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@ -3,8 +3,8 @@ title: Bitcoin as an Anti-Authoritarian Force
date: 2022-05-02
created: 2022-05-02
description: "Episode #7 of our ongoing deep dive into web3 and crypto with Rufus Pollock and Stephen Diehl. This week we’re exploring the thesis that Bitcoin (and crypto more generally) is an anti-authoritarian force and can help undermine tyranny."
youtube:
podcast:
youtube: https://youtu.be/U_-Bdx1mqS8
podcast: https://anchor.fm/life-itself/episodes/Bitcoin-as-an-Anti-Authoritarian-Force-e1i25vg
featured: false
aliases: notes/bitcoin-as-anti-authoritarian.md
---
@ -131,4 +131,4 @@ We will conclude that **Bitcoin and crypto generally is not an liberatory force
1. Pilkington, Marc. 2017. ‘Can Global Elites Pave the Way for a New Transnational Unit of Account? A Reflection on the Numerical Nature of Money’. World Review of Political Economy 8 (4). https://doi.org/10.2139/ssrn.2339678.
1. Popper, Nathaniel. 2019. ‘Terrorists Turn to Bitcoin for Funding, and They’re Learning Fast’. The New York Times, 92–94.
1. Renieris, Elizabeth M. n.d. ‘Why a Little-Known Blockchain-Based Identity Project in Ethiopia Should Concern Us All’. Centre for International Governance Innovation. Accessed 22 February 2022. https://www.cigionline.org/articles/why-a-little-known-blockchain-based-identity-project-in-ethiopia-should-concern-us-all/.
1. Steele, Graham. 2021. ‘The Miner of Last Resort: Digital Currency, Shadow Money and the Role of the Central Bank’. Technology and Government, Emerald Studies in Media and Communications, Forthcoming.
1. Steele, Graham. 2021. ‘The Miner of Last Resort: Digital Currency, Shadow Money and the Role of the Central Bank’. Technology and Government, Emerald Studies in Media and Communications, Forthcoming.

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title: Shri T Rabi Sankar. Cryptocurrencies – An Assessment
date: 2022-05-10
created: 2022-05-10
description: "Keynote address delivered by Shri T Rabi Sankar, Deputy Governor, Reserve Bank of India - February 14th, 2022 - at the Indian Banks Association 17th Annual Banking Technology Conference and Awards."
featured: false
aliases: notes/cryptocurrencies-an-assessment.md
---
* Citation: Shri T Rabi Sankar, ‘Cryptocurrencies – An Assessment’. 14th February 2022. https://rbi.org.in/Scripts/BS_SpeechesView.aspx?Id=1196
* Wiki topic: [Crypto Asset](../concepts/cryptoasset.md)
***
# Overview
* In this address Sankar argues that:
* Cryptocurrencies have specifically been developed to bypass the regulated financial system.
* Cryptocurrencies are not amenable to definition as a currency, asset or commodity; they have no underlying cash flows, they have no intrinsic value; and that they are akin to (or even worse than) Ponzi Schemes.
* They undermine financial integrity, especially the KYC regime and AML/CFT regulations and at least potentially facilitate anti-social activities.
* They can (and if allowed most likely will) wreck the currency system, the monetary authority, the banking system, and in general Governments’ ability to control the economy. They threaten the financial sovereignty of a country and make it susceptible to strategic manipulation by private corporations creating these currencies or Governments that control them.
* Banning cryptocurrency is the most advisable choice open to India. None of the arguments proffered by those advocating that cryptocurrencies should be legalized and regulated stand up to basic scrutiny.
# Summary
* In this address, Sankar gives an introduction to the basics of cryptocurrencies. Sankar then engages in a critical assessment of cryptocurrencies.
## What are Cryptocurrencies?
* While cryptocurrency is designed to be a [currency](https://web3.lifeitself.us/concepts/currency.md), it **does not fulfill the function of a currency**: Cryptocurrencies do not have an issuer, they are not an instrument of debt, or [commodities](https://web3.lifeitself.us/concepts/commodity.md) nor do they have any [intrinsic value](https://web3.lifeitself.us/concepts/use-value.md).
* **Cryptocurrencies are not financial assets**. Cryptocurrencies are neither any person’s liability nor do they have any underlying cash flows and are therefore by definition not financial assets.
* **Cryptocurrencies are not a commodity**: they are not tangible and have no [utility](https://web3.lifeitself.us/concepts/use-value).
* Concludes that cryptocurrencies are not currencies, financial assets, nor commodities. They are rather “an electronic code (with no practical use) which has created enough hype such that people are willing to pay money to buy ownership rights to that electronic code, seemingly on the hope that someone else would buy it at a higher price in future… **Cryptocurrencies are very much like a [speculative](https://web3.lifeitself.us/concepts/speculation.md) or gambling contract working like a [Ponzi scheme](https://web3.lifeitself.us/concepts/ponzi-scheme.md).**”
* It has been argued that the original scheme devised by Charles Ponzi in 1920 is better than cryptocurrencies from a social perspective - even Ponzi schemes invest in income earning assets.<sup>1</sup>
## What useful social or economic role does a cryptocurrency play?
* Can cryptocurrencies perform the functions of a currency? **“The volatility of many cryptocurrencies precludes them as an efficient medium of exchange.”**
* Are cryptocurrencies useful as a [store of value](https://web3.lifeitself.us/concepts/store-of-value)? “Stores of value are either currencies, or financial assets or commodities which are tangible and have intrinsic value… Cryptocurrencies are none of these… if a threshold number of people decide to opt out, the entire values can easily collapse to nothing.”
* “For all the hype about a revolutionary innovation, cryptocurrencies themselves **do not appear to be designed to meet any need in the finance space that is currently not being met or to meet existing needs more efficiently**.”
## What, if any, are the risks posed to a society or an economy?
* 1: They are intended to be private currencies and therefore come with the associated risks.
* Historically, **private currencies have resulted in instability** and therefore have evolved into [fiat currencies](https://web3.lifeitself.us/concepts/fiat-money.md) over centuries.
* With one or more private currencies being allowed, there would be **parallel currency system(s)**. Thus, increased acceptance of cryptocurrencies would result in effective ‘Dollarization’ of the economy.<sup>2</sup> **Dollarization would undermine the ability of authorities to control money supply or interest rates**, as monetary policy would not have any impact on the non-Rupee currencies or payment instruments → ability to control inflation would be materially weakened.
* If private currencies are permitted, the banking system’s ability to **mobilize deposits in Rupees, and consequently, the ability to create credit, would be diminished.**
* There are already indications that **private cross-border flows are taking place in cryptocurrencies.**
* If this trend is legitimized, a part of the flows related to trade payments, personal remittances or cross border investments would be made in these cryptocurrencies. As they are non-reserve currencies, this could have adverse implications for India’s foreign exchange reserves, which lend stability to the external sector.
* Such cryptocurrency payments can take place outside the ambit of capital account regulations. This would adversely affect the integrity of the capital account regime, as policy control on capital flows would be eroded. The consequence of this on foreign exchange reserve accretion and exchange rate management raises serious macroeconomic stability issues.
* [Stablecoins](https://web3.lifeitself.us/concepts/stablecoin) (which are simply cryptocurrencies that are less volatile) are being promoted globally, because they are more stable than, say, Bitcoin. We should be more concerned about stablecoins because they would be more effective as currency than volatile cryptocurrencies. FT: **“Stablecoins pegged to official currencies would increase, rather than dampen risks, if assets and liabilities were mismatched.”**<sup>3</sup>
* 2: They are structured to evade Government control with respect to financial integrity standards such as KYC, AML/CFT etc.
* The raison d’etre of cryptocurrencies is that they **bypass established intermediation and control arrangements that ensure integrity of financial transactions**, such as Know-Your-Customer regimes, Anti-Money Laundering (AML) and Combating the Financing of Terrorism (CFT) rules etc.
* Cryptocurrencies are particularly attractive to illegal/illegitimate transactions which have been largely filtered out of the formal financial system.
* Since valuation is largely based on beliefs, and not on underlying value, it is bound to have a destabilizing effect on monetary stability of a country through large-scale wealth loss to investors (if it is adopted widely), even if not allowed to be used as a currency.
* Wasteful energy use of crypto infrastructure.
* Sankar thus concludes **“there does not appear to be any case to allow cryptocurrencies to be legitimized in India.”** He then goes on to address arguments for permitting cryptocurrencies when subject to close regulations.
## Should cryptocurrencies be permitted and regulated in India?
* **Pro**: Blockchain or Distributed Ledger Technology is a promising technology where Indians might have a global edge. Banning cryptocurrencies would affect the absorption of DLT technology in India.
* **Rebuttal**: Creating native cryptocurrencies<sup>4</sup> is just one way of implementing a blockchain. It should be possible to maintain a blockchain without any native cryptocurrency if transactions are authenticated centrally.
* **Pro**: Most advanced economies (AEs) are not banning cryptocurrencies, but are considering some kind of regulation.
* **Rebuttal**: India is not similarly placed as advanced economies. If some private currency substantially replaces the Rupee, the corporation which manages that cryptocurrency (or the country which has control of that corporation) can practically control India’s economic policy. There are a number of other reasons why it might be in the interest of AEs to not ban them:
* Almost all cryptocurrencies are priced in terms of Dollars (or potentially any of the freely convertible currencies). Wider adoption would result in wider use of these currencies. So cryptocurrencies are not a threat to convertible currencies as they are to the Rupee, which is not an international currency.
* Most cryptocurrencies are owned by businesses of AEs; therefore, better adoption of cryptocurrencies would add to their growth and employment.
* AEs have more mature markets which can withstand the potential disruption from cryptocurrencies. They are, therefore, in a better position to wait and watch.
* AEs have quicker legal systems therefore concerns of misuse of cryptos can be addressed through the legal systems. In India, none of the major instances of consumer exploitation have been redressed legally (e.g. the mis-selling of derivatives in mid 2000s).
* AEs have the political power to control the crypto companies. The recent instance where the US recovered Bitcoins from the hackers of the oil pipeline in the US is an example that AE Governments wield enough power to access the records. India or most other countries would lack such advantages.
* **Pro**: Many Indians have already invested in cryptocurrencies and banning it may lead to wealth loss for them.
* **Rebuttal**: Banning in India does not mean investors would lose money, because they can be provided with a reasonable exit.
* **Rebuttal**: Persons who have invested in these instruments are fully aware of the risks involved. Reserve Bank has been warning investors of the risks for nearly a decade.
* **Rebuttal**: There is no data to justify how many investors have invested in these instruments and what is the amount of investment. Data informally gathered in November seems to indicate that crypto investments by Indians is nowhere near to being significant.<sup>5</sup>
* **Pro**: Banning is unlikely to be effective because by its very nature cryptocurrencies can be acquired and traded in an anonymous manner.
* **Rebuttal**: Could argue that drug trafficking is a rampant phenomenon despite a ban, and therefore drug trafficking should be legalized and regulated. If cryptocurrencies are banned, the vast majority of investors who are law abiding would desist from investing. Those few elements who would continue to invest will be carrying out an illegal activity.
* **Pro**: Some argue that private currencies should not be allowed as legal tender but should be allowed as an investment asset.
* **Rebuttal**: Not allowing them as currency would still amount to cryptocurrencies being used as a store of value. ‘Store of value’ demand is a more substantial source of demand for a currency than transaction demand. If a cryptocurrency is used as a store of value the same concerns arise again.
* Rebuttal: Unlike the value of Rupee, which is anchored by monetary policy and its status as legal tender, the value of crypto assets rests solely on the expectation that others will also value and use them. Since valuation is largely based on beliefs that are not well anchored, it is bound to have a de-stabilising effect on the monetary and fiscal stability of a country, even while it is not permitted to operate as a legal tender.
* **Against**: It would be futile to regulate cryptocurrencies as cryptocurrencies are not currencies, or financial assets or real assets or even digital assets. Therefore, it cannot be regulated by any financial sector regulator - it is not possible to regulate something that one cannot define.
* **Against**: The Financial Stability Institute of the Bank for International Settlements identifies difficulties in regulating cryptos – such as the international nature of crypto transactions, absence of technological solutions to ensuring FATF’s ‘Travel Rule’, the problem of ‘unhosted wallets’, the fact that P2P transactions do not involve any entity subject to AML-CFT regulations, etc.
* **Against**: As it is not always possible to know of the persons who are the management for cryptocurrencies (e.g. Bitcoin), at whom would the regulatory action be directed?
## Conclusion
* Cryptocurrencies can (and, if allowed, most likely will) wreck the currency system, the monetary authority, the banking system, and in general Governments’ ability to control the economy. They threaten the financial sovereignty of a country and make it susceptible to strategic manipulation by private corporations creating these currencies or Governments that control them.
* Banning cryptocurrency is perhaps the most advisable choice open to India. We have examined the arguments proffered by those advocating that cryptocurrencies should be regulated and found that none of them stand up to basic scrutiny.
***
## References and Notes
1. McCauley, Robert. ‘Why Bitcoin Is Worse than a Madoff-Style Ponzi Scheme’, 22 December 2021. https://www.ft.com/content/83a14261-598d-4601-87fc-5dde528b33d0.
2. This could be actual dollarization if stablecoins linked to the US Dollar become widely used, and there is good reason to believe that that they would be popular if permitted.
3. Guthrie, Jonathan. Where Crypto ‘anarchy’ Will End | Lex Megatrends, 2021. https://www.ft.com/video/ccb48782-82f9-44ef-97c7-dcfa02431123.
4. Bitcoin is native currency to Bitcoin Blockchain, Ether to Ethereum
5. The Reserve Bank does not vouch for the reliability of this data as it was collected informally and has not been validated. These conclusions may only be taken as indicative, subject to correction if better data is made available.

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---
title: Walch, Angela. Deconstructing 'Decentralization'; Exploring the Core Claim of Crypto Systems
date: 2022-05-10
created: 2022-05-10
description: "A summary of Angela Walch's 2019 paper 'Deconstructing 'Decentralization': Exploring the Core Claim of Crypto Systems'. Walch demonstrates how pervasive the belief that blockchains are ‘decentralized’ has become, and demonstrates that blockchains’ level of ‘decentralization’ is being used to draw conclusions about, and make decisions regarding, these systems. Walch argues that if ‘decentralized’ is 'transitioning from a marketing term for cryptoassets to one of legal import, we must be clear about what we mean when we describe blockchain networks or systems as ‘decentralized''."
featured: false
aliases: notes/deconstructing-decentralization.md
---
* Citation: Walch, Angela. ‘Deconstructing 'Decentralization'; Exploring the Core Claim of Crypto Systems’ Oxford University Press, 2019
* Wiki topic: [Decentralization](../concepts/decentralization.md)
***
# Overview
* In Part I, Walch outlines the two key senses of the word “decentralized” within this space: describing how power operates in blockchain systems; and describing the network of computers that comprise a permissionless blockchain.
* In Part II, Walch identifies and explores key themes within the commentary, such as the different domains where power is exercised in blockchain systems and the fluid nature of power concentration and diffusion in these systems.
* In Part III, Walch explores examples of events which reveal sites of concentrated power in permissionless blockchain systems.
* In Part IV, Walch explores why using the term “decentralized” in decision making (policy, legal etc) is problematic, paying particular attention to how use of the term can lead to flawed judgements about how accountability or liability of people within a blockchain system should work.
* Walch concludes that courts, regulators, and potential users of crypto assets should use other factors to inform their decisions about a blockchain.
# Summary
## Introduction
* In 2018, William Hinman, Director of the SEC’s Division of Corporation Finance, stated that “current offers and sales of Ether are not securities transactions”. He linked this conclusion to the “sufficiently decentralized” structure of the Ethereum network. While this is not binding law, it demonstrates how **pervasive the belief that blockchains are ‘decentralized’ has become, and that a blockchain’s level of ‘decentralization’ is being used to draw conclusions about these systems.**
* If this is the case, and **‘decentralized’ is transitioning from a marketing term for crypto assets to one of legal import,** we must be clear about what we mean when we describe blockchain networks or systems as ‘decentralized’.
* We must decide whether ‘decentralized’ is a meaningful way to evaluate a blockchain system, and if so, we must be precise about what we mean by the term, and which portions of a complex blockchain system we are referring to.
## I. Mainstream Discourse Around ‘Decentralized’ Permissionless Blockchains
* The terms ‘decentralized’ and ‘decentralization’ are ubiquitous in the discourse around blockchain technologies and cryptoassets.
* Academic work, discussions within the crypto space, businesses, governments, international organizations, legislation.
* It is rare to see clear explanations of ‘decentralized’ or ‘decentralization’ when the terms are used.
* The different ways ‘decentralized’ is used in mainstream blockchain discourse:
* **To describe the network of computers (often referred to as ‘nodes’) that comprise a permissionless blockchain**, as these systems operate through peer‐to‐peer connections between computers, rather than on a central server. The record generated by the system is stored on many computers within the network, rather than just on one.
* **To describe how power or agency works within permissionless blockchain systems.** If there is not a single, central party keeping the record, that means that power is not held centrally, instead power is diffused throughout the blockchain.
* Both political (no one has any power, especially not the state) and physical (we have a lot of computers running, so you can’t easily knock the entire system out) meanings have melded in mainstream usage of the terms.
* Director Hinman’s June 2018 speech reflected these melded meanings of ‘decentralized’. His understanding of the ‘decentralized’ nature of bitcoin and ether led to his conclusion that the two are not securities.
* Walch argues that the SEC’s standard for “sufficiently decentralized” is extremely low, and argues that a deeper analysis of the concept is needed.
## II. The Complex Nature of “Decentralization”
* Key themes identified by the author within commentary on “decentralization”:
* No One Knows What “Decentralization” Means
* Decentralization is often discussed as essential and a feature that differentiates crypto systems from others, yet its complexity is under-acknowledged and what it actually means is poorly understood.
* Crypto systems are comprised of many different actors - developers, [miners](https://web3.lifeitself.us/concepts/mining.md) (or validators), and the nodes. the decentralization level of a crypto system as a whole was dependent upon each subsystem within it being decentralized as well.
* Other sites of potential centralization: actors outside the system eg [exchanges](https://web3.lifeitself.us/concepts/crypto-exchange.md) (have the power to choose whether or not to list a particular token for trading); token holders (in many crypto systems, ownership is concentrated in a very small number of people); number of software implementations of a blockchain system’s protocol, particularly if there is a dominant one.
* **It is not helpful to describe a blockchain system as decentralized unless one is specific about how he is measuring the level of decentralization in each domain of the system.**
* However, it’s **difficult to quantify decentralization.** Possible to count numbers of computer nodes within a system, and potentially determine how ownership of the nodes is distributed. Meanwhile, the governance of the software development process is just as relevant to how decentralized a system is, but is much more difficult to quantify or measure, as it deals with the behavior of individuals and often unwritten norms.
* Satoshi Didn’t Invent Decentralization
* Decentralization is fundamentally about diffusing power by distributing it away from a central point of control – sharing that power among many.
* The idea of decentralization is a foundational principle of many institutional governance structures: the federalist system; the checks and balances inherent in the three branches of the US government; the principle of subsidiarity in the European Union that pushes power away from the center.
* Decentralization is often about disruption or revolution – breaking up existing power structures, with hopes of spreading power around. The decentralization mantra around blockchains follows in that vein, including the discussions about “being your own bank” or “owning your digital identity” or creating money not issued by a [central bank](https://web3.lifeitself.us/concepts/central-banks.md).
* Decentralized Does Not Equal Distributed
* According to the Cambridge Centre for Alternative Finance’s Distributed Ledger Technology Systems: A Conceptual Framework (the “CCAF Report”), **“decentralized”** is used to indicate that the **nodes operating in a system are controlled by different parties, rather than by the same entity.**
* The CCAF Report states that **“distributed”** is used to indicate that **“storage or computation…is divided into parts and occurs across multiple servers or nodes (‘parallelised’), but “may still rely on a central coordinator to act as an authoritative source of records.”**
* Decentralization Exists on a Spectrum
* The CCAF Report: **decentralization “is not a simple binary property,”** as “the degree of centralization reflects the accumulation of interacting decisions and tradeoffs at various layers.
* Decentralization is Dynamic rather than Static
* The CCAF Report: the “power dynamics” within a blockchain system “can be fluid and evolve over time, which further complicates the task of forming a definitive assessment of the system.”
* So many factors affect how decentralized a blockchain system is, so a change to any of those factors can shift the blockchain on the decentralization spectrum.
* Decentralization is Aspirational, Not Actual
* ‘Decentralization’ in blockchain systems is not something that has been achieved yet.
* Some initiatives are open about their current, highly concentrated power structures, noting that they need centralized decision‐making and highly coordinated actions to build the system, and then expect it to become decentralized.
* Decentralization Can Be Used to Hide Power or Enable Rule‐Breaking
* Decentralization enables groups of people to obscure power and escape consequences for breaking rules.
* Calls to Action
* The status quo usage of the terms “decentralized” and “decentralization” is deemed untenable by many commentators, and there are a variety of calls to action in the literature: deeper study of the term; frameworks for better understanding or measuring the decentralization of crypto systems; doing away with the terms altogether in discussing crypto systems.
## III. Examples of Concentrations of Power in Permissionless Blockchain Systems
* Emergency rescues of Bitcoin by small groups of developers in 2018 when a critical software bug was discovered and March 2013 when the blockchain suffered an unintended [hard fork](https://web3.lifeitself.us/concepts/hard-fork).
* Invite‐only meetings held by key software developers of Ethereum in 2018.
* The actions key developers of Ethereum took during the July 2016 hard fork in response to the DAO hack.
* Pockets of power:
* Core developers:
* Only a small number of developers (known as core developers) within a blockchain system have commit keys that enable them to make changes to the code repository. Every line of code reflects a policy choice about the blockchain system as a whole (e.g., how expensive should it be to participate in the system?) and technical choices about how to best reflect the policy mandate in code.
* Mining pools:
* In [proof‐of‐work](https://web3.lifeitself.us/concepts/proof-of-work.md) systems like Bitcoin and (currently) Ethereum, whoever controls more than 50% of the hashing power of the network effectively controls the validation process, and is able to block transactions from being entered onto the blockchain or even alter old entries on the blockchain (sometimes referred to as a block ‘reorg’).
* A series of 51% attacks on many permissionless blockchains, including the January 2019 51% attack on Ethereum Classic, demonstrate the power dominant miners wield over these networks.
## IV. Using ‘Decentralized’ to Make Legal Decisions about Blockchains
* The implications for law of making decisions about permissionless blockchains based on their level of decentralization are significant.
* Decentralization’s **uncertain meaning makes it ill‐suited for a legal standard.**
* As discussed in Part II, no one is sure what it means for a blockchain system to be decentralized.
* We could come up with complicated formulas to measure the ‘level of decentralization’ of a permissionless blockchain system. Issues with this:
* While some aspects of a permissionless blockchain system are easily quantifiable, the roles of software developers, miners, and even nodes in governance are complex and poorly understood, so these actors who strongly influence the success or failure of a blockchain system remain unremarked.
* Could fall prey to the observational bias sometimes referred to as the “streetlight effect” – i.e., paying attention only to matters that have been illuminated, and not ones remaining in the dark.
* “Gresham’s Law of Measurement”: “Easy‐to‐calculate quantitative metrics tend to crowd out more relevant but difficult‐to measure assessments.”<sup>1</sup>
* Decentralization’s **dynamic nature complicates its use as a legal standard.**
* If a system’s level of decentralization were relevant to a legal status, there would have to be periodic evaluations of the decentralization level of the relevant blockchain system to measure it. Issues:
* Can something cease to be a security that has already been one? How? What are the rules for trading it? How is secondary market trading of the token managed when the token can fluctuate between security and non‐security?
* If the measurement and determination of a decentralization level is done periodically to mark the moment when a particular legal status is achieved, then participants in blockchain systems (nodes, miners, developers) may game the standard by taking actions to move along the decentralization spectrum. If the prize is large (as non‐security status would be), then anything gameable (including a level of decentralization) will be gamed.
* If actual decentralization is now just a dream, wait till it comes true.
* Part II noted the largely aspirational nature of ‘decentralization’ in permissionless blockchains. If this is the case, it is premature to use ‘decentralization’ as a way to make legal decisions. The law must deal with present‐day realities rather than hopes or dreams.
* Decentralization veils.
* As outlined above, though they are called ‘decentralized’, there are many parts of blockchain systems that are exceedingly centralized. Thus, the meaning commonly conveyed by the word ‘decentralized’ does not match the reality of these systems, with the consequence that misleading, inaccurate information about how power works in a given blockchain system is being conveyed every time someone describes the system as decentralized. This includes regulators, policy makers, and anyone else making decisions about these systems.
* Misuse of the term ‘decentralized’ can lead to flawed judgements about how accountability or liability of people within a blockchain system should work, effectively providing a liability shield similar to that of limited liability entities.
* If one believes that no particular people are doing things of consequence, and power is diffuse, then there is effectively no human agency within the system to hold accountable for anything. Law has no reason to reach into such a system, as there is no relevant human behavior to direct.
* Misuse can also lead to perceptions that the tokens of a given system are more fixed and less subject to change than they are, potentially impacting any financial product tied to that token as well as other infrastructure built on or related to the blockchain system.
* Legal and risk determinations about tokens like Bitcoin and Ethereum have generally been based on the view that the tokens themselves have fixed characteristics. Eg The Commodity Futures Trading Commission has deemed bitcoins to be commodities.
* This view of tokens as having fixed characteristics underpins decisions to integrate tokens like Bitcoin and Ethereum into the mainstream financial system, whether as collateral for loans or investments by retail and institutional investors.
* When blockchain systems like Bitcoin or Ethereum serve as infrastructure to applications built atop them, and their tokens are integrated into the financial operations of our societies, sudden changes to the infrastructure (tied to the exercise of centralized, unaccountable power), can be destabilizing to everything that rests on the infrastructure.
* If our understandings of the power dynamics within a system were accurate, we would expect fluidity in the characteristics of a token, and therefore factor that fluidity into our risk assessments, our views of the value and potential use cases of the technology, and critically, our legal and regulatory decisions.
## Conclusion
* **Making decisions based on an unsubstantiated conclusion that a given blockchain is ‘decentralized’ is highly problematic. Courts, regulators, and even potential users of crypto assets should use other factors to inform their decisions about a blockchain.**
***
## References
1. Sridhard Ramamoorti et al., The Gresham’s law of measurement and audit quality indicators: Implications for policy making and standard setting, 29 RESEARCH IN ACCOUNTING REG. 79, (2017).

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---
title: Allen, Hilary J. ‘DeFi. Shadow Banking 2.0?’
title: Allen, Hilary J. ‘DeFi; Shadow Banking 2.0?’
date: 2022-05-10
created: 2022-05-10
description: "A summary of Hilary Allen's 2022 paper 'DeFi: Shadow Banking 2.0?'. In this paper Allen explores the concept of decentralized finance, or DeFi, as 'Shadow Banking' - services which provide functional equivalents for banking products but operate outside the regulated banking sphere. Allen likens DeFi to services which contributed to the 2008 banking crisis and thus advises precautionary regulation of DeFi in order to limit its growth and to cordon it off from the established financial system and real-world economy."
description: "A summary of Hilary Allen's 2022 paper 'DeFi; Shadow Banking 2.0?'. In this paper Allen explores the concept of decentralized finance, or DeFi, as 'Shadow Banking' - services which provide functional equivalents for banking products but operate outside the regulated banking sphere. Allen likens DeFi to services which contributed to the 2008 banking crisis and thus advises precautionary regulation of DeFi in order to limit its growth and to cordon it off from the established financial system and real-world economy."
featured: false
aliases: notes/defi-shadow-banking-2-0.md
---
* Citation: Citation: Allen, Hilary J. ‘DeFi: Shadow Banking 2.0?’ SSRN Electronic Journal, 2022. https://doi.org/10.2139/ssrn.4038788.
* Wiki topic: [DeFi](../concepts/defi.md)
***
@ -71,13 +72,13 @@ Allen then explains how we may be facing 'Shadow Banking 2.0' in the form of dec
* DeFi, together with the broader vision of a decentralized [“Web3”](https://web3.lifeitself.us/concepts/web3.md), is marketed in **aspirational terms**; its value is consistently described as lying in its potential.
* **DeFi doesn’t aspire to provide any new financial product or service: instead, the idea is to provide existing financial products and services in a decentralized way.**
* Decentralization, however, is “an entirely unrealistic aspiration” due to the “inescapable need for centralized governance” and the fact that the DeFi ecosystem is already full of intermediaries.
* The Bank for International Settlements has observed that there is “a “decentralisation illusion” in DeFi due to the inescapable need for centralised governance and the tendency of blockchain consensus mechanisms to concentrate power.”
* Tim O’Reilly: “history teaches us that there will always be new avenues for power to become centralized”; “Blockchain turned out to be the most rapid recentralization of a decentralized technology that I've seen in my lifetime.”
* Where there are opportunities to profit from streamlining unwieldy decentralized services for users (especially when venture capitalists are standing ready to fund such projects), the evolution of centralized intermediaries seems inevitable. David Rosenthal: “economics forces successful permissionless blockchains to centralize.”
* The Bank for International Settlements has observed that there is “a “decentralisation illusion” in DeFi due to the inescapable need for centralised governance and the tendency of blockchain consensus mechanisms to concentrate power.”<sup>5</sup>
* Tim O’Reilly: “history teaches us that there will always be new avenues for power to become centralized”; “Blockchain turned out to be the most rapid recentralization of a decentralized technology that I've seen in my lifetime.”<sup>6</sup>
* Where there are opportunities to profit from streamlining unwieldy decentralized services for users (especially when venture capitalists are standing ready to fund such projects), the evolution of centralized intermediaries seems inevitable. David Rosenthal: “economics forces successful permissionless blockchains to centralize.”<sup>7</sup>
* Every level of infrastructure involved in providing DeFi products and services depends on decisions made by human beings - these human beings have the same incentives to concentrate wealth and power that people have always had.
* Many of the investors driving the growth of DeFi are institutional players, often engaging in transactions worth $10 million or more of cryptocurrency, and the holder of a single governance token in a DAO administering a DeFi Dapp is unlikely to have any real voice in how the [DAO](https://web3.lifeitself.us/concepts/dao.md) or the Dapp operates.
* The Dapps operate on top of another layer of infrastructure: a distributed ledger, like the Ethereum blockchain, which is also dependent on many humans for its functioning. Most decisions relating to the operation of a distributed ledger are made by the people with the power to validate transactions on that ledger, and by the core developers of the computer code governing that ledger.
* So-called “core developers” “function as the leaders and decision makers in relation to the code.”
* So-called “core developers” “function as the leaders and decision makers in relation to the code.”<sup>8</sup>
* Validators are also important actors, because they determine the definitive version of the ledger (which is the definitive record of who owns the crypto assets associated with that ledger).
* Ultimately, trust is required in the DeFi ecosystem. **A decentralized foundation just makes financial services more convoluted and replaces trust in established institutions (particularly government institutions and regulated banks) with trust in different – and sometimes unidentified – actors.**
@ -93,9 +94,9 @@ Allen then explains how we may be facing 'Shadow Banking 2.0' in the form of dec
* **Given the financial stability risks that DeFi would create if it were allowed to grow into Shadow Banking 2.0, and given that proponents of the technology involved struggle to demonstrate any concrete superiority over simpler centralized alternatives, policymakers should pursue policies that prevent DeFi from growing.**
* Because negative spillover effects from DeFi will wreak the most havoc on the real economy if regulated banks become integrated into the DeFi ecosystem, **steps should be taken to insulate regulated banks from DeFi.**
* As a priority, regulated banks should be prohibited from: issuing stablecoins or providing any Dapps; holding stablecoin reserves in a deposit account; or investing in any Dapp or stablecoin (banking regulators already have the authority they need to take these steps).
* The President’s Working Group Report recommended that “legislation should require stablecoin issuers to be insured depository institutions.” This recommendation seeks to address stablecoin-related run risk, but if followed, would create [moral hazard](https://web3.lifeitself.us/concepts/moral-hazard.md) by extending the public safety net of deposit insurance to the DeFi ecosystem in which stablecoins are deployed. **Taking this step would legitimize stablecoins in a way that would likely fuel, rather than limit, the growth of DeFi.**
* The President’s Working Group Report recommended that “legislation should require stablecoin issuers to be insured depository institutions.”<sup>9</sup> This recommendation seeks to address stablecoin-related run risk, but if followed, would create [moral hazard](https://web3.lifeitself.us/concepts/moral-hazard.md) by extending the public safety net of deposit insurance to the DeFi ecosystem in which stablecoins are deployed. **Taking this step would legitimize stablecoins in a way that would likely fuel, rather than limit, the growth of DeFi.**
* Other possible regulatory strategies designed to prevent DeFi from growing into Shadow Banking 2.0:
* Gorton and Zhang have noted that Congress has the authority to “tax competitors of [the US dollar] out of existence.”
* Gorton and Zhang have noted that Congress has the authority to “tax competitors of [the US dollar] out of existence.”<sup>10</sup>
* Congress could adopt a licensing regime for Dapps and stablecoins where the applicant would need to demonstrate:
(i) that the Dapp/stablecoin has a purpose that is connected to real-world economic growth (purely aspirational goals would not satisfy this test);
(ii) that the applicant has the institutional capacity to manage both the financial and technological risks associated with the Dapp/stablecoin; and
@ -117,3 +118,9 @@ Allen then explains how we may be facing 'Shadow Banking 2.0' in the form of dec
2. Id. at 30.
3. Tobias Adrian et al., Crypto Prices Move More in Sync With Stocks, Posing New Risks, IMF BLOG (Jan. 11, 2022).
4. Jamie Crawley, US Banks Form Group to Offer USDF Stablecoin, COINDESK (Jan. 12, 2022).
5. Sirio Aramonte et al., DeFi Risks and the Decentralization Illusion, BIS QUARTERLY REVIEW, 22 (Dec. 2021).
6. Dan Patterson, Internet guru Tim O’Reilly on Web3: “Get ready for the crash”, CBSNEWS (Feb. 10, 2022).
7. David Rosenthal, EE380 Talk, (Feb. 9, 2022), https://blog.dshr.org/2022/02/ee380-talk.html.
8. Angela Walch, In Code(rs) We Trust: Software Developers as Fiduciaries in Public Blockchains, in Regulating Blockchain: Techno-Social And Legal Challenges (Hacker et al, Eds), 61 (2019).
9. President’s Working Group on Financial Markets, REPORT ON STABLECOINS, 2 (November 2021).
10. Gary B. Gorton & Jeffery Zhang, Wildcat Stablecoins, 40 (Jul. 19, 2021), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3888752.

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---
title: Bindseil, Ulrich. et al. The encrypted threat; Bitcoin’s social cost and regulatory responses
date: 2022-05-10
created: 2022-05-10
description: "This paper, authored by By Ulrich Bindseil, Patrick Papsdorf and Jurgen Schaaf of the European Central Bank, digs into the social impact of Bitcoin and the regulatory decisions that are being made by state and international bodies in relation to this crypto asset."
featured: false
aliases: notes/the-encrypted-threat.md
---
* Citation: Bindseil, Ulrich et al. ‘The encrypted threat: Bitcoin’s social cost and regulatory responses’ SuERF Policy Note, Issue No 262, January 2022
* Wiki topic: [Bitcoin](../concepts/bitcoin.md)
***
# Overview
* Key points:
* **[Bitcoin](https://web3.lifeitself.us/concepts/bitcoin.md) technology is inefficient and vulnerable.**
* **Bitcoin is not a [currency](https://web3.lifeitself.us/concepts/currency)** (it is too volatile to fulfill the classic functions of money: unit of account, means of payment, [store of value](https://web3.lifeitself.us/concepts/store-of-value.md)).
* **Bitcoin has not been uptaken as a means of payment outside of niches** due to long settlement times and high fees.
* **Bitcoin is unsuitable and unsustainable as an investment [asset](https://web3.lifeitself.us/concepts/assets)**.
* **The market valuation of Bitcoin is purely based on [speculation](https://web3.lifeitself.us/concepts/speculation).** The Bitcoin hype has all the characteristics of a speculative [bubble](https://web3.lifeitself.us/concepts/bubble) along the so-called [greater fool theory](https://web3.lifeitself.us/concepts/greater-fool-theory).
* **The vision that Bitcoin can be a liberatory force is an illusion.** Bitcoin neither empowers, nor relieves the sovereign individual from the state.
* **Illicit activity and Bitcoin are deeply entwined.** Manipulation has been the cause of booms and Bitcoin is also popular for financing criminal activities.
* **Bitcoin is a negative sum game.** It generates no value for society and comes with significant private costs in the form of high energy and hardware consumption of the Bitcoin network.
* **Regulators have been slow in addressing the societal impacts of Bitcoin.** Why?
* The potential development of social risks may have been underestimated.
* Bitcoin raises multi-facetted threats and involves multiple actors. Regulatory responsibilities for Bitcoin are therefore fragmented. And the different risks to different sectors are continually changing and evolving.
* Many aspects are new and do not fit into existing regulatory frameworks.
* The **threats are beginning to be recognized** and a number of jurisdictions have taken or are preparing measures to regulate Bitcoin alongside other crypto-assets.
* However, stances vary between authorities due to differing assessments of the value of crypto-assets.
* **Some bodies are introducing measures which legitimize Bitcoin** and facilitate investment flows and the **integration of Bitcoin into traditional financial systems**.
* Public authorities should:
* Firstly, treat the Bitcoin network **as rigorously as the conventional financial industry** in terms of prevention of illicit payments, money laundering and terrorist financing.
* Secondly, **address the negative externalities of Bitcoin’s energy consumption.**
* Thirdly, **deny recognition of Bitcoin as an investment** and not allow it to become incrementally part of the regular financial system without strictest safeguards. Authorities should: strengthen global implementation of AML/CFT standards and broaden measures to stop Bitcoin being a vehicle for illicit purposes; and avoid measures that invite additional investment flows into Bitcoin.
# Summary
## 1. Introduction
* In November 2021, the market capitalization of crypto assets exceeded USD 3 Trillion for the first time, of which around USD 1.3 trillion were contributed by Bitcoin.
* Summary of the underlying technology and the conceptual set up:
* There is no central authority, but a global network of computers controls, monitors, and stores the system information. New Bitcoins are coined by decentralized [“mining”](https://web3.lifeitself.us/concepts/mining) by users and their computers. New data packets are added to the blockchain every few minutes. The maximum total number of Bitcoins is technically limited to about 21 million, of which just under 19 million are already in circulation. When this limit is reached the transaction fees become the only source of income for the miners, on whose existence Bitcoin depends in the long run. To prove the correctness of the entire blockchain and its extensions, computers must solve a mathematical puzzle for each block. The so-called miners validate the transactions by entering them into a public ledger. Currently rewards are the market value of a bitcoin minus the mining costs.
* This [proof-of-work](https://web3.lifeitself.us/concepts/proof-of-work) method has a scalable difficulty level and aims to keep the incentive for miners to keep running the system sufficiently high. With a higher Bitcoin price, more producers are incentivised to compete for new coins. This in turn requires the encryption puzzle to be more difficult. By consequence, the miners will require more electricity to solve the puzzle and will consume more electricity and increase carbon emissions.
## 2. Vulnerability and inefficiency of the Bitcoin technology
* Several authors have raised **serious doubts concerning Bitcoin’s underlying technology and concept.**<sup>1</sup>
* The proof-of-work concept is generally recognised as **cumbersome and slow**.<sup>2</sup>
* Slow and opaque pricing networks have traditionally attracted predatory high frequency algorithm traders and are vulnerable to related market stress (see the flash crash of 6 May 2010).
* Bitcoin uses the secure hash algorithm (SHA) which is more than twenty years old. The U.S. Department of Defense and many leading IT firms like Microsoft found the SHA-1 standard too weak for cyber-protection and decommissioned its use in the early 2010s. **In the absence of a central legitimized management it is hard to see how the fundamental security technology can be replaced in light of technological advances**.
* The Bitcoin network is prone to a so-called **51 percent attack**, which occurs when miners (potentially malicious) gain control of more than 51 percent of the network's hash-rate: they could then issue coins twice.<sup>3</sup>
* The Bitcoin network is already increasingly run by supercomputers and server farms and the incentive structure of retail miners might take a hit once all Bitcoins are minted and the reward system will rely on fees only. **The hash-rate is consequently likely to be increasingly concentrated in the hands of a few.**
* Due to its reliance on proof-of-work, it **wastes power and is an immense environmental polluter.** The consumed energy further results in 95.9 metric tons of CO2, comparable to the carbon footprint of metropolitan London. The more energy the Bitcoin network uses, the more secure it is.
## 3. Bitcoin is not a currency
* There is a **broad consensus** that Bitcoin fails in its original objective of being a currency.
* Bitcoin is too volatile to fulfill the classic functions of [money](https://web3.lifeitself.us/concepts/money): unit of account, means of payment, store of value.
* Moreover, the system is too slow and expensive to compete with established payment systems and currencies.
* The lack of acceptance by merchants due to long settlement times and high fees (currently between USD 2.5 and 4 per transaction) already shows that Bitcoin cannot be understood as a means of payment outside of niches. Therefore, Bitcoin's business model as a global means of payment is not plausible.
* On 7 September 2021, El Salvador tried to introduce Bitcoin as a second legal tender alongside the US Dollar. The launch was bumpy largely because there was no popular acceptance of the new means of payment. On the day of introduction, the Bitcoin exchange value plummeted by 15 percent, accompanied by protests targeted against President Nayib Bukele.
* Important to note that payments through the Chivo Wallet are actually layered and not settled in the Bitcoin network. Instead, they are just internally settled by the wallet provider, who acts as custodian. Therefore, at best, the Chivo Wallet is a payment system backed by Bitcoin, but fully betrays the fundamental idea of overcoming the dependence of payments on centralized intermediaries.
* President Bukele has launched new plans to push Bitcoin’s use and mining in El Salvador with a new city built around a Bitcoin industry. The construction financing and maintenance of the “Bitcoin City” would be based on new Bitcoin bonds; and the required energy taken from a volcano in the proximity.
## 4. Bitcoin does not appear to be a sustainable investment
* One of the most popular arguments among Bitcoin supporters is that the limited supply of Bitcoin would make it a great asset to protect investors against inflation, while [fiat money](https://web3.lifeitself.us/concepts/fiat-money), which can be multiplied at will, would increasingly lose value.
* Even if one were to assume that Bitcoin could become the new global money, its technically fixed “money supply” would lead the world into a deflation trap in a growing economy. In a deflation, falling prices of goods and services tempt citizens to postpone less urgent purchases into the future → aggregate demand suffers which slows down the economy.
* The advocates of [gold](https://web3.lifeitself.us/concepts/gold-standard) as a weapon against inflation – and those who praise Bitcoin for the same as reason as the new gold – should remember the reasons for the abolition of the gold standard. In 1931 major currencies gave up the gold peg after years of painful recession, deflation, and financial instability.
* The often-used comparison to gold also fails for more basic reasons.
* Gold is both used industrially and has been appreciated as jewelry for centuries before it became a store of value, an investment asset, or a reserve currency.
* It does not degenerate over time and retains its value even in chaotic or degenerative states of the world like natural catastrophes or in the case of failure of the electric or digital infrastructure.
* The objection that the fiat money of modern [central banks](https://web3.lifeitself.us/concepts/central-banks) also has no intrinsic value falls short: because in deliberately moving away from the gold standard, sovereigns and central banks have put in place clearly defined mandates, legal guarantees, institutional and operational arrangements (independence as well as loans against collateral) to be able to release the gold brake without losing stability.
* The alternative of Bitcoin as a store of value is not predominantly central bank fiat money, but the financing through equity and/or debt of real economic projects which serve needs of society and generate a cash flow which allows positive yields to be sustained, anchoring the value of the investment assets in its real productivity.
## 5. Mounting doubts about the sustainability of Bitcoin
* Bitcoin has no [intrinsic value](https://web3.lifeitself.us/concepts/use-value) and does not generate a cash flow or dividends. The market valuation of Bitcoin is purely based on [speculation](https://web3.lifeitself.us/concepts/speculation). **The Bitcoin hype has all the characteristics of a speculative [bubble](https://web3.lifeitself.us/concepts/bubble) along the so-called [greater fool theory](https://web3.lifeitself.us/concepts/greater-fool-theory).**
* Market interest has grown for newer blockchains that use smart contracts and aim to solve the challenges of earlier blockchains by introducing features to ensure scalability, interoperability, and sustainability. The biggest among the newer crypto-assets is Ether, which surpassed Bitcoin trading volumes earlier in 2021.
## 6. The illusion of liberation
* Bitcoin is envisioned by some as a method of restoring freedom from government control and from centralized entities that abuse their power. This is an illusion:
* Mechanistic rules, as Bitcoin appears to create, are not an appropriate solution for a changing world.
* Bitcoin is by no means as grassroots democratic as its community may have believed in the early days. It is shaped by financial interests and powerful shareholders and the exposure to concentration risks, given its large reliance on a few entities, like custodial [wallets](https://web3.lifeitself.us/concepts/wallet) and [exchanges](https://web3.lifeitself.us/concepts/crypto-exchange) (for example, Binance handles more than half of trading volumes). **75 percent of the addresses holds just over 0.2 percent of the market share; the hundred largest Bitcoin shareholders hold more value than the smallest 38 million combined.**<sup>4</sup>
* Bitcoin offers a vision of a global means of payment without national jurisdictions. People could send value across borders for free and unhindered to anyone with a Bitcoin wallet.
* This view ignores that the high cost of conventional cross-border payments is significantly due to costs of market and liquidity risk management and regulatory requirements to combat money laundering and terrorist financing. However, the cost of complying with these requirements, and provisions for legal and exchange rate risks only affect the regulated financial sector. **The fact that some Bitcoin transactions, e.g. like peer-to-peer, have been able to escape this entirely so far is a regulatory gap, not a technological achievement.**
## 7. The use of Bitcoin for illicit activities
* The first bubble in 2013 was fuelled by the Mt Gox exchange which hosted about 70 percent of Bitcoin trading. The exchange lost 650,000 Bitcoins of its users and went bankrupt. Research suggests that the first boom – a rise from USD 100 to USD 1,000 in just two months - was due to manipulation of a trading software.<sup>5</sup>
* The second and third booms were associated with the launch and rise of Tether. Tether is a so-called [stablecoin](https://web3.lifeitself.us/concepts/stablecoin), i.e. a type of crypto-asset that aims to maintain a stable value by being backed by fiat currency or other assets. Tether is nominally [pegged](https://web3.lifeitself.us/concepts/currency-peg) one-to-one to the US Dollar and is backed entirely by cash-like assets. Investigations during the 2017 boom suggested that 50 percent of the sharp price increase was due to manipulation with Tether.<sup>6</sup>
* Bitcoin has also been popular for financing criminal activities. Bitcoin is one of the main crypto assets used in the Darknet (65 percent in Q1 2020).
* Bitcoin’s design attracts illicit usages as it allows to hide identities, to transact entirely within the darknet or on-chain without reliance on regulated entities, to use mixing services to obscure the trail of a transaction or to use exchanges that have not yet adopted the AML/CFT standards of FATF.
* Bitcoin’s set-up can support forensic analysis in tracing illegal activities as transactions never disappear from the blockchain. However, it is complex and time-consuming.
## 8. The high private and social cost of the Bitcoin network
* The longer the boom lasts and the more money flows into the system, the higher the risks and costs for invested individuals and society at large.
* If it is true that Bitcoin is eventually unsustainable and will not persist, and will not have generated value for society, then these private costs will have represented a net loss for society → Bitcoin comes with significant private costs in the form of high energy and hardware consumption of the Bitcoin network and is therefore a negative sum game.
* Are the negative externalities of energy consumption priced in through adequate taxes? Geographical arbitrage of Bitcoin mining will lead to a further concentration of mining in locations where this is least the case.
* Some have argued to locate Bitcoin mining to locations where energy is quasi free and therefore leaves no CO2 footprint: “Bitcoin City” close to a Volcano in El Salvador; Iceland attracted mining operations with its abundance of cheap geothermal energy – before its national energy company decided in December 2021 to cut power to new Bitcoin miners.
* The energy consumption of the Bitcoin network is inversely proportional to the cost of energy. This means that if mining farms move massively to areas where energy is cheaper, then the logic of the proof of work mechanism requires that more energy will be consumed in mining for a given price of Bitcoin.
* The high social cost of Bitcoin and its negative net social value is currently not perceived by Bitcoin investors who believe them to be covered by current and future speculative gains. However, pure speculative gains are not a basis for sustainable price increases.
* Additional social cost: when people realize that they lost hard-earned savings for the benefits of smarter Bitcoin investors it will make them question the functioning of society which permitted such unfairness to happen.
## 9. Regulatory mindset is changing
* The broad use of Bitcoin for illicit activities was recognised early.
* Darknet marketplace Silkroad shut down in 2013 - Bitcoin was used extensively.
* In 2014, the money laundering and terrorist financing by crypto assets started to be picked up by the FATF - issued guidance in 2019 for a “Risk-Based Approach for Virtual Assets and Virtual Asset Service Providers” demanding national implementation and enforcement, making the illicit usage of Bitcoin much more difficult.
* Despite this, regulators have been slow in addressing the above-mentioned societal problems of Bitcoin. Why?
* The potential development of social risks may have been underestimated because of the relatively small size and unleveraged nature of the crypto assets market, which was assessed to not represent a fundamental threat to global financial stability.
* Regulatory responsibilities for Bitcoin seem fragmented - raises multi-facetted threats and involves multiple actors. And the different risks to different sectors are continually changing and evolving (money laundering and terrorist financing, to ransomware attacks to consumer and investor protection concerns).
* Many aspects of Bitcoin are fundamentally new and difficult to comprehend. They do not fit easily into existing regulation and raise regulatory challenges:
* Borderless, does not have a national anchor. Global cooperation amongst regulators is of importance to avoid regulatory gaps and arbitrage → time-intensive process.
* Was not perceived as a legal entity that could be addressed by regulation and incrimination.
* Regulators need to seek suitable design of financial regulation to address risks and avoid gaps as well as unintended consequences, like stifling innovation.
* Not atypical that once a need for regulation has been identified, it can take years until regulation is finalized and applied.
* The vested interests of large Bitcoin holders and financial intermediaries seeking investment and business opportunities might have led to increased lobbying activities.<sup>7</sup>
* The threats, however, are increasingly being recognised and more accentuated calls for addressing the risks of crypto-assets are being made. A number of jurisdictions have taken or are preparing measures to regulate Bitcoin alongside other crypto-assets.
* Some jurisdictions have banned Bitcoin (and similar crypto-assets).
* In December 2021, the Indian government considered prohibiting crypto-asset activities of individuals including use as store of value, unit of account or means of transfer.<sup>8</sup> Violations by individuals could possibly be sanctioned by arrests without bail options. Reportedly the Bill would also include non-custodial wallets, an area of the Bitcoin network that is largely unregulated. However, the Bill has not yet been presented to the Parliament.<sup>9</sup>
* In November, the religious leaders in Indonesia, the National Ulema Council (MuI), have forbidden Muslims (almost 90 percent of the population) to use Bitcoin and other crypto assets. The MuI deemed crypto assets as “haram”, i.e. banned, as it had elements of “uncertainty, wagering and harm”.<sup>10</sup>
* In June 2021, the Chinese central bank announced that all transactions of crypto-assets were illegal, effectively banning Bitcoin and other crypto-assets entirely.<sup>11</sup>
* In November 2021, Sweden proposed an EU wide ban of proof-of-work crypto assets like Bitcoin due to their energy consumption.
* The UK’s FCA (2021) prohibited activities of crypto-exchange Binance and issued a warning to consumers.
* December 2021, Australia introduced a draft legislation aiming at licensing crypto-exchanges and activities in crypto-assets.<sup>12</sup>
* The US:
* The President’s Working Group on Financial Markets, comprising the Secretary of the Treasury and the Heads of all the key US financial regulators, called to speed up efforts on regulation and guided federal agencies to use their existing powers (2021). The group of legislators called for more federal oversight of custodial wallet providers, i.e. firms that offer products that allow users to hold their crypto tokens.
* The SEC has rejected a bitcoin-based exchange traded fund (ETF) in November 2021 due to concerns of possible price manipulation.
* The U.S. Infrastructure Bill of November 2021 called crypto exchanges to notify the tax authority of crypto asset transactions.
* The EU:
* The European Commission (2020) proposed the regulation for Markets in Crypto-Assets (MiCA). In the absence of a central issuer, MiCA will not regulate Bitcoin and other crypto-assets, but target intermediaries, offering services in crypto assets (crypto asset service providers).
* The European Commission (2021) presented a draft legislative proposal to enhance the EU’s framework for AML/CFT. Like MiCA, it requires intermediaries to apply AML/CFT measures and forbids the opening of anonymous crypto asset wallet accounts.
* These regulations, once they apply, will likely address several of the societal issues related to Bitcoin – but not all of them. The rules will not cover Bitcoin transactions that happen without any regulated intermediaries, namely using non-custodial wallets or on-chain peer-to-peer transactions, or if service providers and countries with low compliance levels are used.
* These examples indicate that regulators are progressing in addressing the risks posed by Bitcoin and crypto assets. But we can still see that regulations, apart from those criminalizing Bitcoin, **face limits due to Bitcoin’s decentralized and global set-up and that stances on policy differ because of different assessments of the value of crypto assets for society.**
* To forestall or limit global regulatory gaps and arbitrage, **international cooperation on crypto assets amongst regulators is important**, as the IMF called for.<sup>13</sup>
* International bodies have amplified their efforts in addressing the risks posed by crypto assets over the last years. Some of those international actions have guided national implementations.
* FATF - issued global, binding standards to prevent the use of crypto assets for money laundering and terrorist financing. FATF focuses on the providers offering crypto asset services to apply the same safeguards as the financial sector. However, in its progress report of July 2021, FATF indicated deficits in the implementation in jurisdictions, concluding **“there is not yet a global regime to prevent the misuse of virtual assets and VASPs for money laundering or terrorist financing.”** Also acknowledges that a significant value for peer-to-peer crypto-asset transactions may be operating outside the FATF standards.
* The G7 - raised concerns that ransomware payments are regularly made in crypto-assets and demanded the implementation of the FATF standards.
* The Basel Committee on Banking Supervision (BCBS) (international standard setter) consulted on a preliminary proposal for the prudential treatment of banks' crypto asset exposures, distinguishing crypto assets that may be generally eligible for falling within the current Basel requirements, and other crypto assets, such as Bitcoin, that would require a more conservative prudential treatment.<sup>14</sup>
* While there has been significant progress towards a consistent and effective regulation of crypto assets, Bitcoin prices and market capitalization have still reached new peaks in November 2021.
* Some measures by public authorities may have contributed to these new peaks by supporting renewed investment flows into Bitcoin.
* The US SEC in 2021 gave the green light for a first futures-based Bitcoin ETF (while it has repeatedly rejected Bitcoin spot market ETF).
* The German legislator has adopted in July 2021 a “Fondstandortgesetz” which allows German investment funds for institutional investors (“Spezialfonds”) to invest up to 20 percent into crypto assets.
* **Such public measures seem to legitimize Bitcoin without necessary safeguards. Moreover, these measures facilitate investment flows and the integration of Bitcoin in the traditional financial systems.**
## 10. Conclusion
* If Bitcoin eventually collapses, the net social cost of the Bitcoin life cycle will be very large. And it will be the larger the longer it lasts, and the higher Bitcoin’s maximum market capitalisation will be.
* Public policymakers have not been fast to address all problems related to Bitcoin.
* Although its usage for illicit payments has been noted early, slow global implementation and enforcement of AML/CFT rules for Bitcoin based payments has undermined the efforts made to prevent illicit payments through regulated industries and allowed regulatory arbitrage by criminal actors.
* Moreover, **Bitcoin has become an asset class that everyone can now easily invest into, that is not regulated as a security and that lacks a plausible underlying contribution to society justifying its valuation.**
* More recently, many public authorities have taken or plan to take strong measures against Bitcoin, after concluding that its societal value is negative.
* Also, regulators of advanced western economies have launched significant implementation measures to fight the reliance on Bitcoin for illicit purposes, although the non-intermediated use of the Bitcoin network is still largely out of regulators’ actions. **Further regulatory efforts are therefore needed that effectively address all kinds of illicit payments through Bitcoins.**
* **Legislators and authorities need to be careful to not at the same time contribute to renewed momentum of investment flows into Bitcoin that will contribute to increase the market capitalisation of Bitcoin and to the scale of the eventual cumulated social cost of the Bitcoin network.**
* The spike of Bitcoin valuations in November 2021 is likely attributable to investment inflows that were supported by such measures.
***
## References and Notes
1. Taleb, N (2021), “Bitcoin, currencies, and fragility”, published online: 22 Jul 2021: https://www.tandfonline.com/doi/full/10.1080/14697688.2021.1952702?scroll=top&needAccess=true; Avoca Global Advisors (2021), “Bitcoin: a trojan horse”, wcg avoca 14 Oct 2021, available: https://www.linkedin.com/posts/activity-6854411140617818112-NpKx; Acemoglu, D (2021), “The Bitcoin Fountainhead”, in: Project Syndicate, 5 Oct 2021, available: https://www.projectsyndicate.org/commentary/bitcoin-an-appealing-distraction-by-daron-acemoglu-2021-10; Kolbert, E (2021), “Why Bitcoin Is Bad for the Environment”, in: The New Yorker, published 22 April 2021, https://www.newyorker.com/news/daily-comment/why-bitcoin-is-bad-for-the-environment
2. It can only handle seven to ten transactions per second, whereas the Visa network is said to be able to process an estimated 24,000 transactions per second. Avoca Global Advisors (2021), “Bitcoin: a trojan horse”, wcg avoca 14 Oct 2021 at 4
3. While Bitcoin is in principle less exposed to the risk of a 51 percent attack because of its vast network of 1,000 nodes, in June 2014, the mining pool GHash.IO reached a share of about 55 percent of the Bitcoin hashrate over 24-hours. Although a month later GHash.IO's share of the network's hashrate had dropped to just over 38 percent, the risk remained that a single miner or mining pool could again take control. GHash.IO voluntarily committed to stay far below 40 percent.
4. Dunn, W (2021), “Bitcoin’s gold rush was always an illusion”, in: The New statesman, 20 July 2021, https://www.newstatesman.com/business/finance/2021/07/bitcoins-gold-rush-was-always-illusion
5. Gandal, N, JT Hamrick, T Moore and T Obermana (2018), “Price manipulation in the Bitcoin ecosystem”, Journal of Monetary Economics, Volume 95, May 2018, Pages 86-96, https://www.sciencedirect.com/science/article/pii/S0304393217301666v
6. Griffin, JF and A Shams (2019), “Is Bitcoin Really un-Tethered?”, (October 28, 2019); https://ssrn.com/abstract=3195066 or http://dx.doi.org/10.2139/ssrn.3195066
7. The Economist (2021), “Crypto lobbying is going ballistic - As regulators toughen up, companies hope to influence where the rules end up”, 12 December 2021; https://www.economist.com/finance-and-economics/crypto-lobbying-is-goingballistic/21806674.
8. Reuters (2021)a, “Proposed India bill banning crypto payments could mean jail for violations”, published on 7 December 2021, https://www.reuters.com/markets/currencies/proposed-india-bill-banning-crypto-payments-could-mean-jailviolations-document-2021-12-07/
9. Business Insider India (2021), “India ends Winter Session of Parliament with no crypto bill in sight”, published on 23 December 2021, https://www.businessinsider.in/cryptocurrency/news/no-india-crypto-bill-in-sight-even-after-wintersession-of-parliament-comes-to-a-close/articleshow/88449161.cms.
10. Bloomberg (2021), “Crypto Is Forbidden for Muslims, Indonesia’s National Religious Council Rules”, published 11 Nov 2021, https://www.bloomberg.com/news/articles/2021-11-11/crypto-is-forbidden-for-muslims-says-indonesia-s-ulema-council
11. BBC News (2021)a, “China declares all crypto-currency transactions illegal”, published 24 Sept 2021, https://www.bbc.com/news/technology-58678907
12. Reuters (2021)b, “Australia proposes new laws to regulate crypto, BNPL Proposed India bill banning crypto payments could mean jail for violations”, published on 8 December 2021, https://www.reuters.com/markets/currencies/australia-plansupdate-regulatory-framework-payment-systems-2021-12-07/
13. IMF (2021), “The Crypto ecosystem and financial stability risks”, in: Global Financial Stability report, Chapter 2, October 2021.
14. BCBS (2021), “Prudential treatment of cryptoasset exposures”, published on 10 June 2021, https://www.bis.org/bcbs/publ/d519.htm