Since the creation of Bitcoin in 2008, cryptocurrencies have exploded in use and value. Today, there are over 2,000 different cryptocurrencies, most of which are based on blockchain technology. While some people see cryptocurrency as a way out of global financial issues like poverty, inflation, and corruption, others see it as a tool for money laundering and tax evasion. As such, many countries around the world are now looking into creating their own national digital currency.
While cryptocurrencies themselves aren’t backed by anything physical, they do provide certain advantages over traditional fiat currencies. For example, they eliminate the need for trusted intermediaries like banks and clearinghouses, and allow transactions to happen almost instantly. However, they also present potential problems – including a lack of transparency, volatility, and concerns about security and privacy.
What are cryptocurrencies?
So-called because of their use of cryptography principles, cryptocurrencies are typically exchanged among people on decentralized computer networks known as blockchain systems. Transactions are usually recorded on distributed, tamper proof ledgers known as block chains. This open source framework prevents coins from being copied and eliminates the need for banks to verify transactions.
Bitcoin, created in 2009 by a programmer named Satoshi Nakamoto, is the most famous cryptocurrency. Its total market capitalization is sometimes over $1 trillion. However, dozens of other cryptocurrencies exist, including Ethereum, the world’s second largest. They operate on the same basic principles. Users send money between digital wallet addresses. Unlike traditional currencies, there are no physical coins or bills. Instead, each coin represents ownership of a certain amount of currency.
Why are they popular?
The rise of cryptocurrency began in 2008, when Satoshi Nakamoto published a paper describing how he invented a new type of currency called Bitcoin. Cryptocurrencies such as Bitcoin are “decentralized,” meaning there is no central authority controlling it. Instead, transactions take place via peer-to-peer networks, where each participant keeps track of what everyone else is doing. This makes it difficult to trace money flow and impossible to shut down.
Cryptocurrencies are increasingly being used for illicit activities. For instance, people sell in Bitcoin rather than dollars because they’re harder to trace. And criminals use cryptocurrency to launder money.
Bitcoin and similar cryptocurrencies have become immensely popular over the past few years. As of January 2020, the total market capitalization of cryptocurrencies is about $160 billion.
What is “DeFi”?
Cryptocurrency and blockchain gave rise to a new constellation called decentralized finance, or DeFi, which offers consumers access to financial services without the need for traditional financial institutions like banks and brokers.
Essentially the cryptocurrency version of Wall St., DeFi aims to give people access to financial services — borrowing, lending, and trading — without the need for legacy institutions like banks and brokerage firms, which often charge high fees and take large commissions.
Instead, smart contracts automatically execute transactions when certain criteria are met. This makes it possible to invest in things like loans, insurance products, and even cryptocurrencies without having to go through intermediaries like brokers and banks.
Most DeFi apps are built around the Ethereum blockchain because it’s most suited to running smart contracts. But some developers are building DeFi solutions on other blockchains, including EOS and Stellar.
Because of its usefulness in tracking transaction activity, blockchain technology has a wide array of potential uses beyond cryptocurrency, according to experts. For example, it could help facilitate real estate deals and international trades.
What challenges has this created?
The anonymity and portability of cryptocurrencies make them appealing to criminal organizations, terrorist groups, and rogue states. Cryptocurrencies have also presented new challenges to governments. As well as uncertainty regarding the regulatory treatment of emerging financial technologies, crypto mining can require a great deal of electricity, which has raised concerns about its impact on the environment. As DeFi and crypto payments have grown, concerns have been raised about consumer protection, market volatility, and central banks’ ability to manage monetary policy.
Increasingly, cybercriminals are conducting ransomware attacks, in which they infiltrate and shut down computer networks before demanding payment, often in cryptocurrency, to restore them. According to DEA’s (DEA) most recent annual report, drug cartels and money launderers are also increasingly using virtual currency in their activities. A number of darknet markets specializing in illegal narcotics have been shut down by U.S. and European authorities.
It has been possible for the United States to impose crippling economic sanctions due to the primacy of the U.S. dollar. Iran and North Korea, for example, are increasingly using cryptocurrency to evade sanctions imposed by the United States. Crypto has also been used by terrorist groups like al-Qaeda, the self-proclaimed Islamic State, and Hamas’ military wing.
Environmental harms. Bitcoin mining is a very energy-intensive process: it consumes more electricity than many countries combined. This has led to concerns about crypto’s role in climate change. Many cryptocurrency proponents believe this problem can be solved with renewable energy; El Salvador’s president, for instance, has pledged to mine Bitcoin using volcanic power. Ethereum switched to a proof-of-stake model to reduce its energy consumption due to environmental concerns.
A relatively unregulated finance sector is now home to billions of dollars in transactions involving cryptocurrencies and DeFi enterprises, raising concerns about fraud, tax evasion, and cybersecurity, as well as financial stability in general. The dominance of cryptocurrencies in global payments could limit central banks’ ability to set monetary policy, particularly in smaller countries, by controlling the money supply.
What are governments doing about this?
Countries around the globe are grappling with how to deal with cryptocurrencies and decentralized finance (DeFi), including the potential risk of money laundering and terrorist financing. Some countries, such as South Korea, China and Japan, have banned initial coin offerings (ICOs). Others, like Switzerland, Germany and France, have taken a more permissive stance. Still others, like Australia and Canada, have embraced blockchain technology but stopped short of regulating it.
The problem for policymakers is that cryptocurrencies don’t fit neatly into the existing financial system. They lack the same protections afforded to traditional assets, such as consumer protection, anti-money laundering regulations, capital requirements and know-your-customer procedures.
In addition, cryptocurrencies are often used to facilitate criminal activity, including ransomware attacks, illicit drug sales, child pornography distribution and human trafficking.
Many governments initially took a hands off approach to cryptocurrencies, but the rapid ascent and evolution of the sector, coupled with the rise in popularity of decentralized finance (DeFi) applications, has forced regulators to start crafting rules for the emerging space.
Regulations vary widely around the world. For example, while the European Union has banned ICOs, several EU member states allow crypto trading platforms to operate legally within their borders.
However, the challenge for regulators is to develop rules that protect consumers without stifling innovation. This requires balancing the need to ensure that cryptocurrencies remain secure against the desire to prevent criminals from launder ill-gotten gains.
In the United States, policymakers are considering whether to treat cryptocurrencies as commodities or currencies under securities laws. Such a move would require changing the definition of what constitutes a security.
What is a central bank digital currency?
Proponents argue that CBDC offers the speed and other benefits offered by cryptocurrencies like bitcoin, while avoiding some of their drawbacks. Central banks around the world are increasingly interested in developing CBDC because of recent technological advances, such as blockchain technology and distributed ledger systems, which allow for faster processing times and lower transaction costs.
But critics warn that CBDC poses significant security concerns, especially given the potential for cyberattacks against financial institutions. They also worry about the impact on monetary policy. Some fear that CBDC could undermine the value of national currencies and exacerbate inequality. Others question whether consumers will trust CBDC, given the history of failed attempts at creating electronic money.
Experts say that the most important thing for policymakers is to ensure that CBDC does not become a vehicle for political manipulation. “If you’re looking at a government trying to use a CBDC to do something nefarious, I think the best way to avoid that is just to make sure that it doesn’t work,” says David Andolfatto, former chief economist at the Bipartisan Policy Center and a professor at George Mason University School of Law. “That’s why we’ve seen no evidence of governments doing anything malicious.”
For example, Andolfatto notes that the People’s Bank of China launched a pilot program in November 2018 that allows people to pay bills electronically with a digital yuan. But he adds that the government did not release information about how much money was exchanged during the test phase. “I’m not aware of any instances where the Chinese government tried to hide what happened,” he explains. “They want to know exactly how well it works.”
Andolfatto says that the European Central Bank is also taking steps to address privacy issues. Its research arm published a report in December 2019 that examined the privacy implications of CBDC. It found that existing data protection laws already provide adequate protections for individuals’ personal data. However, the authors noted that the lack of transparency surrounding CBDC creates challenges for regulators and law enforcement agencies.