Bitcoin's Existential Threat
Summary
- Despite opinion to the contrary, it is possible for governments to ban cryptocurrencies, but this likely would have already been done if this is what governments desired.
- If governments want to restrict the usage of cryptocurrencies, it will likely be done by controlling the flow of money into and out of the fiat system.
- With the possibility of an outright ban remote, increased regulation should be viewed as a positive as it will help to legitimize cryptocurrencies as an alternative asset class.
After coming through the 2018 bear market relatively unscathed, the biggest threat to cryptocurrencies now appears to be regulation. Regulation of cryptocurrencies globally is developing but is still minimal in comparison to traditional financial markets. Increased regulation of cryptocurrencies should be viewed as a positive as it will reduce uncertainty and increase protection for investors, helping to legitimize cryptocurrencies as an asset class. Currently, there is minimal protection, and unsophisticated investors can easily be taken advantage of or enticed into investment vehicles without fully understanding the risks. Investors who view cryptocurrencies primarily as a means to avoid government control are likely to be disappointed by regulatory developments as governments will seek to ensure cryptocurrencies are not used to finance crime or avoid taxes.
The complexity of cryptocurrencies and their rapid adoption by a wide user base have left regulators playing catch up. So far, the general goal of regulators has been to protect the investing public, maintain market stability, and prevent theft, fraud, market manipulation and money laundering. There is also the issue of regulatory arbitrage to consider with some jurisdictions taking a favorable view with the aim of encouraging the growth of a local cryptocurrency industry. In some cases, regulators have appeared loathe to introduce regulation for fear of stifling innovation or legitimizing cryptocurrencies as an asset class. More extensive regulation may also be considered unnecessary at this stage as cryptocurrency markets are currently not large enough to cause systemic problems, but their persistence and growth will inevitably lead to more regulation.
Why
There are a number of reasons why governments would want to restrict or regulate the usage of cryptocurrencies, including:
- To maintain control over citizens
- Fear of losing their monopoly right to issue currency
- To prevent the financing of crime
- To prevent tax evasion
- To protect consumers
- To prevent financial instability
Anonymity is promoted as one of the main benefits of cryptocurrencies, but in reality, most cryptocurrencies are pseudonymous not anonymous, meaning transactions can easily be tracked and, with investigation, often can be tied to individuals. This has led to a new industry where firms specialize in cryptocurrency forensic accounting, which is aided by increased know your customer requirements for exchanges. There are more anonymous cryptocurrencies than Bitcoin though, such as Monero where transactions are impossible to trace. Anonymous financial transactions are a high risk for activities like the financing of crime and terrorism, meaning governments are likely to introduce regulations to ensure transactions are traceable.
The monopoly right of governments to issue currency has significant value as it gives them control over the economy and the terms under which they borrow money to finance their budget. Viable alternative currencies could be preferred by citizens if they lose faith in the government, which would cause the national currency to depreciate in value, making it more difficult to repay foreign currency debts and hampering efforts to maintain economic stability. Citizens of countries which are facing economic instability, difficulties repaying debts or which are corrupt are likely to find cryptocurrencies an attractive alternative to the sovereign currency. Governments of these countries are therefore likely to introduce regulations to restrict the adoption of cryptocurrencies.
One of the biggest concerns with cryptocurrencies is their potential use in financing crime. Despite media and government scrutiny, the use of cryptocurrencies in money laundering, terrorism financing, tax evasion, countries avoiding sanctions etc. is likely to be a fraction of that using cash. Much of Bitcoin's bad reputation in this area is likely a result of it being the currency of choice on the dark web in its early days. The increasing use of cryptocurrencies outside of criminal activities and the ability to trace most transactions make a ban for the sole purpose of reducing crime unlikely. Increased know your customer requirements are likely for exchanges etc. to help trace transactions, though.
Bitcoin is a highly volatile asset which arguably has no intrinsic value and, despite its initial success, may not have a long-term future. Unscrupulous actors have taken opportunity of the lack of cryptocurrency regulations to scam investors with Ponzi schemes and ICOs for worthless projects amongst others. Many investors have likely been drawn to the space by the allure of high returns without fully appreciating the risks and may have invested more money than they can afford to lose, particularly in the case of high leverage vehicles. Increased regulation is likely to ensure investment vehicles are legitimate and investors fully understand the investment risks. Investment vehicles which encourage instability (like the use of excessive leverage) could also face increased scrutiny.
Bitcoin is now over 10 years old, which begs the question why governments haven't banned cryptocurrencies yet if that is the plan. While cryptocurrencies initially needed to reach a minimum level of adoption before regulation became worthwhile, this point was reached many years ago. In addition, there have been a number of points during Bitcoin's history where regulating Bitcoin would have been logical.
Silk Road
Silk Road was an early high-profile case of Bitcoin financing illegal activities and is likely how many people first become aware of cryptocurrencies. Silk Road was a dark web market used mainly to purchase illicit drugs using Bitcoin, which was in operation from 2011 to 2013. As Bitcoin has become more widely adopted and its use cases have grown, its use in nefarious activities has become much less important. It is estimated that, in 2012, 7% of bitcoin transactions were on the dark web, whereas that number is now less than 1%. The fact that Bitcoin's first widespread real-world use case was financing crime could have made it a target government regulation. The window for banning Bitcoin while limiting the damage to legitimate users has closed, and the potential benefit from preventing the financing of crime is now far outweighed by the interests of legitimate users.
The concerns about Bitcoin financing crime are not specific to cryptocurrencies. Physical cash is subject to the same concerns and many governments are taking action to prevents cash's use in financing crime. One of the most common actions being taken is to restrict the supply of large denomination notes making it more difficult to conduct large transactions. In 2010, Britain's Serious Organized Crime Agency estimated that 90 percent of 500 Euro banknotes sold from exchange bureaus in the country were in the hands of organized criminals. In 2014, Singapore decided to stop producing 10,000 dollar notes, and the issuance of new 500 Euro notes ended in 2018. Cryptocurrencies may have an advantage in long-distance transactions and can easily be used to transfer money across borders, but cash is still king when it comes to financing crime.
The other issue that Silk Road first brought to light was the genuine potential for Bitcoin as an alternative currency. If governments were genuinely concerned about cryptocurrencies creating competition for sovereign currencies, it would have made sense to restrict their usage at this point rather than try to deal with the more widespread fallout of banning it at a future date.
Mt. Gox
Mt. Gox was a Bitcoin exchange in operation from 2010 to 2014 which went bankrupt after 850,000 Bitcoin's belonging to customers went missing. This event highlighted the vulnerability of exchanges and the risk to users from mismanagement. This event may not have created a potential need to ban cryptocurrencies, but it highlighted weaknesses in the cryptocurrency system and the need for regulation ensuring users are protected.
ICO Explosion
The rapid rise in the price of a range of cryptocurrencies in 2017 led to an explosion in the number of initial coin offerings. While some of these ICOs were an attempt to fund legitimate projects through an alternative source of funding many were a simple crash grab exploiting investors. Research indicates that approximately 80% of projects during this period were scams. This again highlighted the risks of investing in the cryptocurrency space and the need for regulation protecting investors.
Libra
Facebook's (FB) efforts to launch a digital currency have faced significant pushback from regulators globally due to concerns over a company launching their own currency and the potential for Libra to create systemic risk in the financial system. Due to Libra's design and Facebook's large user base, Libra has a much higher likelihood of being widely adopted for payments than Bitcoin, making it a greater threat to sovereign currencies. A number of government officials, central banks and regulatory bodies have expressed concerns over the potential for money laundering, consumer protection and financial stability. Much of the concern around Libra may be specific to the fact that is backed by a for-profit company, something that does not apply to Bitcoin.
The fact that cryptocurrencies made it through these events without being banned or facing draconian restrictions in most countries makes it unlikely they will be banned in the future. A ban now would harm a large base of legitimate users and affect a range of legitimate projects while bringing few benefits to society. At this point, it is much more likely governments will look to regulate cryptocurrencies to protect users and prevent financial instability.
How
While it is unlikely governments will ban cryptocurrencies, it is possible despite the naïve belief that it is not. The most commonly used argument for why Bitcoin cannot be banned is that is protected under the first amendment as Bitcoin is code, and code is a form of speech. The legal precedents for this are cases involving Phil Zimmerman and Daniel Bernstein who were given the right to publish cryptography code by the Supreme Court despite the government's desire for it not to be published due to national security concerns. These cases only involve publishing code, though, and do not protect what the code is used for. Andrew Balthazor from FIU gives a good discussion of why the first amendment is unlikely to protect Bitcoin. Another argument is that Bitcoin cannot be stopped because it is code distributed on the internet. A government ban does not need to eliminate Bitcoin to be effective, it simply needs to prevent its use. The simplest way to do this would be to control the on and off ramps from the traditional financial system, which would likely be extremely effective.
Cryptocurrencies are currently covered by a patchwork of regulation from a range of regulatory bodies with different countries taking different approaches. In the U.S. stocks are regulated by the Securities and Exchange Commission (SEC), commodities by the Commodity Futures Trading Commission (CFTC), and government currency by the Department of the Treasury and the Federal Reserve. The SEC has been monitoring ICOs for fraud and other conduct, the CFTC has been regulating derivative markets and FinCEN has been filling in the gaps by classifying non-securities and non-commodities as "money transmitters" subject to anti-money laundering (AML) requirements. State banking regulators have been overseeing cryptocurrency trading platforms for consumer protection and the Internal Revenue Service (IRS) has been active in ensuring cryptocurrency users understand and are complying with tax laws.
Globally, 14 countries out of 84 with available data have implemented an outright or an implicit ban on cryptocurrencies. Restrictions in some countries have less to do with Bitcoin and are more reflective of issues specific to that country, such as China's restriction on Bitcoin to maintain control over capital flows. Outright or implicit bans are likely in countries which have specific concerns, such as money laundering, terrorism financing, tax evasion, the desire to control capital flows and instability in the sovereign currency.
Summary
Bitcoin's future is uncertain, but its downfall is unlikely to be at the hands of governments. The most beneficial action governments can take at this point is regulate the cryptocurrency industry to protect users and prevent financial instability. Regulations of this nature are a positive for cryptocurrencies as they will reduce risk and uncertainty for users, helping to increase adoption. Cryptocurrency investors should not read too much into the attitude of regulators towards Facebook's Libra project, given that much of their concern is likely specific to a for-profit company launching their own currency.
This article was written by
Analyst’s Disclosure: I am/we are long BTC-USD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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