Cracking the code of crypto

The Securities and Exchange Commission recently launched a broadside against the cryptocurrency world. Testifying before the Senate Banking Committee, Chairman Gary GenslerGary GenslerCracking the code of crypto On The Money — Biden to Democrats: Come together Equilibrium/Sustainability — Presented by The American Petroleum Institute — Tracking the Earth’s ‘ultimate record of change’ MORE announced that finding a way to rein in the fraud, scams and abuse that are rampant in the “crypto assets market” is at the very top of the agency’s priorities. “Frankly, at this time, it’s more like the Wild West,” Gensler concluded, “or the old world of ‘buyer beware’ that existed before the securities laws were enacted.” Gensler is right to be concerned about the Wild West of blockchain, but he underestimates the scope of the problem.

If we want to fix crypto, we need coordinated action from Congress, regulators, and the courts.

A dozen years have passed since Satoshi Nakamoto published his famous white paper describing a new form of virtual currency he called “bitcoin.” Bitcoin, as he described it in his 2008 essay, would be a kind of utopian financial network, a democratic and decentralized money system stored on computers that would be run and maintained by the users themselves, with no role for governments or big banks. At a time when the financial crisis was threatening to lay low Wall Street’s largest institutions, bitcoin and its underlying technology, blockchain, seemed like a promising step forward.

And in fact, in the years that followed, the blockchain ecosystem would explode. A single bitcoin today is worth around $50,000, and the total market cap of bitcoin currently stands at $900 billion. If you had invested $1,000 in bitcoin in 2011, you would have $45 million today. Other cryptocurrencies followed bitcoin’s lead, with Ethereum, Litecoin, Dogecoin and many, many others receiving substantial investment and interest. Some of these had new and different features — Ethereum was good for smart contracts, Monero was good for anonymity, Tether was good at, well, pretending to be a dollar. Cryptocurrency exchanges sprung up to serve the seemingly insatiable appetite of cryptocurrency investors for the newest initial coin offering.

As the blockchain ecosystem has grown, it has received intensifying interest from institutional investors. J.P. Morgan launched a digital currency known as JPM Coin. Facebook proposed to launch a digital currency before having it shot down under a storm of regulatory scrutiny. The NBA created a blockchain-based trading card, known as a non-fungible token. And last month, El Salvador made bitcoin an official national currency.

But the unstoppable momentum of blockchain masks a darker truth. Blockchain poses enormous risks to society, and yet falls into the cracks of our legal system. Real harm has resulted. The problems are three-fold.

The first is crime and fraud. It is well-known that, because of bitcoin’s anonymous ledger, the cryptocurrency has become the currency of choice for criminals and hackers. Way back in 2013, the FBI shut down the Silk Road, a massive dark web marketplace where users bought drugs, guns and the services of hit men, and which used bitcoin as its payment method. Criminal hacking rings have launched ransomware attacks against American corporations that have paralyzed critical infrastructure and required bitcoin payments to unlock them. The surging value of cryptocurrencies have also made crypto-exchanges into attractive targets for hackers. When users have had their accounts at the cryptocurrency exchange Coinbase drained by hackers, they have often been informed, to their dismay, that the illicit transactions are irreversible, and not Coinbase’s responsibility.

The second problem is systemic stability. Cryptocurrencies have always been volatile. But as blockchain has matured, it has become more intertwined with the rest of the economy. The industry is now worth trillions of dollars, and many individuals have large portions of their life savings locked up in it. Concerns have mounted especially around stablecoins, cryptocurrencies designed to track the value of a real-world currency like the dollar, but that are often highly leveraged and used in lending transactions. An external shock, like the hacking of a major exchange or the discovery of an unknown bug in a digital currency’s code, might well send shockwaves that reverberate outside the realms of the virtual world and into the real one.

The third problem is the environment. Because of their decentralization, bitcoin and other cryptocurrencies require massive amounts of energy to maintain, a process known as mining. One recent study estimated that bitcoin mining consumes 91 terawatt-hours of electricity a year, around the energy consumption of the entire nation of Finland. For a currency that is not widely used for actually buying anything, that is an astounding number.

These are major problems, but not unfixable ones.

We should start by focusing on crypto’s gatekeepers.

The blockchain ecosystem is only made possible by a set of actors that serve as the point of entry for regular investors. Developers create cryptocurrencies. Miners maintain them. Exchanges let consumers buy them. All of these actors must be held to higher standards.

First and foremost, the SEC should issue new rules requiring cryptocurrency developers to provide thorough disclosures to investors before launching new digital coins. It should also require crypto-exchanges to protect the accounts of consumers with best-in-class cybersecurity procedures and reimburse them for losses if and when they occur. Congress could help by passing the infrastructure bill, which includes information-providing requirements for crypto-brokers.

The environmental problem is more pernicious but could be mitigated by imposing new taxes on mining farms.

Finally, there is also a role for courts. Technology moves fast. Legislation moves slow. In the meantime, courts should use their powers to interpret decades-old laws to protect regular citizens from the harms of these complex new financial instruments.
If the branches of government work together, we can crack the code of crypto.

William Magnuson is an associate professor at Texas A&M Law School and the author of Blockchain Democracy: Technology, Law and the Rule of the Crowd (Cambridge University Press 2020)

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