of security.

It is against this background that the BitCoin financial product conversation finds its voice. A question as to whether financial products, and the regulatory regime that embodies them, are the way in which the South African BitCoin narrative could be changed to reflect a better narrative of financial inclusion and innovation within the financial services sector.

Financial product wrapper

Notwithstanding the above, the integration of BitCoin within the current regulated financial product sphere is not merely the inclusion of unregulated BitCoin within a regulated financial product wrapper. The proposed process for developing a BitCoin financial product is two-fold:

1. Redefining the legal construct of BitCoin within South Africa; and
2. Determining the type of financial product wrapper that may be built around BitCoin, and understanding the regulatory consequences thereof.

Redefining the legal construct of BitCoin

The current South African legal construct of BitCoin is that of a quasi-currency. As a result of the position taken by the South African Reserve Bank on BitCoin in 2014, the concept, use and value of BitCoin has been developed akin to that of legal tender, albeit never attaining the status of legal tender.

The initial legal constructs of BitCoin were, accordingly, premised on the international understanding of BitCoin as a peer-to-peer payment system that operated without a centralised bank as an intermediary.

The adoption of the "payment system" label, while apt in 2014, did not account for the ability of BitCoin to grow beyond this label, which it, arguably, has. Recent analysis and understanding of BitCoin has revealed that while BitCoin, paired with the underlying blockchain technology, may create a payment system exchanging unregulated currency, BitCoin in itself does embody certain economic characteristics that associate it with a different label:

* BitCoin has a finite supply. The 2008 Satoshi paper has established that only 21 million BitCoin will ever be mined. Currently, just over 16 million of the 21 million cap have been mined.[11]
* The supply of BitCoin in the economy is dependent on the result of mining efforts, and not the issuing of further BitCoin by any entity.[12]
* The minimum denomination in which BitCoin can be held is not one. It is possible to own a fraction of BitCoin. [13]
* The percentage of the world's BitCoin supply held by a particular person is not capable of dilution due to the finite nature of BitCoin.[14]
* BitCoins are not controlled or produced by centralised authority and thus the supply and demand of BitCoin is not a dictated monetary policy.[15]
* The value of BitCoin is dependent on the demand for BitCoin in relation to its current supply, bearing in mind the 21 million cap.

The above characteristics, while not necessarily determinable factors in a currency value inquiry, to a large extent mimic the economic characteristics of gold and other similar commodities. Its value is predicated by its demand and supply - not by monetary policy or the ability of any entity to issue more BitCoins. Accordingly, while BitCoin may operate as a currency on a decentralised payment system, it similarly has economic features that make it an asset, or more accurately, a digital asset.

As such, the first step in redefining the legal construct of BitCoin is to understand that its inherent economic value is not necessarily derived from its worth in relation to another country's currency denomination, but from its value as a finite asset - the supply and demand of which is extraneous to political, economic and governance polices.

The financial product

Financial products within South Africa are currently governed by myriad legislation, all of which is susceptible to change with the introduction of the "Twin Peak" regulatory model.[16] Currently, the regulatory environment in which financial products operate comprises two regulatory components:

1. Regulations that govern the particular financial products in themselves pertaining to the issuing of the product, prudential requirements and requirements to which the structure of such products must adhere. Such regulations include the Collective Investment Scheme Control Act, 2002, the Long and Short-term Insurance Acts, 1998, the Financial Markets Act, 2012, etc.
2. Regulations that govern the manner in which financial products are sold to consumers and traded within the market. Such regulations govern who may sell and trade in such products, the manner in which it is sold and information that must be provided to consumers prior to purchasing the product. Such regulations are predominantly contained within the Financial Advisory and Intermediary Services Act, 2002.

When viewed against the background of the great variety of financial product types offered within South Africa, BitCoin, in its digital asset legal structure, would need to only be utilised in financial products that either derive value from or are backed by an asset. Such financial products include some types of structure securities securities[17], derivative contracts, participatory interests in collective investment schemes, etc. The value of the financial product would be linked or limited to the value of the underlying BitCoin asset.

Once packaged in a regulated financial product, the unregulated nature of BitCoin will become framed by the highly regulated nature of the relevant financial product. This, in turn, will invariably change (i) the way in which BitCoin is accessed, (ii) the way in which BitCoin is held, (iii) the way in which Bitcoin is traded and (iv) the way in which the inherent value in the BitCoin digital asset is realised.

As such, packaging BitCoin in an existing financial product wrapper, and by association, the financial service regulatory environment, may bring about the following consequences that will ultimately change the BitCoin narrative:

1.1 Investors will invest in a financial product which derives its value from BitCoin as the underlying asset

Investors would not be acquiring BitCoin directly but rather a particular interest or right which is backed by the value of the underlying BitCoin. The value of this right or interest is linked to the value of the underlying BitCoin, and fluctuates, accordingly.

1.2 Investors would not hold BitCoins

The BitCoins which back the financial product would be held by the entity issuing the financial product. This minimises the risk of lost keys and lost BitCoins as well increasing the security of BitCoin by housing it in an entity which may have sufficient resources to implement strict security measures. This culture of increased security within the BitCoin economy may, in turn, increase BitCoin demand by reducing the risk of lost BitCoins.

1.3 Investors can unlock the value of BitCoin by trading the financial product

Financial products such as participatory interest in collective investment schemes and securities are regarded as assets in and of themselves, which may be traded either on securities exchanges or through off-market arrangements. The trading value of the BitCoin financial product will be derived from the price of the underlying BitCoin, and accordingly, the inherent value of the BitCoin digital asset can be realised without any actual trade of BitCoin taking place.

1.4 Investors need not have a technical understanding of BitCoin

By enabling consumers to access BitCoin through the more mainstream financial product environment, the stigmatism or fear surrounding the lack of understanding in the technical nature of BitCoin is resolved.

By rendering the acquisition and value realisation of BitCoin to the acquisition of a financial product backed by a digital asset, the manner in which value in BitCoin is viewed and capitalised will be altered, thereby increasing participation in the BitCoin economy and increasing its demand.

That being said, it is likely that issuers and sellers of BitCoin financial products will need to be in a position to provide sufficient disclosures to consumers seeking to invest in such a product. Such disclosures would include, as in the case of any asset-backed financial product, factors that may influence the price of BitCoin as well as the inherent risk of the asset.

1.5 Regulatory requirements

Depending on the financial product type utilised as well as the manner in which the product is distributed, it is likely the participants within the proposed BitCoin financial product market will need to comply with relevant prescribed fit and proper requirements, reporting obligations, prudential standards and licensing requirements and conditions. Due to the current uncertain nature of the underlying asset, regulators may be uncomfortable with the idea of certain financial products being built around BitCoin or the type of investors to which it may be sold.

1.6 Eventual end game

As is the aim of the Winklevoss BitCoin ETF, the integration of BitCoin into financial product wrappers seeks to change the current BitCoin narrative by legitimising BitCoin through increased use and exposure, and in time, stabilising the BitCoin market by increasing its demand.

Irrespective of whether financial product wrappers aid in changing the BitCoin narrative, it is essential to realise the short-comings of this narrative are perpetuated by the cyclical nature of the narrative itself. "I don't invest in BitCoin because its market value is unstable" - the market value of BitCoin is unstable because people do not invest in it. The lack of demand in BitCoin is, in part, attributable to an inability to understand its complex technical nature - the complex technical nature of BitCoin will continue to remain misunderstood unless there is a demand and increased exposure of BitCoin in the market.

The key to breaking this cycle may be by bringing BitCoin within a regulatory framework to encourage its demand and integration. As it stands, regulators continue to be the deciding factor that will either continue to perpetuate the cyclical narrative or bring about the initial step in its demise. The BitCoin economy waits...