The case for banning crypto
On November 11, 2022, the cryptocurrency exchange FTX collapsed, nine days after a copy of the balance sheet of its associated hedge fund, Alameda Research, was leaked. When it was revealed that Alameda and FTX were significantly intertwined, and that FTX was suffering from severe liquidity shortages, the exchange’s customers rushed to withdraw their money. Many found that they could not do it. Behind the scenes, Alameda had cashed out on bad trades and used FTX customer funds to cover those losses. Sam Bankman-Fried resigned as CEO, and FTX filed for bankruptcy. A month later he was arrested. Bankman-Fried faces 13 criminal counts, ranging from fraud to foreign bribery. The implosion of FTX was the most spectacular in a series of collapses in the cryptocurrency industry that began in the spring of 2022.
Modern cryptocurrencies emerged in 2009 with the launch of Bitcoin, the first consequential virtual currency that relies on blockchain technology. Blockchains are essentially databases; their distinguishing feature is that instead of relying on a centralized authority to update them, they use some form of consensus mechanism to decide who should add transactions to the database. The consensus mechanism varies, but the two most common are proof-of-work (as used by Bitcoin) and proof-of-stake (as used by Ethereum). Proof-of-work relies on people known as “miners”, who validate transactions. Proof-of-stake selects validators from a group of people who own the relevant cryptocurrency. In both cases, selected validators are compensated for their work, and although the validator can theoretically be anyone, in reality financial incentives have led to extremely concentrated pools of validators.
With the very public dissolution of FTX, simmering questions about the sustainability of the cryptocurrency industry have boiled over. Other cryptocurrency companies and industry associations have tried to allay investor fears and dissuade regulatory authorities from cracking down, insisting that FTX was just a bad apple. But FTX’s revelation was not an isolated incident. Rather, it exposed fundamental flaws in the cryptocurrency industry. The root of the problem is that cryptocurrency assets can be created at no cost and without limits, and an unlimited supply of assets makes a system more vulnerable to booms. When assets have nothing behind them, there are no reliable financial accounting practices or valuation techniques to reveal the fraudulent manipulation of those assets. As a result, fraudsters have rushed into cryptocurrency, taking advantage of its complexity and hype to dupe the unwary. As Bankman-Fried awaits trial, US policymakers must limit the damage associated with cryptocurrency technologies and business models. At the very least, they shouldn’t loosen existing laws in the name of promoting cryptocurrency innovation. But they should also consider a more serious measure: banning cryptocurrency assets outright.
CRYPTOCURRENCY CONCERNS
Cryptocurrencies already facilitate many different types of harm. Pariah states, including Iran and North Korea, use cryptocurrencies, and the anonymity they provide, to avoid sanctions and launder money. In 2022, for example, Pyongyang reportedly stole $1.7 billion in cryptocurrency, which it is believed to be using to fund development of ballistic missiles and nuclear weapons. Cryptocurrencies, especially Bitcoin, have become the most common form of payment for the ransomware attacks that are increasingly targeting businesses and public services because it allows the nefarious actors behind these attacks to receive large amounts of money quickly and anonymously. Cryptocurrencies are also increasingly used to facilitate drug and human trafficking – and the anonymity they provide users hampers police efforts.
If allowed to continue unchecked, the unlimited growth of the cryptocurrency industry and its future integration with the traditional financial system could produce a major crisis. Blockchain-based finance is complex, automated, highly interconnected, and offers enormous opportunities for leverage because there is a virtually unlimited supply of assets to borrow against. These are the kinds of fragilities that led to the last financial crisis, in 2008. This damaged trust in the traditional financial system, and the cryptocurrency industry waded into the wreckage promoting itself as a reliable alternative to banks. Despite the industry’s claims, most people who invested in cryptocurrency have lost money. Those already disillusioned with traditional finance are likely to become even more cynical after cryptocurrency losses, and this cynicism could have further ramifications. As the professor David Golumbia, author of The Politics of Bitcoin, has argued, much of the conversation surrounding cryptocurrency draws on right-wing rhetoric about government evil. There is a danger that members of the cryptocurrency community, embittered by their losses, may be led into extreme online communities.
Cryptocurrencies also come with an environmental cost. Bitcoin and other cryptocurrency assets that rely on proof-of-work blockchains require miners to run computers that use huge amounts of electricity. Running these computers has sometimes required as much energy as that consumed by the entire Netherlands – a country of around 17 million people. In addition to the resulting emissions, mining burns through computer equipment relatively quickly, contributing to electronic waste and the global semiconductor chip shortage.
There are currently only five people who can approve proposed changes to Bitcoin’s core blockchain software.
Given the many problems with cryptocurrency, it seems foolhardy to allow the industry to continue as it is unless it can be shown to have demonstrable benefits. But it is difficult to identify any advantages. Industry executives and lobbyists tend to argue that the primary benefit of cryptocurrency is its decentralization. Given the sometimes dubious track record of traditional financial institutions, the prospect of a truly decentralized system, requiring no use or trust from intermediaries, is certainly attractive. Unfortunately, the prospects are unrealistic. Decentralization of the technology does not guarantee that the actual control of the technology remains decentralized. Rather, financial incentives have led to extremely concentrated pools of transaction validators, making users dependent on these small groups of people. Furthermore, blockchains are software, and users depend on the people who program the software – people who may have conflicts of interest or may make mistakes during programming. Software is never flawless, it degrades over time, and hackers are always trying to exploit vulnerabilities. This means that the software must be constantly maintained – again, often by a select group of people. To take one example, recent reporting in The Wall Street Journal revealed that there are currently only five people who can approve proposed changes to Bitcoin’s core blockchain software. Some of the applications built on the blockchain are managed in a decentralized manner, but decision-making still tends to rest in the hands of a small group of users. It is a far cry from the claims of decentralization coming from cryptocurrency enthusiasts and advocates.
In sum, the best that the cryptocurrency industry can offer is a version of the traditional financial system that remains economically centralized, but has more vulnerabilities due to the attempts at technological decentralization. Because blockchain-based finance is so complex, it is inherently fragile. The collapses that began in 2022 were not outliers, but symptoms of systemic problems in the cryptocurrency industry.
CRUSHING CRYPTOCURRENCY
Politicians who realize that blockchain technology’s harms outweigh its benefits may believe that government intervention is justified, but wonder if it is even possible. Misleading rhetoric about cryptocurrency’s decentralization is used to convince regulators that the software is calling the shots, implying that there are no business entities or people to regulate. But the reality is that regulation can be applied to the many different intermediaries that are critical to the cryptocurrency’s operation. For example, traditional business entities operate the centralized exchanges that act as gateways to the cryptocurrency markets. If Congress were to pass legislation prohibiting them from listing cryptocurrency assets, the cryptocurrency market would quickly fade. Alternative decentralized exchanges exist, but a ban can also be enforced against them, because control over these exchanges tends to be concentrated in the hands of a few people.
Opponents of a cryptocurrency ban often argue that such action will limit future useful blockchain innovations. However, there is little to fear here. Many of the most hyped innovations, including central bank digital currencies, do not require a blockchain at all. Blockchain technology itself has extremely limited utility. The consensus mechanisms that make blockchains work are inherently less efficient and more expensive than centralized alternatives; they have to be, or it would be too easy for a bad actor to take over. In fact, in 2022, over 1,500 technology experts signed a letter to US congressional leaders stating that “by its very design, blockchain technology is ill-suited for just about any purpose currently touted as a current or potential source of public benefit.”
Cryptocurrency, despite its proponents’ arguments to the contrary, can be regulated.
If policymakers remain reluctant to enact an outright ban, then the next best option is to strictly enforce regulations already in place. Banking regulators should use existing supervisory rules to prevent banks from being exposed to the risks of cryptocurrency assets, and securities regulators should enforce existing rules to protect retail investors from unregistered cryptocurrency offerings and fraud. Fortunately, in the wake of FTX’s fiasco, both banking regulators and the US Securities and Exchange Commission have redoubled their efforts to rein in the cryptocurrency industry, making it clear that regulation has been possible all along. While there are legislative improvements that could strengthen banking and securities regulation, the tailored cryptocurrency bills introduced in Congress so far are insufficient. With provisions designed to limit the SEC’s jurisdiction over the cryptocurrency industry and bring some types of cryptocurrency assets into the heart of the banking system, these bills are designed to legitimize and accommodate cryptocurrency, to allow it to attract funding from institutional investors and otherwise integrate with the traditional financial system. They would not protect the economy and the public from cryptocurrency, but rather reshape the law in cryptocurrency’s favor.
Cryptocurrency, despite its proponents’ arguments to the contrary, can be regulated. But steps to do so will be subject to the long-standing and well-known problem of geographic arbitrage. If the US cracks down, it’s possible that cryptocurrency could migrate elsewhere. But because the global cryptocurrency industry relies on funding from US venture capital firms, it remains an open question whether the industry can survive without that funding.
Some have expressed concern that the United States is losing its edge as a global leader in cryptocurrency innovation, but it is undesirable to be a leader in an innovation that is so damaging. A bigger concern is the development of an offshore cryptocurrency industry, which could cause damage that spills over into the United States. Similar concerns about spillovers from traditional financial activities have driven international efforts to agree on global standards for financial regulation, particularly regarding bank capital requirements. International bodies such as the Basel Committee on Banking Supervision, the Financial Stability Board and the International Organization of Securities Commissions are already working to coordinate approaches to cryptocurrency regulation. The United States should continue to take part in these efforts to limit the damage cryptocurrency can do on a global level. But there’s no reason to delay cracking down on cryptocurrency at home.
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