This paper is part of our new series on how policy should adapt to the opportunities and challenges presented by cryptocurrency.
The next few months will mark a turning point for cryptocurrencies. In the United States, the inter-agency response to President Biden’s executive order on crypto is due in September and the Lummis-Gillibrand bill (which sets out new proposals for regulating crypto) is gaining attention on Capitol Hill. Further consultation on crypto assets is also expected in the UK.
Meanwhile, the value of unbacked cryptocurrencies (those not backed by any collateral) has plunged, undermining their use as a hedge against inflation, as proponents have long suggested.
While we wait for what could amount to sweeping international changes, there is already significant debate over how to define, restrict or embrace this area of innovation. The EU’s package of crypto regulations has moved closer to ratification, but without the proposed ban on the energy-intensive “proof-of-work” protocol underpinning bitcoin that would have limited the use of this popular crypto. The UK government confirmed that stablecoins will be subject to regulations when used as a means of payment and also announced the creation of a Financial Market Infrastructures (FMI) sandbox alongside exploration of government bonds on distributed-ledger technology (DLT). Meanwhile, policymakers in jurisdictions as diverse as the United Arab Emirates and Native American land in South Carolina (US) are pushing for their states or territories to become hubs for crypto assets.
Around the world, countries are now adopting one of three paths to manage crypto, with policy divergence on the role of these new asset forms in financial markets. China's decision to effectively ban crypto mining and exchanges sits at one extreme while, on the other, countries such as Brazil are choosing to apply existing financial-services regulations to crypto assets, despite them differing significantly from mainstream financial products.
However, many jurisdictions are seeking a more nuanced approach, with efforts covering the major classes of crypto assets, including: 1) unbacked cryptocurrencies; 2) stablecoins; 3) central-bank digital currencies (CBDCs); and 4) the broader use of DLTs in the mainstream financial ecosystem.
Given all this, what should politicians and the public be aware of as we navigate this new terrain?
Limit Exposure of Financial Systems to Crypto Risk
Over the past six months, there has been a spate of warnings about the potential of crypto assets to cause a disturbance to global financial stability. The Bank of England, the UK’s Financial Conduct Authority (FCA), the US Federal Reserve and the international Financial Stability Board (FSB) are among those who have expressed concern over the direction of crypto markets.
The total market capitalisation of cryptocurrencies has fluctuated significantly over the past two years, increasing from $200 billion in January 2020 to a high of around $2.9 trillion in October 2021, before falling to $1 trillion after the latest drop in value.
Liquidity risks, the concentration of trust, power and risk in centralised trading platforms and the system's opacity were cited by the FSB as core concerns. Indeed, regulators don’t even have access to the basic information needed to understand the overall system challenges. This includes reporting by financial institutions on the crypto assets they hold and the share of holdings in funds exposed to them. There are also no clear figures on how many households have invested in crypto assets and the share of those assets relative to overall wealth.
In an effort to address these risks, the FSB is examining the implications of unbacked crypto assets and the type of actions undertaken in member jurisdictions while HM Treasury launched a consultation on the same theme. In the meantime, ideas such as a Glass-Steagall system for crypto are emerging – mirroring the post-Great Depression legislation that separated banking and securities. This would separate banking and crypto to limit exposures and avoid a huge system-wide exposure to volatility and the financial risks of crypto.
Ensure Stablecoins Really Are Stable
Stablecoins are one of the first areas of focus for policymakers as major corporations such as Visa and Mastercard now accept payments in stablecoins while several companies including PayPal are looking at launching their own versions.
In theory, stablecoins are designed to be relatively stable. Pegged to an underlying asset – usually a fiat currency, which is a government-issued currency not pegged to a commodity – a stablecoin is backed one-to-one by fiat in its simplest form. $1 of a stablecoin is equivalent to $1 of fiat currency. Yet the crash of terra, an algorithmic stablecoin, has highlighted genuine risks. The currency lost its peg to the dollar and, as of mid-May 2022, could be purchased for $0.58. Tether, the world’s largest stablecoin, also dropped below $1.
As stablecoin risk moves up the political agenda amid concerns of a 2008-style bank run, the heat is on for policymakers to quickly bring this cryptocurrency under a regulatory umbrella. The EU has proposed regulatory measures and the UK government has pledged to do the same in its response to a 2021 consultation on stablecoins, followed by another quickly introduced consultation by HM Treasury in May. This proposed that the Bank of England should have more authority in managing payment systems like stablecoins, which could pose a threat to broader financial stability. Japan has also recently introduced a new raft of stablecoin regulations, with more jurisdictions expected in the months ahead.
CBDC’s Role in Ensuring Financial Participation
Today, more than 1.7 billion adults worldwide are excluded from the formal financial system. In the UK, almost 1 million adults did not have a bank account between 2018 and 2019. While this number has gradually fallen in recent years, for this cohort – and those with limited digital exposure – there are significant challenges to accessing finance and credit, and being able to make quick and cheap payments.
As we have argued previously, CBDCs can play an important role in reducing barriers to financial access, thereby helping to increase financial inclusion. While some countries have high-quality, real-time payment systems, including Brazil and Australia, not enough have been able to address these challenges. CBDCs offer a new route to do this.
Yet CBDCs must overcome several hurdles to operate effectively across the world. This includes addressing privacy concerns. For instance, of the 8,000-plus responses to a European Central Bank consultation last year, 41 per cent of respondents focused on privacy when highlighting their priorities for the digital euro. Core to addressing this issue will be efforts to ensure users can’t “double spend” (the risk that a cryptocurrency can be used twice or more), that a participant’s anonymity in a transaction is guaranteed and that the system is robust in the face of fraudulent activity.
Technical questions are also significant. For example, central banks will need to choose whether to use DLT. While DLT means there is no single point-of-system failure, this is likely to result in a privacy trade-off. The fundamental question of whether DLT is appropriate to provide the scalability and security for a digital currency is also still unanswered. In the future, any form of CBDC will be rooted in cryptography. The development of quantum computers – which may be able to bypass most data-protection methods – should also be factored into planning for CBDCs.
Critically, central banks have the opportunity to design CBDCs with financial inclusion as a key policy objective. This is as much about understanding what people want and the barriers preventing people from accessing financial services, as it is a technical challenge. The development of CBDCs should therefore be viewed as both a digital public service and a new financial mechanism.
Regulators in the UK, the US and Taiwan are currently at the research stage while authorities in China are trialling the digital yuan (e-CNY) at scale. Meanwhile, the eNaira has been introduced in Nigeria – the first CBDC in Africa – and the Bahamas introduced the sand dollar in 2020. Across the world, 80 per cent of central banks are considering or have implemented a CBDC. As regulators seek to resolve the technical and design challenges of CBDCs, financial inclusion should be a central policy goal.
Embed Consumer Protections into Emerging Regulations
As crypto becomes more mainstream, policymakers are renewing their focus on consumer protection. Increasingly, consumers no longer see crypto as a gamble but rather view it as an alternative or complement to mainstream financing. Given this, and as the major crypto exchanges grow, a raft of changes are in motion to manage the implications of widespread adoption of cryptocurrencies.
For instance, the EU’s Markets in Crypto-Assets (MiCA) Regulation includes four objectives, of which consumer and investor protection is one. In the US, federal consumer-protection regulators are now front and centre in responding to the crypto executive order, having previously taken a back seat to other regulators such as the Securities and Exchange Commission (SEC).
A key concern is fraud. The US Federal Trade Commission reported a tenfold increase in crypto scams between 2020 and 2021. In the EU, MiCA now holds crypto exchanges responsible for protecting customers from cyberattacks and theft, but doesn’t go as far as mandatory insurance or reimbursements to customers who fall victim to fraud or accidental loss.
Misleading advertising is also a global area of focus. The UK and Spain have announced plans to tackle misleading adverts while Singapore has placed limits on all public advertising for crypto products.
In addition, there are risks inherent in the decentralised nature of this technology. This includes the irreversibility of transactions and lost private keys. A report in The New Yorker of a man in Wales who lost £500 million in bitcoin acts as one cautionary tale – albeit on a scale beyond most consumers.
Consumer protection is likely to be at the core of regulatory efforts over the coming year. The big question is how strong the action will be in the US – and how much this will act as a standard for economies worldwide.
The Energy-Efficiency Issue and Shift to Renewables
Crypto’s negative climate credentials are well known – with bitcoin mining far exceeding the energy use of many medium-sized countries per year.
It is estimated that a single bitcoin transaction uses 2,100 kilowatt hours (kWhs) – the equivalent of the power consumed by the average American household over 75 days. Indeed, the amount of electricity consumed by the bitcoin network in a single year could power all the kettles used to boil water in the UK for 32 years. In light of this, policymakers should focus on cleaning up energy sources used for crypto and increasing its energy efficiency.
Calls have been growing for greater use of renewables to power mining activity, while some commentators argue that crypto can facilitate the spread of renewables. However, in the absence of regulation, bitcoin miners are likely to pursue the lowest-cost energy options, which remain fossil fuels in several mining locations. A switch to renewables will be challenging and, even if achieved, will create negative impacts. This includes the risk of diverting clean energy away from transport, industrial, building and other sectors that urgently need to decarbonise. A surge in renewable-energy demand from the crypto industry also threatens to strain ageing grid infrastructure. However, raising the bar on renewables is still one of the most practical levers for mitigating crypto mining’s carbon impact. A group of 250 crypto firms created the Crypto Climate Accord, pledging to reach net zero by 2030, partly by switching to 100 per cent renewables. This kind of initiative needs to be supported.
Increasing the energy efficiency of crypto should be a priority. Policymakers and institutional investors should encourage the move to less energy-intensive consensus mechanisms such as “proof-of-stake”, under which the electricity costs of validating transactions are lower than for “proof-of-work” (PoW). In fact, there are more than a dozen consensus mechanisms that are less energy intensive than PoW, with more in the pipeline. New approaches such as Optical PoW (oPoW), which could make bitcoin-mining less energy intensive, should also be considered. The EU’s MiCA Regulation has sought to address PoW’s energy issue, but without international collaboration across geographies its use will likely shift to alternative jurisdictions. Global alignment is key.
Carbon offsets could be the low-hanging-fruit approach to tackling crypto’s climate impact. As more corporations make public pledges to reduce their carbon footprint, voluntary carbon markets are set to increase from $1 billion in 2021 to $50 billion by 2030. Indeed, the global compliance carbon-offset market was valued at $851 billion last year. However, carbon offsets are notoriously problematic, mired in flawed accounting and limited transparency. Policymakers must enact strong international standards and share best practices to ensure carbon offsets deliver climate benefits. Promoting technologies such as remote sensing, satellite imagery and blockchain can improve transparency around offset projects. Until these solutions become the norm, offsets will have a limited impact in solving crypto’s energy problem.
Broadly defined, crypto represents a significant new stream of innovation across the globe. The technology – and the international policy response – is evolving fast. While supporters of crypto see unlimited upsides, critics see nothing but risk. The reality is more nuanced.
Governments need to identify the extent to which they want to bring new asset classes under current legislative provisions, align new regulatory definitions across borders and decide whether to regulate to offset crypto’s negative externalities – from the environmental impact to the lack of consumer protection. The underlying technology behind crypto – DLTs – could unlock public value in creating more efficient financial systems and secure records. It is also prompting central banks to look at creating digital currencies, which could increase financial access and transform government services.
Yet, there is a risk that unbacked cryptocurrencies and stablecoins simply become an application of technology in search of a problem. If crypto is to be truly transformative, industry and policymakers must find ways to improve it. We'll be watching to see the extent to which the decentralised vision of crypto, as articulated by supporters, is maintained over the months ahead or whether regulators take increasing action to address the risks inherent in this market.
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