2 December, 2021

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A Child’s Guide To Cryptos, Crypto Mining & Blockchain: Part IV

By W A Wijewardena –

Dr. W.A Wijewardena

Aseni, whiz kid in economics, and her grandpa, Sarath Mahatthaya, are in dialogue on issues relating to cryptocurrencies and related matters. They had found that sovereign governments are against these alternative currencies because they compete with the monopoly profits currently earned by these governments via currency issues known as seigniorage. Such profits earned by alternative currency issuers are private gains, while those earned by sovereign governments are public gains. The former can use it in any way he likes, but the sovereign governments should share them with citizens through budgetary expenditure programs. However, whether they would lead to an improvement in people’s welfare depends on the nature of such programs; in most case, they noted that they are used for rulers’ personal interest rather than the common interest of the people. In that sense, they are not different from the earnings of private parties through the issue of alternate currencies. To overcome the issue, Grandpa told Aseni that there should be a proper governance structure within the system.

They continued their conversation.

Aseni: Grandpa, you told me that governments seek to regulate or ban alternate currencies because of public interest too. That interest is to protect us as consumers or protect the financial system as the driver of modern economies. How does this happen?

Sarath: These digital currencies also known as alternate currencies serve as a medium of payment, an instrument for making speculative profits, and to the extent you need liquid cash for making payments, as a store of value. If it is negligible, there is no problem. But if it becomes large within the local or the global financial system, it is a problem threatening the entire financial system. You already know that it is called a systemic issue. Initially, bank regulators were not worried because these alternate currencies were only a minor portion of the system. But now, they are growing at a pretty high rate and as a result the regulators can no longer keep a blind eye on them. If they fail, because of their systemic importance, we as customers stand to lose, and the financial system is to face unmanageable crises. That is why regulators have stepped into tightening the noose.

Aseni: You said that the US Treasury Department had released a report by an expert group recommending to the country’s lawmakers to introduce a regulatory mechanism for these alternate currencies which had called stablecoins recently. Had they been guided by the same objective?

Sarath: Yes, indeed. This is a public document and anybody can download it from the website. It is a report by the President’s Working Group on Financial Markets, the Deposit Insurance Corporation and the Office of the Comptroller of Currency. All these institutions in USA are involved in the regulation of the country’s financial system under the multiple regulatory mechanism prevailing there. They have defined stablecoins as “digital assets that are designed to maintain a stable value relative to a national currency or other reference assets”. Though the stability of the coins in question had been a preconceived notion, they had not been stable at all. Their prices had been rising continuously in the market, while there had been occasions of price falls. This is the reason for calling for regulatory interventions.

Aseni: That is understandable Grandpa. Since they are decentralised financial or DeFi assets, investors can move from one asset to another easily. It makes it possible for them to speculate on one asset by temporarily locking into another and move back to the original when the situation is profitable for them. In the case of national currencies which are centralised financial or CeFi assets, the movement is from currency to another asset and backward. If the currency falls during the period, it is practically difficult for them to make this forward and backward movement. Hence, DeFi assets, though not stable, offer easy manoeuvrability. It is their plus point.

Sarath: You are correct. They also have a good liquidity offering easy transfer from one to another. That is the reason for their proliferation within a short period. But with the speculative demand exceeding the supply, prices continue to rise creating a bubble. As you know, every bubble is born with an inherent destructive feature like an inflating balloon. That is, it will burst one day when it is no longer able to support its expansion. This is typical for all those stablecoins too. Hence, they are not only unstable but fraught with high risks. Those who touch them will surely end having their fingers burnt as well.

Aseni: But don’t you think that investors themselves are responsible for the losses should the bubble burst? They have done it on their own and regulators are not responsible for their mistake.

Sarath: It is not the concern of the regulators if it does not have a systemic risk. Suppose that only one or two investors have lost. Regulators can mind their own business without being concerned. But if it affects a large segment of the population like in the pyramid scam of Albania in 1996-’97, the regulators cannot turn a deaf ear and a blind eye to it.

Aseni: I have not heard of this Albanian pyramid scam. What was it and how it affected that tiny economy?

Sarath: There is enough literature now on this issue. You can do a search by yourself. When Albania became free from the former Soviet bloc in early 1990s, it was a fertile ground for those engaged in pyramid schemes to dupe the gullible population into joining them. Gullible I say because they had the greed for making quick money but did not know how to do it within a free market economy. Hence, pyramid proposals caught up like wildfire. According to reports, when about two-thirds of the population had joined them and their investments were as high as a half of the country’s GDP, the schemes collapsed.

It was a systemic collapse. There were widespread riots in the streets leading to the collapse of the Government, causing anarchy and generating a near civil war situation. About 2,000 people had died in the riots. So, a responsible government cannot afford to have a repeat of the Albanian fiasco. That is why when the regulators feel that the situation might descend to a systemic collapse, they would step into preventing it. That is done in the name of consumer protection and avoiding a systemic financial failure.

Aseni: How should the regulators control the proliferation of those digital currencies to avoid a systemic failure? Is it in the same way that they should control the formal financial institutions?

Sarath: The regulatory mechanism is guided by two considerations. One is the avoidance of a systemic failure. The other is the controlling of money laundering and terrorist financing which are guided by the recommendations of the Paris-based inter-governmental body called the Financial Action Task Force or FATF. They also belong to a decentralised financing world called DeFi. However, regulators are handicapped here because the issuers, traders, participants, and wealth holders of privately produced digital currencies are invisible, species living in the clouds or the cyberspace. This handicap does not apply to fiat digital currencies issued by sovereign governments because they are centralised issues or CeFi issues. They could be regulated in the same way as the natural currencies issued by these governments. That is why many governments are now planning to compete out the privately produced digital currencies through the issue of their own currencies.

But they cannot do it alone. Because you have to regulate the exchanges that provide facilities for transactions and offer wallet facilities to participants. They are not present in the local scenario but in the cloud operating from foreign lands like UK. USA, Hong Kong, Singapore, and Australia. However, a large number, about 33, operate from unknown host countries, and it difficult to reach them for regulatory purposes. Hence, regulation of privately produced digital currencies is a global product that must be produced by the global community like the Basel standards introduced for regulating the ordinary financial institutions which are visible and reachable.

Aseni: As against the complete banning of these privately produced digital currencies, the regulation means that the sovereign governments have tacitly accepted them as worthwhile instruments. Why is it so?

Sarath: That is true. When you start regulating them, you accept that they are acceptable financial institutions that provide a service to the community, in this case, the global community. That is because these sovereign governments that have failed to nip it in the bud have now allowed the horse to bolt out of the stable. It is now too late, and you cannot catch the horse. So, the pragmatic course of action is to accept them and try to keep them under the control of the sovereign governments.

Recently, our neighbour, Reserve Bank of India, did exactly this. Instead of banning cryptos altogether, RBI has gone into the middle path of accepting them as convenient modes of payment and wealth holding. In this middle path, RBI will not make them illegal tender. This is because there are many Indians who have invested in cryptos, and if it is banned now, they stand to lose their wealth. Similarly, if it is made legal tender, it will compete with its fiat currency, the Indian Rupee, and perhaps, displace it. Hence, India is planning to enact an Official Digital Currency Regulation Act shortly.

Aseni: How are the regulators planning to regulate digital currencies?

Sarath: In the US Treasury Report which I mentioned earlier, there are three concerns of regulating the digital currencies. One is to address the risks to users and guarding them against any digital currency runs. This happens when a digital currency collapses in the market, and everyone wants to exit the currency in panic mode. In the case of the natural currencies, when a similar bank run occurs, there is a central bank to bring order to the market. But digital currencies are not supported by such a lender of last resort facility and left to meet a quick death in the market. But it will lead to chaos like the Albanian pyramid fiasco.

The second is to address the need for the risks to the payments system if cryptos fail in their role. At present payments are done through digital wallets held by custodians. The regulatory mechanism will seek to bring those custodians into the supervisory net of the regulators. They will be forced to follow appropriate risk management standards like normal financial institutions. A way out is to force them to hold a sufficient stock of reserve assets with them.

A third concern is about the systemic risk that we talked about and the associated concentration of economic power in the producers and big players of cryptos. This is similar to the restrictions placed on banks when they get into businesses that are not directly related to their core businesses and fraught with risks. In a like manner, restrictions will be placed on digital currency producers regarding the business affiliations they can have.

You will now see that the concern has been about the filling of the regulatory gap between the issue of cryptos by these parties and the inability of the regulators to reach them.

Aseni: What is this regulatory gap you are talking about?

Sarath: The gap is a very wide one because there is no regulation at all. This has been put lucidly by the US Treasury report. I will read it for you. They say: “Today, stablecoin arrangements are not subject to a consistent set of prudential regulatory standards that address the risks discussed above. Moreover, the number of different key parties that may be involved in an arrangement, and the operational complexity of these arrangements, pose challenges for supervisory oversight. For example, even if a given issuer of stablecoin is a bank, insight into the activities of key entities in the arrangement depends on the structure of the relationship and the nature of the services, if any, provided to the issuer bank as client. To address these gaps, a consistent and comprehensive regulatory framework is needed both to increase transparency into key aspects of stablecoin arrangements and to ensure that stablecoins function in both normal times and in stressed market conditions.”

To address this, they have recommended the US Congress to introduce the relevant legislations promptly. What this means is that we can expect strictest regulation of digital currencies in their country of origin shortly. It is a matter of time for other countries to follow the US example.

Aseni: You said that Financial Action Task Force or FATF is also concerned about the unexpected growth of cryptos. How have they looked at the issue?

Sarath: FATF has released an update on Virtual Currencies, their key definitions, and risks involving anti-money laundering and terrorist financing in October last year. It is a long report, but you can download it from their website.

Like the financial regulators, they are also concerned about the anonymity of the transactions involved and the possibility of the use of the blockchain technology to engage in money laundering and terrorist financing. In that context, there is also a wide regulatory gap between AML and CFT units of the sovereign governments and the activities relating to these digital currencies.

They have accepted that if these currencies are used legitimately for payment purposes, they offer several benefits to society. But they can also be used for illegal purposes as well. They have four main concerns. One is the anonymity of the transactions done on the internet. As a result, unless adequate audit trails are established, no one can know how, when, and for what purpose these transactions have been made.

A second concern is about the limited identification and verification of participants. Participants are not identified as natural persons but holders of a public key and a private key to authenticate a transaction. Many banks have therefore required users of their services to undertake trading in cryptos to submit identification documents.

A third gap arises from the lack of clarity about the responsibility of AML and CFT regulators regulating those transactions. This is understandable because it is a new subject for many of those regulators and there is a time lag for learning.

The fourth gap relates to the absence of a central regulatory body for these cryptos. Even in the country of origin of cryptos, the US, such a regulatory mechanism is yet to be introduced.

So, there is a growing demand that cryptos produced by private parties should be brought under the regulatory mechanism of sovereign governments.

Aseni: But as you have said that the horse has already bolted out of the stable, and it is already late for such global action. This should receive the highest priority of sovereign governments.

To be continued.

*The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at waw1949@gmail.com

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    Once major sellers like Amazon and Real Estate sites refuse cryptocurrency, it will naturally go downhill. Regulating is easy enough. Right now, all is in experimentation stage by major powers to catch the crypto out and pummel it down. Doubt China will want to stoke any wrath towards their export earnings. But regional players e.g. South Asian region can trade within themselves in spite of the crookery. Imagine Indian caste-system plus crypto? Very insubstantial. Social mobility gone.

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