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Given the decentralized nature of cryptocurrencies like bitcoin and ethereum, how can centralized organisations like banks and the government create policies around it without changing the way traditional economies work?

I have read a little bit about Japan accepting bitcoin as legitimate payments, and also countries like Japan, Russia and Estonia wanting to create their own cryptocurrency so it definitely appears to be something that is going into mainstream finances soon.

Can someone explain how a typical government would deal with this?

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In order to increase use of a cryptocurrency it could be suggested that the developers making this currency should not seek to develop a medium of exchange which would work separately from the country's currency as an independent currency, but rather seek to work together with it.

Though having a cryptocurrency working with an already existing currency would seemingly result in this cryptocurrency being backed on the by the country's pre-existing currency (which in return would give the same reliability), nonetheless, to attempt to establish a new method of payment which would be reliable, it is necessary to create a relationship with the country's previously existing currency, regardless of the previous currency's basis

W.J. Luther writes in his paper "Cryptocurrencies, Network Effects, and Switching costs" (Contemporary Economic Policy, 34, 2016, 553-571)

"By anchoring expectations- perhaps by committing to (or refusing to) accept a currency for payment of taxes- a government can effectively determine the medium of exchange"

Hope this helps.

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    $\begingroup$ +1 I would agree with this simply because the forces of economics has always proven to be stronger than any laws or regulations can hold back. $\endgroup$ – Michael Lai Nov 9 '17 at 23:05
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Governments and financial institutions usually don’t like anything that is not under their control. The same applies to cryptocurrencies. In this case, however, it seems that such careful policy (so-called risk-based approach) is justified.

To sum it shortly, I think most central banks and governments view cryptocurrencies as a means of exchange, rather than as a means of payment. As a result, state administrations accepts usage of cryptocurrencies between private entities, but will not accept cryptocurrency as a mean to pay taxes, just as it will not accept a payment of taxes in eggs.

See comprehensive examples of countries’ risk-based approach to virtual currency payments, prepared by Financial Action Task Force (2015).

Also, please see below citations from some institutions in this regard:

International Monetary Fund (2016)

VCs [virtual currencies] offer many potential benefits, including greater speed and efficiency in making payments and transfers—particularly across borders––and ultimately promoting financial inclusion. The distributed ledger technology underlying some VC schemes—an innovative decentralized means of keeping track of transactions in a large network––offers potential benefits that go far beyond VCs themselves.

At the same time, VCs pose considerable risks as potential vehicles for money laundering, terrorist financing, tax evasion and fraud. While risks to the conduct of monetary policy seem less likely to arise at this stage given the very small scale of VCs, risks to financial stability may eventually emerge as the new technologies become more widely used.

The development of effective regulatory responses to VCs is still at an early stage. VCs are difficult to regulate as they cut across the responsibilities of different agencies at the national level, and operate on a global scale. Many are opaque and operate outside of the conventional financial system, making it difficult to monitor their operations.

Regulators have begun to address these challenges, with a variety of approaches across countries. Responses have included clarifying the applicability of existing legislation to VCs, issuing warnings to consumers, imposing licensing requirements on certain VC market participants, prohibiting financial institutions from dealing in VCs, completely banning the use of VCs, and prosecuting violators. These approaches represent an initial policy response to the challenges that VCs pose, but further development is needed. In particular, national authorities will need to calibrate regulation in a manner that appropriately addresses the risks without stifling innovation.

European Central Bank (2015)

A number of international authorities have developed an interest in VCS [Virtual currency schemes], including the Financial Action Task Force (FATF), given the potential risks for the integrity of the international financial system. Several central banks and financial and supervisory authorities around the world have warned users of the risks related to holding and transacting virtual currencies, provided clarifications on the legal status, started regulating certain activities or issued an outright ban. However, the responses vary, depending to some degree on the part of the world from which they originate and on the type of authority.

[...]

For the tasks of the ECB as regards monetary policy and price stability, financial stability, promoting the smooth operation of payment systems, and prudential supervision, the materialisation of these risks depends on the volume of VCS issued, their connection to the real economy – including through supervised institutions involved with VCS – their traded volume and user acceptance. For the moment, all these risk drivers have remained low, which implies that there is no material risk for any of the central bank’s tasks as yet. Nevertheless, a major incident involving VCS and a subsequent loss of trust in them could also undermine users’ confidence in electronic payment instruments, in e-money and/or in specific payment solutions, such as those in place for e-commerce. Therefore, the Eurosystem intends to continue to monitor payments-related developments in virtual currency schemes.

Please also be aware of two issues while researching this topic:

  1. financial institutions often concentrate on virtual currencies as a whole rather than on a cryptocurrencies, which are type of virtual currencies without supervision of some central authority (so if Japan, Russia or Estonia issues virtual currency under their central bank, technically it will not ba a cryptocurrency); this means that while saying positive things about virtual currencies they often don’t think about eq. bitcoin, but rather new form of virtual currency under supervision of a central bank,
  2. the people most interested in cryptocurrencies are those, who own cryptocurrencies; thus, the information is usually presented more positive than the source of information intended.
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Governments have had very varied reactions to cryptocurrencies in the past years. Some forbid them based on the fact that they're mainly used for criminal activity such as drug dealing, human traficking and tax evasion. Others embrace the idea, as you mentioned. There is no 'typical government' way of dealing with this so far.

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  • $\begingroup$ So for the countries that are embracing it like Japan and Estonia, how do they treat fiat and cryptocurrency differently in their fiscal policies? $\endgroup$ – Michael Lai Nov 8 '17 at 4:57

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