Cryptocurrencies - An assessment1
Shri Goel, Chairman IBA, Shri Mehta, Chief Executive IBA, Prof Phatak, Chairman of Awards
Jury, members of the Jury, MDs and CEOs and other senior functionaries of banks, ladies and
gentlemen
Let me begin by congratulating the winners of the IBA Banking Technology Awards. It is
indeed a privilege to be among so august an audience and so learned a gathering and be able
to talk about an issue of momentous significance - how to deal with cryptocurrencies. Crypto
technology and Web 3.0 is dominating the mind-space not just among the technology
community but the financial industry as well. Cryptocurrencies, as per their proponents, have
the potential to play a critical role in how finance pans out in the future; indeed, there is open
speculation about whether finance as we know it and banking as we know it can survive the
rise of cryptocurrencies. In this talk I will try and give you my assessment of cryptocurrencies
and what they mean for our financial system.
Introduction
2. As many of you would already know, cryptocurrencies and other crypto products (like
non-fungible tokens or NFTs) are being hailed as the innovations that would usher in
decentralized finance or DeFi, which are blockchain applications geared to disrupt the
traditional financial system. The basic purpose of blockchain, or more generally the
distributed ledger, the technology on which these crypto-products run, is to make
financial intermediation, and therefore banks, redundant.
3. What might have escaped the attention of the common man, is that cryptos might be
more than just a technology, they appear to embody an ideology as well. A Financial
Times video characterizes the success of Bitcoin, the first and most popular
cryptocurrency, to "healthy dissent, base greed, lofty idealism, and sheer fear of
missing out"2. The same FT video also says "Cryptos embody a core tenet of
anarchism, co-operation in the absence of centralised authority". The class of crypto
products are fundamentally designed to bypass the established financial system, and
on a larger scale Government itself. Some enthusiasts even claim that
cryptocurrencies can usher in a separation of money and State, like separation of
Church and State. Some refer to it as 'freedom' money. Or, as Nassim Nicholas
Taleb is quoted to have written in the Time3 magazine, bitcoin is an insurance policy
against an Orwellian future. It may thus not be adequate, from a regulatory point of
view, to treat cryptos as just another type of currency or asset or commodity but also
as a potential social movement.
Cryptocurrency Basics
4. Let us briefly, and in very general terms, understand the basics of cryptocurrencies.
5. When a transaction is made using paper currency, all that the receiver needs to check
is that the currency is not counterfeit. Thus, it is the receiver who authenticates the
instrument of payment. This arrangement generally works, except for those few
instances when the receiver fails to detect a counterfeit currency. In the case of digital
transactions, the authentication of the payment is done by an intermediary like a bank,
because almost all electronic transactions are transfer of money from one bank
account to another. This arrangement also works as the bank certifies that the sender
has adequate balance in her account to cover the transaction.
6. Some people felt that intermediation by banks is avoidable. Either they felt that banks
are not trustworthy, or they considered that the cost charged by banks is excessive, or
they were not comfortable with their transactions being tracked. Guided by the idea
that cash remains one of the best ways to exercise free speech (refer footnote 3), their
solution was to create their own private currency and a transaction arrangement or
network that bypassed banks or any other financial or social institution. The basic
problem they had to get over was as follows - since electronic money (just some lines
of code) can be easily replicated, in the absence of a trust institution like a bank, how
does the network ensure that the same currency is not spent again, and again. This
was called the 'double spending problem'.
7. The first 'person' to effectively solve this problem was one Satoshi Nakamoto, a
fictional person or persons or corporate or any other entity, no one knows as yet. And
bitcoin was born. He did this by creating the blockchain. On a blockchain, when a
transaction occurs, it is broadcast to all computers on the network. A set of new
transactions, called a block, are authenticated by an agreed consensus mechanism,
and then the validated transaction block is added to the previous chain of blocks. Every
block is linked to the previous block, making double spending difficult because it would
involve changing every subsequent block. Bitcoin was followed by many others, like
ether, cardano, dogecoin, tether, stellar etc. Collectively they are called
cryptocurrencies. The prefix 'crypto-' refers to the fact that cryptography is used to
generate or authenticate transactions.
8. The defining characteristics of cryptocurrencies are: -
a. That cryptocurrencies are decentralized systems where transactions are
authenticated by participants themselves by consensus. They are designed to
bypass the financial system and all its controls. They cannot be traced or
confiscated or frozen by Governments.
b. They are anonymous - transactions are verified, but not the purposes or
counterparties of transactions.
c. They are borderless - that is, they work over the internet without any physical
existence.
9. While Bitcoin started more than a decade back in 2008, until 5 years ago, total market
capitalisation of all cryptocurrencies was only $20 billion (February 2017). This went
up to $289 billion in February 2020 and thereafter exploded to reach a peak of $2.9
trillion in November 2021. Currently (Feb 09, 2022) it stands at $1.98 trillion. Bitcoin
accounts for 42% of this market capitalisation, the top two cryptocurrencies account
for 61% while the top five account for 71%. The total number of cryptocurrencies is at
17,436 and the total number of crypto exchanges is 458.4
A critical assessment of cryptocurrencies
10. With that brief, and somewhat simplistic, introduction to cryptocurrencies, we will now
take a deeper look at the exact nature of cryptocurrencies and their implications,
particularly in the context of the current debate in India on the topic. The starting point
is to get a clear understanding on (a) What precisely is a cryptocurrency, (b) What
useful economic role does a cryptocurrency play, and (c) What, if any, are the risks it
poses to the society and economy?
(i) What precisely is a cryptocurrency?
11. A cryptocurrency is designed to be a currency, but does it really function like a currency
as we understand it. Firstly, currency always has an issuer, usually a trusted entity like
the sovereign. Even when gold is used as a currency, the gold coins had to be issued
by a sovereign entity. Secondly, historically, a currency has always been either a
commodity with intrinsic value or a debt instrument. Cryptocurrencies do not conform
to this understanding of a currency as they do not have an issuer, they are not an
instrument of debt, or commodities nor do they have any intrinsic value. Currency
needs trust, not everything that can be trusted is a currency. So even if technology (as
in a blockchain) provides the trust for cryptocurrencies, they can at best perform the
role of a currency within the private and closed environment of that cryptocurrency.
They do not, and should not, automatically become a currency for the larger society.
12. Some countries tend to treat cryptocurrencies as a financial asset. This is also
problematic because all financial assets have underlying cash flows and need to be
some person's liability. Cryptocurrencies are neither any person's liability nor do they
have any underlying cash flows. They are not financial assets, by definition.
13. There is also an effort to treat cryptocurrencies as a commodity. But commodities are
tangible and have utility; cryptocurrencies have neither. There is this somewhat
awkward attempt to equate some of them with gold, hence limiting their supply like
natural resources, or creating them through mining. Limiting supply by design is not
the same thing as limited supply in nature (like gold) because (a) design can always
be modified and hence such limitation is artificial, and (b) even if one cryptocurrency
has limited supply, that limitation does not work for all cryptocurrencies taken together.
Further the fact that gold is mined does not in itself make it money, it has to be stamped
and issued by a sovereign to make it money.
14. If cryptocurrencies are neither a currency in the usual sense of the term, nor a financial
asset nor a physical asset what are they? The proponents have improvised to call them
as digital assets. Even that is doubtful as cryptocurrencies do not have any underlying
use, like for instance car hiring softwares or a core banking systems, or, for that matter,
smartphones. That basically leads to the conclusion that it is an electronic code (with
no practical use) which has created enough hype such that people are willing to pay
money to buy ownership rights to that electronic code, seemingly on the hope that
someone else would buy it at a higher price in future. What started off as a medium of
exchange has appeal similar to that of a speculative asset.
15. As a store of value, cryptocurrencies like bitcoin have given impressive returns so far,
but so did tulips in 17th century Netherlands. Cryptocurrencies are very much like a
speculative or gambling contract working like a Ponzi scheme. In fact, it has been
argued that the original scheme devised by Charles Ponzi in 1920 is better than
cryptocurrencies from a social perspective5. Even Ponzi schemes invest in income
earning assets. A bitcoin is akin to a zero-coupon perpetual; it's like you paid money
to buy a bond which pays no interest and which will never pay back the principal. A
bond with similar cash flows would be valued at zero, which, in fact, can be argued as
the fundamental value of a cryptocurrency. If everything eventually returns to its
equilibrium value, then the prognosis for investors in cryptocurrencies is not a happy
one.
(ii) What useful social or economic role does a cryptocurrency play?
16. If cryptocurrencies are actually intended to revolutionize finance, we need to
understand what precise role they play in finance. An equity share enables a business
to mobilize risk capital, a bond enables a company/Government to borrow money, a
mutual fund enables retail investors to diversify their portfolio, derivatives enable users
to manage their risk and so on. Every financial instrument exists to serve a basic
purpose quite distinct from its use as an investment asset. What is the basic role played
by cryptocurrencies? Since it claims to be a currency, does it perform the functions of
a currency? The answer is that the volatility of many cryptocurrencies precludes them
as an efficient medium of exchange. Besides, a priori there is no ground to believe that
people place the same trust in them as they do in legal tender currencies. While there
is anecdotal evidence of businesses using bitcoins, there really is no reliable data
available; by all indications their use as a currency appears to be negligible.
17. Are cryptocurrencies useful as a store of value? Given the surge in value of some
cryptocurrencies, it has been argued that they are. A closer look exposes that
argument. Think of any store of value - they are either currencies, or financial assets
or commodities which are tangible and have intrinsic value (works of art like paintings
also have historical, aesthetic and scarcity value). We have seen that cryptocurrencies
are none of these. Notwithstanding their current valuations, if a threshold number of
people decide to opt out, the entire values can easily collapse to nothing.
18. For all the hype about a revolutionary innovation, cryptocurrencies themselves do not
appear to be designed to meet any need in the finance space that is currently not being
met or to meet existing needs more efficiently. The innovation, if at all, is of distributed
ledger, which, contrary to the claims of proponents, can flourish even if
cryptocurrencies themselves are banned across the world.
(iii) What, if any, are the risks posed to a society or an economy?
19. The fundamental risks of cryptocurrencies are two - they are intended to be private
currencies and they are structured to evade Government control with respect to
financial integrity standards such as KYC, AML/CFT etc. Let us examine each of these
two points in a little more detail.
Impact of private currencies or currency like products on the economy
20. Historically, private currencies have resulted in instability and therefore have evolved
into fiat currencies over centuries. The retrograde step back to private currencies
cannot be taken simply because technology allows it (it always did, actually) without
any consideration for the dislocation it causes to the legal, social and economic fabric
of society. Every private currency will eventually replace the Rupee to some extent.
Consequently, the role of the Rupee as a currency will be undermined. With one or
more private currencies being allowed, there would be parallel currency system(s) in
the country. Thus, increased acceptance of cryptocurrencies would result in effective
'Dollarization' of our economy6. Dollarization, it is well understood, would undermine
the ability of authorities to control money supply or interest rates, as monetary policy
would not have any impact on the non-Rupee currencies or payment instruments.
When that happens, India loses not just its currency, a defining feature of its
sovereignty, but its policy control of the economy. With loss of traction for monetary
policy, the ability to control inflation would be materially weakened.
21. Given a choice, people may like to hold at least a part of their deposits in convertible
currencies like the US Dollar or Euro. Cryptocurrencies priced in these convertible
currencies would provide such an opportunity. If private currencies are permitted, the
banking system's ability to mobilise deposits in Rupees, and consequently, the ability
to create credit, would diminished. Credit creation in convertible currencies would be
impervious to monetary policy. In the extreme case where a major part of deposits and
credit shift to cryptocurrencies, the result would be a weakened, even crumbling,
banking system, impairing financial stability.
22. There are already indications that private cross-border flows are taking place in
cryptocurrencies. If this trend is legitimised, a part of the flows related to trade
payments, personal remittances or cross border investments would be made in these
cryptocurrencies. As they are non-reserve currencies, this could have adverse
implications for India's foreign exchange reserves, which lend stability to the external
sector. Besides, such cryptocurrency payments can take place outside the ambit of
capital account regulations. This would adversely affect the integrity of the capital
account regime, as policy control on capital flows would be eroded. The consequence
of this on foreign exchange reserve accretion and exchange rate management raises
serious macroeconomic stability issues.
23. It is important to appreciate that the concern with private currencies is not limited to
bitcoin or just cryptocurrencies. The concern extends to any private currency, whether
digital or physical, whether crypto-based or not. Stablecoins (which are simply
cryptocurrencies that are less volatile) are being promoted globally, presumably
because they are more stable than, say, bitcoin. We should in fact be more concerned
about stablecoins because they would be more effective as currency than volatile
cryptocurrencies. As the FT video cited above says "Stablecoins pegged to official
currencies would increase, rather than dampen risks, if assets and liabilities were
mismatched."
Impact on global financial integrity standards
24. The very raison d'etre of cryptocurrencies is that they bypass established
intermediation and control arrangements7 that ensure integrity of financial
transactions, such as Know-Your-Customer regimes, Anti-Money Laundering (AML)
and Combating the Financing of Terrorism (CFT) rules etc. The fact that they are
anonymous, decentralized systems that operate purely virtually makes
cryptocurrencies particularly attractive to illegal/illegitimate transactions which have
been largely filtered out of the formal financial system. Total crimes using
cryptocurrencies in 2021 was estimated to be $14 billion (Wall Street Journal, January
06, 2022). The amount itself is not much but the implications for the AML/CFT
framework built painstakingly over the last two decades is rather substantial.
25. There are other important negative consequences of allowing cryptocurrencies into the
formal financial system. We have already noted that there is no basis for valuation of
cryptocurrencies. Since valuation is largely based on beliefs, and not on underlying
value, it is bound to have a destabilizing effect on monetary stability of a country
through large-scale wealth loss to investors (if it is adopted widely), even if it not
allowed to be used as a currency.
26. The socially wasteful energy use of crypto infrastructure has been a subject of
widespread discussion. About 900 new bitcoin a day require electricity worth $45m a
day (refer footnote 5). By some estimates electricity use of bitcoins equaled that of the
entire country of Switzerland8, in 2019.
27. From what we have seen so far, there does not appear to be any case to allow
cryptocurrencies to be legitimized in India. Nonetheless various arguments have been
extended to permit cryptocurrencies and subject them to close regulations. In the next
section, we would examine the validity of these arguments.
Should cryptocurrencies be permitted and regulated in India
28. The basic arguments being made for regulating cryptocurrencies are as follows:
d. Blockchain or Distributed Ledger Technology is a promising technology where
Indians might have a global edge. Banning cryptocurrencies would affect the
absorption of DLT technology in India.
e. Most major countries are not banning cryptocurrencies, but are considering
some kind of regulation.
f. Many Indians have already invested in cryptocurrencies and banning it may
lead to wealth loss for them.
g. Banning in any case is unlikely to be effective because by its very nature
cryptocurrencies can be acquired and traded in an anonymous manner.
29. Cryptocurrencies are typically native to a blockchain. For instance, bitcoin is the native
coin (or token) of the Bitcoin blockchain, or, ether is the native currency of the
Ethereum blockchain. They can be used as units of account to settle transactions or
they can be used as tokens to reward work done in the blockchain, say, for mining.
Either of these two functions do not appear to be essential to the basic function of a
blockchain. It should be possible to maintain a blockchain without any native
cryptocurrency if transactions are authenticated centrally. Even in case of private
authentication through consensus mechanisms, accounts can be kept and rewards
can be given in any legal tender currency. In other words, creating native
cryptocurrencies is just one way of implementing a blockchain; it can be viewed as just
one use case of the blockchain technology. To argue that banning cryptocurrencies
would stunt the absorption of blockchain technology is therefore akin to saying that
banning human cloning would kill innovations in biotechnology or banning nuclear
weapons would hurt nuclear physics as a discipline. There are many other uses of
blockchain technology or more generally, distributed ledger technology, that do not
involve creation of a virtual currency. Thus, claims that cryptocurrencies must be
permitted for blockchain technology to thrive are not sustainable.
30. An argument often advanced against banning cryptocurrencies is that advanced
economies (AEs) are not resorting to such bans. While replicating the practices
followed in AEs is often an acceptable route to reforms, as far as cryptocurrencies are
concerned, it has to be noted that India is not similarly placed as AEs. We should
particularly be alert to the possibility that these private currencies can be used for
global strategic control. If, for example, some private currency substantially replaces
the Rupee, the corporate which manages that cryptocurrency (or the country which
has control of that corporate) can practically control India's economic policy. There are
a number of other reasons why it might be in the interest of AEs to not ban them, as
below.
a. Almost all cryptocurrencies are priced in terms of Dollars (or potentially any of
the freely convertible currencies). Wider adoption would actually result in wider
use of these currencies. So cryptocurrencies are not a threat to convertible
currencies as they are to the Rupee, which is not an international currency.
Following the example of AEs in the matter of cryptocurrencies would
effectively amount to working against the interest of the national currency.
b. Most cryptocurrencies are owned by businesses of AEs; therefore, better
adoption of cryptocurrencies would add to their growth and employment.
Significantly, it might be of advantage to the AEs if cryptocurrencies replace
emerging market (EM) currencies as that would give AEs a better strategic
control on the EMEs.
c. AEs have more mature markets which can withstand the potential disruption
from cryptocurrencies. They are, therefore, in a better position to wait and
watch.
d. AEs have quicker legal systems and hence concerns of misuse of cryptos can
be addressed through the legal systems. In India, on the other hand none of
the major instances of consumer exploitation have been redressed legally (e.g.,
the mis-selling of derivatives in mid 2000s).
e. AEs have the political power to control the crypto companies. The recent
instance where the US recovered bitcoins from the hackers of the oil pipeline
in US, is an example that notwithstanding claims of non-traceability of
cryptocurrencies, AE Governments wield enough power to access the records.
India or most other countries would lack such advantages.
31. Another argument often advanced is that so many Indians have already invested in
cryptocurrencies and banning cryptocurrencies would lead to a loss of wealth for them.
There are three reasons such arguments do not appear justified. One, banning in India
does not mean investors would lose money, because they can be provided with a
reasonable exit. Two, persons who have invested in these instruments are fully aware
of the risks involved. Reserve Bank has been warning investors of the risks for nearly
a decade. That an Inter-Ministerial Committee of the Government has recommended
banning cryptocurrencies was widely known for the last three years, as was the fact
that cryptocurrencies are not regulated products and there are no investor protection
norms in place. Investors who have acquired these instruments have done so with their
eyes wide open, at their own risk and do not warrant any regulatory dispensation.
Three, there is no data to justify how many investors have invested in these
instruments and what is the amount of investment. Data informally gathered in
November seems to indicate that crypto investments by Indians is nowhere near to
being significant (although the pace of growth could make it a concern in future). This
data showed9 that four out of five investor accounts10 held investments of less than
Rs.10,000, with an average holding size of Rs.1,566. Wealth loss, if at all it is a
possibility, is likely to affect only a small fraction of these investors.
32. Interestingly, concentrated ownership appears to be characteristic of cryptocurrencies.
As a January 2021 report published in The Telegraph11 points out: "According to
industry data, around 13% of all Bitcoin sits in the hands of just over 100 individual
accounts." They are referred to "crypto whales". Such concentrated ownership, usually
by creators or initial investors, in what is touted to be (or at least hoped to be) the
alternative monetary system, would make that system prone to manipulation.
33. That cryptocurrencies should not be banned because a ban is unlikely to be effective
is a superficial argument. One might as well argue that drug trafficking is a rampant
phenomenon despite a ban, and therefore drug trafficking should be legalised and
regulated. If cryptocurrencies are banned, the vast majority of investors who are law
abiding would desist from investing. Those few elements who would continue to invest
will essentially be carrying out an illegal activity. Such exceptions should reinforce the
need for a ban, rather than invalidate it.
34. It has also been argued by some that the concerns raised in allowing private currencies
as a 'medium exchange' are valid. Therefore, they may not be allowed as legal tender
but should be allowed as an investment asset. This argument appears to be made
more with hope than with any real conviction. Not allowing them as currency would still
amount to cryptocurrencies being used as store of value. 'Store of value' demand is a
more substantial source of demand for a currency than transaction demand. One only
needs to compare the volume of time deposits with transactional deposits to
understand this. If a cryptocurrency is used as a store of value the same concerns
arise again. Also, unlike the value of Rupee, which is anchored by monetary policy and
its status as legal tender, the value of crypto assets rests solely on the expectation that
others will also value and use them. Since valuation is largely based on beliefs that are
not well anchored, it is bound to have a de-stabilising effect on the monetary and fiscal
stability of a country, even while it is not permitted to operate as a legal tender.
35. There are other reasons why it would be futile to regulate cryptocurrencies. As
discussed, cryptocurrencies are not currencies, or financial assets or real assets or
even digital assets. Therefore, it cannot be regulated by any financial sector regulator.
It is not possible to regulate something that one cannot define.
36. Cryptocurrencies are typically global products whose defining characteristic is that they
are outside official control and they cannot be regulated by country-specific regulators.
The Financial Stability Institute of the Bank for International Settlements identifies
difficulties in regulating cryptos - such as the international nature of crypto
transactions, absence of technological solutions to ensuring FATF's 'Travel Rule', the
problem of 'unhosted wallets', the fact that P2P transactions do not involve any entity
subject to AML-CFT regulations, etc. Let us suppose India decides to regulate
cryptocurrencies. How would it regulate and redress a case of mis-selling as it has no
access to the ledger, nor to any audit trail. As it is not always possible to know of the
persons who are the management for cryptocurrencies (e.g., bitcoin), at whom would
the regulatory action be directed? If for any reason the entire system collapses what
possible regulatory redressal exists for investors? These are questions with very
uncomfortable implications that do not have satisfactory solutions.
Conclusion
37. We have seen that crypto-technology is underpinned by a philosophy to evade
Government controls. Cryptocurrencies have specifically been developed to bypass
the regulated financial system. These should be reason enough to treat them with
caution. We have also seen that cryptocurrencies are not amenable to definition as a
currency, asset or commodity; they have no underlying cash flows, they have no
intrinsic value; that they are akin to Ponzi Schemes, and may even be worse. These
should be reason enough to keep them away from the formal financial system.
Additionally, they undermine financial integrity, especially the KYC regime and
AML/CFT regulations and at least potentially facilitate anti-social activities. More
substantially, they can (and if allowed most likely will) wreck the currency system, the
monetary authority, the banking system, and in general Government's ability to control
the economy. They threaten the financial sovereignty of a country and make it
susceptible to strategic manipulation by private corporates creating these currencies
or Governments that control them. All these factors lead to the conclusion that banning
cryptocurrency is perhaps the most advisable choice open to India. We have examined
the arguments proffered by those advocating that cryptocurrencies should be
regulated and found that none of them stand up to basic scrutiny.
38. Writing in the New York Times12 Adrian Chen noted as far back as 2013 that Bitcoin is
built on a weird mix of speculative greed bolstered by a utopian cyberlibertarian
ideology and likened it to a digital gold rush. Indeed, hyperbole continues to
characterise all aspects of the crypto world. Crypto messaging does not appear to be
directed at the rational or sensible. Global advertisements with themes such as the
'fortune favours the brave'13 is reflected somewhat in our very own 'lag ja re...kuch to
badlega'. It would serve us well if the understanding about cryptocurrencies goes
beyond the hype and gets rooted in reason and pragmatism.