States, sovereignty and the brave new world of cryptocurrencies

Cryptocurrencies pose an unprecedented challenge to the existing monetary system. Powered by a decentralised blockchain platform, they transcend national sovereignty, central banks and commercial finance.

While cryptocurrencies were designed to be independent of any particular nation-state, that doesn’t mean countries or multilateral institutions can afford to be indifferent to them.

Less than two weeks ago, the independent body, G30, published a report that put global policymakers and central bankers on notice, warning against technocratic passivity as digital currency systems rapidly develop and begin to shape the future of finance.

Having largely defied international coordination, the advent of cryptocurrencies and their increasing popularity has led to disjointed approaches by governments that often rely on arcane laws to regulate radically new technologies. Some states have started wielding it to promote their political agendas, project influence, and bypass economic sanctions.

As a consequence of Covid-19, the desire for digital payments and the growing appetite for cryptocurrencies like bitcoin has only accelerated, thrusting digital currencies onto the agenda of public officials – forcing nation states to adjust to the brave new world of cryptocurrencies with their own central bank-backed digital tenders.

In an effort to tame anarchic cryptographic systems while appropriating its ability to reshape the financial order, could we see a super-sovereign digital currency that fundamentally reconstructs the global monetary system?

A spectacularly capricious rise

Cryptocurrency is a form of digital currency that relies on cryptography to facilitate direct peer-to-peer (P2P) online payments and eliminate the need for financial intermediaries. The first cryptocurrency, bitcoin, was conceived by a mysterious programmer Satoshi Nakamoto in a 2008 whitepaper at the peak of the financial crisis.

While bitcoin has been the most popular, the cryptocurrency family members include ethereum, ripple, cardano, and litecoin, to name but a few.

The main technological innovation underpinning cryptocurrencies is the blockchain: a ledger containing all transactions for every single unit of currency. It differs from existing physical and digital ledgers in that there is no central authority verifying the validity of transactions.

What makes blockchain computing unique is the strong commitments between users, developers and the platform. Trust arises from the mathematical and game-theoretic properties of the system without having to depend on the trustworthiness of individual network participants.

Authentication is built on cryptographic proof, where various members of the network verify ‘blocks’ of transactions approximately every 10 minutes. The incentive is compensation in the form of newly ‘minted’ cryptocurrency for the first member who provides the verification. This mining, while digitally rendered, requires specialised equipment as well as substantial electricity costs.

Scarcity is used to instill monetary value, much like gold. Ostensibly to prevent inflation, there will only ever be 21 million bitcoin's in existence, and once miners have unlocked all of them (currently it stands at 18.5 million) supply will have tapped out unless protocols are changed.

As the limit is approached, the coin-creating algorithms get more difficult to solve, demanding additional computing power. Bitcoin's mining difficulty is now said to be at a record high, coming two months after its quadrennial halving.

Seven years since the first initial coin offering (ICO), the total market capitalization of crypto assets stands at $357 billion. Market valuations have been notoriously volatile – in December 2017 Bitcoin hit an all-time-high of $19,783 only to lose 84 percent of its value by the same time next year.

Some have dismissed bitcoin as a fad, evoking parallels with other great historical manias like the Dutch tulip bulb frenzy of the 1630s, the South Sea bubble of the 1710s and the US stock market orgies of the 1920s and 1990s.

Indeed, one of the core contentions with cryptocurrencies is their speculative nature; the broad correction that occurred in 2018 points to the threat of collapse. “Digital gold” comparisons aside, questions linger over their reliability as a store of value and means of exchange – in other words, the classic properties of money. Their environmental impact cannot be dismissed either.

To mitigate the problem of volatility is a category of cryptocurrencies called stablecoins, which can be pegged to a currency or exchange-traded commodities. Many new issuers have entered the stablecoin market in recent years (Tether being the major one) with the total value of issued US dollar stablecoins reaching almost $3 billion by 2019.

After bitcoin’s meteoric rise into the mainstream in 2015 and the subsequent crypto boom in 2017, financial institutions and governments alike could no longer ignore the growth of digital currencies and decentralised finance (DeFi) projects.

Cryptocurrencies like bitcoin are not localised to a particular country or region. Due to its decentralised nature, bitcoin’s circulation has largely circumvented regulatory oversight or monetary policy that traditionally is enforced upon private currencies and e-money.

For new technology enthusiasts and those who want to build a world outside the control of state machineries and regulatory authorities, cryptocurrencies are revolutionary – for some, even the basis for a post-capitalist future in which nations have withered away.

For governments and central banks, its very design undermines notions of national sovereignty and how fiat money functions.

Meanwhile, unregulated exchanges are also expanding incredibly fast. Mature blockchain startups are gaining market share and a new crypto services industry is taking shape as part of the evolution towards Web 3.0, or the next iteration of the Internet premised on decentralised tenets.

New consumer products range from DIY index fund creators, bitcoin derivatives, crypto wallet-cum-domain registrars, decentralised exchange aggregators, interest-earning savings accounts, to dividend reinvestment plans.

If the industry is able to move beyond the current phase of speculation and volatility, and build more institutional structures, crypto assets have the potential to play a pivotal role in underpinning a new financial architecture.

But some technology experts warn that for all the promise of new cryptographic systems, it could take between five to ten years to “harden”. For any country that decides to transition, a substantial amount of risk is inevitable.

An evolving regulatory landscape

As with any emerging market, regulators are having to play catch up, tasked with protecting the public and maintaining market stability while not stifling innovation.

Last June, G20 members published a request for a global regulatory framework to be implemented to manage the benefits and challenges of the emerging crypto ecosystem.

Yet, something as fundamental as classification evades consensus: Are cryptocurrencies an entirely new asset class? Are they monetary, commodities, taxable property?

Within the first few months of 2020 alone, French, German and Australian authorities issued decisions with three different interpretations of bitcoin: as a currency, a financial instrument, and a security.

Regulators have particularly honed on the risks crypto assets pose concerning terrorism, money laundering, and other forms of financial crime. A US Drug Enforcement Administration report warned that virtual currencies like bitcoin “enable transnational criminal organisations to easily transfer illicit proceeds internationally”.

Globally, regulatory approaches have been divergent, albeit constantly evolving.

South Korea, which experienced arguably the greatest crypto mania to date, has seen proactive government intervention. In March, the National Assembly passed one of the world’s first comprehensive cryptocurrency laws that will provide the framework for regulation and legalisation of cryptocurrencies and exchanges.

Japan recognises Bitcoin as a currency and was the first country to have enacted a law defining “Virtual Currency” as a legal term. Amendments to laws that regulate crypto in Japan were passed this May, tightening measures aimed at helping the market mature in the long run.

Singapore, commonly referred to as one of the world’s “cryptohavens”, has fostered a balanced legal and regulatory regime. In June, the carpooling app Ryde became the world’s first ride-sharing company to incorporate crypto as a native payment method.

By contrast, China has one of the most restrictive crypto environments in the world, having banned all ICOs and domestic crypto exchanges in 2017. It still permits crypto mining activities – at its peak China was home to over 80 percent of the world’s bitcoin miners – although it has cracked down on those operations too. Last month, the supreme court called for stronger protections of digital currency rights.

In India, where a cashless economy is actively promoted, crypto still remains an outlier. The industry has been growing exponentially since March, when the supreme court overturned the Reserve Bank of India’s prohibition on banks providing services to crypto-related entities. Three months later however, the government was reconsidering a blanket ban.

Russia meanwhile has been hostile to the industry. At the end of last month, Russian President Vladimir Putin signed the first of two bills on digital assets into law that makes it illegal to issue and trade crypto on Russian-based infrastructure.

The UK’s Financial Conduct Authority (FCA) took over as the Anti-Money Laundering and Counter-Terrorist Financing (AML/CTF) supervisor last October and since the jurisdiction officially came into effect on January 10, all UK crypto firms are mandated to register with the agency and operate under its supervision within a year or be forced to terminate all activity.

In January, the 5th EU Anti-Money Laundering Directive came into effect, requiring registration of crypto exchanges with financial regulators and the transfer of client wallet addresses to them. While bitcoin has legal status in the EU there exists no overarching framework, leaving member states to forge their own regulatory paths.

Malta has taken a very progressive approach and positioned itself as a global leader in crypto regulation. While not legal tender, cryptocurrency exchanges are, and in 2018 the government introduced landmark legislation that defined a regulatory framework and addressed AML/CFT concerns.

Portugal has pushed the spread of crypto with technological free zones. As the first European country to develop rules governing ICOs, Gibraltar is positioning itself as a crypto hotspot this year, attracting firms with regulations that grant formal licenses.

Switzerland has long been a blockchain startup magnet; the city of Zug was nicknamed “Crypto Valley” during the 2017 bonanza. In July, the Swiss government passed a legislative package intended to encourage crypto businesses by lowering legal barriers to applications of blockchain and distributed ledger technology.

In the US and Canada, a piecemeal approach prevails where federal and state regulators claim portions of the regulatory responsibility. At the federal level, both countries view cryptocurrencies as securities. However, provincial and state regulation differ in their taxation requirements of profits from crypto investments.

The US does not prohibit cryptocurrencies but it is still not integrated into the country’s financial structure. Glen Goodman, the author of The Crypto Trader, highlights a fundamental tension: the US government has an interest in maintaining the dollar’s dominant position in global finance and encouraging cryptocurrencies would ultimately undermine that power.

The sovereign strikes back

While cryptocurrencies challenge the primacy of the state and its monopoly on creating, printing and control of legal tender, the recent development of state-sanctioned, sovereign-backed cryptocurrencies reveals that states (along with Big Tech platforms and financial institutions) have begun to maneuver and adapt to this disruptive landscape.

Central banks have since begun exploring the concept of central bank digital currencies (CBDC) through the creation of research and working groups, as have international organisations like the International Monetary Fund (IMF), the Bank for International Settlements (BIS) in addition to a CBDC Group think tank.

A BIS survey published in January showed that advanced economies were actively analysing the potential impact of stablecoins, with central banks like the US Federal Reserve, European Central Bank (ECB), Bank of England (BoE) and Bank of Japan (BoJ) all actively exploring the space. 

In contrast to bitcoin and other decentralised digital currencies, CBCDs are issued and tracked by central banks. They are intended to be digital versions of fiat currencies and represent many of the same features. CBDCs attempt to upgrade payment infrastructure, while bitcoin is an attempt to upgrade money.

The launch of Facebook’s stablecoin Libra, announced in the summer of 2019, undoubtedly raised the stakes. Here was an entity with 2.7 billion users proposing to institute a private parallel currency that would bypass central banks, regulators and existing currency systems.

State authorities naturally feared their monetary autonomy was at risk of being undermined by a privately centralised digital currency.

Libra has been a motivating factor behind the pursuit by governments to begin issuing their own digital currencies – and a key impetus behind China’s launching its own sovereign digital currency project.

Against the backdrop of a trade war, Facebook founder Mark Zuckerberg cautioned Congress to support Libra lest the Chinese get a head start in the digital currency arms race. Anxiety that the yuan could be cut out from Libra’s basket of currencies was duly registered by Chinese bankers.

Beijing then moved into high gear. On October 24, 2019, a day now called “China Blockchain Day,” President Xi Jinping announced the rollout of the country’s state-sanctioned cryptocurrency called the Digital Currency and Electronic Payment (DCEP), linked to the yuan on a 1-to-1 basis.

The contrast was clear. While Libra sought to challenge government authority over legal tender, China’s DCEP reinforces state control, discarding paper currency not central banks.

In late April, China trialled the digital yuan in four cities: Shenzhen, Suzhou, Chengdu and Xiong’an. The trial was adopted into the cities’ monetary systems, with some government employees and public servants receiving salaries in the digital currency and select food and retail outlets also involved.

By running the most advanced simulation to date, China is well on its way to launching the world’s first official digital currency.

There are multiple motivations behind Beijing’s drive to tokenise the yuan.

For one, Beijing understood bitcoin’s popularity in China and the potential of cryptocurrencies to usurp the state’s money-printing capabilities. While the response was a ban at first, it was savvy enough to convert cryptocurrency’s most beneficial aspects to serve state goals: reducing transaction costs for business and friction in P2P payment; easier cross-border payments; and potentially bringing millions of unbanked Chinese citizens into the system. Not to mention, a more hygienic payment option in a pandemic-ridden world.

Secondly, by developing a sovereign digital currency administered by the People Bank of China (PBOC), a supervisory architecture would be in place to stem capital flight, which China considers high risk despite extensive capital controls currently in place.

There is also a more ambitious long-term goal: internationalisation of the yuan. If widely implemented, the expectation is that a digital yuan would compete with the US dollar-denominated financial order and make attacks on and speculation of the yuan harder – something PBOC governor Yi Gang has made explicit.

Another ambition of the DCEP is to regionalise the currency and tie it to China’s expansive Belt and Road Initiative (BRI). To accelerate adoption, what if Beijing makes it a condition for recipient countries taking loans to accept the digital yuan? 

With pressure mounting to catch up with China, the BoJ has prioritised a digital yen and confirmed that it will be considered as part of this year’s legislative agenda. The Philippine central bank has also commissioned CBDC research.

Project Ubin, designed by the Monetary Authority of Singapore (MAS) in partnership with state-owned investor Temasek and US investment bank JP Morgan, just completed its fifth phase and has branched out to capital markets, supply chain finance and insurance. With the Singaporean blockchain payments initiative moving closer to commercialisation, it could eventually form the basis of a global payments platform for central banks.

There are shadier sides to CBDCs too. Venezuela created its own cryptocurrency – the Petro – designed to skirt US sanctions on the country’s oil trade business and secure liquidity for the Maduro regime in the face of exorbitant inflation and a collapsing economy.

The Petro was met with major resistance from the US, and Donald Trump’s executive order ban might set a precedent for how future (foreign) state-backed cryptocurrencies will be regulated by Washington.

In each of these cases, a clear theme has emerged: the state is alive and well, and not going away anytime soon.

Amid the fallout of a global pandemic, the managerial role of the state has only increased. With geopolitics slowly shaping the landscape of the cryptosphere, investors that have so far been insulated from government oversight are unlikely to be for much longer.

Centralised digital currencies now present governments with the capacity to upgrade payment infrastructures while retaining fiduciary hegemony, a win-win.

As James Cooper, a law professor and blockchain adviser, poignantly observes: “nothing is more centralising than a state’s control over decentralized technologies like blockchain and cryptocurrency.”

For the moment, the libertarian dream of cryptocurrencies being pregnant with the ability to transcend the state apparatus appears premature. Governance mechanisms will continue to exist as long as someone controls the supply of digital money.

The more relevant question to ask now is: have we entered into an era of sovereign digital currencies?