Overview, Policy, and the Future of Cryptocurrency and Blockchain Technology
Janice Negvesky contributed to this post.
Introduction and Overview of Digital Currency
Over the last decade, cryptocurrencies, blockchain applications, and related ventures have changed how we think about financial services. Cryptocurrency is a virtual or digital currency that is “secured by cryptography,” making double-spending or counterfeit nearly impossible. Hypothetically, digital currencies are systems that allow for secure, online payments which are “denominated” as virtual “tokens.”
While bitcoin is the most widely used virtual currency, there are over 7,800 other currencies— or “altcoins”— in existence. There is little agreement on how to define cryptocurrency, thus many terms are used to describe the currency, including digital assets and virtual currency. What is unique about cryptocurrencies is that they are decentralized networks “based on blockchain technology”, which is “a distributed ledger enforced by a disparate network of computers.” Crypto is generally not issued by a central authority, which renders it insusceptible to government interference.
Digital assets are supposed to allow for the effortless transfer of funds from one agent to another without a third party, such as a bank. The transactions are, instead, secured by public and private keys or incentive systems, such as Proof of Work. Cryptocurrency is extolled for its divisibility, portability, transparency, potential growth, and resistance to inflation. Conversely, cryptocurrency has its issues: namely regarding its use for illegal activity, exchange rate volatility, and its infrastructure volatility.
Who Invests in Cryptocurrency and Why?
While cryptocurrency started as an alternative form of exchange, it has now entered the mainstream. As of 2021, roughly 59 million Americans own a form of cryptocurrency; 66.7 percent of digital wallets contain bitcoin. Other digital currencies are catching up with 28.6 percent of crypto investors holding the popular “memecoin” Dogecoin and 23.9 percent of investors holding Ethereum. Of all cryptocurrency investors, 44.3 percent of them are millennials, followed by 28.6 percent of Gen X, and 17.8 percent of Gen Z. Baby boomers accounted for only 8.2 percent of all cryptocurrency investors. Looking at the total sum invested in crypto in dollars, the difference is even more stark. 86.0 percent of all crypto investments are held by millennials and Gen X. Thus, cryptocurrency is an interest of the newly emerging generations, and assumedly, will only grow in the coming decades.
The average amount in a cryptocurrency wallet is approximately $1,000. Using the coin as a form of investment is the most common reason the vast majority of people choose to invest in crypto. It is the reason cited by 68 percent investors who say they own a cryptocurrency. Using digital currency as a form of payment is the second most common reason for using crypto at 26.2 percent (roughly 15.5 million Americans), followed by using crypto as an alternative to government-controlled currency at 23.7 percent (about 14.0 million Americans). Using the tokens to store one’s savings outside of traditional banks is also a popular reason for owning crypto, with 19.7 percent of those surveyed saying it’s the reason they own coins, totaling some 11.6 million Americans. Another popular reason was to hedge against potential price crashes in traditional assets, with 17.10 percent of those surveyed saying it was a reason they invested in crypto (about 10.1 million Americans). It is no surprise that a deregulated, anonymous currency would be used for illicit activity as well.
The decentralized construction of virtual currency is an excellent opportunity for criminals to easily hack and then launder money. As such, Ciphertrace Cryptocurrency Intelligence, a blockchain forensics team, notes that cryptocurrency is the most preferred form of exchange for ransomware attacks. In fact, their 2019 report notes that, in the first quarter of that year alone, more than $356 million was stolen from exchanges and infrastructure. Furthermore, that year, the New York Attorney General’s office disclosed that about $851 million was lost by a major cryptocurrency exchange, Bitfinex.
In the Review of Financial Studies, Oxford University Press, a research team assessed that approximately one-quarter of bitcoin users are involved in illegal activity. Roughly, $76 billion worth of illegal activity per year involve bitcoin (46 percent of bitcoin transactions), which is close to the scale of the U.S. and European markets for illegal drugs. The illegal share of bitcoin activity declines with mainstream interest in bitcoin and with the emergence of more opaque cryptocurrencies. According to the review and others, virtual currencies transform the black market by enabling “black e-commerce.”
Similarly, using cryptocurrency to evade taxation is another major issue that more recently is concerning the Internal Revenue Service (IRS). In December 2020, an indictment was filed in the U.S. Southern District Court of New York. The IRS has charged Amir Bruno Elmaani, the founder of blockchain technology Oyster Pearl, on two counts of tax evasion. Rather than reporting the income earned from the sales to the IRS, Elmaani allegedly falsified his 2017 tax return and failed to file one in 2018, instead pocketing the millions. Elmaani is only one example of tax evasion, and no doubt others exist.
Other Issues with Cryptocurrency
A double-edged sword for cryptocurrency is its volatile nature. This is driven by multiple factors. On one hand, cryptocurrencies have the ability to burst in value, garnering massive profit for investors. But it has the capacity to plummet, destroying the portfolio of holders. This volatility is mainly due to its lack of regulation. Take the most popular cryptocurrency, bitcoin, for example. Bitcoin's value has been historically quite volatile. In a three-month span from October of 2017 to January of 2018, for instance, the volatility of the price of bitcoin reached nearly eight percent. This is more than twice the volatility of bitcoin in the 30-day period ending January 15, 2020.
Per cryptocurrency’s lack of regulation, it is also susceptible to market manipulation that would otherwise be illegal. News developments and speculation are responsible for fueling price swings in crypto and mainstream markets alike. Their effect is exaggerated in digital asset markets as they have less liquidity than traditional financial markets — a result of cryptocurrency markets lacking a robust ecosystem of institutional investors and large trading firms. Heightened volatility and a lack of liquidity can create a dangerous combination because both exacerbate each other.
Other than bitcoin, most other cryptocurrencies also lack established and widely adopted derivatives markets. Under the sway of day traders and speculators, crypto prices sometimes exhibit healthy volatility of the type generally seen in mainstream markets. But there are signs that volatility in crypto markets is improving. Institutional investors and trading firms are beginning to enter the asset class with more conviction, and a derivatives market for cryptocurrencies is also beginning to take shape as part of the development and expansion of the broader crypto market ecosystem. Financial actors still have their hesitations. For instance, Fidelity Investments offers a bitcoin index for a select group of qualified investors through various family offices and institutions. That being said, many of these financial actors believe in cryptocurrency, but are afraid to fully enter the market and popularize it among the general public because of its obvious safety issues. Because it is not regulated, it has minimal consumer protection.
While cryptocurrency has its merits, there are obvious downfalls. Lawmakers have grown more interested in effectively regulating this new territory, but the question on how to do so remains.
Global Landscape for Cryptocurrency
The U.S. is behind its allies, partners, and adversaries when it comes to regulating cryptocurrency. According to The Law Library of Congress, some countries— like the U.S.— simply take a laid-back approach, warning crypto users that they naturally incur a sense of risk by investing in digital currencies. Others have expanded their laws to deal with “money laundering, counterterrorism, and organized crimes to include cryptocurrency markets'' and now require their financial institutions to conduct all the due “diligence requirements” imposed under said laws. For example, Canada, Australia, and the Isle of Man recently enacted laws to bring cryptocurrency transactions and their corresponding institutions under the domain of counter-terrorist financing laws and anti-money laundering.
Some nations have gone so far as to impose restrictions on investments in cryptocurrencies, the extent of which varies from one jurisdiction to another. Places like Algeria, Nepal, Bolivia, Pakistan, Morocco, and Vietnam ban all activities involving cryptocurrencies. Qatar takes a slightly gentler approach by barring their citizens from any cryptocurrency-related activities locally, but they allow citizens to do so outside their borders. Iran, Bangladesh, Thailand, Lesotho, Lithuania, Colombia, and China do not ban their citizens from investing in cryptocurrencies, but they impose “indirect restrictions by barring financial institutions within their borders from facilitating transactions involving cryptocurrencies”.
A few of the states surveyed by The Law Library of Congress note that they regulate initial coin offerings (ICOs), which “use cryptocurrencies as a mechanism to raise funds.” Among the nations that address ICOs, some— like Macau and Pakistan — wholly ban them, while others regulate them. In most cases, the regulation of ICOs varies “depending on how an ICO is categorized.” In New Zealand, for instance, specific obligations may apply “depending on whether the token offered is categorized as a debt security, equity security, managed investment product, or derivative.”
U.S. Takes on Cryptocurrency: Where Do We Go from Here?
Internationally, there seems to be no concrete way to approach virtual currencies, thus the U.S. will have to forge its own standards. Policymakers have struggled with how to respond to the mostly unregulated $1.6 trillion market, which has seen explosive growth and wild price swings.
The leading approach in Washington is to treat digital currency like a security. Securities and Exchange Commission (SEC) Chairman Gary Gensler stated that cryptocurrency indeed is “implicated by the securities laws and must work within our securities regime.” The SEC has already started to crack down on what it argues are unregistered cryptocurrency securities through legal action. The SEC is in court right now with cryptocurrency startup Ripple to address that very issue.
Chairman Gensler warned of the lack of investor protection at decentralized finance (DeFi) platforms, like cryptocurrency. He said to the extent there are securities traded on the platforms or in hosted wallets, they would need to register with the agency unless they have an exemption. He said the SEC was prepared to apply "full investor protections" to them.
The President's Working Group on Financial Markets — which includes Chairman Gensler, Treasury Secretary Janet Yellen and Federal Reserve Chair Jerome Powell — is also working together on how to regulate the cryptocurrency market. Chairman Gensler's pursuit of new authority from Congress would likely be a heavy lift.
Back on the Hill, lawmakers have been at odds over a provision of the infrastructure bill that would subject cryptocurrency brokers to tax reporting rules. On August 4, Sens. Ron Wyden (D-OR), Cynthia Lummis (R-WY), and Pat Toomey (R-PA) proposed an amendment to narrow the definition of what qualifies as a broker in the provision to exclude certain crypto groups, including miners, software developers and transaction validators. Over the next several days, the Senate debated these tax reporting provisions, particularly their amendments pertaining to the definition of a cryptocurrency “broker.” Ultimately, the Senate advanced the infrastructure package on August 10 with some of the first tax regulations for cryptocurrency, but with no further clarification on the broker definition.
The infrastructure bill now heads to the House, where it remains unclear if Speaker Nancy Pelosi (D-CA) will hold a vote in August or wait until the fall once the Senate has also passed a $3.5 trillion reconciliation measure. It is uncertain how much the House will be able to modify the Senate-passed bill, but Reps. Patrick McHenry (R-NC), Darren Soto (D-FL), Tom Emmer (R-MN), and Ted Budd (R-NC) have already expressed interest in attempting to tweak the cryptocurrency language. The cryptocurrency industry, still, is up in arms about any regulation.
What to Expect Next
Depending on how the upcoming infrastructure package turns out, cryptocurrency could fundamentally change forever. According to the former Deputy Assistant Secretary of State for International Law Enforcement Jonathan Winer, if cryptocurrency is regulated and taxed like securities and subject to reporting requirements like other forms of currency, the very essence and utility of cryptocurrency may cease to exist. Cryptocurrencies were designed to provide people with an alternative that couldn’t be inflated beyond a limited amount-- and they would be crowdsourced. The point is there are no intermediaries. With time, some currencies became more of a speculative investment, like a security, which is why there is a growing push to officially deem and regulate it as such. The upcoming legislation, then, is essentially about reporting losses and gains. But, to meet these standards, certain attributes of cryptocurrency, such as their anonymity would be erased. What, then, is its utility?
On one hand, a level of transparency and stability may encourage other financial actors to expand and popularize digital currencies. The aforementioned Fidelity Investment Bitcoin may be an example. CEO Abigail Johnson is bullish on bitcoin but is apprehensive to open it to the public because of its apparent liabilities. A regulated bitcoin may encourage Fidelity, for instance, to open its ETF to everyone and grow dramatically.
Winer points out another direction cryptocurrency may go. If cryptocurrency becomes just like any other currency that is transparent and taxable, then what is its point? Yes, as an instrument that has no function other than as a token of stored value, its exchange value is only based on its perceived scarcity value, not its ability to generate dividends from profits. Virtual currencies value is entirely based on what someone is willing to pay for it. If the demand is based on no government control or inflation, what happens when those marketable attributes are erased? With regulation and reporting requirements on large transactions the cryptocurrency game changes. The very value of cryptocurrency may cease to exist.
Additionally, the fact that there is no harmonized, international standard for cryptocurrency can become an issue. Innovative businesses, like cryptocurrency, rely on regulatory and enforcement arbitrage. That being, the difference between likelihood of being caught having to deal with getting punished. For instance, Panama has similar regulations to what the U.S. is proposing, but their prosecution standards are vastly different. It is quite possible that some exchanges will move offshore or unhosted wallets where they suspect they will not be punished, and these actors will continue to do so until they run out of money— primarily as they’re prosecuted. As digital currencies become highly regulated and lose their distinctive elements, they are at risk of becoming unimportant. The digital currency industry has quite an issue: they can either be free but damaging to customers or safe for trade yet potentially worthless.
Virtual currencies can save themselves from going under by instituting new incentives, what former Deputy Assistant Secretary Winer calls “loyalty programs.” Any company with a sufficiently large customer base could issue virtual currencies as a reward for using the company and allow that reward not only to be redeemed by the company, but to be redeemed for goods offered by others, or to be traded by users, in a further update to the types of programs offered by airline frequent flyer programs. Branded cryptocurrencies could prove very popular with consumers and drive their preferences towards the offeror. But there will also be risks for the offeror if a customer uses its branded coin for an improper purpose, creating reputational risk, and thus inhibiting companies from providing such coins without some form of controls.
By contrast, blockchain as a technology has already proven itself as an effective mechanism for corporate use. Blockchain is a central component of cryptocurrency, yet it is not exclusively used for this purpose. For instance, Walmart now uses blockchain to efficiently manage and secure its supply chain. While cryptocurrency is riddled with its own issues pertaining to utility, blockchain has proven to be useful across the board. Blockchain is always secure.The transactions are performed instantly and transparently because the ledger is updated automatically. It is a decentralized system with no required intermediary fee. The authenticity of a transaction is verified and confirmed by participants, so the personnel and administrative costs are minimal.