Representation of the Ethereum virtual currency standing on the PC motherboard is seen in this illustration picture, February 3, 2018. REUTERS/Dado Ruvic/Illustration
From a global monetary perspective, the emergence of cryptocurrency as a functioning measure of value globally will have broad implications for the Bretton Woods system.
Blockchain: Why U.S Technological and Financial Dominance is at Stake
The past twelve months have proven to be a banner year for blockchain and cryptocurrencies. The technology became a household name and the subject of breathless news coverage. Capital formation through so-called initial coin offerings (ICOs) approached $16 billion, surpassing traditional venture capital. A rogue nation-state created its own cryptocurrency to avoid sanctions, and the price of Bitcoin increased by nearly 1,000 percent to become arguably the largest financial bubble in the history of human civilization.
This Cambrian explosion of activity is an indication that these inventions, though still in their early and frothy stages, hold far-reaching implications for the global financial system and the United States’ standing as a global economic and innovation powerhouse.On the national security front, the actors that control these technologies will have substantial hard- and soft-power leverage at their disposal in a future where conflicts are waged in cyberspace and through the use of economic technology.
From an international monetary perspective, the emergence of cryptocurrency as a functioning measure of value globally will have broad implications for the Bretton Woods system, where the dollar’s status as primary reserve currency has afforded the United States no shortage of geopolitical leverage. Global financial institutions and organizations such as the International Monetary Fund (IMF), the G20, the Bank of International Settlements (BIS) and the Organization for Economic Cooperation and Development are closely tracking these trends and moving deliberately to understand the consequences.
Competitor nations are also keenly monitoring these developments, eyeing an enhanced role for themselves on the global stage and investing in their own proprietary versions of the technology. China, for instance, is investing billions of dollars into blockchain development and leads the world in blockchain patent filings. Russia has been quite candid in that it sees blockchain as a means of dethroning the United States from its financial and economic pedestal.
What’s definite is that a new digital monetary era is on the horizon; what’s uncertain is what role America will play in this system.
While the United States successfully employed a magic formula of light-touch regulation and targeted government support to spur the growth of the Internet two decades ago, it has taken a less visionary approach this time around. Instead, misconceptions, misunderstandings and a lack of regulatory clarity and applicability are inadvertently stifling innovation and forcing homegrown entrepreneurs to go elsewhere to build and test their products. These mistakes could result in the United States effectively ceding leadership in this area to other nations.
To date, the United States’ official stance toward blockchain and cryptocurrencies has largely centered on money laundering concerns, even though documented Bitcoin usage by bad actors—while a threat—is actually quite rare. In January 2018, the Foundation for Defense of Democracies found that just 0.61 percent of all transactions on the Bitcoin blockchain from 2013 to 2016 originated from an illicit entity. These concerns also frequently overlook the fact that blockchains are not inherently anonymous and can be programmed with Anti-Money Laundering (aml) and Know Your Customer provisions baked in, something that many good actors are actively trying to do.
The application of Industrial Era–regulatory taxonomy to new blockchain-fueled capital formation methods has also been a recurring theme. This reached a fever pitch in June when a Securities and Exchange Commission official remarked that ether, the native cryptocurrency of the Ethereum blockchain, is not a security in its current state—but didn’t offer concrete guide rails to similar projects looking to follow suit.
Such comments have obfuscated the role that crypto-tokens will soon play in economic activity and the true potential these systems offer—particularly in conjunction with other emerging technologies like artificial intelligence, the Internet of Things and robotic process automation. They also take for granted the question of the United States’ status as a leader in innovation, and fail to consider the steps it must take to spearhead the next technological revolution in the same way it led the last one.
At the crux of the problem is a regulatory logjam that applies yesterday’s rules to tomorrow’s economy. Numerous federal agencies have asserted jurisdiction over cryptocurrencies and issued confusing and even contradictory regulatory guidance, bogging innovators down with compliance costs and legal risk. States individually have their own diverse rules and regulations governing securities and money service businesses, complicating matters even further.
Such labyrinthine and non-malleable structures are a liability in a rapidly evolving state of play. In a 2016 essay about the onsetting Fourth Industrial Revolution, Klaus Schwab, founder and executive chairman of the World Economic Forum, argued that the ability of governmental systems to be nimble and adapt in the face of new technologies that redistribute and decentralize power will ultimately determine their survival.
As it currently stands, the United States is playing from behind in this emerging Distributed Era—in which business models and governance structures will be global, decentralized and mediated by technologies such as blockchains. There will be far-reaching implications if it is unable to regain a leadership position, as both technological and financial hegemony are at play this time around. Jobs, talent, capital formation and economic opportunity could be lost in the short term; technological dominance in the medium term; and a hastened phasing out of the dollar’s status as the global reserve currency in the long term. This development that would have unpredictable effects on both the United States and global economies.
But such a scenario is far from set in stone. By providing targeted action that affords regulatory clarity and relief, research and development support and a venue for experimentation with these technologies and business models until they can be better understood, as recommended in a July 2018 report by the U.S. Treasury Department, the United States can lead the next technological revolution in the same manner that it led the previous one.
Comparisons of the current blockchain boom to the Internet craze of the 1990s are frequently and appropriately made, as both periods have been characterized by rapid technological disruption and new forms of wealth creation. However, the reality is that the current pace of technological change far surpasses anything witnessed two decades ago. This heightened pace of change is attributable to the Internet’s maturity as a global communication platform—allowing for instantaneous collaboration, criticism and feedback loops. Further, enormous sums of money are being thrown directly at technologists who don’t have traditional boards, management structures or investors attaching strings to those funds.
In 2017, an estimated $6.5 billion was raised through ICOs, whereby a startup funds itself by issuing a native cryptocurrency for use in its platform rather than equity. This trend has showed no signs of slowing down in 2018, with $9 billion being raised via ICOs through June, according to Autonomous NEXT, an industry research group. This activity comes against a backdrop of a marked slowdown in companies undertaking traditional initial public offerings, with the number of public companies in the United States now just half of what it was twenty years ago.
The Internet comparison also fails to paint a full picture of how disruptive blockchain and cryptocurrencies will truly be. While the Dot-com Era was largely a technology and business model play, blockchain has broader implications for the high-tech, financial markets and supply chain–driven business models that are the primary sources of U.S. economic strength. Technological innovation joined at the hip with financial, economic and capital formation innovations will make the wealth created by Silicon Valley in the 1990s look miniscule. Thus, the threat posed by falling behind the blockchain curve is that of losing Internet leadership multiplied by the threat of losing leadership of the capital formation industry.
It’s a troubling exercise to imagine what the world might look like today had Internet giants Google, Amazon, Apple and Facebook developed elsewhere. It’s far more concerning to envision a future in which the protocols that undergird global finance and commerce are controlled by an unfriendly nation.
After Bitcoin was introduced in 2009 and incubated for years in the underworld of cypherpunk activists and anti–central bank libertarians, many U.S. financial and tech industry incumbents began taking heightened interest in the underlying blockchain systems around 2015.
To counter negative perceptions of Bitcoin, these incumbents began marketing a sanitized “blockchain, not Bitcoin” pitch that touts the technology, sans the cryptocurrency component, as a new type of database called “distributed ledger technology.”
While blockchain does have unique records management functionalities through its ability to seamlessly transfer value and achieve consensus among disparate parties that may not trust one another, the technology’s true value proposition has been overlooked: the ability to create programmable digital money that is governed by rules codified at the protocol level. This has led to the creation of economic ‘games’ in which the parties that play the game correctly and most effectively receive a financial reward that is significant enough to make playing by the rules more economical than trying to cheat.
Take Bitcoin. A disparate network of global players spends billions of dollars on computing power annually and consumes as much electricity as the nation of Switzerland, all in a race to be the first player to verify the transactions processed over the Bitcoin network—a process known as ‘mining.’ The winner earns a reward denominated in a ‘currency’ that exists only in cyberspace, yet today has a market capitalization in excess of $100 billion despite having no intrinsic value and no centralized authority ensuring proper conduct.
While the Bitcoin network will continue to exist in one form or another, history will remember its lasting contribution as being the sociological experiment that demonstrated how a decentralized global financial game can incentivize desired behavior. Using this new architecture, forward-thinking countries and entrepreneurs are exploring new crypto-economic systems that will spur tremendous wealth creation by facilitating an increased number of turns throughout an economy and efficiency gains in the form of reduced need for third-party trust intermediaries such as banks, auditors and regulators.
In this model, crypto-economic systems can offer built-in solutions to the aforementioned money laundering concerns. While many cryptocurrencies in existence today are anonymous or pseudonymous in nature, that is a byproduct of the developer’s intent rather than an inherent characteristic of blockchain technology. It’s equally plausible that a team or government could create a fully-transparent crypto-economic game that offers enough financial reward so as to make illicit activity less economical than playing by the rules.
Blockchains also provide transparent transaction tracking to such a degree that cryptocurrencies will be the tender that makes money laundering virtually impossible. An example of this came in 2015, when federal prosecutors used the Bitcoin blockchain to uncover a rogue fbi agent’s involvement in the illicit Silk Road online marketplace. Alternatively, if technologists continue to flee the United States in search of friendlier regulatory climates, U.S. authorities will find themselves at the mercy of foreign jurisdictions with far less-stringent aml rules—a challenge that fincen expressed concern about at a June 2018 congressional hearing.
Further, the nations that embrace blockchain and cryptoeconomics are priming themselves for significant economic breakthroughs. Price-stable cryptocurrencies that function as cash equivalents will significantly lower the cost of cross-border transactions and settlement, while providing businesses, consumers and governments a low-cost means of monetizing traditionally illiquid assets. These systems are creating new means by which businesses and governments can raise capital without issuing traditional debt or equity—such as through the sale of blockchain-based tokens that allow purchasers to buy down the cost of future goods and services.
Further, blockchain protocols will provide unprecedented levels of financial visibility into publicly-traded companies and supply chain networks, greatly minimizing counterparty risk for all stakeholders and potentially preventing the next Enron. From a trade policy perspective, antiquated instruments like tariffs and quotas could be replaced by crypto-economic import-export schemes that provide financial incentives for customers to undertake a desired behavior (i.e. purchasing American-made steel over illegally-subsidized Chinese steel).
The concept of programmable money will have numerous economy-wide applications. Government outlays could be earmarked, automated and deployed in ways that significantly reduce opportunities for corruption, thus opening the door to economy-wide efficiency gains. Small taxes, even basis points in value, could be shaved off of transactions and automatically routed toward tackling the pension and sovereign debt time bombs that confront both industrialized and developing nations.
Yet another underappreciated application lies in the concept of an atomic transaction—an all-or-nothing series of operations in which a set of states cannot be out of sync with one another. Currently, in any commercial transaction the financial status, legal status and accounting status of the asset being exchanged and the identities of the involved parties must be reconciled with one another. These four must then be reconciled with the real-world state of the asset, creating an (N2-N)/2 problem—where n is the number of states that must agree—in which a minimum of eight relationships must be validated by at least two parties, resulting in a minimum of sixteen separate validations. The reason most auditing and financial regulatory functions exist is to ensure that these states are in harmony, as most fraud, manipulation and error in commerce occur across these areas. However, the process of performing these reconciliations is both highly expensive and time-consuming.
Protocols built on blockchain can make it possible for these states to move in atomic fashion, rendering it impossible for them to be in disagreement and reducing the total number of reconciliations needed from sixteen, at minimum, to a maximum of two: the blockchain transaction record and reality. This innovation will severely reduce the need for the third-party trust intermediaries that are relied upon today to ensure the veracity of all types of transactions, and holds the potential to unleash trillions of dollars’ worth of efficiency gains globally.
Many countries have grasped these implications and are racing to gain the all-important first mover advantage by attracting blockchain talent, investing in the technology and facilitating cryptocurrency-based capital formation.
China sits atop nearly every list in this regard, even though it has been much maligned in the cryptocurrency space for its heavy-handed clampdowns on ICOs and Bitcoin exchanges within its borders. Behind the scenes, however, China has been aggressively investing in the technology, including but not limited to blockchain-specific investment funds, government-funded think tanks, a digital currency backed by the People’s Bank of China and even quantum computing that can potentially reverse-engineer the public key cryptography that secures blockchains.
Russia is aggressively pursuing blockchain to re-establish its technological superiority. At a 2017 meeting of the International Standards Organization the head of Russia’s delegation told the group, “The internet belongs to the Americans –– but blockchain will belong to us,” as reported by the New York Times.
Rogue and potentially hostile nations are experimenting with cryptocurrencies for purposes of avoiding U.S.-imposed sanctions, most notably the Venezuelan Petro that launched in early 2018. While the Petro is almost universally regarded as farcical in nature, it is a harbinger of what could happen if a critical mass of determined rogue states were to band together—especially given the reports that have emerged about Russia aiding the Petro’s development.
Japan became the first major country in 2017 to offer legal legitimacy to Bitcoin and cryptocurrency exchanges as a means of kickstarting financial innovation. Other industrial powers like the United Kingdom and the Netherlands are quietly ramping up their interest in blockchain as a bedrock for their respective economic futures. Canada also established a regulatory sandbox last year that has launched ICOs.
Jurisdictions reliant on financial services and commerce such as Singapore, Hong Kong, UAE, Switzerland, Malta, Mauritius and Gibraltar have proactively lured blockchain talent with innovation-friendly climates and regulatory sandboxes. Former Soviet bloc nations like Estonia, Lithuania, Belarus and Georgia are also using blockchain to digitize government services and have offered incentives to attract talent and investment.
While the aforementioned nations have rolled out the red carpet for blockchain and cryptocurrency entrepreneurs to set up shop, America’s approach has not been as welcoming. A great deal of early blockchain development originated in the United States—a testament to the deep talent pool and innovative climate held over from the Internet days—but businesses in the space have been confronted by formidable legal and compliance hurdles that have prevented them from deploying their business models in the domestic market.
Serious cryptocurrency companies in the United States must either wait patiently in a state of regulatory purgatory, issue tokens through ill-fitting means that restrict the customer base and resale ability, or bypass the U.S. market altogether. The result is that only the well-capitalized projects that can stomach substantial legal expenses currently have staying power in the United States. A March 2018 report by the Government Accountability Office (GAO) outlined how the convoluted framework for financial technology, or fintech, regulation in the United States is weighing heavily on the sector’s development. Ten federal agencies have claimed some form of jurisdiction over fintech, of which blockchain and cryptocurrencies can be considered a large subset. While many of these agencies—such as the Commodity Futures Trading Commission (CFTC)—have taken laudably forward-thinking approaches to cryptocurrencies and understanding the technology, the complexity of the maze has made it challenging for startups to even know which regulator to call when they have a question.
Depending on the specifics, cryptocurrency startups must grapple simultaneously with multiple federal agencies that employ overly broad definitions of the term. For instance, the CFTC views cryptocurrencies as commodities, the Internal Revenue Service (IRS) treats them as forms of property that are subject to capital gains taxes, fincen says they are a form of currency, and the Securities and Exchange Commission (SEC) announced in 2017 that many crypto-tokens are illegally-issued securities, and has been issuing subpoenas and enforcement actions.
This creates confusion about which regulator oversees a given activity, and it raises the risk that the United States will end up regulating the technology itself rather the activities it can be used for. By contrast, Hong Kong has four agencies involved in financial regulation, the UK has three and Singapore just one.
Additionally, many fintech companies are subject to state money transmission laws. While money transmitters must apply and maintain forty-seven separate state licenses, cryptocurrency innovators don’t yet know whether they need a license in every jurisdiction. Some states say yes, others say no. Most haven’t answered the question. To date, no cryptocurrency company has obtained all of the licenses required to operate across the entire United States, according to the Chamber of Digital Commerce, an industry trade group.
Not surprisingly, the GAO report found that businesses trying to navigate this labyrinth are spending extraordinary amounts of money on legal fees. Several surveyed businesses reported spending half of their initial capital raise on compliance alone, and many have decided to simply leave the United States altogether.
While these regulations are ostensibly in place for consumer and investor protection purposes, the GAO found that consumers aren’t being prejudiced by fintech companies any more than they are by other types of financial service businesses. In fact, consumers were more likely on a weighted basis to file complaints with the Consumer Financial Protection Bureau against traditional financial institutions than fintech startups.
While there are hurdles and unknowns associated with embracing any new technology, the greatest risk to the United States is that of sitting by idly in a state of “paralysis by analysis” as other nations aggressively advance ahead. Though blockchain is still in the experimental stage, the race to develop and utilize it is in full force. The societies that master it first will win out on both the technological and financial fronts.
Cyberwarfare could soon become yesterday’s news as economic tech emerges as a battleground of the future. In addition to penetrating or destroying cyber networks, state actors will look to syphon off economic value and activity from their competitors, weakening their currencies in the process. Should America remain on its current trajectory, it could soon find itself standing at the precipice of a perfect storm of painful repercussions. These would include lost jobs and economic opportunity, forfeiture of technological and financial hegemony, and a hastened transition away from the dollar’s reserve currency status—which has bestowed ample benefits on the domestic economy for seventy years, has allowed the United States to finance its burgeoning national debt and has effectuated the use of sanctions as a powerful tool in the nation’s diplomatic toolbox.
The most immediate consequence would be a loss of economic opportunity for American citizens, as business models that incorporate blockchains and crypto-economic financial games will soon be substantial drivers of value, jobs and talent and GDP-level economic impact in the places they are allowed to incubate.
Loss of leadership in capital formation, which is quickly becoming a global phenomenon, would soon follow. Cryptocurrency ecosystems can create globally decentralized economic networks that pool capital and risk at a scale that has only been achievable by governments in the past. If the United States chooses to recuse itself from these developments, the wealth and foreign direct investment flows these systems create—and the benefits to small and medium-sized enterprises they provide—will accrue elsewhere.
To unlock their full economic potential, these networks must be integrated with financial, regulatory and legal systems. The countries that do this will realize substantial reductions in financial and regulatory overhead, along with an enhanced ability for regulators and law enforcement to monitor and police with less need for heavy-handed enforcement actions. These new digital currency networks will also weigh on the dollar’s reserve status should nations and private companies adopt them for business-to-business and cross-border payments without thought to the effects on the dollar.
For now, the U.S. dollar still remains the dominant currency in international payments and trade. In 2014, 52 percent of all such transactions were settled in dollars, 31 percent in euros and 5 percent in pounds, according to SWIFT. Further, dollars were involved in 88 percent of all foreign currency exchanges in 2016, according to the Bank of International Settlements. It can be argued that this prevalence is artificial given that U.S. gross domestic product (GDP) represents just 24 percent of the total world economy. Because of this imbalance, seemingly small declines in the demand for dollars, particularly if they outpace the rate of global GDP growth, will have broad ripple effects that could create a global financial crisis far more significant than witnessed in 2008.
The 1.0 version cryptocurrencies currently on the market, such as Bitcoin and Ethereum, do not represent a tangible threat in this regard because of scalability and volatility limitations—as the BIS noted in a recent report. However, price-stable cryptocurrencies that can be pegged to either fiat currencies or baskets of commodities and currencies, such as IMF Special Drawing Rights, are rapidly being developed. Once these stability mechanisms are solidified and relevant money transmission approvals are obtained, these currencies could become reliable mediums of exchange and settlement in global trade.
These payment networks will likely be faster, cheaper and more convenient than the existing banking system by orders of magnitude, and will therefore see widespread adoption. There is ample demand for a digital payment medium that circumvents the existing dollar-dominated banking networks—particularly in regions of the world where the encumbrance of exchange rate conversions represents a sizeable value drain on a transaction. Should these alternative settlement mechanisms be created by a nation other than the United States and be decoupled from the dollar, worldwide demand for the currency would quickly depress.
Similar downward pressure on the dollar—and disruption to the Bretton Woods system—will come from central banks transitioning from fiat to digital currencies. In April, Kim Yong-jin, South Korea’s Deputy Minister of Strategy and Finance, raised eyebrows by publicly calling on the country’s central bank to “consider the emergence of alternative payment methods such as cryptocurrencies as a threat to the existence of the traditional fiat system.”
Though not cryptocurrencies per se, central bank digital currencies will present additional digital alternatives to dollar-based settlement. For instance, the Chinese and Russian central securities depositories have been coordinating on blockchain usage for nearly two years, and are thought to be developing a smart contract–based scheme that would allow parties to settle directly using cross-currency swaps.
The exchange rates of such sovereign digital currencies will eventually be governed by protocols, algorithms, oracles and smart contracts, reducing the need for central banks to hold hard currencies in their foreign exchange reserves—of which dollars currently comprise 64 percent.
While the eventual loss of the dollar’s international supremacy, and the “exorbitant privilege” it has bestowed upon the American economy, is nearly certain, the speed at which this could transpire in the age of cryptocurrencies could wreak havoc on both the American and wider global economy if not properly managed. The United States has reaped substantial benefit by virtue of the dollar being the lubricant of the engine that is global commerce. It has also afforded the United States the ability to print money to pay its debts and to conduct experimental monetary policy as a means of kickstarting its economy, most notably in response to the 2008 Financial Crisis. Despite meager returns, investors have long flocked to U.S. Treasury bonds as a low-risk “safe haven” in times of turbulence. A stark devaluing of the dollar would prompt a sell-off of Treasury notes. Investors would then demand higher yields in exchange for purchasing them, effectively putting an end to the era of cheap borrowing.
This would prompt a decrease in domestic purchasing power and also render America a market of reduced importance for exporters vis-a-vis faster growing emerging markets in Asia, thereby leaving American citizens less wealthy relative to the rest of the world. Taxes would need to be raised to finance continued deficit spending and service the national debt, along with unfunded liabilities like Social Security and Medicare. This would need to occur in conjunction with public sector spending austerity measures, prompting a further throttling of economic growth.
America should seek to promote and foster responsible new innovation in ways that offer consumer and investor protections and fraud enforcement, without sacrificing the technological and financial leadership roles it currently enjoys.
As the recent Treasury report on financial innovation and regulatory reform articulates, Washington doesn’t have the luxury of devoting several years to studying the pros and cons of these ecosystems, only to then determine what role it wants to play. Rather, Washington must allow for these new global industries to be led by domestic entrepreneurs, innovators and thought leaders. Unlocking productive and responsible developments in this space requires leadership from either the White House or Congress to demand and provide the regulatory and definitional clarity that innovators have been seeking. Moving forward, a more progressive and forward-looking approach to regulating will be required, predicated on an understanding that Industrial Era–rules simply won’t work for long at the current rate of technological advancement.
As Schwab of the World Economic Forum articulated, an “agile governance” approach is required: “Regulators must continuously adapt to a new, fast-changing environment, reinventing themselves so they can truly understand what it is they are regulating.”
This means that Congress and current involved regulators—particularly the CFTC, SEC, IRS, FinCEN and the Federal Reserve—must define the meaning of cryptocurrencies in the context of capital raising, investment or utilities, and articulate boundaries for innovators in this space while providing breathing room for experimentation. Over-regulating or creating excessive ambiguity will only exacerbate the current problems.
The creation of federal and state venues for experimentation can help shepherd these technologies with meaningful regulatory oversight and keep them contained until the implications can be better understood. The regulatory sandboxes that have been successfully deployed by places like the UK, Hong Kong and Singapore can serve as helpful guide rails. Further, nonpartisan and not-for-profit think tanks and research institutions focused on the economy-wide impacts of blockchain and cryptocurrencies, as well as implications for the future international monetary system, must be established and capitalized. These institutions should focus on the deeper issues of crypto-economic models, governance structures for decentralized business networks and how blockchain and related technologies can be leveraged to help regulators and law enforcement do their jobs more effectively.
Greater education efforts from innovators are also needed to help inform Congress and Executive-branch policymakers about the shifting technological landscape and the operational challenges posed by the current regulatory uncertainty. A vibrant two-way dialogue will be critical to asking the right questions about what this technology truly means for America’s position on the global stage. A discussion of the obstacles deriving from state regulatory dissonance should be encouraged, and states should work in concert with the federal government to ensure that entrepreneurs can offer their products throughout the country without excessive compliance burdens.
The United States proved two decades ago the model for fomenting, spurring on and leading a technological revolution that transformed the world—freedom and restraint of regulatory zeal. If it incorporates those lessons learned and takes steps to reinvigorate and provide a streamlined means of experimentation for its entrepreneurs and innovators, it can serve as the epicenter of yet another world-changing technological transition.