The following Report is derived from the Discuss Track of the São Paulo node of the 2018 Computational Law & Blockchain Festival, hosted by São Paulo Legal Hackers, which encompassed presentations by and roundtable conversations among the participants.
We are living in an era of a new revolution. The world is moving from the Internet of Information to the Internet of Value.1
The Internet of Information began with the World Wide Web, when users gained access to content available on the network with a global reach, bringing all people closer within a society of connected information.
With the Internet of Value, fueled by blockchain technology and its use of a network with distributed ledger technology, not only can information be stored and transmitted, but also enabled is value as a digital asset transmissible from one person to another, which can represent a good, or a right, or a title, and so forth.
This technology is already impacting numerous markets, such as the financial market, legal market, health market, education market, and digital content.
Cryptographic payment assets are representations of assets and rights used as payment instruments, and per the IMF,2 they are much broader than cryptocurrencies. Indeed, this differentiation is interesting particularly given that one of the bills presented by Brazilian Congressman Expedito Netto3 placed all of the aforementioned in the same category.
Regarding the bill presented, there remains much to discuss. Some interested parties maintain that any legislation has to be shaped in layers, following the concept of “sandbox regulation,” as the full meaning and impact of cryptocurrencies is yet unclear, especially with respect to Congress and civil society. Therefore it appears best to avoid imposing rigid parameters on a subject that is embedded in futurology and dynamic changes.
In Brazil, there are already more than ten active cryptocurrencies exchanges, and among the more than 1800 types of cryptocurrencies existing in the world, there are around twenty national options encompassing different types of business models. Following their rise, two dedicated associations were created, the Brazilian Association of Cryptocurrencies and Blockchain (“ABCB”) and the Brazilian Association of Cryptoeconomy (“ABCripto”). The ecosystem is becoming more structured nationally with input from the private sector.4
To address the questions surrounding how policymakers should approach cryptocurrencies’ regulation, SP Legal Hackers5 hosted a roundtable discussion on March 16, 2018 in São Paulo, inviting experts from a wide array of backgrounds to discuss how we should deal with this situation.
A disclaimer must be made that any opinions, arguments, and ideas discussed and provided are not related to advocacy, consultancy, or any affiliation with the presenters’ professional relations, and did not constitute legal or financial advice, nor create an attorney-client relationship. The goal of the discussion was for participants to engage in an open-minded effort to explore potential problems, concerns, and solutions.
This report captures the essence of the discussion and is accompanied by references and citations to ideas mentioned during the day. After this Introduction, Part I discusses the economic and legal dimensions of the functions of money. Part II also deals with the concept of money itself, and touches upon the regulatory affairs and landscape with respect to the authorities’ concerns in Brazil. Finally, Part III examines criminal aspects of this new market.
The ongoing discussion on cryptocurrencies grants us a golden opportunity to debate a commonly ignored aspect of modern money, as well as its many legal aspects. Here I intend to raise some theoretical questions on which legal labels should be put on cryptocurrencies (if any at all), as well as how the question of “are cryptocurrencies money?” directs the debate on how and why they should be regulated.
In modern monetary economies, money serves three main functions: it is a medium of exchange, a store of value and a unit of account. Together, they make money the most liquid asset available in the economy—which serves both an economic and a legal purpose. Economically, liquidity substitutes a traditional exchange economy with a monetary economy, allowing for the development of more complex capitalist financial relations between social players; legally, it grants legal subjects the right to equally participate in market relations, thus upholding the rational-formal equality of a bourgeois legal order. Economic and legal aspects of money intertwine, making it a key aspect of a capitalist society organized around traditional modern institutional forms, such as the rule of law and the market economy.
This, of course, leads to the question of how money comes to be. In this regard, thinkers have traditionally divided between two main schools—herein broadly referred to as “nominalists” (or “chartalists”) and “valuelists” (or “metallists”). They differ mostly on the origins of monetary phenomena and the role of markets and states in them: while chartalists, such as Georg Friedrich Knapp6 and Karl Olivecrona,7 see money mainly as a creature of law, metallists, such as Karl Menger,8 conceive it as a creature of markets. One school sees the legal order as a constitutive element of money, whilst the other sees monetary phenomena as simply the result of the collective interaction of social players, who freely and unintentionally elect one commodity among all others to serve as a common media of exchange between other commodities.
Although there seems to be little doubt that law serves a thoroughly constitutional role in the creation of money,9 the classical division between chartalist and metallist monetary theories is a convenient reminder that the ability of money of performing its three main functions in an economy largely depends not only on its legal validity (i.e., on the existence of a formally valid legal norm that imposes its acceptance on economic players), but also on its legal acceptance (i.e., on social players’ willingness to continue to take it as the main reference for these three functions). In other words, money is greatly dependent on social trust, which is constructed by law not only formally, but also instrumentally and even symbolically.10 In extreme scenarios, such as hyperinflation, crises of social trust in national currencies may result in said currencies being rejected by the economy, as social players turn to more stable means of payment. In other words, money’s ability to work as a media of exchange depends heavily on its ability to function as a store of value or unit of account; legal positivity is not independent, but constituted by social acceptance.11
This discussion has become especially relevant in recent decades, since the Dollar-ballasted version of the International Gold Standard imposed by Bretton Woods has been all but completely replaced with fiat currency—which, practically, makes modern western capitalist economies’ currencies completely fiduciary and therefore largely dependent on the markets’ trust in governments’ ability of preserving stability. Since the end of Bretton Woods, this goal has been achieved basically through the adoption of orthodox formulae, such as independent central banks, floating exchange regimes, inflation targeting by the manipulation of overnight interest rates and avoiding sudden valuations or devaluations of national currencies by doing swaps in international currency markets.
This finally leads us to the matter of cryptocurrencies. From a strictly rational-formal legal stance, bitcoin and its siblings are not money: no social actor in a capitalist monetary economy is legally obliged to accept them as payment for any debt, which jeopardizes their ability to function as a medium of exchange. The other two functions (store of value and unit of account), however, do not depend directly on rational-formal law, but rather on social acceptance—i.e., on the economy’s willingness to consider it a reference for these two economic roles. Obviously, law is typically instrumental for this purpose, but not inherently necessary.
In extreme situations, unusually strong social trust in cryptocurrencies’ ability to serve as stores of value and units of account, especially in comparison to actual money, could theoretically make up for their lack of legal rationality in building legitimacy and gathering social acceptance, making them, de facto, a broadly accepted medium of exchange.12 This, of course, would be a borderline dystopian scenario: in practice, cryptocurrencies’ inherent instability and the lack of global state actors to keep them from instantly valuing and devaluing at alarming rates, as well as their lack of ballast in the real economy, have tended to relegate them to speculative assets.
Law is not typically revoked by social behavior. Monetary regulation, however, is dictated by currencies’ complex relations with law and the ambiguous functions that the legal order fulfills in assuring its liquidity and public trust. Cryptocurrencies, being strictly social creations, are different in the sense that they lack rational-formal validity, but are theoretically capable of serving all three functions of money, given that certain social and economic conditions are met. Legal regulation is, in this regard, essential to determining their path: law may aid cryptocurrencies in becoming more like traditional currencies, turn them simply into high-tech international means of payment, or relegate them to the speculative purposes that they mostly have served so far. The choices to be made in this regard refer to how political constituencies see risk and value innovation, as well as to overall institutional designs.
In 2017 there was a boom in cryptocurrencies, with both a rise in prices and launching of many cryptocurrencies and tokens. Hence market capitalization of cryptocurrencies rallied from USD $18 billion to USD $566 billion, while bitcoin, the pioneer and still most important cryptocurrency, lost participation in terms of market capitalization, dropping from 81% to 38%.13 Blockchain is the technological innovation behind cryptocurrencies, allowing “online payments to be sent directly from one party to another without going through a financial institution,”14 Like currency, cryptocurrencies can be transferred on a peer-to-peer and anonymous basis, but unlike them, cryptocurrencies’ supply is determined by protocols instead of an issuer. This report compares cryptocurrencies with money, electronic money (e-money), securities and financial assets, according to the Brazilian legal system, presenting a hint of their legal nature and how cryptocurrencies might be regulated.
Money has three functions: as a means of payment, unit of account, and store of value. In sovereign States, money is an institution created by Law, which means money’s functions rely on the legal order. In Brazil, Decree-Law 857/1969 (interpreted jointly with Law 9,069/1995) states that contracts and other obligations are not valid if the debtor is not allowed to pay her obligations in Brazilian money, except in foreign exchange markets. Also, the National Tax Code sets forth, in its article 162, that payment of taxes must be in national money or instruments issued by States. Besides, Law 9,069/1995 sets forth the Real’s function as a unit of account in its Article 5. The last function, store of value, is the most complex because it depends not only on the national legal system, but also on the international monetary system. With the gold standard, this function was assured by pegging currencies to gold, even though imbalances did not result in gold being transferred from debtor to creditor countries. In the 1970s, advanced economies abandoned fixed exchange rates, and nowadays most advanced countries and many emerging economies adopt inflation targeting as a means of maintaining this function.
The Brazilian Central Bank (“BCB”), created towards the end of 1964 with the institutional mission of ensuring currency purchasing power stability, has never committed itself to a fixed or exchange rate, and in the first three decades following BCB’s creation inflation rose to a 4-digit annual level. To cope with high inflation rates, the Real (“BRL”) was launched on July 1, 1994 at the exchange rate of one U.S. Dollar (“USD”). Against common sense, there was no commitment to a fixed exchange rate, but to a pre-announced and variable band. Moreover, monetary emissions were bounded by the level of international reserves and quantitative limits (Law 9,069/1995, Articles. 3 and 4). Due to this monetary reform, consumer inflation dropped from 2,477% in 1993 to single-digit level inflation since 1996, but at the cost of a valuation of the real effective exchange rate by 25% between the launching of BRL and December of 1998, increasing current account deficits from 0.3% of the GDP in 1994 to 4.0% of the GDP in 1998. Due to the overvaluation of the BRL, the BCB was forced to adopt a flexible exchange rate regime. Moreover, Decree 3,088/1999 instituted inflation targeting. Between 1999 and 2017, the official consumer price inflation index increased 6.6% per year, historically low for Brazilian standards.
Money is a liability against the State, and in general, a central bank could never be insolvent in the money it itself issues, which can be digital (central bank or commercial bank money) or physical (notes and coins). In contemporary economies, most monetary basis is electronic: while treasuries and financial institutions have accounts at central banks, households and non-financial firms have accounts at financial institutions. Large value transfers are done on a real time gross settlement basis, while most retail payments are netted by financial market infrastructures. Digital money is accessible only for those with access to the banking system and, outside of central bank accounts, depositors are exposed to the risks of a bank run. Transfers are not wholly anonymous and have a fixed cost regardless of the transferred value. Currency, on the other hand, is accessible to everyone, even for people without access to the banking system, and does not expose holders to the bankruptcy of financial institutions. While currency manufacturing is expensive (high fixed cost), transfers are free (marginal cost is given by depreciation rate) and anonymous. In that sense, currency is potentially more efficient than digital money in low value retail transfers and might be the only alternative for those with no access to the banking system and internet.
E-money, regulated by Law 12,865/13 (and in the European Union by Directive 2009/110), only exists in an electronic form and performs payment functions, especially in retail market, akin to cryptocurrencies. On the other hand, e-money is a liability of a trusted authority—payment schemes and payment institutions—and must be convertible into money per contractual rules. Cryptocurrencies’ use as means of payment is very limited compared to traditional forms of electronic payments—no more than 350,000 transactions per day are made using bitcoin, and under 2% of transactions are processed by the two Visa datacenters in the United States.15 The reduced scale of bitcoin as a means of payment is not only due to network externalities of traditional payment schemes, but also due to the limited scalability that results from the proof-of-work concept and excessive energy consumption from mining, making existing payment schemes much faster and cheaper than bitcoin.
Despite its decentralized nature, bitcoin property is very concentrated: according to Credit Suisse, as of January 2018, 97% of bitcoins are owned by 4% of addresses, while 86% of addresses own 0.6% of bitcoins.16 This leads to very volatile prices and vulnerability to manipulation, meaning price discovery in a bitcoin-based economy would be very costly and inefficient.
Cryptocurrencies’ price volatility and use as speculative investment resemble those of securities and financial assets. In Brazil, securities are listed in Article 2 of Law 6,385/76 (Securities Act), and in general do not fit the characterization of most types of securities (e.g., shares, corporate bonds, derivatives, investment funds etc.). The only exception might be Initial Coin Offerings (“ICOs”), “understood as a form of raising funds from the investing public, the counterpart being the issuance of virtual assets (tokens or coins), which, depending on the economic context of issuance and on the rights conferred to investors, may meet the definition of securities pursuant to article 2 of the Securities Act.”17 Financial assets, on the other hand, comprise an open legal category not defined by Law 12,810/2013,18 which means cryptocurrencies might fit into this category, putting them under Monetary National Council (“CMN”), CVM and BCB regulatory and supervisory oversight.
Nevertheless, due to the lack of legal basis, both the CVM and BCB have proven more cautious about regulating cryptocurrencies. CVM, besides its warning about ICOs, informed investment funds that they are prohibited from investing in cryptocurrencies.19 BCB, through Policy Statement 31,349/2017,20 asserted that it neither regulates nor supervises transactions with cryptocurrencies, highlighting their differences with e-money, their intrinsic financial risks, and the regulatory needs of international transfers through institutions authorized by the BCB for operation in the foreign exchange market; in effect rendering international transfers using only cryptocurrencies unlawful under current regulation.
Although it appears nearly impossible to regulate cryptocurrencies themselves, activities performed by intermediates, such as trading venues, brokers, custodians as well as cryptocurrencies’ conversion into money could be regulated via existing regulations over such activities as performed by traditional intermediates, and the expertise of supervisory bodies such as CVM and BCB. In fact, multiple functions performed by cryptocurrencies demand joint regulation and supervision by either CVM and BCB, as is already the case in other activities, such as the Brazilian Payment System (“SPB”), Central Securities Depositories (“CSD”s) and trade repositories. While CVM already regulates trading venues to prevent price manipulation and imposes publicity and suitability requirements on intermediates, CMN and BCB regulate interoperability, non-discriminatory access and operational reliability of payment schemes.
Despite performing functions as a means of payment and store of value, cryptocurrencies are not money as we know it and are not likely to eclipse money in the foreseeable future. As means of payment, they are akin to e-money, while as a store of value there are many similarities with securities and financial assets. Nowadays, cryptocurrencies have many disadvantages compared to money and e-money, reducing their practicality as a means of payment—at least in a decentralized manner. However, blockchain may readily improve some markets such as trade repositories and international transfers internally within financial conglomerates.
Blockchain is beginning to be used by banks to register over the counter (“OTC”) derivatives terms and international money transfers internally within financial conglomerates, and there have been studies to incorporate the technology into trade repositories and payment schemes. Morten Bech and Rodney Garrat argue that if central banks adopt their own cryptocurrencies and establish them as fully convertible to their issuing currency, the banks would be able to set negative interest rates; decreasing costs would have the benefit of not exposing their deposits to commercial banks’ risks.21 In Brazil, BCB’s technical experts studied distributed ledger technology uses as a contingency alternative to the Reserve Transfer System, an essential payment system operating in Brazil provided by the BCB to Treasury, financial institutions and financial market infrastructures. The experts concluded that consensus demanded by technology did not meet regulatory requirements with respect to privacy.22
At present, cryptocurrencies are not regulated in Brazilian criminal law. There are difficulties on the part of lawmakers in understanding the lack of a “middleman” figure, traditionally associated with financial institutions, to which legislation confers competence and responsibilities regarding the regulation of the National Financial System, as well as the establishment of integrity obligations and compliance standards.
Remarkably, Satoshi Nakamoto’s famous whitepaper, which originated bitcoin, was released only a few months after the Lehman Brothers’ collapse, a fact that makes one speculate if this was a “no banking” movement. Nevertheless, it is a fact that “exchanges”23 themselves have been trying to understand the role of cryptocurrencies and whether or not they can be traded as financial assets. In regard to the interactions of new technologies with criminal law, which is subject of this paper, it can be said that the movement also creates new forms of threats to legal interests. Many “exchanges” operating in Brazil, for instance, do not follow minimum compliance rules, unlike financial institutions which are subject to strict rules of governance.
This scenario is in line with the state’s drive to regulate financial markets in absolute terms, as there is a risk of an over-enforcement posture in order to face the waves of valuation and devaluation of cryptocurrencies. It is possible that the Brazilian lawmaker, unused to the study of new theoretical fields, takes an exaggerated reactive position.
An illustrative example was the initiative of the Brazilian Revenue Service that, in the eagerness to tax, included cryptocurrencies in the instructions for annual declaration of Income Tax. In this matter, the Treasury clarified that “although they are not considered currency under the current regulatory framework, [‘virtual’ currencies such as bitcoin] should be declared in the Goods and Rights Tab as ‘other assets,’ since they can be equivalent to a financial asset.”24 However, as they are protected by cryptography, there are no ways in which public authorities can guarantee that cryptocurrencies are declared by contributors, and therefore, no ways to enforce tax policies. It would be better if a well-grounded discussion on the subject preceded the instruction.
Initiatives such as the one described above point out a vulnerability in cryptocurrency carriers’ privacy in Brazil. Notwithstanding the fact that the Brazilian Revenue statement will generate data from its declarants, there is nothing that prevents this data from being accessed directly in the registries of the “exchanges,” due to the lack of any type of regulation.
In this regard, let us take the example of the United States. Despite New York State’s unsuccessful BitLicense—which issued only three licenses between 2015 and 2017, demonstrating a regulatory failure—the Internal Revenue Service (“IRS”) launched a legal battle against the world’s largest cryptocurrencies marketplace, Coinbase, to access the data of all its customers. The mere possibility of violation of user data in a coin marketplace represents an extremely serious issue.
In Brazil there is not yet such a deep-rooted discussion about the subject, but the country has been witness to a relativization of secrecy in and out of virtual environments.
For the purposes of illustration of the risk involved, in February 2016, the Direct Actions of Unconstitutionality No. 2,390, 2,386, 2,397 and 2,859 were analyzed by the Brazilian Supreme Court, as well as Extraordinary Appeal No. 601,314 (this one with general repercussions). In the analysis process, the protection of users’ privacy has been the subject of long discussions, and the thesis is that Article 6 of Complementary Law No. 105/2001 is compatible with the Brazilian Federal Constitution, which leads to the conclusion that there is no breach of confidentiality from the tax authorities, but a simple transference, which would make prior judicial authorization unnecessary.
Some bills have emerged to solve issues such as this. The first of these, Bill No. 2,303/2015, inspired by the Japanese model, proposes to include cryptocurrencies in the regulation of “payment arrangements,” under the terms of Law No. 12,865/2013. Without discussing the merits of the proposal, the demonstrations during the public hearings conveyed concern, as they revealed misconceptions regarding the new technology and were based on inadequate comparisons with foreign law.
In fact, as some of the cases that have already come to the public showed (including within the so-called “Operation Car Wash,”25 or “Lava Jato” in Portuguese), the core to the lack of regulation on cryptocurrencies is the risk of smuggling, tax evasion and money laundering.26 Compared to other countries, Brazil has a closed and highly monitored economy in the banking sector (through strict compliance rules, with authorities acting clearly and sufficiently, etc.), but financial crimes are facilitated through the use of digital tokens. In this scenario, regulation based on the rules of payment arrangements may be a path, although it needs to be widely discussed and improved.
The discussion should cover other fields of law, as there is a very large discrepancy between regulators, prosecutors and judges, who often conduct arbitrary operations or issue disproportional orders due to their lack of knowledge on technology matters. Debate is the best way to establish viable alternatives.