Regulating bitcoin exchanges

: a risk-based approach

Abstract

Bitcoin, the decentralised peer-to-peer payment system equips us with a new revolutionary financial tool to send codified value across the globe. In the past few years, bitcoin has attracted tremendous uptake from retail and institutional investors with bitcoin exchanges spreading like wild fire in most technologically advanced nations. Whether in bubble territory or not, bitcoin’s prominence in the wider financial landscape has proliferated significant academic and regulatory debate. Most significantly, regulatory discussion has analysed how pre-existing regulatory frameworks and laws apply to the bitcoin network. As a peer- to-peer payment network, however, bitcoin’s decentralised architecture makes it significantly challenging for regulators to command control over bitcoin governance. Stated simply, regulators cannot regulate the bitcoin network.

This presents a pivotal regulatory challenge. If regulators cannot regulate the bitcoin network, then they must allocate their scare regulatory resources to regulate other controllable bitcoin phenomenon. With bitcoin exchanges now penetrating deeper into the financial sector, these monetary conduits that connect the cryptocurrency ecosystem to legacy economic actors present unaccounted for risks. From consumer protection, financial stability, and money laundering and terrorist financing risk categories, bitcoin exchanges subject regulators to new idiosyncratic perils. With over half of all bitcoin exchanges closing within one year of operation due to various security breaches, consumers patroning bitcoin exchanges have lost roughly $USD 14 billion in bitcoin funds. Without a doubt, bitcoin exchanges typify as a clear market failure example.
Stark academic regulatory analysis on the risks that extend from bitcoin exchanges creates a profound gap in the literature and sets a logical starting point for this thesis. Analysing risk in this context necessitates that I employ a tailored regulatory strategy to advance positive and normative regulatory explanations. By constructing a technical objective risk-based regulatory framework, I identify salient bitcoin exchange risks. Starting from a broad appraisal of the bitcoin exchange marketplace before subsequently examining the largest bitcoin derivatives exchange (Bitcoin Mercantile Exchange), I analyse risks that threaten regulators’ consumer protection, financial stability, and money laundering and terrorist financing regulatory objectives. I then proceed to suggest regulatory policies that regulators can implement into their own regulatory frameworks to minimise bitcoin exchange market failures.

After analysing bitcoin exchange risks on a broad and narrow spectrum, I argue that consumer protection risks trump all other risk categories. Unlike mainstream bitcoin regulatory policy, I argue that regulators should first use their scarce regulatory resources to rectify consumer protection risks before mandating anti money laundering and terrorist financing regulations. From ubiquitous hacking, bitcoin fund mismanagement, and severe information asymmetries, consumer protection risks within the bitcoin exchange marketplace continually crystallise and amass harm onto consumers. Empirical data on these risks elucidate that regulators can justify their interference in the market to address acute adverse selection and moral hazard problems. Consumer regulatory policies can remedy market failures and engender an economically efficient use of bitcoin exchange resources. This conclusion coincides with broader literature consensus that financial markets benefit from regulation.

Date of Award	Jul 2019
Original language	English
Awarding Institution	Queen's University Belfast
Supervisor	Sally Wheeler (Supervisor) & Federico Lupo Pasini (Supervisor)