Bitcoin continues to ride waves of popular interest and market volatility. But behind the swings is an unwavering reality: The largest species of cryptocurrency doesn’t measure up to its promised benefits as a peer-to-peer network, a uniquely quick and efficient payment system, or a store of value.
Bitcoin’s risks, meanwhile, are sizable. The creation and use of Bitcoin have been associated with a concentration of power among relatively few operators and owners, high energy consumption, market opacity, significant price volatility, and illicit and illegal transactions.
Together, these risks and unrealized rewards argue for enhancing cryptocurrency regulation, which currently ranges around the world from nonexistent or partial regulations to prohibitions. Discussion and action need to focus on:
- the intersection of cryptocurrency and the traditional financial system
- consumer protection
- financial stability
- public security (i.e., countering money laundering, the financing of terrorism, and other illegal activities)
Theory and practice
Distributed ledger technology is key to the promotion of cryptocurrencies like Bitcoin, which was launched in 2008. The technology enables network members, called miners, to authenticate financial transactions. The work entails solving mathematical “proof of work” problems, and miners are rewarded with newly created or “mined” encrypted Bitcoin. In this way, network users can transact directly with their peers without being monitored or controlled by a central bank or trusted financial intermediaries such as commercial banks. Bitcoin’s approach is thus “trustless,” in that it does not require trust on the part of users in a third party.
In practice, mining operations are increasingly difficult and require investing in vast computing power. Not everyone can be a miner. At present, the top five mining pools control 64 percent of total hashrates (the computing power needed to mine and process Bitcoin transactions). A few mining pools could influence the process by delaying or denying the verification of transactions, undercutting the notion of a democratized payment system.
Miners congregate in regions where electricity is relatively cheap or accessible due to lax regulatory oversight. Cambridge University’s Bitcoin Mining Map shows that more than 80 percent of global mining activity is located in remote areas of four countries:
- China: more than 65 percent of hashrates, primarily in areas like Inner Mongolia and Xinjiang, though the Chinese government has been cracking down on mining operations this year
- Russia: 6.9 percent
- Kazakhstan: 6.2 percent
- Iran: 3.8 percent
The concentration of hashrates in countries lacking in transparency has heightened the opaqueness of these mining operations. (As a point of reference, 7.2 percent of operations are located in the United States.)
These regions also tend to produce electricity using coal or other fossil fuels, making Bitcoin and similar cryptocurrencies “dirty money.” The annual usage of electricity for Bitcoin mining is comparable to Norway’s total electrical usage and matches the carbon footprint of Morocco, according to the Digiconomist Bitcoin Energy Consumption Index.
For twelve years, the Bitcoin buzz has been that it is quicker, less costly, and more efficient than conventional means of payment. But Bitcoin payments can only be made with a limited number of merchants and remain a sliver of those merchants’ sales: only 5 percent of their transactions.
Relative to credit cards, it also takes longer to authenticate and finish Bitcoin transactions: Bitcoin processes 4.6 transactions per second on average, compared to Visa’s 1,700-plus per second. Miners can reject a transaction with a fee deemed too low. A refund? Forget about it. Bitcoin payments are irreversible, excluding redress for error or fraud.
Bitcoin ownership, like Bitcoin mining, is concentrated. An estimated 1,000 individuals—known as whales—own 40 percent of the Bitcoin market. Whales are in a position to influence or manipulate the market to the disadvantage of most other participants.
The state of the market makes Bitcoin unreliable and unsuitable as a means of payments and settlement for ordinary users. Moreover, gyrating prices make Bitcoin a poor instrument for savings. Earlier this year, for example, Bitcoin prices rose to more than $60,000 before swiftly falling by 50 percent. Bitcoin has become a vehicle for speculation; participants expect its price to go up as more people join the club, even though there is no intrinsic value or practical use for Bitcoin—the hallmark of a speculative bubble. Central to the expectation of price appreciation is the fact that the Bitcoin protocol limits the total supply to 21 million units, with 18.7 million Bitcoin already in circulation.
For bad actors, however, Bitcoin offers a dark medium to engage in illegal activities including money laundering, financing terrorism, collecting ransoms in hacks or cyberattacks, and buying or selling banned substances or other objects. Though transactions leave a digital footprint that can be traced, especially through exchanges and other services converting Bitcoin to central bank-issued currencies and vice versa, the anonymity of Bitcoin makes tracing transactions more difficult.
Globally, the regulatory landscape for Bitcoin is a mixed bag: outright bans of cryptocurrencies, different forms and degrees of regulation, or no regulation at all. According to the Financial Stability Board, an international body that monitors the global financial system, many countries—such as Algeria, Bolivia, Ecuador, Nepal, Nigeria, and Turkey—have imposed outright bans. Others have partial bans: Vietnam and Russia bar the use of cryptocurrencies as a means of payment but have not prohibited their citizens from trading and investing in cryptocurrencies.
China, for its part, has prohibited registered financial institutions from engaging in cryptocurrency transactions or providing custodian, clearing, and payment services to cryptocurrency users.
The European Central Bank, meanwhile, has classified Bitcoin as a virtual decentralized currency but not money or currency from a legal perspective. It has advised financial institutions with exposure to crypto assets to put in place appropriate risk-management frameworks, with further regulatory measures being considered.
In Japan, Bitcoin and other cryptocurrencies can be used as legally accepted means of payment, but authorities have not designated Bitcoin as legal tender. (El Salvador was the first country to do so.) Japan’s Financial Services Agency recognizes and regulates Bitcoin exchange operators.
US federal agencies define cryptocurrencies in various ways:
- The US Treasury views Bitcoin as a virtual decentralized currency but not as legal tender. Entities helping to process Bitcoin transactions are viewed as money transmitters subject to the supervision of the US Treasury’s Financial Crimes Enforcement Network (FinCEN), including being required to make suspicious activity reports.
- The Internal Revenue Service has defined Bitcoin as property subject to a capital gains tax.
- The Commodity Futures Trading Commission has determined that Bitcoin is a commodity, which therefore means any activity involving Bitcoin and derivative contracts based on Bitcoin falls under its purview.
- The Securities and Exchange Commission (SEC) has ruled that while Bitcoin as such is not a security, Bitcoin assets or tokens can be defined as a security and thus subject to its supervisory authority. Initial coin offerings to raise funds from the public against issuance of cryptocurrencies are required to be registered with the SEC, similar to other initial public offerings. Exchange-traded funds based on cryptocurrencies have to be approved by the SEC. Collective investment arrangements that invest more than 40 percent of their assets in cryptocurrencies have to register under the Investment Company Act and Investment Advisers Act, and exchanges facilitating the trading of Bitcoin assets have to register unless exempt as alternative trading venues. However, many if not most of these entities have not registered with the SEC. As Reuters reports, SEC Chairman Gary Gensler recently said that “he would like to see more regulation around cryptocurrency exchanges, including those that solely trade Bitcoin.”
US states and municipalities take different regulatory approaches. These range from being friendly to cryptocurrency businesses by issuing, for instance, a new state banking charter, called a special purpose depository institution, for banks that deal mostly in digital assets (Wyoming); to banning cryptocurrency mining; to requiring the registration of exchanges and other companies servicing Bitcoin transactions as money-services companies or money transmitters. New York, Rhode Island, and Arizona have developed reputations as less friendly to cryptocurrency activities because of their attempts to regulate those businesses, while several states have created regulatory sandboxes that exempt cryptography businesses from regulatory oversight for the initial development period.
Updating the regulatory framework
Given the shift in the balance between the potential benefits of cryptocurrencies and their costs and risks, it is important to revamp and update the global regulatory framework governing them. Several steps can be considered.
The first and most important step is to review the distinction between activities within the Bitcoin network and its interfaces with the conventional financial system. Examples of such interfaces include conversion into cash as well as offering and trading in Bitcoin-based assets or tokens as securities or derivatives. This is especially critical given the increasingly popularity of Bitcoin. The concentration of miners and owners creates opportunities for market manipulation that could hurt members of the public.
These developments have made it difficult to differentiate between Bitcoin and Bitcoin assets or tokens. In this vein, the Financial Stability Board should update and extend its 2020 high-level recommendations on “Regulation, Supervision, and Oversight of ‘Global Stablecoin’ Arrangements” to include cryptocurrencies such as Bitcoin.
Second, measures are needed to heighten transparency and investor protection. If initial coin offerings require registration, then the mining of substantial volumes of Bitcoin—which affects the supply and demand conditions of the market, and the integrity of the market’s transfer-of-value network—should be subject to registration and disclosure. These requirements would allow current and potential members of the Bitcoin network to be aware of what they are engaging in.
Furthermore, holders of Bitcoin exceeding a threshold value should be required to disclose that fact—in a manner similar to the disclosure requirement for investors who acquire more than 5 percent of a corporation’s outstanding shares.
Companies servicing Bitcoin should also report the capital gains or losses of their customers to authorities in order to avoid tax-evasion problems, rather like the reporting requirements for securities broker-dealers.
Third, this updated framework must safeguard financial stability. Registered financial institutions should establish robust monitoring, risk management, and reporting capabilities when engaging in cryptocurrency broker-dealer activities. These practices should be designed and implemented to prevent financial losses or reputational damage if the computer systems of these institutions are hacked and their customers lose their Bitcoin holdings.
Finally, federal authorities should tighten monitoring and supervision to protect public security. Authorities responsible for countering money laundering and terrorism financing should strengthen oversight over Bitcoin services. Any transfers of Bitcoin valued at more than $10,000 should be reported to the authorities, in a similar fashion to bank transfers.
The trustless nature of cryptocurrencies is part of its much-touted origin story. The big idea was that individuals could participate in a peer-to-peer network and exchange things of value without the involvement of a central authority or trusted intermediaries like commercial banks. And yet, years out from the cryptocurrency’s origins, Bitcoin advocates seem to have accepted a concentration of power in a handful of miners and holders. It’s a reality at odds with early visions of a democratized and dispersed network.
Hung Tran is a nonresident senior fellow at the Atlantic Council’s GeoEconomics Center, former executive managing director at the Institute of International Finance, and former deputy director at the International Monetary Fund.
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