Cryptocurrencies, Digital Dollars, and the Future of Money

Anshu Siripurapu and Noah Berman

Source Link

Introduction

In the span of a few years, cryptocurrencies have grown from digital novelties to trillion-dollar technologies with the potential to disrupt the global financial system. Bitcoin and hundreds of other cryptocurrencies are increasingly held as investments and used as currencies to buy a swath of goods and services, such as software, digital real estate, and illegal drugs.

To their proponents, cryptocurrencies are a democratizing force, wresting the power of money creation and control from central banks and Wall Street. Critics, however, say that a lack of regulation for cryptocurrencies empowers criminal groups, terrorist organizations, and rogue states, while the assets themselves stoke inequality, suffer from drastic market volatility, and consume vast amounts of electricity. Regulations vary considerably around the world, with some governments embracing cryptocurrencies and others banning or limiting their use. As of February 2023, 114 countries, including the United States, are considering introducing their own central bank digital currencies (CBDCs) to compete with the cryptocurrency boom.

What are cryptocurrencies?

So called for their use of cryptography principles to mint virtual coins, cryptocurrencies are typically exchanged on decentralized computer networks between people with virtual wallets. These transactions are recorded publicly on distributed, tamper-proof ledgers known as blockchains. This open-source framework prevents coins from being duplicated and eliminates the need for a central authority such as a bank to validate transactions. Bitcoin, created in 2009 by the pseudonymous software engineer Satoshi Nakamoto, is by far the most prominent cryptocurrency, and its market capitalization has peaked at over $1 trillion. Numerous others, including Ethereum, the second-most popular, have proliferated in recent years.

Cryptocurrency users send funds between digital wallet addresses. These transactions are then recorded into a sequence of numbers known as a “block” and confirmed across the network. Blockchains do not record real names or physical addresses, only the transfers between digital wallets, and thus confer a degree of anonymity on users. Some cryptocurrencies, such as Monero, claim to provide additional privacy. However, if the identity of a wallet owner becomes known, their transactions can be traced.

Bitcoin “miners” earn coins by organizing these blocks, thereby validating transactions on the network; the process requires a system known as “proof of work,” based on using computers to solve math problems. Many cryptocurrencies use this method, but Ethereum and some others instead use a validation mechanism known as “proof of stake.” In Bitcoin’s case, a transaction block is added to the chain every ten minutes, at which point new Bitcoin is awarded. (The reward decreases steadily over time.) The total supply of Bitcoin is capped at twenty-one million coins, but not all cryptocurrencies have such a constraint.

The prices of Bitcoin and many other cryptocurrencies vary based on global supply and demand. However, the values of some cryptocurrencies are fixed because they are backed by other assets, thus earning them the name “stablecoins.” While these coins tend to claim a peg to a traditional currency, such as $1 per coin, many such currencies were knocked from their pegs during a spate of volatility in 2022.

Why are they popular?

Once dismissed as a fringe interest of tech evangelists, cryptocurrencies—particularly Bitcoin—have skyrocketed to mainstream popularity and trillion dollar valuations. In November 2021, the price of Bitcoin surged to more than $60,000 for the first time. (By February 2023, it had fallen to $23,000.) As of mid 2022, an estimated 20 percent of U.S. adults polled by NBC News had invested in, traded, or used cryptocurrency.

Different currencies have different appeals, but the popularity of cryptocurrencies largely stems from their decentralized nature: They can be transferred relatively quickly and anonymously, even across borders, without the need for a bank that could block the transaction or charge a fee. Dissidents in authoritarian countries have raised funds in Bitcoin to circumvent state controls, including to avoid U.S. sanctions on Russia.

Some experts say that digital assets are primarily tools for investment. People buy cryptocurrencies “because of a speculative belief that these tokens are going to go up in the future, because a new future is being built on the blockchain,” says CFR Senior Fellow Sebastian Mallaby. “It’s a very risky bet, as the last twelve months have shown.”

The price of Bitcoin and other cryptocurrencies fluctuates wildly, and some experts say this limits their usefulness as a means of transaction. (Most buyers and sellers don’t want to accept payment in something whose value can change dramatically from day to day.) Nevertheless, some businesses accept Bitcoin. Many investors see Bitcoin as a speculative asset to hold over time, rather than make payments with, and it often draws comparisons to gold. Some see Bitcoin as a hedge against inflation because the supply is permanently fixed unlike those of fiat currencies, which central banks can expand indefinitely. However, after Bitcoin plummeted amid stock market volatility in 2022, many experts questioned this argument. The valuation of other cryptocurrencies can be harder to explain, though many are associated with a larger project within the digital asset industry. Some cryptocurrencies, such as Dogecoin, were created as jokes, but have retained value and garnered investment from high profile investors.

In countries with historically weak currencies, including several Latin American and African countries, Bitcoin has become popular with populist leaders. In 2021, El Salvador made waves by becoming the first country to make Bitcoin legal tender (residents can pay taxes and settle debts with it), though the move has sparked protests. Some politicians in other parts of the region have expressed support for the idea.

Stablecoins, meanwhile, have the potential to rival fiat currencies as the dominant form of payments, experts say. Their value is relatively stable, and they can be sent instantly without the transaction fees associated with credit cards or international remittance services such as Western Union. In addition, because stablecoins can be used by anyone with a smartphone, they represent an opportunity to bring millions of people who lack traditional bank accounts into the financial system. However, they have drawn increased scrutiny from regulators, especially after several stablecoins sunk below their $1 pegs during 2022’s market volatility.

What is “DeFi”?

Cryptocurrencies and blockchains have given rise to a new constellation of “decentralized finance” or DeFi businesses and projects. Essentially the cryptocurrency version of Wall Street, DeFi aims to offer people access to financial services—borrowing, lending, and trading—without the need for legacy institutions such as banks and brokerages, which often take large commissions and other fees. Instead, “smart contracts” automatically execute transactions when certain conditions are met. DeFi is surging in popularity, with investors pouring tens of billions of dollars into the sector.

Most DeFi apps are built on the Ethereum blockchain. Because of its usefulness in tracking transactions, blockchain technology has a range of potential applications beyond cryptocurrency, experts say, such as facilitating real estate deals and international trade [PDF].

“You can imagine a new kind of financial system being constructed out of blockchain-based tokens that have advantages over the old, centralized kinds of money. You trust the code, and you trust the blockchain and the decentralized ledger, and it’s a new way of organizing finance,” says CFR’s Mallaby.

Are Cryptocurrencies Still the Future of Money?

What challenges has this created?

Cryptocurrencies have also given rise to a new set of challenges for governments to contend with, including concerns over criminal activity, environmental harms, and consumer protection.

Illicit activities. In recent years, cybercriminals have increasingly carried out ransomware attacks, by which they infiltrate and shut down computer networks and then demand payment to restore them, often in cryptocurrency. Drug cartels and money launderers are also “increasingly incorporating virtual currency” into their activities, according to the U.S. Drug Enforcement Agency’s (DEA) most recent annual assessment. U.S. and European authorities have shut down a number of so-called darknet markets—websites where anonymous individuals can use cryptocurrency to buy and sell illegal goods and services, primarily narcotics. Critics say these enforcement efforts have fallen short, exemplified by the theft of over $1 billion in cryptocurrency by a North Korean hacking group in 2022.

Terrorism and sanctions evasion. The primacy of the U.S. dollar has provided the United States unrivaled power to impose crippling economic sanctions. However, states including Iran, North Korea, and Russia are increasingly using cryptocurrency to evade U.S. sanctions. Meanwhile, terrorist groups such as the self-proclaimed Islamic State, al-Qaeda, and the military wing of the Palestinian organization Hamas also traffic in cryptocurrency.

Environmental harms. Bitcoin mining is an enormously energy-intensive process: the network now consumes more electricity than many countries. This has sparked fears about the cryptocurrency’s contribution to climate change. Cryptocurrency proponents say this problem can be solved using renewable energy; El Salvador’s president has pledged to use volcanic energy to mine Bitcoin, for example. Environmental concerns reportedly prompted Ethereum’s move to a proof of stake model, which uses less energy.

Volatility and lack of regulation. The rapid rise of cryptocurrencies and DeFi enterprises means that billions of dollars in transactions are now taking place in a relatively unregulated sector, raising concerns about fraud, tax evasion, and cybersecurity, as well as broader financial stability. If cryptocurrencies become a dominant form of global payments, they could limit the ability of central banks, particularly those in smaller countries, to set monetary policy through control of the money supply.

After high levels of volatility diminished the value of several prominent cryptocurrencies in 2022, a handful of crypto firms were unable to pay back their lenders, which were primarily other crypto firms. Many borrowers and lenders declared bankruptcy, including FTX, at the time the world’s third-largest cryptocurrency exchange. The collapse of FTX and other firms resulted in tens of billions of dollars in losses to investors, though traditional financial firms were relatively unscathed.

What are governments doing about this?

Many governments have taken a hands-off approach to crypto, but its rapid ascent and evolution, coupled with the rise of DeFi, has forced regulators to begin crafting rules for the emerging sector. Regulations vary widely around the world, with some governments embracing cryptocurrencies and others banning them outright. The challenge for regulators, experts say, is to develop rules that limit traditional financial risks without stifling innovation.

In the United States, policymakers have indicated they are slowly moving to regulate cryptocurrencies and the emerging DeFi sector. However, cryptocurrencies do not fit neatly into the existing regulatory framework, creating ambiguity that lawmakers will likely have to resolve. U.S. Securities and Exchange Commission (SEC) Chairman Gary Gensler has called the cryptocurrency sector a “Wild West,” and urged Congress to give the SEC greater powers. Federal Reserve Chairman Jerome Powell and Treasury Secretary Janet Yellen have both called for stronger regulations of stablecoins. But regulators have thus far been reluctant to extend crypto investors the same protections that exist in more traditional finance, such as deposit insurance. “If you buy crypto-assets and the price goes to zero at some point, please don’t be surprised and don’t expect taxpayers to socialize your losses,” the Federal Reserve Board of Governors’ Christopher J. Waller said in 2023.

To limit illicit activities, authorities have targeted the exchanges that allow users to convert cryptocurrencies to U.S. dollars and other national currencies. Under pressure from regulators, major exchanges including Coinbase, Binance, and Gemini adhere to “know your customer” and other anti–money laundering requirements. Law enforcement and intelligence agencies, meanwhile, have learned to leverage the traceability of most cryptocurrencies by using blockchains to analyze and track criminal activity. For example, some of the ransom paid to the Colonial Pipeline hackers was later recovered by the FBI. In August 2022, the Treasury Department announced a crackdown on so-called cryptocurrency mixers that criminals can use to anonymize transactions on the blockchain, calling them a “threat to U.S. national security.”

China, which accounts for most of the world’s Bitcoin mining, has moved aggressively to crack down on cryptocurrencies. In September 2021, Chinese authorities announced a sweeping ban on all crypto transactions and mining, causing the price of some cryptocurrencies to fall sharply in the immediate aftermath. According to the U.S. Law Library of Congress, eight other countries (Algeria, Bangladesh, Egypt, Iraq, Morocco, Nepal, Qatar, and Tunisia) have banned cryptocurrencies [PDF], while dozens more have sought to restrict adoption of digital assets. Still, most governments have so far taken a relatively limited approach.

What is a central bank digital currency?

In an effort to assert sovereignty, many central banks, including the U.S. Federal Reserve, are considering introducing their own digital cash, known as a central bank digital currency (CBDC). For proponents, CBDCs promise the speed and other benefits of cryptocurrency without the associated risks. Dozens of countries—together representing more than 90 percent of the global economy—are exploring CBDCs. Eleven countries have fully launched CBDCs. All are lower-income and ten are in the Caribbean (Nigeria is the eleventh). Since piloting a digital yuan in 2019, China is now expected to extend its CBDC pilot program to its population of over one billion by the end of 2023. In the United States, there is reportedly disagreement among Fed officials over the need for a digital dollar.

Experts say interest in CBDCs intensified in 2019 when Facebook announced it would create its own digital currency called Libra, potentially offering a new payment option for its more than two billion users. (The company has since scaled back the project, renamed Diem.) China is another motivating factor: A digital yuan could give Beijing even more control over its economy and citizens, and threaten the U.S. dollar’s status as the favored international reserve currency, experts say.

One way to implement CBDCs would be for citizens to have accounts directly with the central bank [PDF]. This would give governments powerful new ways of managing the economy—stimulus payments and other benefits could be credited to people directly, for example—and the central bank’s imprimatur would make CBDCs a safe digital asset to hold. But their introduction could also create new problems, experts say, by centralizing an enormous amount of power, data, and risk within a single bank and potentially compromising privacy and cybersecurity.

Some experts say the potential for CBDCs to cut out commercial banks as intermediaries carries risks, because these banks perform a critical economic role by creating and allocating credit (i.e., making loans). If people chose to bank directly with the Fed, that would require the central bank to either facilitate consumer borrowing, which it might not be equipped to do, or find new ways of injecting credit. For these reasons, some experts say private, regulated digital currencies are preferable to CBDCs.