What is the endgame for cryptocurrency regulation?

Author: Kenneth Rogoff is Professor of Economics and Public Policy at Harvard University, winner of the 2011 Deutsche Bank Prize in Financial Economics, and Chief Economist of the International Monetary Fund from 2001 to 2003.

Compiled and edited by Zeqi YI

As central banks begin to raise interest rates, cryptocurrency prices plummet, and many are wondering if this is the end of the crypto bubble? Perhaps not yet. However, higher monetary opportunity costs will disproportionately push asset prices down, while more use cases for these cryptocurrencies are in the future. Ultra-low interest rates have made cryptocurrencies taste sweet, while young investors are now suffering from rising interest rates.

A more interesting question is what happens when governments finally get serious about regulating Bitcoin and other cryptocurrencies? Among major economies, only China has so far begun to regulate. Most other policymakers have instead tried to change the subject by talking about central bank-issued digital currencies (CBDCs).

A growing problem

But this is clearly a non sequitur. While CBDCs may allow for privacy in small transactions, larger transactions will almost certainly require transparent identity information. In contrast, one of the biggest attractions of cryptocurrencies is that they offer an opportunity to bypass the use of government-issued fiat currencies. Granted, cryptocurrency transactions are fully traceable through blockchain ledgers, but users often set up accounts under pseudonyms, making it difficult to identify users without additional information, and the cost of obtaining this information is also very high.

Some economists naively believe that there is no particular urgency to regulate Bitcoin and other cryptocurrencies because they are difficult and costly to use in ordinary transactions. They try to make these points to policymakers in developing economies, where cryptocurrencies have become an important tool for circumventing taxes, regulations and capital controls.

Cryptocurrency is a growing problem for poor countries with limited state capacity. Citizens don’t need to be computer savvy to circumvent the authorities. They can simply log on to one of a few simple centralized exchanges. While cryptocurrency transactions conducted on exchanges are in principle traceable, these exchanges are all located in developed economies. In the real world, this information is mostly inaccessible to authorities in poor countries.

Money laundering, tax evasion

But isn’t this the promise of cryptocurrencies to help citizens bypass corrupt, inefficient, and untrustworthy governments? Perhaps, but, like fiat currencies, cryptocurrencies have the potential to be used by criminals in some developing countries.

Venezuela, for example, is a major player in the cryptocurrency market, in part because expatriates use cryptocurrencies to send money back and forth so that their funds won’t be seized by the country’s corrupt regime. But cryptocurrencies are certainly also used by the Venezuelan military in its drug smuggling operations, not to mention wealthy businessmen and politicians who are subject to financial sanctions. Given that the United States currently has financial sanctions against more than a dozen countries, hundreds of entities, and thousands of individuals, cryptocurrencies are a natural safe haven.

One reason why regulators in developed economies have been slow to act is that they believe that as long as cryptocurrency-related issues do not primarily affect their own jurisdictions, they are not their concern. Clearly, regulators believe that cryptocurrencies are essentially investable assets, but they are more concerned about the protection of domestic investors and the stability of financial markets.

Crypto = Conflict Diamond

But economic theory has long demonstrated that the value of any currency ultimately depends on its underlying fundamental use. The largest investors in cryptocurrencies may be in developed economies, but so far their uses and harms have been concentrated primarily in emerging markets and developing economies. One could even argue that investing in some developed economy cryptocurrency instruments is in some sense no different than investing in conflict diamonds.

It is likely that governments in advanced economies will find that the problem with cryptocurrencies will eventually explode. When that happens, they will be forced to impose broad bans on digital currencies that do not allow users to be easily traced (unless technological advances eventually strip away all anonymity, in which case the price of cryptocurrencies will collapse on their own). The ban will certainly extend to financial institutions and physical businesses, and may also include some restrictions on individuals.

Such a move would significantly weaken current cryptocurrency prices by reducing liquidity. Of course, the more countries that implement restrictions, the more effective they will be, but universal implementation does not need to have a significant impact locally.

Lobbying hard to prevent regulation

Could some version of a ban be implemented? As China has demonstrated, it’s relatively easy to shut down the exchanges that the vast majority of people use to trade digital currencies. Blocking transactions “on-chain” is difficult because the associated personal information is less identifiable. Ironically, effectively banning 21st century cryptocurrencies may also require phasing out (or at least reducing) older paper devices, since cash is by far the most convenient way for people to get funds “on-chain” to their digital wallets without being easily discovered.

To be clear, I am not saying that all blockchain applications should be restricted. For example, regulated stablecoins, backed by central bank balance sheets, can still flourish, but there needs to be a direct legal mechanism to track the identity of users when necessary.

When will stricter cryptocurrency regulation actually happen? Without a series of crises, tighter regulation of the cryptocurrency industry could take decades, especially given that major industry players are investing huge sums of money in lobbying, just as the financial industry did before the 2008 global financial crisis. Now it seems that regulation may not take that long to come, because unfortunately, the crisis of digital currencies may come sooner or later.