America's Crypto Dilemma

Safeguarding Security Without Suppressing Innovation.

This year, digital currencies entered the mainstream. China tested its first-ever digital currency in some of its largest cities last spring, hackers breached a major U.S. oil pipeline and successfully demanded a ransom of over $4 million in Bitcoin, cryptocurrencies surged to a record combined market capitalization of over $2 trillion, and Jerome Powell, the chair of the U.S. Federal Reserve, warned that cryptocurrencies are "highly volatile" and "may pose potential risks to the United States."

What many in Washington had disregarded for years as a pet project of techies and West Coast libertarians is now one of the most critical, if least understood, policy concerns on the Biden administration's agenda. Digital currencies are fueling enormous innovation that has the potential to increase the efficiency of entire economic sectors. However, they also pose different challenges to national security and the economy, and could potentially reduce the United States' influence internationally.

One reason digital currencies have such disruptive potential is that their software design frequently reflects a certain policy stance — namely, that the government should have less authority over money. Early adopters frequently invested their use of digital currency with political and philosophical significance. Even if the majority of Bitcoin buyers today are only interested in making a profit, the values inherent in the code are still included with every purchase. There are possible benefits to less government control of money, such as a reduction in the cost of payments. But it can also impede the ability of authorities to respond to economic crises, combat cybercrime and financial crime, and provide other fundamental services that citizens across the political spectrum expect.

Digital currency policy debates have reached a fever pitch due to the immense upside and downside potential. On the one hand, opponents of digital currencies view them primarily as criminal finance tools and have urged the government to limit their growth, with some even demanding a ban on private-sector coins. On the other side are evangelists who view digital currencies as revolutionary and have advocated for their fate to be determined by the private market.

But what the United States needs is a framework for public policy that takes a balanced approach, preserving the market's capacity for innovation without compromising the government's ability to carry out critical functions. In other words, politicians require both the humility to understand that markets will be most effective at sorting genuine innovation from hype and the confidence to enact essential safeguards. To this purpose, the Biden administration should erect barriers in the areas where virtual currencies represent the greatest collateral risk, notably in the government's ability to make monetary policy, maintain financial stability, and combat illicit finance. Concurrently, the United States should create the basis for the introduction of a digital dollar or endorse a private-sector solution that ensures the dollar's preeminent position in international payments. This two-pronged strategy would be a clever middle ground between the unproductive extremes of prohibiting digital currency and allowing the market to function unimpeded.

The U.S. government should respond swiftly. Beijing has recently cracked down on Bitcoin mining, and China and other nations are moving forward with their own digital currencies. Uncertainty regarding the United States' actions has contributed to the regulatory risk that looms over the business. The sooner the United States takes sensible steps to clarify its policies, the sooner innovation can flourish.

Cheaper, quicker, and riskier

There are both public- and private-sector digital currencies. The holders of sovereign digital currencies, such as China's digital yuan, have a direct claim on the central bank. As with conventional currencies, central banks validate transactions with sovereign digital currencies. In other words, virtual currencies are simply digital extensions of traditional currencies, with the exception that they can make central banks appear more like commercial banks. Depending on its design, sovereign digital currencies may allow regular depositors to have direct accounts with central banks and may augment rather than lessen government control over money.

In contrast, private-sector digital currencies rely on decentralized blockchain technology to settle accounts between users. These currencies include Bitcoin and Ether, whose value fluctuates relative to the U.S. dollar, and a subset of cryptocurrencies known as "stablecoins," such as USD Coin, usually known as USDC, and Facebook's Diem, which are tied to a fiat currency and meant not to vary in value. Instead than relying on a central authority such as the U.S. Federal Reserve, the blockchain technology that underpins digital currencies permits a community of users to validate transactions on a distributed ledger. A particular number of coin holders may be required to authenticate a transaction before coins can be transferred from one user to another, or coin holders may be required to confirm a cryptographic key. Users of a network fulfill the formerly centralized function of a central bank, regardless of the precise procedure.

If transactions are moved outside of the banking system, transaction fees may be reduced. Since 2018, the average cost of transmitting Bitcoin from one digital wallet to another has been approximately $4. For similar-speed transactions, the largest American banks charge consumers far more: approximately $28 for a domestic wire transfer (slower methods, such as using the Automated Clearing House, are less expensive) and approximately $40 for an international transfer. However, decentralized systems are not necessarily less expensive than centralized ones. A centralized ledger can be managed just as efficiently as a distributed one. Bitcoin eliminates most of the infrastructure and related expenses of the old, centralized banking system, which is one reason why transferring Bitcoin is cheaper than sending dollars. A portion of this infrastructure, such as anti-money-laundering systems, is indispensable. Therefore, the decreased cost of transferring Bitcoin and other cryptocurrencies partially reflects temporary reductions in regulatory and compliance costs. Other expenses of the legacy payments system, however, originate from inefficiencies that may be removed through competition. If the threat posed by cryptocurrencies compels the conventional payments system to reduce expenses, the United States would undoubtedly benefit.

In addition to providing cheaper transaction costs, cryptocurrencies are spawning a new breed of decentralized business ideas. Unlike Dropbox or Amazon Web Services, blockchain-enabled file-storage services allow anyone who joins a network to rent extra hard-drive capacity directly to other network members. Other companies enable the sharing and monetization of social media material independent of Facebook and Instagram. In what is known as "decentralized finance," the blockchain can also permit lending without the need for a bank. Numerous business models could be rethought with a community of users administering a network instead of a central organization. It is usually difficult to forecast how successful future technologies will be at replacing legacy systems, but the market will do a lot better job of determining this than the government.

As some cryptocurrency supporters contend, decentralization is not simply another instance of a new technology upending established industries. True, blockchain technology will need businesses to adapt. However, cryptocurrencies promise to displace more than simply private-sector incumbents. They can undermine some key government tasks that are valued by all parties; this is the risk that a limited framework for public policy should address.

WHO IS IN CHARGE OF THE MONEY SUPPLY?

The authority of the U.S. Federal Reserve to determine monetary policy is one of the greatest threats posed by cryptocurrencies. Although such a situation is improbable, it is possible that a cryptocurrency such as Bitcoin may become a prevalent enough means of exchange to remove a significant chunk of the money supply from the Fed's control. Moreover, despite the fact that cryptocurrencies typically have predetermined algorithms for currency growth or caps on the total number of coins, the majority of cryptocurrencies let a group of decision-makers, such as a majority of coin holders, to alter these protocols. Therefore, coin holders, and not central bankers, may decide whether to grow or decrease the amount of digital currency in circulation.

This is currently a theoretical worry. Bitcoin and other cryptocurrencies, despite being dubbed "currencies," are predominantly held as investment assets in the United States. Bitcoin is not used to price goods and services, thus most Bitcoin holders use it as a substitute for gold or stocks, and sometimes as a hedge against inflation. The Internal Revenue Service has declared that any transaction involving digital currency is a taxable "realization event," meaning that users must pay tax on any increase in the value of Bitcoin between the time they purchased it and the time they used it to purchase something. In other words, Bitcoin is classified as a stock for tax purposes, making its usage as cash unfeasible.

But even if the IRS were to modify its stance, Bitcoin and other cryptocurrencies would not be extensively used as a medium of exchange for a more fundamental reason: the dollar's price stability. In the past year, the price of a single Bitcoin has ranged from less than $15,000 to more than $60,000 per coin. Therefore, anyone that values their goods and services in Bitcoin must either accept this volatility risk or constantly adjust their prices to maintain dollar purchasing power.

However, not all digital currencies face the same barriers to mainstream adoption. Stablecoins, such as Diem, are often neither volatile nor taxable at the moment of use, in contrast to Bitcoin and comparable cryptocurrencies. As their name implies, they are stable because they are tied to the value of a fiat currency, such as always being worth $1. Because of this, there are no gains to be taxed when stablecoins are used in transactions, and there is no price risk for merchants that price their goods and services in stablecoins.

The total value of stablecoins has increased from approximately $10 billion to over $100 billion during the past year. Moreover, the backing of huge platforms such as Facebook increases the likelihood that digital currencies will gain widespread acceptance as a medium of exchange. As long as stablecoin platforms deposit a preset dollar amount into a reserve account for every stablecoin in circulation, this would not necessarily constitute a threat to the Fed's power to set monetary policy. The money supply could expand significantly if a stablecoin achieved widespread adoption and reduced its reserve requirement from, say, $1 per coin to 10 cents. Such a decision would not be taken by the Federal Reserve, but by a party authorized to alter the stablecoin's protocol, such as a private governing association or a proportion of coin holders. Not only would this remove the government from crucial monetary policy choices, but it might also allow foreign powers to gain control over the U.S. money supply, for instance by owning a majority of that stablecoin.

In a world where it is difficult to forecast how technology will evolve, authorities should take preemptive measures to prevent private-sector digital currencies from undermining the Federal Reserve's power over monetary policy. Particularly, they should increase the implementation of tax restrictions, such as those mandating the payment of capital gains tax on cryptocurrency transactions, so that non-stablecoins remain more appealing as an asset than as a medium of exchange. Recent legislative efforts to include cryptocurrency-specific tax reporting wording are a positive start in this regard. In addition, policymakers should mandate that stablecoins always retain a fixed reserve ratio, so that they do not limit the Fed's authority to determine monetary policy even if they reach widespread adoption.

UNCLEAR RULES, UNCERTAIN AUTHORITIES

In addition to complicating monetary policy, Powell cautioned earlier this year that cryptocurrencies might pose threats to the financial system. They trade on secondary markets, both over-the-counter and through exchanges that are widely accessible to the general public, but their regulatory framework is unclear. A source of uncertainty is whether cryptocurrencies are securities governed by the Securities and Exchange Commission (SEC) or commodities governed by the Commodity Futures Trading Commission (CFTC). There is considerable doubt in the sector regarding which regulatory system, if any, applies to which currency, based on the divergent opinions of attorneys on this issue. A $2 trillion market need greater clarity.

Even if a cryptocurrency plainly fell under the CFTC's purview, a second set of difficulties would persist. The CFTC can supervise futures markets for cryptocurrencies such as Bitcoin, but its authority over cash markets is restricted to punishing fraud and manipulation. The same exchange may support trading in both futures and cash markets for Bitcoin, for example, but the CFTC would only regulate futures markets. In the absence of federal regulatory authority, cash markets could be subject to different regulations in each of the 50 states, which would be both confusing for consumers and detrimental to American competitiveness; entrepreneurs will conduct less business in the United States if they must comply with 50 different legal regimes there, compared to a single regime in other nations.

Depending on the specifics of specific digital currencies, federal regulators may be able to discover inventive ways to exert their authority. Congress must ensure that someone has unambiguous regulatory authority, as cash markets for digital currencies could slip through a regulatory coverage gap between the SEC and CFTC. Congress need not be heavy-handed; it is not the government's responsibility to implement price controls to prevent speculation. However, Congress should move swiftly.

Besides jurisdictional difficulties, cryptocurrencies also raise concerns about financial stability. For example, minimal rules control stablecoin reserve or liquidity management. Consequently, coin holders may have difficulty exchanging their coins for dollars, and they may be exposed to greater danger than they know. To the amazement of many coin holders, the popular stablecoin Tether first claimed that its coins were backed by dollars but then discovered that it had placed its reserves in a variety of riskier assets.

So long as these currencies are not widely held, these risks will be carried primarily by the owners of individual coins. Nonetheless, if the collateral backing a systemically significant stablecoin were to deteriorate, a run on the currency could develop, affecting the stability of many markets - a scenario that grows more probable when the economy is already suffering problems. Existing regulatory frameworks, such as the one governing money markets, might be implemented partially for cryptocurrencies. Washington, though, has made little measures in this regard thus far.

ILLICIT MONEY

Allowing anonymity is perhaps the biggest immediate concern posed by cryptocurrency. The United States does not permit the anonymous and electronic transfer of huge sums of money. It mandates banks and money transfer companies, including Western Union, to collect identifying information and conduct some due diligence for high-risk transactions. Suspicious transfers and those over $10,000 must be reported to the Financial Crimes Enforcement Network, the division of the U.S. Treasury Department dedicated to combating illegal finance. These restrictions have not eliminated the existence of financial criminals, but they have created several difficulties for them. Cases of cash are cumbersome and risky, and anonymizing electronic transfers is challenging.

Unlike bank accounts, most digital currency ledgers just require a cryptographic key for identification. This greatly encourages illegal conduct, despite the fact that anonymous flows may be tracked on a blockchain ledger, which occasionally facilitates criminals' capture. The majority of digital currency transactions—roughly 60 to 99 percent, depending on how one measures—are for legal purposes, but the appeal of cryptocurrencies for criminals is evident: virtually all ransomware attacks, including the one earlier this year on a U.S. oil pipeline, demand payment in digital currency, and money launderers, terrorists, drug traffickers, and tax evaders also use the technology.

U.S. banking regulations permit the government to collect identification information for some digital currency accounts, but only at financial organizations, such as the currency exchange platform Coinbase, who have already taken steps to be responsible corporate citizens. The government has less apparent jurisdiction to compel the identity of users who keep their cash directly, such as on a USB drive or in a "non-hosted" digital wallet. As long as banking laws protect anonymity, private companies are limited in their efforts to identify the users of anonymous accounts. It is incredibly difficult to trace digital currency transfers across international borders and through previously unused, unhosted wallets.

Congress must enact legislation to minimize the negative impacts of anonymity, including by prohibiting massive anonymous bitcoin transfers that are illegal within the financial system. However, anonymity is not always negative, and policymakers could safeguard it under certain conditions. For instance, in totalitarian nations, ID verification would make it easier for governments to hunt down and potentially take the assets of their opponents. Therefore, policymakers must strike a balance between supporting freedom overseas and ensuring domestic security. One method to accomplish this would be to eliminate the need for identification for digital currency transactions under $10,000. Such an exception would allow the majority of families to meaningfully protect their assets (the median savings of a U.S. family is less than $10,000, and it is much less for families in the majority of autocratic nations), while making it much more difficult to purchase expensive weapons with digital currencies or demand six- and seven-figure ransoms. Similar to the usage of cash, this exception could also offer anonymity for smaller, everyday transactions.

Absence of a centralized body to monitor ID verification is a hindrance to reducing anonymity. Decentralized digital currencies resist this form of monitoring by their very nature. However, it is possible to overcome this difficulty by innovative thought. For example, digital currency exchanges or other private organizations may maintain lists of wallets whose users have been verified, and the algorithms that operate these currencies could automatically check users against such a list. However, policymakers should maintain a degree of humility and refrain from too prescribing how to manage a rapidly growing market. If politicians mandate ID verification, the market will offer decentralization-compatible and minimally disruptive solutions.

Policymakers will also need to be inventive in their approach to enforcement. Some digital currency users could be pushed toward anonymity-enhanced coins or offshore exchanges and wallets outside of U.S. jurisdiction if ID verification is required. In addition to not requiring ID verification, coins with increased anonymity, such as Monero, conceal other transaction data, such as amounts and wallet addresses, making them more difficult to track. Because their trademarks are so closely associated with anonymity, these coins may be less likely to comply with ID verification regulations and hence more likely to attract illegal users. However, such a result would not necessarily be entirely negative, as it would provide authorities tracking illegal finance with a focal point for their efforts. As indicated by the prevalence of regulated platforms such as Coinbase, the vast majority of digital currency users are not engaging in illicit activity, and many would likely accept ID requirements comparable to those required for cash deposits or stock purchases. Users who reject these conditions and migrate their transactions to coins with better anonymity will have provided law enforcement with vital information.

The growth of offshore digital currencies is a concern that the G-7 and the G-20 should address by coordinating as they do with other financial matters. In reality, digital currencies are already a topic of debate when these international bodies convene, and a number of nations have signaled their intent to crack down on the unlawful usage of digital currencies. To discourage criminals from forum shopping, the United States should take an active role in influencing these talks and encourage other nations to adopt restrictions similar to those it enacts domestically.

A DIGITAL DOLLAR

Geopolitical concerns are the last type of threats offered by digital currency. The majority of the world's major central banks are considering creating sovereign digital currencies, sometimes known as "central bank digital currencies," in response to the proliferation of private digital currencies and the problem of sluggish and expensive payments. In light of this, the United States must evaluate the risks to the dollar's international position if it does not establish its own digital dollar.

This risk is frequently oversimplified as a concern that China's digital yuan may jeopardize the dollar's reserve position. Beijing has not concealed its goal to boost the proportion of foreign payments denominated in yuan at the expense of the dollar. Mu Changchun, the head of digital currency at China's central bank, has expressed China's intention to reduce "dollarization" in the global economy. Moreover, the Chinese Communist Party cherishes the data and monitoring capabilities that the digital yuan will provide to the authoritarian state. China's intention to project economic influence via the digital yuan is evident when viewed alongside its massive infrastructure investment initiative, the Belt and Road Initiative.

However, the United States must evaluate Beijing's aspirations in light of its capabilities. China confronts a number of structural disadvantages, including a regulated exchange rate and a lack of economic openness, which will make it impossible for its sovereign digital currency to challenge the dollar's standing as the world's reserve currency in the near future. Some will adopt the digital yuan, and others may be coerced or coerced into using it as a condition of doing business with China; Washington must hold Beijing accountable for this. However, apprehensive of China's capital controls and deteriorating property rights, the majority of people are unlikely to abandon the dollar for the digital yuan in sufficient numbers to undermine the dollar's reserve status. In other words, the same real-world constraints that have historically restrained China's fiat currency will also restrain its digital currency.

The digital yuan could aid Beijing's facilitation of sanctions evasion, which is a greater but mostly underestimated issue. The United States may ban the sale of weapons to North Korea, for example, by adopting secondary sanctions that prohibit Americans from doing business not only with the North Korean military but also with any foreign company that does business with the North Korean military. Because no financial institution can afford to lose access to the U.S. financial system, almost none will arrange payments for Pyongyang's military acquisitions. The digital yuan may allow North Korea to circumvent the banking system. If a foreign corporation that does no business in the United States wishes to sell to a North Korean military entity, both parties may create accounts with the Chinese state bank, allowing money to travel between them without touching commercial banks, thereby circumventing U.S. sanctions. The introduction of a digital currency would have no effect on this threat.

Although the United States must be cognizant of the threats posed by the digital yuan, particularly its potential to undercut U.S. sanctions, the threat to the dollar-based international monetary system is much broader than China alone. International transactions are typically expensive and delayed. They pass via a patchwork of several national systems and multiple commercial banks, which is a costly and time-consuming operation. Clearly, a new system designed with a global economy in mind might increase efficiency, which is one reason so many countries are considering adopting digital currencies issued by their central banks. If central banks agreed to provide foreigners with direct account access, adopted common standards, or even shared technology, international payments could become more streamlined and cost-effective than the current dollar-dependent system, thereby eroding the dollar's position on the international stage.

However, despite the reality of this threat, the United States should not worry. With the exception of China, the majority of nations are in the early stages of developing central bank digital currencies, and the United States is engaged in international discussions aimed at establishing standards for the underlying technology, which means it will be able to shape those standards. In addition, the Federal Reserve is currently studying the technological possibilities for a digital dollar in collaboration with the Massachusetts Institute of Technology. Even if the United States does not create a digital dollar, it may be able to endorse one or more private-sector digital currencies that facilitate low-cost international payments. Depending on how the international scene evolves, a properly regulated stablecoin may be able to fulfill the need for efficient dollar transfers.

The United States must also evaluate the consequences of a digital money for domestic policy. Providing direct access to Fed accounts to the public could facilitate the incorporation of the approximately five percent of Americans who are now unbanked into the nation's financial system. But a digital currency might also raise privacy problems if the government is privy to individual spending decisions or lead to government overreach if deposits are guaranteed in exchange for compliance with a contentious social program. In addition, Fed accounts could cause banks to lose deposits, which would reduce their capacity to provide loans and hinder economic growth.

There are methods for mitigating these risks, including using private-sector intermediaries that do not share spending information with Washington, limiting what the government may do through Fed accounts, and capping the size of Fed accounts. However, the United States must balance these local reasons with the need to ensuring that international dollar transactions are supported by technology that is efficient, resilient, and interoperable with technology being developed by other central banks. This might be accomplished with a digital dollar or a properly regulated alternative from the private sector, such as a stablecoin. To secure the worldwide position of the dollar, which has brought stability to the United States and its allies for decades, Washington must adapt to and influence the global transition toward central bank digital currencies.

A PATH FORWARD

If digital currencies continue to gain popularity, the discussion surrounding how to regulate them will only intensify. It will be challenging for Washington to find a middle ground. Because digital currencies affect so many policy areas, they cut across the traditional decision-making silos of the U.S. government, increasing the likelihood of bureaucratic snags and risking a disjointed, piecemeal approach. Several agencies within the executive branch, including the Treasury Department, the SEC, the CFTC, the Federal Reserve, the Justice Department, and the State Department, have a stake in the problem. Several various congressional committees, including those on banking, finance, agriculture, and foreign affairs, are interested in digital currencies.

The Biden administration should regularly convene a high-level group similar to the President's Working Group on Financial Markets, which includes the treasury secretary, the Fed chair, the SEC chair, and the CFTC chair, but with the addition of the attorney general and the secretary of state or their deputies. Congress might also form a bipartisan task force to seek committee-wide consensus.

The majority of Americans want their government to be capable of responding to economic downturns, preventing widespread financial instability, and combating terrorism and other crimes. However, the majority also seek to take use of the inventive possibilities of new technologies such as digital currency. Both of these goals can only be attained through the implementation of sensible safeguards and, ultimately, a digital currency or a properly regulated private-sector alternative. The control of government funds must be determined not only by software developers, but also by elected officials who are accountable to the American people.

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