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December 9, 2013
What Do Crayons and Virtual Currencies Have in Common?
Coloring with my young boys the other day, I was a bit amazed by the variety in colors. The days of a single blue crayon from my childhood has now expanded to at least 10 different shades of blue with names such as "Pacific blue" and "cerulean." I quickly learned that my regulation of the usage of crayons by the boys also varied by color. For example, the lone black crayon required ample regulation (and was quite challenging to enforce) to prevent an all-out toddler brawl. Because the blue crayons had such variety, they clearly required less and were much easier to enforce.
Just as crayons come in a variety of colors and shades, virtual currencies have a variety of different attributes, including:
- Open or closed: Closed virtual currencies can be used only within a specific community. Open virtual currencies can be used anywhere the currency is accepted.
- Unidirectional or bidirectional: Unidirectional flow allows the currency to be obtained at a specific exchange rate using fiat currency. This currency cannot be exchanged back to the fiat currency. Bidirectional currencies are bought and sold according to exchange rates.
- Centralized or decentralized: A centralized currency has a central authority that issues the currency and operates the system. A decentralized currency does not have a single entity acting as a central issuer or clearing house.
- Asset backed or demand backed: An asset-backed currency is tied to an asset or assets held in reserve while a demand-backed currency has no tangible value other than the value established by its market.
- Machine-based or human-based: Monetary policy of machine-based currencies, or crypto-currencies, is managed by computers. A central authority establishes monetary policy with human-based currencies.
The regulation of my children's crayon usage differed depending on the particular crayon being used. In that case, it was a matter of scarcity, so the analogy isn't perfect—but it will also be imperative for the regulation of virtual currencies and their enforcement to differ according to the characteristics of the various currencies. Undoubtedly, a decentralized, demand-backed currency not only poses different risks than a centralized asset-backed currency does but it may also include a unique set of participants not part of other virtual currency schemes.
Most of the regulatory discussion currently taking place is focused squarely on a particular virtual currency. And while this particular currency has an enormous market share of the virtual currency market, there are at least 50 other virtual currencies in the marketplace. If I had regulated the blue crayons in a similar way as the black crayon, my children would likely have left their coloring books and moved on to the train table.
I fear that should regulations be developed based on a single virtual currency and then applied to the market at large, the regulations could drive away the innovators in the virtual currency space that may hold long-term promise if they promote a faster, more secure, and more efficient payment system.
By Douglas A. King, payments risk expert in the Retail Payments Risk Forum at the Atlanta Fed
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