Faced with the disruptive power of cryptocurrencies such as bitcoin and ethereum, many central banks are considering laws to regulate their use. Other countries have already come down against them: China has banned cryptocurrency exchanges while India has stopped banks from dealing with anyone using cryptocurrencies.
You can understand why governments are wary: cryptocurrencies erode the monopoly of central banks to issue and regulate currencies. But the debate remains live whether regulation or a blanket ban is the better strategy for controlling the misuse of cryptocurrencies.
In my view, the best option for containing the misuse of cryptocurrencies for criminal activities and money laundering is a mixture of a ban and the promotion of sovereign-backed cryptos.
Some policy analysts support a ban on cryptocurrencies because they can be misused for hawala -- a cross-border wealth transfer system that has traditionally relied on smuggling or money laundering -- or in Ponzi schemes. Unregulated cryptos are a safe alternative for criminals, given their hard-to-crack anonymity.
Banning cryptocurrencies will actually increase their misuse, however. Those who have them will have to sell them off for cash to hawala agents as nobody else will buy them. This drives money into the hawala system, out of the regular monetary system, without any paper trail.
On the other hand, if cryptoassets are regulated, cryptocurrency exchanges and traders will have to maintain detailed know-your-client, or KYC, documentation. Most transactions will happen through these exchanges. Regulators will have access to the flow of cryptocurrencies across wallets and users, and the exchanges will be a trove of intelligence and data for enforcement agencies.
Regulators can also demand they give prior approval for cryptocurrency schemes to protect investor interests.
A blanket ban is more effective than regulation only if the ban creates sufficient deterrence. Even if the law severely punishes owning cryptocurrencies, it is extremely difficult to detect violations and make a case when they already sit outside the law.
Banning cryptos also makes it less likely that victims of Ponzi schemes involving digital currencies will come forward.
In contrast, regulation acts as a deterrent for those running Ponzi schemes. They know governments can pursue them across jurisdictions for economic offenses and can freeze their assets even in tax havens by using bilateral treaties.
However, regulation itself creates a host of problems. A policy to regulate cryptocurrencies effectively legitimizes them, and the number of cryptocurrencies available, according to one industry website, is 2,390.
Legitimizing cryptoassets means moving from a single currency to almost 2,391 currencies. For an economy with no capital controls, this is acceptable, but where a central bank maintains control over cross-border capital movement, it is deadly: capital can move out of the economy under the influence of speculators and central banks can do nothing about it.
Further, regulation only prevents the misuse of cryptos for laundering purposes to a limited extent. A stark feature of cryptocurrencies is their anonymity, and users are not going to give it up.
Despite recent advice from the global Financial Action Task Force advising countries to enforce KYC and reporting norms on crypto-exchanges, peer-to-peer transactions outside exchanges can still happen anonymously.
One option is for a country's central bank to ban cryptocurrencies used internationally but promote a limited number of domestic cryptocurrencies, which will retain all anonymity features. Since it is backed by the central bank, domestic netizens could prefer to store their value in the domestic cryptocurrency over the banned international ones.
What if the central bank releases its own cryptocurrency? A central bank can float a cryptocurrency and establish exchanges for its conversion to the local currency. It will sell the cryptocurrency wholesale to financial institutions.
At the retail level, the system will have distributed records that will be verified by administrators. This way, the central bank maintains neither control nor supervision over transactions but ensures that exchange of the cryptocurrency with local currency or any foreign currency is mostly under its supervision.
The availability of a sovereign-backed asset for anonymous transactions will discourage law-abiding citizens from using banned cryptocurrencies that lie outside the ambit of anti-money laundering regulations. As the exchanges will be under control of the central bank, it can detect any risk of capital flight using the cryptoasset.
This is the way for central banks to address, if not completely eliminate, major concerns about unregulated cryptocurrencies.
Smarak Swain is the author of "Loophole Games: A Treatise on Tax Avoidance Strategies."