Budget 2018: Nothing is more powerful than an idea whose time has come. With the total market capitalization of the cryptocurrency universe at more than USD 500 Billion, many are wondering whether these digital currencies represent that big idea. The non-believers of cryptocurrencies have a standard answer: Blockchain is the big idea. Digital currencies are a bubble. However, as of today, the sheer size and volumes of the cryptocurrency market make it a force to reckon with. One cannot think of the underlying blockchain technology in isolation of cryptocurrency transactions without which we would have an empty ledger. Regulators and policymakers must now layout a clear roadmap on how they intend to regulate cryptocurrencies. In order to put a regulatory framework in place, regulators must accept that owning and trading cryptocurrencies is legal and that they envisage these digital currencies being an integral part of the global financial system going forward.
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While Dr.Arun Jaitley in his budget speech did express his negative bias towards cryptocurrencies, we believe there is a need for healthy dialogue around this issue. Even if Indian authorities want to stick by their categorization of cryptocurrencies as illegitimate and illegal, sound arguments must be provided to back why they hold their view. Below are some issues where we believe all stakeholders must have an informed debate on.
One of the main concerns voiced by governments and critics of bitcoin and other cryptocurrencies is the anonymity of cryptocurrency transactions. It is a common belief that bitcoin transactions are impossible to track and can aid terrorists, criminals, tax evaders etc. in avoiding detection by government agencies.
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This however is just a myth. While cryptocurrencies vary in their level of anonymity, some of the biggest ones, Bitcoin, Ethereum, Ripple etc. are only pseudo-anonymous. What this means is that while every wallet has an encrypted alpha-numeric address instead of a real person’s name and every transaction seems to be between unidentified entities, once any part of the chain is linked to a real world identity, all the transactions linked to that entity can be easily tracked back to it since the whole blockchain is in the public domain. Today, most major exchanges around the world require KYC verification before allowing users to buy or sell cryptocurrencies, this links the very first transactions of most individuals to their real world identities. Additionally, web trackers and cookies on merchant websites are notorious for passing on user data such as purchase details, names, email addresses etc. to third parties and this breach of anonymity will only rise with the increased use of cryptocurrencies for making online purchases.
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While there are still many ways of making transactions more hidden than they are by default such as using more anonymous cryptocurrencies like Monero, employing mixers or using browsers like TOR, the majority of individuals in this space today are there for the love of blockchain and/or for speculation purposes are more open than the government might believe to regulatory oversight.
Many investors and consequently governments get spooked and rightly so by cyber-attacks targeting cryptocurrency wallets and exchanges and some have even deemed the technology unsafe. The infamous Mt.Gox breach of 2014 and the more recent hacking of Japanese cryptocurrency exchange, CoinCheck, where hackers made their way with close to USD 500mn worth of cryptocurrency have only affirmed these fears. Online forums are also rife with users claiming to have lost their private keys and ultimately access to their wallets with no way to claim the deposits back.
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But is this is the first time criminals have targeted a store of value? Even skipping through the countless incidents of thefts, big and small, through hundreds of years of traditional banking, one would find it hard to argue that the current banking system is perfectly safe. In February 2016, cyber criminals stole USD 81 million from Bangladesh Bank compromising all security features in place. According to a report by Javelin Strategy & Research, consumers in the US lost more than USD 16 billion in 2016 to identity theft or fraud. Cybersecurity Ventures predicts that by 2021, cybercrime will cost the global economy USD 6 trillion (not all of which would be a direct monetary loss) annually. The banking system or any other stores of value, have forever been and will continue to be a target for criminal elements and each breach will be followed by further innovation.
The blockchain protects itself against malicious users through a consensus building mechanism known as Proof of Work. Once a computer wins the initial race to get the right to add the next block of transactions, the other miners collectively verify if the transactions added are actually valid or not and the transactions are often not confirmed till the next few blocks are added on top. This means that in order to add a transaction that didn’t actually happen to the blockchain, a miner would need to have 51% or more of the total network hashrate (computing power) is extremely expensive and very unlikely to succeed.
Most commonly though, instead of the actual blockchain it is the individual coin holders that are targeted by cyber criminals and users should protect themselves by following a few basic preventive measures like, 1) Never leaving currencies in an exchange wallet 2) Moving currencies to cold wallets or offline storage for added safety 3) Keeping backups of all private keys in hard copy in a safe place.
Do cryptocurrencies pose a substantial threat to central banks and the how will monetary policy work if the so called ‘masters of the universe’ aka central bankers lose their power to set interest rates.
Firstly, let us accept that the purchasing power of fiat currencies has consistently diminished and the ZIRP (Zero Interest Rate Policy) era where endless cheap money (money supply) was pumped into the system has led to many spillover effects including inflated asset prices. It is for the first time in financial history that we have seen stocks, bonds, commodities and real estate all rise at the same time. The only reason these policies have not created runaway inflation was due to subdued aggregate demand. In that sense, would we not be better off by a monetary system governed by a computer algorithm? It would be ‘’a digital cash supply free of political manipulation’’ as David Andolfatto, Vice President, Federal Reserve Bank of St. Louis put it.
Policymakers need to make clear what they think about money supply when it comes to cryptocurrencies. Now let us assume that a cryptocurrency, say bitcoin, were to partially supplant central bank fiat currency. The agreed protocols that govern Bitcoin are effectively its monetary policy. Miners expend computing power to verify the legitimacy of transactions and record them. In return, these Bitcoin “miners” get paid in Bitcoin. This leads to an increase in the supply of Bitcoin.
But this growth of Bitcoin money supply is constrained by the increasing difficulty of verifying transactions. As more and more computing power is needed to verify each transaction and create new Bitcoin, which means that the total supply gradually approaches its limit of about 21 million.
Another concern for policymakers is how an asset so volatile be accepted as a store of value. From just a money supply and money demand framework, this volatility can be attributed to the fact that the above money supply rule cannot respond fast enough to changes in money demand leading to high price fluctuations or volatility.
And how would money supply in a partial crypto dominated world react to the underlying state of the economy. Can there be in built a set of rules? And more importantly, will they always be followed. There is a reason central banks do not follow the Taylor rule blindly. Sometimes a preset mandate of a central bank—say a specific level of unemployment and inflation—which when achieved would lead to certain policy measures—say a 25 bps interest rate hike—do not play out as per the rules laid out. So are the policymakers worried that a protocol where the verification reward for the miners are a function of the state of the economy cannot be hard-coded?
Another issue which may be on the minds of policymakers and central bankers is that while cryptocurrencies are ‘borderless’ and may well promote greater capital flows and trade, will the bitcoin ‘area’ be similar to an ‘optimal currency area’? As the whole idea is to be decentralized, how can there be a central authority directing fiscal transfers making up for the inability to adjust exchange rates in that ‘area’.
Many old debates in monetary economics such as Milton Friedman’s constant money growth rule versus the discretion over interest rates that has prevailed over the last two decades will prop up again in answering the above question pertaining to the new age of monetary policy in the digital currency era. Change is always hard to accept. During the gold rush, central bankers also called gold an asset without any intrinsic value as it gives no cash flows which one could use for discounting. But it has stood the test of time and commands a systemic risk premium.
By Rohan Juneja & Vatsal Srivastava