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MasterCard response to Digital currencies: Call for Information MasterCard Worldwide (MasterCard) is grateful for the opportunity to submit this response to the 03 November 2014 paper issued by the government, Digital Currencies: Call for Information (the Paper), which seeks views from interested parties in relation to digital currencies, with a particular focus on whether they should be regulated. About MasterCard MasterCard is a publicly-listed, global payments technology company that connects billions of consumers, thousands of financial institutions, millions of merchants, governments and businesses in more than 210 countries and territories around the world, including the United Kingdom. MasterCard owns the MasterCard family of well-known brands, including MasterCard, Maestro and Cirrus and licenses financial services providers to use those brands in conducting payment transactions. We operate the worlds fastest payments processing network to facilitate the processing of payment transactions in more than 150 currencies, including authorisation, clearing and settlement. MasterCards open system delivers solutions for consumers, businesses and governments who seek faster, more secure and smarter payment methods for the widest possible range of goods and services. Executive summary The Paper explores the benefits and risks associated with digital currencies and their underlying technology and whether government should take action to support innovation, whilst also seeking comment on monetary and financial stability. Rather than answer specifically each question posed, MasterCard has organised its response under four sub-headings: Definitions, Benefits of digital currencies, Risks of digital currencies, and Potential government activity. The middle two subheadings follow the format of the Paper and address the questions posed therein. MasterCard believes that electronic payments should enable consumers and merchants (service-users) to conduct business and commerce in a way that is safe, simple and reliable for all. Digital currencies are currently a small part of the electronic payments landscape but have the potential to become much more significant payment systems. While the Paper outlines several potential benefits of digital currencies, including the innovation of the distributed ledger, it acknowledges that there also several potential limitations. If digital currencies are to grow and compete with more established forms of electronic payment, there needs to be wider trust in the technology, which we believe is only likely to occur if certain regulatory and non-regulatory actions occur. 1. Definition of digital currency It is important to understand what is meant by the term digital currency and how it is used prior to discussing the perceived benefits and the risks of the technology, particularly when determining what, if any, government action might be required.. MasterCard supports the definition that a digital currency is any type of digital unit that is used as a medium of exchange that does not have all the attributes of a fiat currency and is convertible into, and has an equivalent value in, a fiat currency, or acts as a substitute for a fiat currency. Examples of digital currencies include Bitcoin (the predominant digital currency), Litecoin and Ripple. The scope of the Paper focuses on the perceived benefits and the risks of digital currencies in their function as a payment method, defining a digital currency as one which incorporates both a decentralised payment system and a related currency. While our response is therefore framed in this regard, the payment system and the currency itself are distinct elements of digital currencies. Any regulatory or other activity the government might adopt to address risks linked to the currency itself (e.g. price volatility) may therefore be different to the risks linked to digital currencies as payment systems (e.g. system failure). It may also be worth the government considering that most users of

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digital currencies appear to be holding them for investment purposes, which in turn will have a longer-term impact on their utility as a retail payment system given their low rate of usage in this regard.

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2. Benefits of digital currencies The Paper articulates some of the perceived potential benefits of digital currencies for service-users. Low transaction costs and faster processing are mentioned as providing particular advantages, as is the safety of the system. However, we would argue that, when compared to MasterCards network, the claims pertaining to the speed and safety of digital currencies does not hold up, not least given that on average it takes 10 minutes for a block to be verified and that digital currencies are far more susceptible to hacking attacks. Additionally, while digital currency transaction costs are currently lower, this is because providers of digital currency services do not currently bear any compliance costs, whereas providers of other forms of electronic payment bear the cost of complying with consumer protection laws and anti-money laundering laws. As outlined below, in the current environment we feel that the risks of digital currencies outweigh the benefits. The central innovation that sits behind all of the beneficial claims about digital currencies is the distributed ledger technology, or the block chain in relation to cryptocurrencies. This removes the need for any intermediary banks and it has been asserted that this could fundamentally change not only the way in which electronic payment systems operate but all forms of digital assets.

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However, while there is no reliance on intermediary banks, as discussed below there is no central authority sitting behind the system itself. Regardless of the perceived security of the decentralised system, if a digital currency system collapses then all funds are lost. In comparison, depositors in the UK are protected by the Financial Services Compensation Scheme up to 85,000 per person per firm (170,000 per joint account per firm). 3. Risks of digital currencies In order for any payment system to be viable long-term and compete with more established payment systems, it must be trusted by a critical mass of those who use it. In order for this to occur, it can be envisioned that a set of standards needs to be created. It would therefore seem sensible that the minimum standards for any payment service, including the exchange and transmission of digital currency, are that it should be safe, stable and reliable for service-users; it should provide an accepted value guarantee without exposure to significant fluctuation and risk; and it should offer all the basic protections that service-users have come to expect when using more established electronic payment systems. All of these standards, if met, would contribute significantly to the long-term viability of digital currencies. However, currently MasterCard is not aware of any digital currency that meets these criteria and we would encourage the government to consider these factors if it decides that regulation is necessary to strengthen the long-term viability of digital currencies industry. In so doing, there are a number of challenges that should be addressed. Consumer protection The Paper identifies a number of potential limitations to or risks emanating from digital currencies. One of the most oft-cited risks, which concerns digital currencies as a payment system, is the current lack of basic consumer protections that are associated with more developed electronic payment systems. One example is a lack of redress if a consumer uses a digital currency to make a purchase online and the merchant fails to deliver the goods. Similarly, if a consumers device containing digital currencies is lost, stolen or hacked, the digital currencies are likely to be irretrievable. Another example is if the holder of a digital currency forgets or loses their private key, there is no way to recover it, unlike if they forget the PIN to their debit or credit account or online banking password.

1 The economics of digital currencies, Bank of England Quarterly Bulletin 2014 Q3, p.5 http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q3digitalcurrenciesbitcoin2.pdf 2 Innovations in payment technologies and the emergence of digital currencies, Bank of England Quarterly Bulletin 2014 Q3, p.5,

http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q3digitalcurrenciesbitcoin1.pdf pp.6-11

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These concerns can be applied to wallet providers, vaults, and other parties that hold or transmit digital currencies for service users. Anti-Money Laundering Separate but no less significant are the digital currency payment system risks associated with Anti-Money Laundering (AML). AML concerns emanate from the anonymity that digital currencies provide to each party in a transaction. This anonymity enables any party to facilitate the purchase of illegal goods or services; to launder money or finance terrorism; and to pursue other activity that introduces consumer and social harm without detection and enforcement by regulatory or police authorities. As we have learned from the Mt. Gox situation the existence of a block chain does little to enable law enforcement, other government authorities or the public to identify the real identity of the parties to a digital currency transaction and therefore seek redress. Again, these concerns are equally valid in relation to wallet providers, vaults, and other parties that hold or transmit digital currencies for service users. Systems failures Another risk associated with digital currencies as a payment system concern that fact that when transacting with a digital currency, there is currently no bank, administrator, or regulator that could otherwise stand behind the network. This means that consumers have no recourse if the digital currency system fails. Exchanges Digital currency exchanges are often both an exchange and a deposit-taking entity with no separation of the functions and no depositor protection. Under European legislation, stock exchanges and central security depositories are not allowed to operate within the same legal entity for precisely this reason. This creates the risk that if an exchange fails there is the potential for the deposits to be lost, as we have seen with the Mt. Gox failure. In addition, operating standards such as record keeping are still developing, as witnessed by the fact that in the Mt. Gox case, 200,000 bitcoins were subsequently discovered lying in a dormant wallet. Fixed supply and fraud risks The fixed supply of digital currencies can also, in theory, be viewed as another significant payment system risk to the longer-term viability of digital currencies.

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dependent upon achieving consensus amongst multiple miners in order to ensure valid transactions and eliminate fraudulent ones. As long as one miner or pool of miners does not acquire a sustained dominance of computing power, transactions that have been verified will continue to be accepted as valid. Digital currencies typically have a fixed supply (e.g. there will only ever be 21 million bitcoins) and currently attract low transaction fees, a feature cited by proponents as a significant benefit. Transaction fees are currently very low, not only because miners receive a subsidy in the form of new digital currency but also because of the collective belief amongst miners about the increased future usage of the payment systems, which in turn should drive price increases of the currency. However, marginal costs for miners are generally higher than for centralised payment systems and as usage increases the marginal cost of mining can actually be expected to increase rather than remain broadly constant, due to reducing margins for miners as they overinvest in computing power. Coupled with the fixed supply of currency, this will result in the current subsidy for miners becoming unsustainable, which in turn will force them to compete on a cost basis with centralised payment systems. To achieve economies of scale, the higher marginal costs of digital currencies will lead to a reduction in the number of miners down to a monopoly miner, defeating the original design of digital currencies and opening them up to system-wide fraud. Price volatility Another risk, associated with digital currencies as money and as an investment, is their high price volatility, meaning that they are not a reliable store of value. For example, during 2014 the price of

3 Ibid - this theoretical risk is described in detail pp.6-7

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bitcoins fluctuated significantly, ranging from $400 USD $1100 USD4. This can be attributed to a

number of factors such as speculative investors, security vulnerabilities, lack of liquidity, and the uncertainty of the long term value and viability of the bitcoins. These price fluctuations can create significant losses for consumers and hinder the utility and development of digital currencies as a reliable means of payment or investment. 4. Potential government activity The Paper is clear that the government is alive to the difficulties of balancing the desire for innovation and market entry with the need to ensure a stable, secure, safe and reliable payments environment. Some of the risks outlined above could be mitigated by non-regulatory activity, such as digital currency systems adopting rule changes that removed the fixed supply of the currencies. However, others may need to be addressed via regulatory solutions, whether at a domestic, European or global level. In an effort to promote discussion around this topic, we have described briefly below observations from other countries:

In June 2014, the European Banking Authority (EBA) identified approximately seventy risks associated with digital currencies: risks to non-user market participants; risks to financial integrity, such as money laundering and other financial crimes; risks to existing payment systems in conventional fiat currencies; and risks to regulatory authorities. The EBA acknowledged that regulation to address all elements would be substantial and therefore recommended that national supervisory authorities discourage credit institutions, payment institutions and e-money institutions from buying, holding and selling digital currencies.

In addition, Russia deemed digital currencies as an unlawful substitute for money and is planning to pass a law in 2015 that would ban digital currencies. China banned their financial institutions from handling digital currency transactions.

In 2013, the U.S. Department of the Treasurys Financial Crimes Enforcement Network published guidance stating that digital currency exchangers and administrators are money services businesses requiring registration, reporting and recordkeeping. This includes, among other things, establishing an AML program and filing suspicious activity reports.

The New York Department of Financial Services (NYDFS) proposed a BitLicense framework that included provisions for companies operating in the digital currency space to, for example, conduct Know Your Customer checks on customers; obtain a bond to safeguard consumers digital currency deposits; hire a Chief Information Security Officer and Compliance Officer; and submit quarterly financial statements.

Suggestions for an effective regulatory system As we have mentioned above, in order for digital currencies to flourish we believe the government will have to address risks that harm service-users and introduce the criminal element, while developing clear and consistent regulation that allows lawful digital currency businesses to flourish. To help achieve these outcomes, the following elements - while not exhaustive - should be considered for regulation:

A requirement that all transactions go through regulated and transparent administrators subject to supervision by the relevant domestic, European or global authority, rather than just the current block chain process.

Licensing and prudential supervision of all administrators should be comparable to non-bank money transmitters, with obligations to perform Know Your Customer checks, maintain an AML program, file suspicious activity reports and address cybersecurity vulnerabilities.

Develop a set of consumer protections such as reversal of unauthorised charges, return of faulty goods and a formal consumer complaint process.

4 Innovations in payment technologies and the emergence of digital currencies, Bank of England Quarterly Bulletin 2014 Q3, p.5, http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q3digitalcurrenciesbitcoin1.pdf