Tag Archives: cryptocurrency

Crypto is new instruments and institutions, not new money

Posted on by

Speaking at the Paris Fintech Forum in June 2021, Francois Villeroy de Galhau, the Governor of the Bank of France, said that there is no such thing as a cryptocurrency, only crypto-assets. I understand what he means. Brett Scott, who is always thoughtful about such things, wrote making a similar point. He said that just as a child trading an action figure for a football (or whatever) “does not undermine the Federal Reserve (which issues dollars that both are priced in)” so “swapping a dollar-priced Bitcoin collectible for dollar-priced goods does not fundamentally alter the structure of the monetary system”.

Collectibles

NFT available direct from the artist at TheOfficeMuse (CC-BY-ND 4.0)

I have to say, I agree with them. While some people (quite rightly, in my opinion) saw Bitcoin as more of a protest movement than a viable alternative to the Bretton Woods world and while other people saw it as a replacement for a rotten the international money and financial system, I’ve been pretty consistent in my view that Bitcoin (to take the obvious example) is not money but a new form of digital asset that might, in certain circumstances, exhibit money-like characteristics.

In the very early days of Bitcoin, I met a number of people who saw crypto-assets as the basis for an alternative system of money and finance, a kind of trustless base layer for a universal “internet of value” that would sweep away the sclerotic institutions of global corporatism and unleash a new wave of capitalism. These people often talked about a new gold standard, although I’m not sure why, because society had long ago decided that a gold standard was not the best way to run modern economies. I don’t see any evidence that this alternative system is emerging. On social media we see what Concoda calls “ a non-stop stream of ‘freedom porn’” yet in reality the crypto-asset markets are thin, opaque and manipulated.

So if it is not money, what is it for?

Crypto Choices

In other words, why do people buy and sell crypto? I have often wondered whether most people dabbling in the leading cryptocurrencies see it as a protest movemement, an alternative financial system, digital gold or something else and now the question has been answered. The Bank for International Settlements (BIS) Monetary and Economic Department have just published a working paper (no. 951) Raphael Auer and David Tercero-Lucas called “Distrust or Speculation? The Socioeconomic Drivers of U.S. Cryptocurrency Investments”, which is a fascinating analysis of the market drivers in that space. What they find, using data from the U.S. Survey of Consumer Payment Choice, is that there no evidence at all that (despite the cacophony on Twitter and the ranting observed at cryptocurrency gatherings) cryptocurrency investors are motivated by distrust in fiat currencies or regulated finance. None. In fact crypto investors (speculators?) are no different to the general population with respect to security concerns over cash and commercial banking services.

Ultimately, then, people trade crypto-assets because (as David Gerard has consistently observed) “number go up”. This is essentially a post-modern digitally-turbocharged version of the greater fool theory that all you need to profit from an investment is to find someone willing to buy the asset at an even higher price, no matter whether the asset is worthless or not. A friend of mine, who recently made tens of thousands of pounds from buying and then selling a single NFT told me (I paraphrase) “maybe someone understands this, but I don’t”.

Future Markets

The crypto-asset market just like any other market. This is an important and serious conclusion of the BIS work, which implies that since the objectives of investors are the same as those for other asset classes, so should be the regulation. Cryptocurrencies are not sought as an alternative to fiat currencies or regulated finance, but instead are a “niche digital speculation object”. Quite. This is why I have always been much more interested in the world of digital assets, tokens and decentralised finance than the cryptocurrencies themselves. From this perspective, I can see that Circle (going public through a SPAC with a $4.5 billion valuation) makes sense: they provide the market with a token, the USDC “stablecoin”, that can be used in decentralised finance markets to execute trades through smart contracts. This has real utility and a window into a future of markets in which bots engage in complex trades around instruments that are too complicated for human traders to understand!

The crypto-asset market just like any other market. Click To Tweet

Unfortunately, the last time we let human traders loose on instruments they didn’t understand (mortgage-backed securities) they blew up the financial system. So what’s to stop the bots from doing the same? Well, it may be that we can make bots follow rules, whereas we can’t make human traders behave ethically no matter what the sanctions. I was interested to read in the BIS report that one “promising option” for supervisory and regulatory agencies to pursue is what the authors refer to as “embedded supervision”. In other words, embedding the supervisory framework for the trading of digital assets in the smart contracts themselves. This is a useful confirmation of the applicability of “ambient accountability” — a concept set out in detail in a paper by Richard Brown (now CTO of R3), Salome Parulava (then with Consult Hyperion) and me in our 2016 paper for the Journal of Payments Strategy and Systems — and reinforces the value of my “glass bank” metaphor for a more transparent and stable financial system.

Just to be clear, by the way, I am not saying that because as crypto-assets aren’t currencies they are not useful. Quite the contrary. In this respect I agree with the economist Tyler Cowen, who said in a recent podcast that “I don’t think of crypto as a currency. I think of it as a new set of institutions”. If these institutions can reduce the costs of financial intermediation (largely by reducing the costs of regulation, compliance and auditing) then they will make a very significant contribution to improving the lives of all.

(An edited version of this article first appeared on Forbes, 12th July 2021.)

Separating the sheepcoins from the goatcoins

Posted on by

Some people mine Bitcoin for profits but some some people mine it for politics. The operator of a Bitcoin mining pool (a group of miners who work together to share the profits) quoted in CoinDesk recently said that some are investing not to convert electricity into cash but for other reasons “such as to avoid capital controls or avoid sanctions”. Indeed. And this has some serious implications. The Foundation for Defense of Democracies (FDD), a Washington think tank, summarised the emerging situation rather well in their position paper “Crypto Rogues“. They noted that “blockchain technology may be the innovation that enables U.S. adversaries for the first time to operate entire economies outside the U.S.-led financial system”. Now, while this may be technically slightly inaccurate (there are ways to create anonymous transactions without a blockchain and, indeed, the Swiss central bank has just published a working paper describing how to do so) it again flags up that the widespread availability of decentralised financial services threatens to bypass the existing infrastructure.

Iran provides an obvious example. They have every incentive to want to try new approaches to skirt the long arm of American law. The country already published a new set of regulations designed to funnel Bitcoin mined by Iranians to the state so that the country can use them to pay for imports. When the Iranian regime, for example, set up a venture to explore Bitcoin payments with a Swedish startup, the Swedish banks refused it a bank account because they themselves did not want to become subject to secondary sanctions. As America’s Treasury Secretary Mnuchin said at the time (talking about Iran), “If you want to participate in the dollar system you abide by US sanctions”.

On the other side of the world, North Korea has been developing a digital currency of its own. According to Alejandro Cao de Benós, President of the Korean Friendship Association, the Democratic People’s Republic of Korea intends to go down the Facebook route by creating an asset-backed digital currency rather than a digital fiat currency and then use some sort of blockchain with “Ethereum-style smart contracts” to do business and avoid sanctions. The regime sees this as a way to enforce deals it makes with foreign counterparties by developing a “token based on something with physical value” (eg, gold) in order to create a stable mechanism for payments in international trade between the regime and “other companies/individuals” (although it will not be available to individuals in the DPRK, who will be stuck with the Korean Won).

Across the Pacific in Venezuela, a country often mentioned by Bitcoin enthusiasts as a living case study of the benefits of decentralised cryptocurrency in the fight against tyranny, we find more mining going on: a video posted on Instagram by the 61st Battalion of the 6th Corps of Engineers of the Venezuelan Army shows military buildings converted into giant cryptocurrency mining centres and a warehouse that appears to be full of specialist Bitcoin mining equipment is labelled the “Center for the Production of Digital Assets”.

(I noted with interest that they do not appear to be mining “The Petro”, the digital currency of the revolution which according to the Bolivarian Council of Mayors’ recent “National Tax Harmonization Agreement” may soon be required for the payment of taxes.)

What… Whatible?

It seems to me that Bitcoin is a pretty poor choice for sanction-busting shenanigans though. Not only is the record of transactions public, but the Bitcoin value is not fungible. This matters. Remember that 2014 IRS Ruling about Bitcoins being a commodity, so that traders would have to track the buying and selling price of each individual Bitcoin in order to assess their tax liability? No? Here’s a reminder : “the real lesson from the IRS Bitcoin ruling is that for a currency-or any payment system-to work, its units must be completely fungible”.

Fungible (from the Latin “to enjoy” via Medieval Latin phrases such as “fungi vice”, meaning “to take the place of”) is one of my favourite adjectives. It means that all tokens are the same and can be substituted one for another. You owe me a quarter. It doesn’t matter _which_ quarter that you give me. Any will do. Any quarter can substitute for any other quarter because they are all the same. The same is true of the Pounds in my bank account, but it isn’t true of bitcoins. They are all different and their history can be tracked through the blockchain which is, as we are often reminded, and immutable public record of all transactions.

As my good friend Marc Hochstein observed about this some time ago, blockchain’s openness could turn out to be a bug for law-abiding citizens. Click To Tweet

The lack of fungibility has major implications for criminals, but also for the rest of us.  In England, the High Court (in the decision of AA v Persons Unknown & Ors, Re Bitcoin [2019]) has already ruled that crypto assets such as bitcoins are a form of property capable of being the subject of injunction. You can see what is going to happen: cryptographic exchanges will be required to identity who owns stolen coins and the owner will then be the subject of legal action to recover them. This owner might be entirely innocent about the origin of the coins and will say that they didn’t know that the bitcoins they bought are the proceeds of a ransonware attack and may ask to the keep them. But, J.P. Koning points out, that’s not how property law works. Even if you accidentally come into possession of stolen property then a judge can still force you to give it back to the rightful owner.

Launderette

You can own these cartoons!
NFTs available from the artist Helen Holmes from at TheOfficeMuse (CC-BY-ND 4.0)

The UK has been experimenting with the “Unexplained Wealth Order” as a way to combat crime and corruption through the traditional money and finance system, but how would this translate to the world of cryptocurrency? Well, perhaps it doesn’t need to. In the world of Bitcoin, smart criminals may well try to use “mixers” or “tumblrs” that jumble together bitcoins to obfuscate their origin but I don’t think this will help in the long run. Apart from anything else, future consumers might want to know the provenance of their money, an idea explored by the artist Nitipak Samsen a decade ago in the Future of Money Design Awards. Check out the brilliant video he made here.

Have you ever wondered where the money in your pocket had come from? Who was the previous owner? Who was the owner before that? Might it be a famous celebrity?… Smart banknotes work by presenting a readable history of ownership on the note itself, an innovation designed to prevent money laundering. 

This might work in some interesting ways. People might pay a premium for coins that have an interesting past! Maybe coins that were used by a celebrity to buy drugs or were used to bribe a politician, coins that belonged to a murderer, that kind of thing, might be worth more than coins that belonged to boring people like me.

Clean Money

In the mundane world of dollar, dollar bills we have the concept of “money laundering” to describe what happens when dirty money is mixed with clean money (surely every one of us has touched banknotes that have been involved in some criminal activity!). But this doesn’t work for bitcoins. The “tainted” money stays tainted. Ross Anderson, Ilia Shumailov and Mansoor Ahmed from the Cambridge University Computer Laboratory wrote a terrific paper on this theme a couple of years ago. In “Making Bitcoin Legal” they pose some interesting questions about what to do with tainted cryptocurrency asking, for example, “If an identified customer says ‘Hi, what will you give me for UTXO x?’ and the exchange replies, ‘Sorry, 22% of that was stolen in a robbery last Tuesday, so we’ll only give you 78%’ does the customer then have to turn over the crime proceeds?”. Their idea of a public “taintchain” is an interesting way forward.  This would be a mechanism to make stolen coins visible, in which case they might display a futuristic Gresham’s Law dynamic as good coins drive out bad ones!

Whether by taintchain or some other mechanism, it’s actually pretty each to track dirty bitcoins. You can see where this might lead: if law enforcement agencies go to the biggest miners in the world and tell them that if they continue to confirm easily identifiable mixing transaction outputs, they will be accused of money laundering? This is not difficult to imagine, which suggests to me that Bitcoin’s lack of fungibility has far-reaching implications.

These implications have not gone unnoticed in the United States. Two of the largest Bitcoin mining companies there, Marathon Patent Inc. and DMG Blockchain Solutions Inc. (which together account for about a one-twelfth the power of the Bitcoin networks), recently joined forces to create the Digital Currency Miners of North America (DCMNA). This not-for-profit trade association has come up with pretty interesting idea: their miners will only process transactions that comply with American laws, thus extending the benevolent embrace of the U.S. Government into cryptocurrency. The idea (known as “clean mining“) is that instead of selecting transactions on the basis of which ones will bring the biggest fees, they will mine transactions based on the wallets that they come from.

Along the same lines, the “celebrity investor” (as described by CNBC) Kevin O’Leary announced that he will only buy bitcoins mined sustainably in countries that use clean energy. What’s more, he also said that he will not buy “blood coin” mined in China. Mr. O’Leary was quoted as saying that he sees “two kinds of coin”, which reinforces the point about fungibility and money and suggests to me, at least, that we could well see a strange and interesting twist in the world of cryptocurrency that has no analog in the analogue world of notes and coins: black and white money, or clean and dirty money, or light and dark money (an idea that goes back to the earliest days of cryptocurrency) in which some bitcoins will be worth more than others! Maybe a year or two from now, exchanges will be quoted two BTC-USD pairs: clean BTC at $100,000 and dirty BTC at $75,000. This doesn’t happen for GBP-USD or JPY-GBP, which confirms my feeling that whatever Bitcoin is, it isn’t currency.

[An edited version of this article first appeared on Forbes, 28th February 2021.]

Bitcoins stay dirty, no matter how much you launder them

Posted on by

Some people mine Bitcoin for profits but some some people mine it for politics. The operator of a Bitcoin mining pool (a group of miners who work together to share the profits) quoted in CoinDesk recently says that some are investing not to convert electricity into cash but for other reasons “such as to avoid capital controls or avoid sanctions”. Indeed. And this has some serious implications. The Foundation for Defense of Democracies (FDD), a Washington think tank, summarised the emerging situation rather well in their position paper “Crypto Rogues“. They noted that “blockchain technology may be the innovation that enables U.S. adversaries for the first time to operate entire economies outside the U.S.-led financial system”. Now, while this may be technically slightly inaccurate (there are ways to create anonymous transactions without a blockchain and, indeed, the Swiss central bank has just published a working paper describing how to do so) it again flags up that the widespread availability of decentralised financial services threatens to bypass the existing infrastructure.

Iran provides an obvious example. They have every incentive to want to try new approaches to skirt the long arm of American law. The country already published a new set of regulations designed to funnel Bitcoin mined by Iranians to the state so that the country can use them to pay for imports. When the Iranian regime, for example, set up a venture to explore Bitcoin payments with a Swedish startup, the Swedish banks refused it a bank account because they themselves did not want to become subject to secondary sanctions. As America’s Treasury Secretary Mnuchin said at the time (talking about Iran), “If you want to participate in the dollar system you abide by US sanctions”.

On the other side of the world, North Korea has been developing a digital currency of its own. According to Alejandro Cao de Benós, President of the Korean Friendship Association, the Democratic People’s Republic of Korea intends to go down the Facebook route by creating an asset-backed digital currency rather than a digital fiat currency and then use some sort of blockchain with “Ethereum-style smart contracts” to do business and avoid sanctions. The regime sees this as a way to enforce deals it makes with foreign counterparties by developing a “token based on something with physical value” (eg, gold) in order to create a stable mechanism for payments in international trade between the regime and “other companies/individuals” (although it will not be available to individuals in the DPRK, who will be stuck with the Korean Won).

Across the Pacific in Venezuela, a country often mentioned by Bitcoin enthusiasts as a living case study of the benefits of decentralised cryptocurrency in the fight against tyranny, we find more mining going on: a video posted on Instagram by the 61st Battalion of the 6th Corps of Engineers of the Venezuelan Army shows military buildings converted into giant cryptocurrency mining centres and a warehouse that appears to be full of specialist Bitcoin mining equipment is labelled the “Center for the Production of Digital Assets”.

(I noted with interest that they do not appear to be mining “The Petro”, the digital currency of the revolution which according to the Bolivarian Council of Mayors’ recent “National Tax Harmonization Agreement” may soon be required for the payment of taxes.)

What… Whatible?

It seems to me that Bitcoin is a pretty poor choice for sanction-busting shenanigans though. Not only is the record of transactions public, but the Bitcoin value is not fungible. This matters. Remember that 2014 IRS Ruling about Bitcoins being a commodity, so that traders would have to track the buying and selling price of each individual Bitcoin in order to assess their tax liability? No? Here’s a reminder : “the real lesson from the IRS Bitcoin ruling is that for a currency-or any payment system-to work, its units must be completely fungible”.

Fungible (from the Latin “to enjoy” via Medieval Latin phrases such as “fungi vice”, meaning “to take the place of”) is one of my favourite adjectives. It means that all tokens are the same and can be substituted one for another. You owe me a quarter. It doesn’t matter _which_ quarter that you give me. Any will do. Any quarter can substitute for any other quarter because they are all the same. The same is true of the Pounds in my bank account, but it isn’t true of bitcoins. They are all different and their history can be tracked through the blockchain which is, as we are often reminded, and immutable public record of all transactions. 

The lack of fungibility has major implications for criminals, but also for the rest of us. As my good friend Marc Hochstein observed about this some time ago, blockchain’s openness could turn out to be a bug for law-abiding citizens. In England, the High Court (in the decision of AA v Persons Unknown & Ors, Re Bitcoin [2019]) has already ruled that crypto assets such as bitcoins are a form of property capable of being the subject of injunction. You can see what is going to happen: cryptographic exchanges will be required to identity who owns stolen coins and the owner will then be the subject of legal action to recover them. This owner might be entirely innocent about the origin of the coins and will say that they didn’t know that the bitcoins they bought are the proceeds of a ransonware attack and may ask to the keep them. But, J.P. Koning points out, that’s not how property law works. Even if you accidentally come into possession of stolen property then a judge can still force you to give it back to the rightful owner.

Launderette

with kind permission of TheOfficeMuse (CC-BY-ND 4.0)

The UK has been experimenting with the “Unexplained Wealth Order” as a way to combat crime and corruption through the traditional money and finance system, but how would this translate to the world of cryptocurrency? Well, perhaps it doesn’t need to. In the world of Bitcoin, smart criminals may well try to use “mixers” or “tumblrs” that jumble together bitcoins to obfuscate their origin but I don’t think this will help in the long run. Apart from anything else, future consumers might want to know the provenance of their money, an idea explored by the artist Nitipak Samsen a decade ago in the Future of Money Design Awards. Check out the brilliant video he made here.

Have you ever wondered where the money in your pocket had come from? Who was the previous owner? Who was the owner before that? Might it be a famous celebrity?… Smart banknotes work by presenting a readable history of ownership on the note itself, an innovation designed to prevent money laundering. 

This might work in some interesting ways. People might pay a premium for coins that have an interesting past! Maybe coins that were used by a celebrity to buy drugs or were used to bribe a politician, coins that belonged to a murderer, that kind of thing, might be worth more than coins that belonged to boring people like me.

Clean Money

In the mundane world of dollar, dollar bills we have the concept of “money laundering” to describe what happens when dirty money is mixed with clean money (surely every one of us has touched banknotes that have been involved in some criminal activity!). But this doesn’t work for bitcoins. The “tainted” money stays tainted. Ross Anderson, Ilia Shumailov and Mansoor Ahmed from the Cambridge University Computer Laboratory wrote a terrific paper on this theme a couple of years ago. In “Making Bitcoin Legal” they pose some interesting questions about what to do with tainted cryptocurrency asking, for example, “If an identified customer says ‘Hi, what will you give me for UTXO x?’ and the exchange replies, ‘Sorry, 22% of that was stolen in a robbery last Tuesday, so we’ll only give you 78%’ does the customer then have to turn over the crime proceeds?”. Their idea of a public “taintchain” is an interesting way forward.  This would be a mechanism to make stolen coins visible, in which case they might display a futuristic Gresham’s Law dynamic as good coins drive out bad ones!

Whether by taintchain or some other mechanism, it’s actually pretty each to track dirty bitcoins. You can see where this might lead: if law enforcement agencies go to the biggest miners in the world and tell them that if they continue to confirm easily identifiable mixing transaction outputs, they will be accused of money laundering? This is not difficult to imagine, which suggests to me that Bitcoin’s lack of fungibility has far-reaching implications.

These implications have not gone unnoticed in the United States. Two of the largest Bitcoin mining companies there, Marathon Patent Inc. and DMG Blockchain Solutions Inc. (which together account for about a one-twelfth the power of the Bitcoin networks), recently joined forces to create the Digital Currency Miners of North America (DCMNA). This not-for-profit trade association has come up with pretty interesting idea: their miners will only process transactions that comply with American laws, thus extending the benevolent embrace of the U.S. Government into cryptocurrency. The idea (known as “clean mining“) is that instead of selecting transactions on the basis of which ones will bring the biggest fees, they will mine transactions based on the wallets that they come from.

We could well see a strange and interesting twist in the world of cryptocurrency that has no analog in the analogue world of notes and coins: black and white money, or clean and dirty money, or light and dark money (an idea that goes back to the earliest days of cryptocurrency) in which some bitcoins will be worth more than others! Maybe a year or two from now, exchanges will be quoted two BTC-USD pairs: clean BTC at $100,000 and dirty BTC at $75,000. This doesn’t happen for GBP-USD or JPY-GBP, which confirms my feeling that whatever Bitcoin is, it isn’t currency.

[An edited version of this article first appeared on Forbes, 28th February 2021.]

Tulips, steam and decentralised finance

Posted on by

When we are thinking about where the worlds of Bitcoin and cryptocurrencies, “smart” “contracts” and decentralised finance (defi) will go, it can be helpful to find historical analogies that can provide a shared narrative to facilitate communications between stakeholders and provide foundations for strategic planning. But it’s important to find the right analogies and, even more importantly, to derive the right lessons from them.

For example: people discussing Bitcoin will often refer to the famous “tulip bubble” in 17th century Holland. But if you study this episode, what you discover is not a mass market mania but speculation by a small group of rich people who could well afford to lose money. And you will also see the creation of a regulated futures market that played a role in the financial revolution that contributed to a Dutch golden age which meant that balances at the Bank of Amsterdam became a pan-European currency and, as noted in an interesting paper from the Atlanta Fed last year, the florin (the unit of account for those balances) played a role “not unlike that of the U.S. dollar today”.

FOMO

with kind permission of TheOfficeMuse (CC-BY-ND 4.0)

As I am very interested in learning from a) history and b) smart people, I set up a room to discuss the topic on Clubhouse. (I have to say this transformed my view of Clubhouse, because I was blown away by the quality of the discussion that ensued and how much I learned in such a short time. Truly, arguing with smart people is by far and away the fastest way to acquire actual knowledge!)

Cryptocurrencies are more like railway shares in Victorian Britain than tulips in the Dutch Golden Age. Click To Tweet

Aside from tulips, another well-known “bubble”, Britain’s 19th century railway mania, was the subject of some discussion in the room. This particular example is worth studying because I agree with Nouriel Roubini and Preston Byrne’s observation that that the cryptocurrency mania of today “is not unlike the railway mania at the dawn of the industrial revolution in the mid-19th century”. If you want to read more about this, I wrote a detailed article about it a couple of years ago and, in fact, noted the incredible scale of the mania in Financial World magazine a decade back: The first railway service in the world started running between Liverpool and Manchester in 1830 and less than twenty years later the London & North Western railway had become the Apple of its day, the biggest company in the world. This boom in turn led to a colossal crash in 1866, which then led to a revolution in accounting and auditing.

My good friend Maya Zahavi drew the parallel between railway mania driving the introduction of accounting standards that led to new global capital markets in Victorian times (which in turn led to new kinds of regulation and institutions) and that world of defi: The world of financial services, including lending, exchanges, investment and more that are built on shared ledgers and smart contracts. I think she is right. I have long held the view that while cryptocurrencies themselves may or may not have a future as money, the evolution of digital assets that are secured by the underlying networks (“tokens”) points towards new services, markets and institutions that may well lead to a better financial sector.

This view, that digital assets (“tokens”) are where the next generation of financial services will be forged, was reinforced in a new paper published in the Federal Reserve Bank of St. Louis Review. In it, Fabian Shar explores the evolution of markets based on tokens that sit on blockchains of one form or another. He looks at three models for “promise-based” tokens: off-chain collateral, on-chain collateral, and no collateral.

  • Off-chain collateral means that the underlying assets are stored with an escrow service, for example, a commercial bank. There are already several examples of off-chain collateralised stablecoins. The most popular ones are USDT and USDC which both USD-backed* ERC-20 tokens on the Ethereum blockchain.
  • On-chain collateral means that the assets are locked on the blockchain (in a smart contract).
  • Algorithmic tokens that are not backed by collateral at all, but whose value is maintained by algorithmic market interaction. This was, incidentally,  the original meaning of the word “stablecoins” that has now been hijacked by imprecision)

The trading of these tokens, if it were to take place in the existing market infrastructures, would be interesting enough. But to Maya’s point, this is not where we are going. We are heading into the defi era where there is an impending explosion of business models, institutional arrangements and transaction complexity which, when it settles, will leave us in a new financial world. I strongly agree with the view of Jay Clayton (when chairman of the U.S. Securities and Exchange Commission) that “everything will be tokenised” and the obvious corollary to this that everything will be decentralised. It is not the underlying cryptocurrencies that will be the money of the future but the that they support. As the St. Louis Fed’s paper concludes, and as I wrote in Forbes back in January, defi may potentially contribute to a more robust and transparent financial infrastructure.

In the long run (and the lessons from history are clear), I think this will be much more important and lead to much greater structural change (and therefore opportunities) than cryptocurrencies. We can already see the world of tokens entering the mainstream: Dapper Labs (the company behind the famous token game CryptoKitties) is as I write raising $250 million at a $2 billion valuation and Celo, a defi alternative to Facebook’s Diem, has just raised $20 million from (amongst others) noted Silicon Valley investors Andreessen Horowitz.

There are good reasons to welcome these pointers to the emerging paradigm. While defi is now mainly used for speculation between tokens of many varieties, in the longer term it offers the promise of much reduced costs in financial intermediation by both removing middlemen and automating them, it opens up the possibilities for new financial instruments better suited to the new economy (instruments built for bots to trade, not for people to understand). It also, and most importantly (for reasons discussed before), offers a more transparent market with accountability as part of the infrastructure. Don’t be put off by the Wild West of defi as it stands now, begin your scenario planning for defi as it will (inevitably) become.

*Does not constitute financial advice.

[An edited version of this article was first posted at Forbes, 15th February 2021.]

Crime, Coins, Cryptography and the Quantum Future

Posted on by

There are people who prefer to exist in a cash economy for reasons other than their negative economic analysis of central bank monetary policies or an attachment to the iconography of banknotes. Criminals and corrupt politicians, for example. Cash works rather well for them, but can sometimes be quite inconvenient.

Last year I wrote about two Californian working-from-home pharmaceutical freelancers who were arrested after police caught them dumping nearly $1 million in cash which was intended to buy Mary Jane for business purposes. Dumping a million bucks in notes is time-consuming and inconvenient, which set me thinking.

I can understand why the disconnected, marginalised poor in remote parts of the world eschew the benefits of electronic payments for the currency of choice for the global criminal on the go, the $100 bill. But in California? Don’t they have Bitcoin there? Given the huge hassle of counting, bagging and transporting the Benjamins, why didn’t these wacky baccy impressarios simply buy a few Bitcoins, drive to the drop zones and press the “giddy up” button when the goods were in place!

They stayed analogue. They packed up the greenbacks and set off in their car. It could have been that they’d read that quantum computers will be able to break Bitcoin’s cryptography next year and decided that the trunk of a car was the more secure alternative. The point is they were not interested in friction-free instant dollar dollars. So I must ask the obvious question: if drug dealers won’t use Bitcoin for purchases, who will? How can it be more convenient to cart around great wodges of cash than to zip some magic internet money through the interweb tubes?

It is important to note that Bitcoin is far from being a perfect solution for criminal on the go, though. Speaking at this year’s virtual Davos, Glenn Hutchin (co-founder of global technology investment firm, Silver Lake) said that Bitcoin is not the best choice for criminals and that “a drug dealer, for example, would not want to have to speculate on the price of bitcoin while selling his wares”. This clearly not true for all drug dealers: a counterexample being the Irish drug dealer who wisely decided to invest in cryptocurrency rather than euros and who amassed a fortune in digital loot. He hid the passwords to the digital wallets holding his ill-gotten gains in his fishing rod.

The drug dealer in question, Mr. Collins, was stopped but the Irish police in the early hours of the morning by chance. Unfortunately for him, he had €2,000-worth of weed in the car and he was arrrested. His properties were searched, and industrial scale cannabis farming was discovered.

He got five years.

Meanwhile, his 12 Bitcoin wallets, containing 6,000 Bitcoin (then worth $50m-ish but now worth $200m-ish) were seized by Ireland’s Criminal Assets Bureau (CAB). Unfortunately the fishing rod with the scribbled passwords had “gone missing” but CAB believes it is “only a matter of time” before computer advances allow them open the digital treasure chest.

Quantumvault

with kind permission of TheOfficeMuse (CC-BY-ND 4.0)

Presumably, by “only a matter of time” they mean that they are waiting for the quantum computers to come along a unlock the wallets. They are in good company, because a great many other people (eg, organised crime, unscrupulous “whales” and the tax authorities of many nations) are waiting for them too. Now, code-cracking quantum computers will happen (as I wrote 15 years ago), but they won’t happen tomorrow. Professor John Martinis, who used to be the top scientist in the Google quantum computing team, says that Google’s plan in this field is to build a million-qubit system with sufficiently a low error rate that error correction will be effective. He says that at this point, about a decade away, then the system will have enough logical quits that the system will be able to execute powerful algorithms that attack problems that are beyond the capability of classical supercomputers.

By “only a matter of time” they mean that they are waiting for quantum computers to come along a unlock the Bitcoin wallets. Click To Tweet

For technical reasons to do with public keys and things, the accountants Deloitte reckon that about four million Bitcoins could be stolen by a quantum computer. With Bitcoin at $30,000 that means a pot of a hundred billion dollars or so is at the end of the quantum rainbow. Well worth spending a few billion to build such a device if you are a criminal, well worth spending tens of billions or even hundreds of billions on such a device when Bitcoin has taken over and has become the need digital gold worth $1m each or whatever.

It’s a serious threat, and plenty of people have already started work on plans to migrate Bitcoin to more quantum-resistant forms of cryptography (see, for example, “Committing to quantum resistance: a slow defence for Bitcoin against a fast quantum computing attack” from 2018) but these schemes still need access to the old, vulnerable wallets to transfer the cryptocurrency to the new, less vulnerable wallets.

The idea of using quantum technology to make better electronic money is not a new idea, b the way. As the Swedish Central Bank’s recent working paper on Quantum Technology for Economists points out, out the original concept of quantum money (dating back to the early 1980s) exploits “the no-cloning theorem” proven by Wootters and Zurek (1982). This means that it is not possible to clone an unknown quantum state so a counterfeiter with unlimited resources will still not be able to copy a quantum coin. Therefore quantum cryptocoins can act more like actual coins (that cannot be double-spent) and that opens up some pretty interesting thinking. As my digital currency technology tree (below) shows, this opens up an interesting third way to pan-galactic digital currency in the future: we can prevent double spending of person-to-person digital cash in hardware (using chips), in software (using blockchains) or in nature (using qubits).

Digital Currency Taxonomy with Quantum

Still, assuming that the Irish police get hold a quantum computer before the Mafia do, there is a tidy amount sitting not only in Mr. Collins wallets (as there is in Mr. Satoshi’s) and the next time the Gardai pull someone over in the middle of the night it will be in a Lambo.

[An edited version of this post appeared on Forbes, 10th January 2020.]

PayPal’s Bitcoin strategy is about much more than bitcoin

Posted on by

Given that the people who are great supporters of bitcoin often talk about its key characteristic being that it is person-to-person, uncensorable value transfer you do have to wonder who will be using the new PayPal service that will allow them to pay merchants using the cryptocurrency. My good friend Ron Shevlin drew on a survey of 3,000 US consumers conducted by Cornerstone Advisors and FICO which found that around two-thirds of US smartphone users have the PayPal app installed (as I do), a seventh of all PayPal users already own some form of cryptocurrency and of those PayPal users, half of them used Bitcoin to buy products or services in the past year. So does this mean that the mass market use of cryptocurrency for payments is just around the corner?

I think not. The overwhelming majority of all cryptocurrency transactions are purely speculative and the people who think that bitcoin is a good investment* are never going to use it for payments. Bitcoin was originally billed as an elecronic cash system but most bitcoins aren’t used as currency in transactions for goods and services. Surveys have shown that the majority of bitcoin are held for speculative purposes and while some retailers accept Bitcoin, they see cryptocurrency purchases having a higher drop-out rate than cards and cash payments.

Paypalpassword

with kind permission of TheOfficeMuse (CC-BY-ND 4.0)

So this can’t be much of a payments play. Think about it. If you think that the bitcoin is going to the moon (and will be worth $1 million each within five years, as this former Goldman Sachs hedge fund person has just predicted) then why would you waste even a tiny fraction of a bitcoin buying the pizza or a Pez dispenser? No, the people who will use their PayPal wallet to exchange bank dollars for PayPal bitcoin are simply investing. If they choose to pay a merchant using bitcoin from their wallet, PayPal gives the merchant dollars anyway. Neither the consumer nor the merchant ever has any actual bitcoins in their possession.

When people do use bitcoin to buy things it tends to be things they can't buy using PayPal anyway. Click To Tweet

The amount of cryptocurrency spent on “dark markets” rose two-thirds to reach a new high in the final quarter of 2019, according to Chainalysis and the New York Times says that this data is likely to understate the number transactions for illegal purposes because the company cannot identify all activities relating to drugs, ransomware, tax evasion and money laundering. If I use bitcoin to buy illegal drugs, example, because of its “anonymity” and uncensorability, then I am hardly likely to start buying drugs using PayPal. The example of adult services makes this point rather well. Adult performers who are engaged in a perfectly legal business complain that PayPal refuses to allow payments to them and so they are forced to use third-parties who, according to the New York Times, take anywhere from a third to four-fifths of performers earnings in fees. Those people still won’t be able to use PayPal, whether in dollar or bitcoin, so the new service won’t make any difference to them.

PayPal’s Big Picture

Well, since the people who run PayPal are much richer and much smarter than I am, I am forced to conclude that they must have a plan that goes beyond earning some spreads from buying and selling cryptocurrency for retail speculators. I have no knowledge what PayPal are doing or why, but I do have some experience looking at strategies for financial institutions exploiting new technology, so I think I can make some informed guesses.

First of all, PayPal’s move is to be admired purely in marketing terms. The announcement put five percent on their stock price and garnered gazillions of column inches, links and commentary such as this. Even if they never turn a profit on bitcoin itself, their investment in software and licences has already paid off. I worked on a project for a global financial services financial services organisation a couple of years ago and I can remember the calculations around brand and exposure. To old-timers like me, PayPal is the grandparent of fintech, an upstart storming the walls of the entrenched incumbent financial services giants. But to youngsters, such as the son who I just asked about the company, PayPal are part of the establishment, no different to Wells Fargo or Barclaycard. A bit of cryptocurrency glitter does not hurt the brand, even if it is cosmetic.

Secondly, the technologies of cryptocurrency (shared ledgers, cryptographic proofs and so on) are going to be the foundations of a longer term shift to the trading of digital bearer instruments that are exchanged without clearing or settlement networks so building up institutional expertise is valuable. It’s reasonable to imagine that these instruments might well be implemented as tokens traded across decentralised networks, so exploring the trade-offs around infrastructures and interfaces is a good investment of time and effort.

Thirdly, and much more importantly though, I suspect that PayPal are making two much more strategic and long-term plays around the wallet and its contents. They are no doubt looking enviously across the water to the Asian “super apps” and thinking about the impending Alipay IPO. Turning PayPal from being a repository of balances to fund payments into a financial hub managing a number of different assets for a broad range of consumers is attractive to them. In their scenario planning, PayPal undoubtably started to think about the opportunities that will arise from the trading and management of digital assets (in the form of tokens) in the not-too-distant future. By gaining expertise in decentralised alternatives to commercial bank money and the regulation that does with them, PayPal is being very smart.

I don’t think PayPal’s experiment with bitcoin is really much about bitcoin at all. I think this is a measured and intelligent step towards the transactional environments of the future where digital assets compete with digital fiat across a payments landscape that is utterly different to that of today. As Ajit Tripathi pointed out, crypto-believers might feel they have occupied Wall Street but the reverse is true. Banks (and their regulators) have won and some of these interesting new digital assets are on their way to becoming part of the financial mainstream.

There is one particular category of digital asset that is inevitable: Central Bank Digital Currency (CBDC). In the run-up to the biggest IPO in history, Jack Ma talked about how digital currencies may play an important role in building the type of a financial system that will be needed for the coming generation and said that digital currency could “create value and we should think about how to establish a new type of financial system through digital currency”. Just as the Chinese government have begun to distribute their digital currency through third parties, including commercial banks and apps, so PayPal might reasonably expect to be an invaluable partner to the US government when it finally gets its act together to deliver some sort of digital dollar. If PayPal were to pivot away from the traditional infrastructure of banks and accounts, payments cards and interchange towards an infrastructure of wallets exchanging digital dollars (or perhaps, as Meltem Demirors speculates from a very well-informed perspective, their own alternative to Facebook’s Libra private currency) that would be a significant shift in the dynamics of the payments sector.

* I am not saying that I do or do not think cryptocurrency is a good investment. I am not making any comments that might be misconstrued as financial advice. Please note that any comments I make about cryptocurrencies as an asset class are for entertainment purposes only.

[This is an edited version of a piece that first appeared on Forbes.com, 25th October 2020.]

What is the point of the “travel rule”?

Posted on by

A couple of years ago, as you may have read in the Financial Times at the time, the Financial Action Task Force (FATF) extended their recommendations to include cryptocurrency exchange and wallet providers and such like, referred to as Virtual Asset Service Providers (VASPs). This meant that all countries must supervise and monitor these, and that they should apply anti-money laundering and anti-terrorist financing controls: that is, customer due diligence (CDD), suspicious transaction reporting (STR) and the “travel rule”.

The decision to apply the same travel rule on VASPs as on traditional financial institutions was greeted with some dismay in the cryptocurrency world, because it means that the service providers must collect and exchange customer information during transactions. The technically non-binding guidance on how member jurisdictions should regulate their ‘virtual asset’ marketplace included the contentious detail that whenever a user of one exchange sends cryptocurrency worth more than 1,000 dollars or euros to a user of a different exchange, the originating exchange must send identifying information about both the sender and the intended recipient to the beneficiary exchange. The information must also be recorded and made available to “appropriate authorities on request”.

This identifying information, according to the FATF Interpretive Note to Recommendation 16, should include name and account number of the originator and benefactor, the originator’s (physical) address, national identity number (or something similar) or date and place of birth. In essence, this means that personal information will be smeared all over the interweb tubes. My good friend Simon Lelieveldt, who is very well-informed and level-headed about such things, said at the time that this is a “disproportional silly measure by regulators who don’t understand blockchain technology”, which may be a little harsh even if not too far from the truth.

Anyway, some folks from the land of crypto have put together a standard for implementing the travel rule in the hope of spurring interoperability and reducing the costs for all involved. The standard, known as IVMS101, defines a uniform model for data that must be exchanged by virtual asset service providers (VASPs) alongside cryptocurrency transactions. The standard (you can download it here) will identify the senders and receivers of crypto payments, with such information “traveling” alongside the cryptocurrency transactions but along a separate path (that is, the IVMS101 messages do not themselves need the blockchain or any other crypto infrastructure).

(If you are wondering why it’s called IVMS101, it’s because the SWIFT MT101 message is the global standard request for the electronic transfer of funds from one account to another. For those of us in the payments world, MT101 is mother’s milk: mandatory Tag 20 Sender Reference, optional Tag 21 Customer Specified Reference and so on and so on. The MT101 message is used throughout the business world to send bulk payment instructions (ie, a header and multiple payment instructions in a single message). There is also the MT103 message that instructs a single transfer but this is mainly used to move funds between banks and other financial institutions such as money transfer companies.)

IVMS101 is pretty thorough and it sets out in detail what messages should be passed from (eg) one Bitcoin exchange to another, along the lines of:

if the originator is a NaturalPerson then either (
     geographicAddress
          with an addressType value of GEOG or HOME or BIZZ 
     and/or customerNumber
     and/or nationalIdentification
     and/or dateAndPlaceOfBirth )
is required.

This sort of thing is needed because there’s no global standard digital identity that could be attached to messages so market participants have to make do with national solutions or proxies. Nevertheless, it’s a good standard (as you’d expect when you see who wrote it) but uncharitable persons might well be asking what the point of it is because law enforcement agencies can already get this information by presenting a warrant. What the travel rule does is to, essentially, automate mass surveillance without a warrant or any other oversight and force personal information on to marketplace intermediaries (where, in my opinion, it doesn’t belong – my date and place of birth is no business of either intermediary exchanges or, indeed, the destination exchange). What’s more, since the travel rule is for value transfers between exchanges, it seems rather unlikely that it will catch any criminal flows at all.

I, for example, have a Coinbase hosted Bitcoin wallet and a Bitcoin wallet on a USB stick. If I want to send money to criminals, I will transfer it from my Coinbase wallet to my USB wallet and then from my USB wallet off via mixers to the criminal’s USB wallet and the travel rule is irrelevant. The uncharitable people mentioned earlier will undoubtedly observe that since the actual travel rule doesn’t seem to have stopped money laundering which is a massive global industry, there’s no obvious reason why the virtual travel rule will stop electronic money laundering on a similar grand scale.

The enforcement of a regulation (the travel rule) that was created over 20 years ago for a fast-evolving industry, may not be the best approach for cryptocurrency. Click To Tweet

Writing in this month’s Chartwell “Compass” magazine, Omar Magana hits the nail on the head with respect to the travel rule, asking if “the enforcement of a regulation that was created over 20 years ago for a fast-evolving industry, may not be the best approach”. Note that he is not arguing against regulation, he is arguing (as I do) for a form of regulation more appropriate for our age (for which I use the umbrella term “Digital Due Diligence”, or DDD) using artificial intelligence and machine learning to track, trace and connect the dots to find the bad actors.

I am genuinely curious to learn more about whether the travel rule will make the slightest difference to the money launderers, so please do let me know in the comments whether such scepticism is misguided or whether the travel rule will make the world a safer place.

Send lawyers, guns and Bitcoin passwords

Posted on by

One of the arguments about the transition to a cashless, less-cash or contact-free economy is that such an economy marginalises people who are trapped in the cash economy and is very bad for them. I’m not sure it’s bad for them, though. I don’t want people to be marginalised, of course, but the people who are trapped in the cash economy are the people who end up paying the highest costs. Just to pick one random news story this week (and I could have chosen many), here’s a case from China in which a man who didn’t trust banks buried his life savings underground five years ago. When he dug it up, a quarter of it was beyond repair and he lost 500,000 Yuan.

Of course, there are people who prefer to exist in a cash economy for reasons other than a fundamental lack of trust in the international financial and monetary system. Criminals and corrupt politicians, for example. Cash works rather well for them, but can sometime be quite inconvenient. For remote purchasing, for example. Only yesterday I read about two freelance pharmaceutical intermediaries who were arrested in California after police caught them dumping nearly $1 million in cash which was intended to buy marijuana some distance from their main place of residence.

(If you are wondering why they didn’t just Venmo or Square Cash the money along I-5, remember that the state of California imposes a 15% excise tax on licensed cannabis so the cash-based black market avoids tax. The state estimates the regulated market has captured less than one-third of activity, once again suggesting to me that the primary function of $100 bills is tax evasion.)

“Well, we’ll see how smart you are when the K9 come!” / I got 99 problems but the Bitcoin aint one.

California, incidentally, has a huge $100 bill problem right now. The coronavirus has disrupted supply chains so that drug dealers in the USA cannot use the normal trade-based cross-border money laundering pathways to pesos. Hence, Hugh quantities of dollars are piling up outside the financial system.

(In other news, the Fed reports that as of 8th April there are $1.84 TRILLION of Federal Reserve notes in circulation, around $200 billion more than this time last year.)

Now, I can understand why the disconnected, marginalised poor in remote parts of the world eschew the benefits of electronic payments for the currency of choice for the global criminal on the go, the $100 bill. But in California? Don’t they have Bitcoin there? Given the huge hassle of counting, bagging and transporting the Benjamins, why didn’t these entrepreneurs simply buy a few Bitcoins, drive to the drop zones and press the “send” button when the goods are in from of them. It only takes an hour or so for the half a dozen confirmations that the wholesale distributors would want to see, and then Bob’s your uncle. 

But no, they packed up the greenbacks and set off in their car.

Surely, I have to reflect, if drug dealers won’t use Bitcoin, then who will? There must be many people who don’t want to carry around huge wads of cash for such purchases. Why aren’t they in crypto? What about the millions of people who buy things that they would prefer not to show up on their credit card statements? Remember the newspaper story about noted England rugby player Lawrence Dallaglio’s credit card being used in a brothel in London? A police raid on the establishment uncovered burner phones, diaries, POS terminals, a bag filled with bank cards and receipts (what a well-run organisation!) showing that customers were were paying between £80 and £100 for a gram of coke and… no Bitcoin hard wallets or passwords written on Post-Its.

(If I was off to brothel and wanted to buy some cocaine while I was there, I would certainly be at the very least reticent to use my credit card, even if the establishment was PCI-DSS compliant, which I’m pretty sure a bag full of bank cards in a plastic bag in a toilet is not.)

Anyway, back to the point. How can it be more convenient to cart around great wodges of cash than to zip some magic internet money through the interweb tubes? That’s not to say that Bitcoin is the perfect solution for criminal on the go, though. For example, in a recent Irish case, a drug dealer who wisely decided to invest in cryptocurrency rather than the euro amassed a fortune of €54 million in digital loot. He hid the passwords to the digital wallets holding his ill-gotten gains with his fishing rod. Unfortunately, the fishing rod has “gone missing” so while the Irish Criminal Assets Bureau (CAB) has in theory confiscated the 12 wallets (containing 6,000 bitcoin), in practice they cannot get hold of them.

(On the other hand, thanks to people such as Chainalysis, the Irish police can at least find out who sent money to the wallet and where money from the wallets was sent to, which ought to help them further their investigations.)

The noted software entrepreneur John Macafee said, on a recent episode of the Breaking Banks radio show that I was co-hosting, said something similar. He said that Bitcoin is no good for this sort of thing because it can be traced (he has previously called Bitcoin “ancient technology”) and he advised listeners to use Monero instead saying that it hs 99% of the “dark” market right now and also that he is launching a distributed exchange for Monero in the near future. A recently published Rand Corporation study shows that Bitcoin and Monero dominate the black market with Zcash (the other leading privacy coin) nowhere to be seen. 

(The price of Monero has roughly halved over the last year so I guess that there just aren’t that many criminals out there right now, but who knows. )

I should note, though, that the issue of more private versions of digital currencies is not of exclusive interest to criminals and corrupt politicians. There are many people who are engaged in perfectly legal businesses (eg, selling weed in Colorado, performing adult services in Nevada or trying to buy food in Venezuela) that are still excluded from the global financial system and are therefore driven to look for alternatives.

Venezuela is an interesting example. It used to crop up in talks by Bitcoin fans although restaurants, shops, supermarkets and even the street vendors today accept – and prefer – dollars in cash or by bank transfer. You can pay by Zelle in supermarkets there! A Columbian start up, Valiu, has just launched to provide a USD “stablecoin” for the Venezuelan market so perhaps that might eat into the bank transfer market but I wouldn’t bet on it.

What, no Bitcoin?

What’s the niche for cryptocurrency then? A quick investigation tells me that the market-leading porn site accepts four cryptocurrencies, three of which I’ve never heard of, and not Bitcoin, Monero or Zcash although that may change soon as a number of campaigners have sent letters to Visa, Mastercard, Amex and all demanding that they stop processing payments for porn. Mastercard said that they were investigating claims made the and would “terminate their connection to our network” if illegal activity was confirmed.

If the porn people won’t use Bitcoin, then who will? Maybe taking payment cards away from sites such as PornHub will stimulate evolution in user journey and ease of use for Monero et al and push them into the mainstream at last.

(It won’t, of course. What will actually happen is that the porn and gambling guys will get together and launch an over-18 version of Libra which, as it will be the only way to pay for these services, will soon become the currency of choice for adult services.  You read it here first. Pretty soon, the average person will have a digital wallet full of Facebucks and Buttbucks and precious little else.

Digital currency is getting serious

Posted on by

North Korea is, apparently, developing a digital currency of its own. According to Alejandro Cao de Benós, President of the Korean Friendship Association, the Democratic People’s Republic of Korea intends to go down the Facebook route by creating an asset-backed digital currency rather than a digital fiat currency and then use some sort of blockchain with “Ethereum-style smart contracts” to do business and avoid sanctions.

Why use a blockchain? Well, the regime sees such “smart” “contracts” as a way to enforce deals it makes with foreign counterparties. Since it doesn’t trust the U.N., it relies on Chinese intermediaries to enforce deals abroad. But sometimes, so sources claim, those intermediaries cheat the North Koreans. Hence, they want to bypass intermediaries altogether by developing a  “token based on something with physical value” (eg, gold) in order to create a stable mechanism for payments in international trade between the regime and “other companies/individuals” (although it will not be available to individuals in the DPRK, who will be stuck with the Korean Won).

(This is not a new idea, by the way. A couple of years ago, the Venezuelans tried a similar idea “the petro”, a digital currency to be backed by the country’s natural resources — diamonds, gas, gold and oil — to beat the “financial blockade” imposed by the U.S. and others. I will check the world currency markets later on, but my general sense of the matter is that the petro is yet to topple the Swiss Franc. It, may, however have served as a useful input to other regime’s feasibility studies.)

This is why U.S. (and other countries) care whether the North Koreans launch an eWon that stops them from being cheated in international transactions. As the Financial Times points out, the U.S. has a genuine and well-founded concern that, the financial implications of a change to U.S. currency hegemony to one side, foreign countries will increasingly use digital currencies, “such as Facebook’s planned Libra coin“, to avoid sanctions. Indeed, this was one of the arguments that David Marcus uses. He says, for example, that a Chinese digital currency running on a Chinese permissioned blockchain could mean the potential for “a whole part of the world completely blocked from U.S. sanctions and protected from U.S. sanctions and having a new digital reserve currency”.

Sanctions are a serious thing and cryptocurrency doesn’t have a magic shield against them. An Ethereum developer was recently arrested for violating U.S. sanctions against North Korea. According to the U.S. Department of Justice, one Virgil Griffith was arrested at Los Angeles airport and charged with violating their International Emergency Economic Powers Act (“IEEPA”) by travelling to North Korea to give a presentation about using cryptocurrency to evade sanctions. As observers pointed out, Mr. Griffith may have evolved a sub-optimal communications strategy in connection with his travel plans.

A North Korean digital currency has every chance of succeeding under the stewardship of the Korean Worker’s Party and the divine tutelage of Kim Jong-Un, the Dear Leader. His father, the previous Dear Leader, most famous for being the greatest golfer in history, was responsible for an earlier experiment in radical transformation through money, when the DPRK fell into chaos after his government revalued the currency and restricted the trading in of the old money (thus wiping out the personal savings of counter-revolutionary running-dog lackeys of U.S. imperialism).

When the North Korean people were not eating tree bark to stay alive, they must surely have noticed that the revaluation of the unit of account didn’t make the slightest difference to the supply and demand for goods and services. It made a difference to the market, though. The revaluation and exchange limits triggered panic, particularly among market traders with substantial hoards of old North Korean won — much of which became worthless. Gresham’s Law took immediate effect: the KRW disappeared from the marketplace and people began to use whatever hard currencies they could get their hands on. The Dear Leader therefore launched an attack on this as well, banning everyone (including foreigners) from using foreign currencies such as euros or dollars. The authorities started a TV campaign asking good citizens to report anybody using dollars directly and I imagine that the same will apply to digital dollars or electronic euros.

So, if a North Korean digital currency based on gold or whatever does appear, would it help the regime and others to avoid sanctions? Well, it depends. It is certainly possible to design digital currencies that have unconditional anonymity that Bitcoin (for example) does not. Perhaps this is what Mr. Griffith was explaining to the North Koreans in Pyongyang, although to be honest they could have discovered this for themselves on the Internet without too much trouble. So let’s imagine that they do indeed create such a beast, a bastard child of ZCash and Quorum. What will happen? Well, in a recent “war-game” of this scenario hosted by the Economic Diplomacy Initiative and co-sponsored by the Belfer Center for Science and International Affairs at Harvard (involving U.S. administration veterans, diplomats and academics), the rise of an encrypted digital currency attacked the dollar’s international position and ended up allowing North Korea to bypass sanctions and build an intercontinental ballistic missile. Ruh roh, as they say on the internet.

(The North Koreans have other options for disruption using digital currency, by the way. See John Cooley’s book on counterfeiting Currency Wars, which is about various attempts to destabilise countries by forging their currencies. He talks a lot about North Korea’s “superdollar” forgeries and the like. Now, think what the coming version of this might be: not counterfeiting physical money, but creating electronic money. I can’t help but wonder whether the shift to digital money for retail and person-to-person payments will make a modern-day Operation Bernhard — Hitler’s plan to undermine the British economy by forging £5 notes — easier or harder?)

The Foundation for Defense of Democracies (FDD), a Washington think tank, summarise the situation quite well in their position paper “Crypto Rogues” observing that “blockchain technology may be the innovation that enables U.S. adversaries for the first time to operate entire economies outside the U.S.-led financial system”. Now, while this may be technically slightly inaccurate (there are ways to create anonymous transactions without a blockchain, but let’s take this use of “blockchain” to mean “third-party anonymous digital currency”) it does accurately flag up that the widespread availability of decentralised financial services threatens to bypass the existing infrastructure. The FDD are surely right to say that “blockchain sanctions resistance is a long-term strategy for U.S. adversaries”.

Now, whether using the blockchain to create an immutable record of sanctions-busting transactions is a good idea or not I couldn’t say, but as a general rule I’m someone who believes in the democratic process and therefore I’d prefer it if sanctions could not be so easily evaded. Especially when you consider why the sanctions are there in the first place.

(A recent U.N. report estimates that North Korea has generated some $2 billion for its weapons of mass destruction programs using “widespread and increasingly sophisticated” cyberattacks to steal from banks and cryptocurrency exchanges. It makes you nostalgic for the days when hackers were stealing credit card numbers to access porn.)

No-one would imagine that a digital currency by itself would render sanctions ineffective. When the Iranian regime, for example, set up a venture to explore Bitcoin payments with a Swedish startup, the Swedish banks refused it a bank account because they themselves did not want to become subject to secondary sanctions. As US Treasury Secretary Mnuchin said at the G7 in July (talking about Iran), “If you want to participate in the dollar system you abide by US sanctions”. There is no doubt, though, that moving transactions outside of the international monetary and finance system could help to make other sanctions-evading tactics more effective by making it more difficult to track, trace and monitor transactions.

Stablecoins and stable coins

Posted on by

I notice that in the considerable press comment concerning the possible introduction of a Facebook payment system and perhaps even a Facebook currency of some kind, commentators continually refer to a Facebook “stablecoin”. I am certain that they are wrong to use this term, because it does not mean what they think it means. I may well be facing a losing battle about this, but I am stickler for correct currency terminology.

So. Stablecoin. What?

In the Bank of England’s excellent “Bank Underground” blog, there was a post on this topic that said “The chances of a stablecoin keeping a stable price depends on its design. There are generally two designs of stablecoin: those backed by assets, and those that are unbacked or ‘algorithmic’”. They are right, of course, but I would like to present slightly more granular classification of stablecoin currencies. I think there are three kinds:

  1. Algorithmic Currencies, in which algorithms manage supply and demand to obtain stability of the digital currency. This is what a stable cryptocurrency is: since a cryptocurrency is backed by nothing other than mathematics, it is mathematics that manages the money supply to hold the value of the steady against some external benchmark. This is what is meant by stablecoin in the original crypto use of the term.

  2. Asset–backed Currencies, in which an asset or basket of assets are used to back the digital currency. I don’t know why people refer to these a stablecoins, since they are stable only against the specific assets that back them. An asset that is backed by, say, crude oil is stable against crude oil but nothing else.

  3. Fiat-backed (aka Currency Boards), which are similar to a asset-backed currencies but where the assets backing the digital currency are fiat currencies only. There are mundane versions of these already: in Bulgaria, for example, where the local currency (the Lev) is backed by a 100% reserve of Euros. 

As for that last category, it is effectively what is currently defined as electronic money under the existing EU directives, and therefore already regulated. Those coins backed by fiat currency, such as JPM Coin, simply provide a convenient way to transfer value around the internet without going through banking networks. Now, this may well be an advantage in cost and convenience for some uses cases but it is a long way from an algorithmic currency. If this is indeed what Facebucks turn out to be (ie, actual bucks that you can send around on Facebook, something along the lines of Apple Cash), then I have written before why I think they will be successful.

So will any or all of these catch on?

Predictions are of course difficult, but my general feeling is that it is the asset-backed currencies that are most interesting and most likely to succeed in causing an actual revolution in finance and banking. Algorithmic stablecoins and fiat “stablecoins” exist to serve a demand for value transfer, but this is increasingly served well by conventional means. I notice this week, for example, that Transferwise can now send money from the UK to Hong Kong in 11 seconds, a feat made possible by their direct connection to the payments networks of both countries. Why would I use a fiat token when I can send fiat money faster and cheaper?

Of course, you might argue that a digital currency board might allow people who are excluded from the global financial system to hold and transfer value but I am unconvinced. There plenty of ways to hold and transfer electronic value (eg, M-PESA) without using bank accounts. Generally speaking, people around the world are excluded because of regulation (eg, KYC) and if we want to do something about inclusion we should probably start here. If you are going to require KYC for the electronic wallet needed to hold your digital currency they customers may as well open a bank account, right?

(I’ve written before about how the need for an account hampered Mondex. When it was first launched, I went to a bank branch with £50 expecting to walk out with a Mondex card with £50 on it. What I actually walked out with was a multi-page form to open a bank account so that I could get a Mondex card which arrived some time later. And since I had to put my debit card into the ATM in order to load the Mondex card, I did what most other people did and drew out cash instead.)

I suppose there are some people who think that the anonymity and pseduonymity of cryptocurrencies might make them an attractive alternative to certain sectors, but this is probably a window. If cryptocurrencies were used for crime on a large scale then efforts would be made to police them. Bitcoin, in particular, is not a good choice for criminals since it leaves a public and immutable record of their actions but you can imagine a future in which the mere possession of an anonymous cryptocurrency becomes a prima facie cash of money laundering.

Looking at the “stable” stable, then, I’ll put my money on the middle way. I’ve said it before and I’ll say it again, there is a real marketplace logic to the trading of asset-backed currencies in the form of tokens and I expect to see an explosion of different kinds.