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ACTIVE 204720915v.1

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 world’s fastest payments processing network to fac

ilitate the processing of payment transactions in more than 150 currencies, including authorisation, clearing and settlement.

MasterCard’s ‘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 bu

siness 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 innova

tion 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 MasterCard’s 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 consumer’s 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.

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“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

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“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 Launderi

ng (‘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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The success of the ‘block chain’ is

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

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