Before regulating Bitcoin, Congress should learn how it works

Bitcoin celebrates its eighth birthday this January as the digital currency slowly moves into the mainstream on a path to becoming a household name.

The growing interest means lawmakers are under pressure to provide more clarity about how cryptocurrencies are treated legally, and perhaps rightly so. This represents a brand new frontier and, as with all economies and technologies, regulations to protect from fraud and ill intent must follow.

Yet perhaps the biggest threat to digital currency is over-regulation. Lawmakers should not stifle innovation and exploration but instead allow it to progress and grow under a watchful eye. Establishing legislation around a currency that is yet to be fully understood could be detrimental — and perhaps an over-extension of government.

Defining Possession

Case in point: The introduction of a bill in May called the “Combating Money Laundering, Terrorist Financing, and Counterfeiting Act of 2017” includes a provision requiring anyone in possession of more than $10,000 of cryptocurrency to disclose it when passing a U.S. customs checkpoint, which would seem like a natural progression to the existing requirement to declare if you are physically carrying financial instruments worth more than $10,000 when entering the U.S.

{mosads}This presents some problems, especially regarding how to define possession. Do Bitcoins stored on an exchange for trading count? How about if the private key for the Bitcoins is stored in a safe deposit box instead of on a computer? What about the fact that these currencies, particularly the ones with smaller market caps currently, fluctuate in value wildly over very short time spans?

The disclosure requirement imposes a burden on anyone owning substantial amounts of cryptocurrency and invades privacy and safety while providing no substantial benefit. Additionally, enforcement is near impossible and subject to an officer’s whims — this is a classic example of unnecessary over-regulation.

Differentiating a Store Of Value and a Security

The IRS currently treats Bitcoin and other cryptocurrencies as property for federal tax purposes, but as these digital currencies develop more advanced features, this definition may require re-evaluation.

Ethereum, a newer entrant to the scene, presents a good example. It offers the distributed ledger technology pioneered by Bitcoin but combined with the functionality of smart contracts, which allows the automated transfer of its tokens through code.

Mark Cuban to invest in cryptocurrency after calling bitcoin “a bubble” https://t.co/33m90kI335 pic.twitter.com/lRfA8DIHq1

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Startups around the world have leveraged Ethereum’s smart contract feature to raise funds directly from the masses through Initial Coin Offerings (ICOs). ICOs entirely circumvent the private venture capital and public equities markets that have traditionally served as their financiers, which has its pros and cons. The possibility of directly raising capital bears semblance to Kickstarter projects and greatly reduces the amount of time required to fundraise, which can accelerate innovation, especially in parts of the world where the financial markets are not as mature as the U.S.

Unfortunately, it also has the ugly side effect of attracting con artists who create projects that deliver no value, solely to take advantage of new investors who don’t have the knowledge to properly perform due diligence but want in on the action nonetheless due to the hype generated by the soaring prices in the space.

The most high profile offering was for a new organization called The DAO, which imploded after the smart contract written to govern the organization was discovered to have a security vulnerability that allowed an individual to transfer a bulk of funds.

Bitcoin hits record high value https://t.co/Kqtm2acvjh pic.twitter.com/PndG2dlo0k

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The high visibility event resulted in the SEC investigating and issuing a statement declaring that these tokens constitute the sale of a security and therefore are subject to U.S. securities laws. However, with no clear actions taken regarding enforcement, the statement just acts as a proverbial slap on the wrist and provides no clear indication of the where the line is drawn for future token sales.

Regulators need to have a well defined method to distinguish between the tokens generated by digital currencies such as Ethereum, which represent shares of a company and will require some regulation, versus digital currencies that just act as a store of value, like Bitcoin, which can rightfully be classified as property.

There is no doubt that carefully conceived regulation can only benefit consumers as well as the overall market, but lawmakers need to take caution not to overstep their bounds and create rules without thoroughly understanding the underlying technology and their ramifications on society.

Han Chang is a serial entrepreneur and co-founder of InvestmentZen, an online publisher of financial news and advice and comparisons of financial tools and products. Disclosure: He holds positions in Bitcoin and Ethereum.

The views expressed by contributors are their own and not the views of The Hill.