A couple of weeks ago, we published a piece called 'Why Regulating Bitcoin Won't Work’. Here Bob Swarup provides the counter argument, assessing what regulations could do for bitcoin. Bob has extensive global experience in financial markets, macroeconomics and regulation. He has also recently released his new book Money Mania: Booms, Panics, and Busts from Ancient Rome to the Great Meltdown.

Is it a commodity? Is it a currency? No, it’s bitcoin.

There is a touch of Messianic fervour about virtual currencies these days, most notably bitcoin.

Newsweek relaunched its print edition on 6th March, with an exclusive scoop on the unmasking of one Satoshi Nakamoto, the founder of bitcoin, sparking a Keystone Cops farcical chase of reporters rushing to question him.

A fortnight earlier, the Winklevoss twins (of Facebook fame) launched the Winkdex to track the price of bitcoin and talked of the market being as large as $400bn – some 50 times larger than the current valuation.

Meanwhile, countless firms now talk of taking bitcoins as payment, including Richard Branson for anyone wanting to hitch a spaceflight on Virgin Galactic; Bitcoin ATMs have mushroomed since the first launched in Vancouver, Canada, in November 2013; and an army of bitcoin miners are recreating the digital equivalent of the California Gold Rush.

Bitcoin supporters are everywhere right now, if a tad more defensive in the wake of Mt. Gox. They invoke – in sentiment at least – the arguments of the noted Austrian economist, Friedrich Hayek, who advocated a free market of competing denationalised currencies. Provide people with choice, Hayek held, and they would instinctively choose those currencies that retained their value best and were least subject to the whims of errant policymakers.

Certainly, in an era where trust in the traditional monetary system has been shaken, bitcoin’s limited supply and freedom from human interference are powerful assets. They have transformed what was an interesting intellectual experiment into a living economy. Today, over 100 virtual currencies – bitcoin, Ripple, Unobtanium, HoboNickels, iCoin and their tribe – are fighting it out in a market $10bn large and growing.

But let’s not get ahead of ourselves. None of this is enough to create a sustainable pervasive currency. The reason is simple: currencies that thrive do so because they are endorsed and, thereby, legitimised by the state.

Money is a social construct. History shows us anything – wooden sticks, huge stones, coins, gold, boxes of detergent and now, bits of enigmatic computer code – can function as money.

Any meaning we attach is imparted through the polyglot of social interactions – status, social conformity and human behaviour – that money encodes. Without the trust born of these, no medium of exchange can exist. Even when two nations trade, the money exchanged needs to be credible and convertible, which is why they often use a reserve currency, such as the US dollar.

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But for a currency to become widespread, lots of people need to accept it. That implies the presence of society and the overarching institutions it creates. In other words, it presupposes the existence of a dominant state that can influence the behaviour of individuals. The currencies that succeed, therefore, are not those that circumvent the state, but rather those that are legitimised by the state.

Once the state accepts said trinkets – digital or otherwise – and starts to regulate them, you also drive individuals to find new ways of acquiring this new medium. They now work for others, trade goods or services, and importantly, begin to use this new medium as a pervasive social hierarchy begins to emerge.

History demonstrates this time and time again. Most notably, in 1100, Henry I of England issued an edict that going forward, taxes could only be paid using tallies – humble wooden sticks. He also prescribed their form – rudimentary medieval regulation – stating that each tally was to be cleaved in half between debtor and creditor, with the sum of money represented by an abacus of carefully delineated notches.

The results were dramatic. Growing confidence created a natural demand. The need to acquire the sticks for taxes meant that transactions began to be done using them. For the next seven centuries, wood passed as proxy for money and the English even evolved a sophisticated system of government financing based around tallies.

Done intelligently, regulation can solve key problems that bitcoin is now facing in its efforts to become a proper currency.

First, regulation can create demand for bitcoins. By making them a means of paying taxes or closing major financial transactions, it provides legitimacy to the currency. That naturally diffuses knowledge, familiarity and demand for bitcoins across a wider swathe of people, breeding acceptance. This is essential. The majority of Americans today – 80% according to a recent poll by TheStreet.com – still have no idea what bitcoin is.

This increased demand in turn can help manage the volatile swings that typify bitcoin today. The currency’s volatility may be loved by speculators looking to claw profits, but businesses still file tax returns and accounts in dollars, euros and other mainstream currencies.

The need to convert back from bitcoins to these and maintain consistent margins means many will prioritise earnings stability over continual monitoring of fluctuating bitcoin prices. But as more people embrace bitcoin, the marketplace gains more liquidity, naturally dampening volatility and making bitcoin transactions more than a marketing gimmick.

Second, the rationale for regulation is always simple: markets may fail and cause financial crisis. This is not surprising – what we term financial markets are little more than a collective noun for the hopes, greed and fears of countless individuals jostling with each other in the continual pursuit of wealth (and status).

The widespread use of any currency, including bitcoin, is predicated on the assurance that it is ‘safe’. Thus, currencies are dependent on the qualitative metric of confidence for their long-term survival.

Bitcoin – more than most other currencies – runs the risk of ‘bank runs’. The limited quantum – a maximum of 21 million – is problematic for the needs of a wider economy that is structurally dependent on borrowing. If bitcoins gain wider acceptance, simple transactions involving exchange will soon give way to borrowing and lending in bitcoins.

This financialisation is an inevitable consequence of human innovation, as people seek to make money out of these contours of supply and demand. But given the limited number of bitcoins, there will inevitably also be bottlenecks as demand occasionally outstrips supply and people overextend themselves.

In the absence of externally imposed safeguards to instil social confidence, people are more likely to panic at the first whiff of trouble, creating a disorderly stampede that could irreparably harm bitcoin’s credibility in the eyes of consumers.

Regulation will not prevent future bitcoin crises, but it can help manage their impact and minimise the disruption caused. This is critical. As humans, we have strong aversions to loss and uncertainty. Regulation provides an emotional salve that soothes our tail risk. It creates an abstract implicit trust that the economic infrastructure we are using is sound, with better behaviour enforced by the threat of sanction. Good regulation also focuses on transparency – an important component of allowing us to judge risks and make reasoned decisions.

Given regulation and the sanction of the state, bitcoin has a chance of progressing past its adolescence. Otherwise, it remains just another interesting economic experiment, confined to niche corners of the digiverse, much like cigarettes in prison or trading cards in the playground.

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