Global Trend

In November 2022, the cryptocurrency exchange FTX and its affiliated hedge fund, Alameda Research, collapsed. Behind the scenes, Alameda had been hemorrhaging money on bad trades and using FTX customer funds to cover those losses.

Once it was revealed that Alameda and FTX were significantly intertwined, and that FTX was suffering from serious liquidity shortages, the exchange’s customers rushed to withdraw their funds. Many found that they could not do so.

The resulting implosion of FTX was the most spectacular in a series of cryptocurrency industry collapses that started in the spring of 2022. Other less obvious examples include Signature Bank, which contributed to the collapse of Silicon Valley Bank.

With the public disintegration of FTX, controversies about the sustainability of the cryptocurrency industry became mainstream.

Other cryptocurrency companies and industry associations have tried to dispel investor fears and dissuade regulatory authorities from cracking down. They’ve argued that FTX was just one “bad apple.”

But as Professor Hillary Allen of American University argued recently in Foreign Policy magazine, “FTX’s unraveling was not an isolated incident. Rather, it revealed fundamental flaws in the cryptocurrency industry. The root of the problem is that cryptocurrency assets can be created at no cost and without limit, and an unlimited supply of assets makes a system more vulnerable to booms and busts. When assets have nothing behind them, no reliable financial accounting practices or valuation techniques exist to expose the fraudulent manipulation of those assets. The result is that fraudsters have rushed into cryptocurrency, exploiting the complexity and hype to dupe the unwary.”

This observation prompts us to ask, “What benefits and risks are private cryptocurrencies likely to create for investors, society at large, and the underlying financial system?”

Consider their role in ordinary commerce.

Cryptocurrencies already facilitate many different kinds of harm. Pariah states, including Iran and North Korea, use cryptocurrencies, and the anonymity that they grant, to evade sanctions and launder money.

For example, in 2022, Pyongyang reportedly stole $1.7 billion in cryptocurrency, which it is believed to be using to fund ballistic missile and nuclear weapons development.

Cryptocurrencies, particularly Bitcoin, have become the most common form of payment for the ransomware attacks increasingly targeting businesses and public services because it allows the nefarious actors behind these attacks to receive large amounts of money quickly and anonymously.

Cryptocurrencies are also increasingly being used to facilitate drug and human trafficking - and the anonymity that they grant users inhibits law enforcement efforts.

Next consider their implication for managing systemic financial risk.

If allowed to proceed unchecked, the unrestricted growth of the cryptocurrency industry and its future integration with the traditional financial system could lead to a major crisis.

Blockchain-based finance is complex, automated, highly interconnected, and it offers vast opportunities for creating leverage, because there is a virtually unlimited supply of assets to borrow against. These are the kinds of “fragilities” that led to the Great Financial Crisis, in 2008.

Paradoxically, it was right after this crisis had damaged trust in the traditional financial system that the cryptocurrency industry arrived on the scene, promoting itself as a reliable alternative to banks. Not surprisingly, most of those who invested in cryptocurrency have lost money, despite the industry’s claims.

Furthermore, the cryptocurrency industry consumes physical resources in ways that are essentially “unproductive.” Bitcoin and other cryptocurrency assets which rely on “proof-of-work blockchains” require miners to run computers that consume enormous amounts of electricity.

According to Allen, “powering these computers has sometimes required as much energy as that consumed by the entirety of the Netherlands - a country of some 17 million people.” And the enormous arrays of crypto-mining computers, contribute to electronic waste and the global semiconductor chip shortage.

Given these and other current and potential problems with cryptocurrency, it seems foolhardy to allow the industry to continue as it is unless it can be shown to have real demonstrable benefits for society. The problem is that it’s hard for an objective observer to identify any real upsides, despite all of the industry-driven hype.

Industry leaders and lobbyists tend to argue that the primary benefit of cryptocurrency is its decentralization. Given the sometimes-dubious track record of traditional financial institutions, the prospect of a truly decentralized system, which does not require the use or trust of intermediaries, is certainly an appealing one. Unfortunately, that prospect is unrealistic.

First, decentralizing the technology does not guarantee that control of that technology will remain decentralized. On the contrary, economic incentives have led to extremely concentrated pools of transaction validators, leaving users dependent on these small groups of people.

Furthermore, blockchains are software, and users depend on the people programming the software. These people may have conflicts of interest or may make mistakes when programming.

Moreover, software is never flawless, it degrades over time, and hackers are always seeking to exploit its vulnerabilities. This means that software must be constantly maintained - again, often by a select group of people.

To take one example, recent reporting in the Wall Street Journal revealed that there are currently just five people who can approve proposed changes to Bitcoin’s core blockchain software.

Some of the applications built on the blockchain are administered in a decentralized way, but decision-making still tends to lie in the hands of a small group of users. So, it remains a far cry from the claims of decentralization made by cryptocurrency enthusiasts and advocates.

Notably, the Trends Editors are not alone in reaching this conclusion. In 2022, 1500 computer scientists, software engineers, and technologists signed a letter to members of Congress challenging claims made by the cryptocurrency industry.

These experts argued that “Financial technologies that serve the public must always have mechanisms for fraud mitigation and allow a human-in-the-loop to reverse transactions; blockchain permits neither.” They went on to say:

“By its very design, blockchain technology is poorly suited for just about every purpose currently touted as a present or potential source of public benefit. From its inception, this technology has been a solution in search of a problem and has now latched onto concepts such as financial inclusion and data transparency to justify its existence, despite far better solutions to these issues already in use. Despite more than thirteen years of development, it has severe limitations and design flaws that preclude almost all applications that deal with public customer data and regulated financial transactions and are not an improvement on existing non-blockchain solutions.”

“Finally, blockchain technologies facilitate few, if any, real-economy uses. On the other hand, the underlying crypto-assets have been the vehicle for unsound and highly volatile speculative investment schemes that are being actively promoted to retail investors who may be unable to understand their nature and risk. Other significant externalities include threats to national security through money laundering and ransomware attacks, financial stability risks from high price volatility, speculation and susceptibility to run risk, massive climate emissions from the proof-of-work technology utilized by some of the most widely traded crypto-assets, and investor risk from large scale scams and other criminal financial activity.”

What’s the bottom line?

After 13 years of real-world experience, it appears that the best that the cryptocurrency industry can offer is a version of the traditional financial system that remains economically centralized but has more vulnerabilities because of its attempts at technological decentralization. And, because blockchain-based finance is so complex, it is inherently fragile. It seems clear that the collapses that began in 2022 were not outliers but symptoms of systemic problems in the cryptocurrency industry.

So, rather than revolutionizing financial services, the cryptocurrency industry has become an increasingly controversial and problem-prone niche. As a result, it’s advocates and detractors are locked in a battle to define its future.

Given this trend, we offer the following forecasts for your consideration.

As explained in the October 2021 Trends issue, a type-one popular delusion involves speculation in an asset class which creates essentially no economic value. Just as a tiny group of enthusiasts truly valued 17th century tulip bulbs, there is a tiny group of outsiders and malefactors who truly value a medium of exchange that keeps their transactions secret.

But for everyone else involved in the market, their transactions simply constitute extreme speculation analogous to buying lottery tickets or gambling at a casino. For this reason, these markets are prone to frequent and extreme boom-bust cycles as well as manipulation.

The reality is that regulation can be applied to the many different intermediaries that are critical to cryptocurrency’ operation. For example, traditional business entities operate the centralized exchanges that serve as gateways to the cryptocurrency markets.

If Congress were to pass legislation banning them from listing cryptocurrency assets, the cryptocurrency market would quickly fade. Even when decentralized exchanges do exist, a ban could be enforced against them because control of those exchanges tends to be concentrated in the hands of a few individuals or corporations. And,

This will be a negative for crypto-speculators and criminal enterprises. But for average consumers and legitimate businesses trying to create economic value, it will be a net plus. Fiat digital currencies will take the place of private cryptocurrencies but will not supplant conventional fiat currency in the near future.