Seasons

Internet architecture and the layers principle: a conceptual framework for regulating Bitcoin

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INTRODUCTION

Information technology has been a key driver of transformation in the financial services sector because of its high information density. Walter Wriston, the then CEO of Citibank, famously stated that “information about money” has been almost as important than money itself in 1984 (Bass 1996). However, traditional banks and other payment processors were responsible for bringing finance to life until very recently. Cyberspace is now shaping the realm of high finance. 2009 was the year that Bitcoin was created. This was the turning point. Bitcoin is the culmination of all we know about cryptography and the internet. It creates a platform that allows financial innovation.

Bitcoin is the first peer-to-peer, decentralised network that permits the transfer and proof of ownership of virtual currency without the need of a trusted third party. This bypasses traditional financial institutions. It is a foundation for financial innovation. Governments fear the end of financial regulation.

This article examines the policy dilemma of how to capture Bitcoin’s potential economic benefits while also addressing the challenges of law enforcement. We lack the necessary conceptual anchors to model how law and finance interact in the digital space. This article is inspired by the alignment strategy that Choucri and Clark (2012) developed for cyberspace and international political. It seeks to create an alignment strategy to explain the Bitcoin ecosystem using well-established principles in internet architecture. It also provides important insights into a regulatory approach to Bitcoin.

This article is organized as follows. First, we establish Bitcoin as a logical financial layer on which innovation can occur. The layered model of internet governance allows us to extend our analysis to the entire Bitcoin ecosystem. The layers principle of internet governance allows us to identify the appropriate layer for regulation. Finally, we conclude with recommendations for government policy to help create adaptive organizations that can match Bitcoin’s incredible potential.

BITCOIN IS THE LOGICAL LAYER OF FINANCE

2008 was the first time Bitcoin was described in a whitepaper (Nakamoto 2008), published under Satoshi Nakamoto’s pseudonym, which is still a mystery to its creator. Newsweek (Goodman 2014) reported that it had found Nakamoto. This is not true. Although curiosity about Nakamoto’s identity may be understandable, it also offers an opportunity to explore the nature of Bitcoin. Bitcoin is intentionally decentralised and open-source, with no leader. Nakamoto gave control of Bitcoin to an open-source community in mid-2010. Because the Bitcoin protocol is generative, third parties can write software that runs on top of it. As Zittrain (2006, pp. Zittrain (2006, pp. 295-296) explains that such code is “first nurtured by its author and then free to find its life within a larger community.” Knowing Nakamoto’s identity is not necessary. Garzik (2014), a Bitcoin developer, blogs about the Newsweek report. “Much like other spoken languages around world, the Bitcoin protocol grows as its users change. It is ultimately controlled by no one.”

Bitcoin shares many of the same characteristics as the internet, making it the most important platform for creativity and innovation in modern times. It is important to understand the layers architecture of Bitcoin as suggested by Solum & Chung (2004) in order to appreciate its significance. The internet is neutral. TCP/IP is the protocol that makes it possible to create network applications. It is the logical layer, on which internet applications like the World Wide Web and email are built. Because no permission is required to create applications, abstraction of an upper “application layer” is crucial. Innovation is decentralised and left in the hands of individual inventors. The’stupid network can ignore specific smart applications that are being used. The broadest version of the end-to–end arguments results in a network that is not discriminatory (van Schewick 2010, 2010). Vint Cerf, one of the founders of the internet, described this as permissionless innovation. It allows the internet to maximize its overall value to society.

The real value of Bitcoin is not in its potential to replace money but in its ability to act like the internet of money (Bitcoin’s Future: Hidden Flipside, 2014). Bitcoin is more than just a replacement for money. It is like a logical layer of finance (Dourado 2014). This will enable people to own and pay for goods in a revolutionary way. Money can be programmed with conditions because every Bitcoin transaction is coded. Money can be programmed to have conditions. For example, money won’t be released unless a third party agrees or the project is funded by people who meet a certain threshold. Because of the prohibitive transaction fees, continuous micropayments are possible with Bitcoin. This allows for fine-grained usage-based pricing. Bitcoin can also be used to own physical assets. A Bitcoin token can be used to turn on a car, for example. Although it is difficult to predict the future, we know that there will be waves of financial innovation on the Bitcoin platform.

Like the changes brought about by the internet, the interest of policymakers in Bitcoin is similar. Both politicians and bureaucrats have both hopes and concerns about Bitcoin, a disruptive technology that is rapidly changing the world. There are both hopes and fears because of the potential for innovation. However, there is almost no way to regulate Bitcoin due to its peer-to-peer nature. It is difficult and challenging to get policy right. These are the two main themes that were reflected in hearings held by the US Senate in November 2013. (US Senate Committee on Homeland Security & Governmental Affairs, 2013,; US Senate Committee on Banking, Housing & Urban Affairs, 2013, 2013). It is clear that there is a lot of innovation and development taking place. Ben Bernanke, the former chairman of Federal Reserve, stated that virtual currencies may have “long-term promise”. There is also a need to protect against the illicit use of Bitcoin. Tom Carper, chairman of the Homeland Security Committee, summarized this nuanced sentiment well. “Rather than playing ‘whack-amole’ with the latest currency or website criminals use…we need to develop thoughtful federal policies that protect the public and don’t stifle innovation and economic growth.” (Strauss & Foley, 2013).

REGULATION – ADAPTIVE APPROACH

The lessons learned from advanced digital economies that have enjoyed the internet’s economic and social benefits, suggest that governments adopt an adaptive approach to regulate Bitcoin intermediaries. This is based on experimentation, adaptation, and learning from past experiences (Boston Consulting Group 2012). Whitt (2009) explains the importance of “adaptive policy-making” by governments in order to deal with technological changes and maximize innovation. As with many other technologies, Bitcoin is disruptive to the status quo and governments are under pressure to react. Overreacting can lead to innovation being slowed down. While there will be new challenges, the opportunities are endless. This is a stark comparison: Silk Road, an illegal Bitcoin marketplace, had $1.2 million per month in transactions, compared to a Bitcoin economy of $770 million (Brito 2013, 2013a). While illegal activities make up a small portion of the Bitcoin economy they draw disproportionate media attention. It is more important to see how regulators and businesses work together to create a new financial ecosystem that better serves the real economy.

Traditional financial regulators are not well-equipped to comprehend the intricate, fine-grained nature of internet architecture. Further, they are constrained by the organisational culture. They are at worst inward-looking and resist change. The fact that Bitcoin doesn’t exactly fit into existing regulatory definitions for currency, commodity, and payment network complicates matters. In response to competition, new entrants will also be part of the financial system. It is crucial for them to keep up-to-date with technology trends and new business models across the globe in this context (Cainey 2014). Despite the blurred borders, regulatory authorities will have to collaborate in new ways. Collaboration mechanisms between different industries should also be established (Villasenor Monk and Bronk 2011, 2011).

Importantly, regulators shouldn’t place new intermediaries under the same regulatory burden as traditional financial institutions. Traditional financial institutions often have a long history of creating and deploying systems to detect illicit financial transactions. (Brito 2013b). They must modify and refine existing practices. Christopher (2013) points out that the focus of law enforcement efforts to stop money laundering has traditionally been on prosecuting financial institutions for regulatory violations in order to prevent criminal activity. This heavy-handed approach to cyberspace will lead to a situation in which Bitcoin intermediaries will disappear into anonymity and then reemerge in another area of the ecosystem. Instead of treating them as adversaries, law enforcement can gain a better understanding and make informed decisions about who to target for the underlying crime. This innovative approach allows for learning that will benefit future policymaking, without limiting innovation.

The layered model of internet architecture allows us to examine key features of the Bitcoin ecosystem. Policymakers need to recognize that Bitcoin, just like the internet is a promising platform for financial innovation. The layers principle distills the complexity of the ecosystem into control points, guidelines for regulation, and guidelines that protect the integrity of all layers. The regulation of Bitcoin intermediaries in information layer is appropriate. This strategy allows policymakers to reduce online harms, and prevent interference with online architectures and innovation. To establish a regulatory system, policymakers must adopt an adaptive and innovative approach in order to deter illicit activity and allow society to fully benefit from the creativity and innovation of the Bitcoin network.