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.

Mumbai (ABC Live India):  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?

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.

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.

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.

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.

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?

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.

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.

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.

(What, if any, are the risks posed to a society or an economy?

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

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.

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.

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.

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

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.

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.

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.

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.

Conclusion

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.

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.

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Explained: The Basics of the Cryptocurrency