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On June 17, 2018, the Bank for International Settlements (BIS) released Cryptocurrencies: looking beyond the hype within Chapter V of its Annual Economic Report (Chapter). While cryptocurrency advocates purport that it will unseat trusted, long-standing institutions, the Chapter notes that, looking beyond the hype, it is hard to identify a specific economic problem within the existing monetary landscape that these new currencies solve. Today’s crypto transactions are slow, costly, and prone to congestion, consume vast amounts of energy and cannot scale with demand. Further, the decentralized consensus is fragile because of its need for trust between honest network participants who, in turn, must control the majority of the network. However, the BIS does see promising non-cryptocurrency-based use-cases that leverage the underlying distributed ledger technology (DLT).
Growing societies and the expansion of economic activity required a more convenient means of facilitating transactions than bartering commodities. To fulfill this need, money needed to both scale with the economy and have elasticity to address fluctuating demand. Episodes of monetary instability and failed currencies illustrate the need for specific institutional arrangements to address these considerations. The role of central banks has evolved considerably over the years, giving rise to the emergence of today’s independent central banks, which ensure that financial systems operate smoothly and that the monetary supply responds appropriately to shifting demand. Thanks to active supervision and central bank accountability, today’s diverse payment systems have achieved safety, cost-effectiveness, scalability and trust that a payment, once made, is final. These payment system attributes are perhaps so commonplace that they have come to be taken for granted.
Chief among digital money’s flaws is that it can be fraudulently spent on multiple transactions through digital duplication. Until cryptocurrencies, the only solution to this “double-spend problem” was for a centralized agent to record and verify all transactions. Cryptocurrencies introduced the use of a distributed ledger to solve this problem. In Blockchain, this ledger is updated in groups of transactions called blocks, which are chained sequentially using cryptography to form the “blockchain”, a concept adapted by countless other cryptocurrencies. The computer code specifying how participants can transact (protocol) is designed to ensure participants follow the rules for their own self-interest.
Updating the ledger requires “proof-of-work”, mathematical evidence that a certain amount of computational work has been performed, which can be costly because of both the need for sophisticated equipment and high electricity consumption. This process is often referred to as “mining”. In return for their efforts, miners receive transaction fees and, if specified by the protocol, newly-minted cryptocurrency. If a ledger update includes an invalid transaction, it is rejected by the network and the miner’s rewards are void, impelling miners to add only valid transactions. Furthermore, the protocol specifies rules to achieve a consensus on the order of updates to the ledger by incentivizing individual miners to follow the computing majority of all other miners when they implement updates. Taken together, these attributes make it costly for any individual to forge a transaction, as a successful attack on the network would require controlling a substantial share of the mining community’s computing power.
Overall, the Chapter asserts that decentralized cryptocurrency technology is a poor substitute for the solid institutional backing of money.
Cryptocurrencies are expensive and do not scale. Decentralized trust is expensive. Theoretically, miners will continue to compete to add new blocks to the ledger until their anticipated profits fall to zero, but it is becoming increasingly difficult for individuals to mine. Facilities have emerged with computing power equivalent to millions of personal computers, and electricity use rivals mid-sized economies making decentralized trust extremely expensive. Additionally, over time, the ledger grows substantially, making it unwieldy for recording everyday payments. For example, to process the number of digital transactions currently handled by national retail payment systems, the size of the ledger would eclipse that of large servers in a matter of months, and only supercomputers could keep up with verifying the incoming transactions. Another aspect of scalability is that updating the ledger is subject to congestion. New blocks can only be added at pre-specified intervals limiting the number of transactions added at any time. If newly-added blocks are already at the maximum size permitted by the protocol, transactions may go into a queue for several hours, interrupting the payment process. The more people who use a particular cryptocurrency, the more cumbersome the payments become, disincentivizing widespread adoption.
Cryptocurrencies have unstable value. Central banks stabilize the domestic value of their sovereign currency by adjusting supply in line with demand. They expand or contract their balance sheet, and will trade against the market if need be. This contrasts with cryptocurrency, where fluctuation in demand translates into changes in valuation because there is no central agent to stabilize value. Additionally, the sheer number and rapid appearance of new cryptocurrencies adds to unstable valuations.
Cryptocurrency-based systems are fragile. Unlike mainstream payment systems, permissionless cryptocurrencies (like Bitcoin) cannot guarantee payment finality. Although users can verify that a specific transaction is included in a ledger, rival versions may exist as a result of a simultaneous update by two separate miners. Only one of the two updates can survive, making the finality of payments probabilistic. Not only is the trust in individual payments uncertain, but the trust in each cryptocurrency is fragile due to “forking”. A fork is generated when a subset of cryptocurrency holders elect to use a new version of the ledger and protocol, while others remain with the original, effectively splitting the cryptocurrency into two networks. Forking is an indication that coordination on how the ledger should be updated could break down at any time.
Due to their relative anonymity, cryptocurrencies pose money laundering and terrorist financing concerns for regulators. Securities regulators are also actively monitoring cryptocurrencies and initial coin offerings (ICO). Businesses turning to ICOs to raise funds for their projects are striving to develop functional tokens, which could enable them to be classified as “utility tokens” – possibly outside the reach of securities regulators. However, even if the token falls outside the scope of securities regulation, consumer protection regulations will likely still apply. A longer-term regulatory challenge concerns the overall stability of the financial system, and whether widespread use of cryptocurrencies and related smart contracts will create financial vulnerabilities and systemic risks. Overall, the Chapter acknowledged the difficulty of regulating cryptocurrencies under existing frameworks and stressed the need for global coordination and flexible regulatory boundaries.
For more information, please contact Tracy Molino or a member of our Securities and Corporate Finance group.