The Death of Cryptocurrency

I. Introduction

Despite a decade of hype and a largely hands-off approach from regulators, cryptocurrency technology has not revolutionized payments or other parts of the financial system. The most ambitious attempted integration of cryptocurrency into the economy at-large thus far was a spectacular failure.

The truth about cryptocurrencies is that they fail to accomplish nearly every objective they purportedly were created to achieve. They do not work as currency or a store of value. They are neither trustless nor decentralized. They cannot create a new paradigm for the web, finance, and micropayments.

II. The Theory of Cryptocurrency Payments and Digital Money

Our modern economy runs on digital money: our "money" consists of entries in ledgers maintained by trusted and regulated institutions. For decades we have used electronic payments on a daily basis, using payment systems maintained by these regulated intermediaries.

The idea behind Bitcoin was to enable electronic payments that behave more like cash. In Bitcoin there purports to be no need to rely on trusted intermediaries. Bitcoin transactions, like cash, are irreversible—but unlike cash, they are electronic in nature.

III. The Practice of Cryptocurrency Payments

The irreversible design and volatile nature of most cryptocurrencies makes them unsuitable for use as a payment channel for either domestic or international payments. The inherent volatility means that the recipient will, at some point, need to convert from the cryptocurrency back to local currency.

Transactions with two currency conversion steps can become significantly more expensive than conventional payment methods. The irreversibility of cryptocurrencies also creates an incompatibility that makes cryptocurrencies hard to buy due to increased cost of transaction between buyer and seller.

Beyond speculation, cryptocurrencies serve as an effective payment channel for items which would not be processed by the normal payment channels, or where physical money is simply too bulky or restrictive to use.

IV. The Theory of Decentralization and Distributed Systems

Cryptocurrency advocates claim that the underlying technology offers a huge advantage over existing systems through "decentralization," with hundreds or thousands of systems all acting independently but creating and maintaining a common view of the world.

For a generation we have successfully built distributed (also sometimes termed federated) systems. In a distributed or federated system, we have a collection of named and identified actors who are explicitly trusted within their limited sphere of operation.

V. The Practice of Decentralization

In the end, all decentralized systems rely on some form of a voting scheme to decide the current state of the world. The biggest problem faced by decentralized systems is the threat of "Sybils"—fake participants created to gain a larger share of any voting system.

Proof-of-work systems inevitably converge into a system where a few entities control the majority vote of the network. As of this writing, five entities control 75% of the vote on the Bitcoin blockchain.

In all of these decentralized systems, trust relationships continue to exist but are hidden and obscured. Cryptocurrency participants need to trust the code that runs their wallets, the exchanges where they trade their cryptocurrencies, the miners who maintain the public ledger, and the developers who code the cryptocurrency itself.

VI. The Theory of "Smart Contracts" and Programmable Money

Another promise of the cryptocurrency space is to enable "programmable money": instead of simply having our money be a passive ledger, we can program actions to occur based on events. This claim neglects that we've had such systems for generations.

In theory, cryptocurrencies such as Ethereum, which enable "smart contracts," are intended to replicate the functionality that already exists within our financial system within the cryptocurrency space.

VII. The Practice of "Smart Contracts"

In practice, these smart contracts have proven to be a disaster. Unlike the programmable money that runs our society, smart contracts have two massive defects: they run on an irreversible fabric and are open to the world for potential exploitation.

If a smart contract has a bug that causes a loss of value, there is no remedy unless the underlying blockchain is updated to undo the effects. This has regularly resulted in multi-million-dollar losses.

The "computer" these smart contracts actually execute on is remarkably poor. The entire Ethereum "global computer" has effectively 0.02% the computational power of a $45 Raspberry Pi 4.

VIII. The Theory and Practice of DAOs and Join-Stock Companies

Most modern corporations are effectively autonomous organizations. There is a group of managers in charge of day-to-day operations who receive a salary or other compensation. The shareholders themselves can collectively vote on proposals on how the company should be governed.

A DAO is an attempt to replicate this corporate structure but using an existing cryptocurrency as the fabric for voting. The only major difference between a DAO and a modern joint-stock corporation is the paperwork.

The result is the commercialization of "securities fraud by proxy." A venture capital firm invests in a blockchain-related startup that issues tokens, allowing the VC to profit without needing to create a viable-enough company to withstand mandatory disclosures.

IX. The Theory and Practice of Stablecoins and Banknotes

During the "Free Bank Era," the US government only issued money in the form of coins. State-chartered banks would accept coinage and in return issue paper notes. This system had problems, notably "wildcat banks" that issued banknotes not actually backed by specie.

Backed stablecoins literally recapitulate the model of the free bank era. A stablecoin issuer accepts a deposit and returns an equivalent amount of the stablecoin. This stablecoin is now a digital bearer asset that can be arbitrarily transferred.

There is substantial evidence that the price bubbles seen in both 2017 and 2021 were largely driven by the issuance of new tether, as Tether printed billions of new coin.

X. Regulatory Principles

By now, it should be clear that the cryptocurrency space is not novel and cannot improve our existing financial system in a meaningful way. Instead, most innovations involve recapitulating the real financial system, overlaying it with a surfeit of historical frauds and failures.

Fortunately most of the regulations constructed to deal with the cryptocurrency-related failures are also old, and most implement a "duck test": if it looks like a duck, quacks like a duck, and swims like a duck, it's probably a duck.

XI. Regulating Tokens

Cryptocurrencies don't work for legal, above-the-board payments. Instead the legal use is restricted almost exclusively to a speculative casino where participants bet on whether the value of tokens goes up or down.

Newly released cryptocurrencies and related items generally fall into at least one of four categories: new "L1 cryptocurrencies," "utility tokens," "governance tokens," and "non-fungible tokens." All except NFTs are securities under existing US law.

The SEC should start by reminding the cryptocurrency community that newly issued tokens, unless formally specified otherwise, fall under the Howey Test.

XII. Regulating Cryptocurrency Exchanges

Cryptocurrency exchanges take three forms: lightly regulated exchanges with banking ties, unregulated offshore exchanges without significant bank connections, and decentralized exchanges that operate directly as a combination of a smart contract and a web page.

The lightly regulated exchanges must be more heavily regulated. To begin with, these exchanges are acting as broker/dealers—after all, their pitch is that individuals are "investing" in cryptocurrencies. Thus they should be regulated like broker/dealers.

The offshore exchanges represent two additional problems which need further regulatory action: money-laundering risks and blatant market manipulation.

XIII. Regulating Stablecoins

The final area that needs substantial regulation is the backed stablecoins. In the end, the backed stablecoins like Tether and Circle are the foundation upon which the entire edifice of unregulated exchanges are built.

The philosophy for regulating stablecoins should be straightforward: all users of a stablecoin are considered customers of the stablecoin issuer for all relevant money transmission regulations.

This would require just a minor technical change for the stablecoin's underlying smart contract. Instead of allowing the stablecoin to be transmitted between arbitrary individuals, the code should be modified to only allow transfers between individual public keys vetted by the stablecoin issuer.

XIV. Conclusions

Regulators, especially regulators in the United States, often fear accusations of stifling innovation. As such, the cryptocurrency space has grown over the past decade with very little regulatory oversight.

But fortunately for regulators, there is no actual innovation to stifle. Cryptocurrencies cannot revolutionize payments or finance, as the basic nature of all cryptocurrencies render them fundamentally unsuitable to revolutionize our financial system.

When regulating cryptocurrencies, the best starting point is history. Regulating various tokens is best done through the existing securities law framework, an area where the US has a near century of well-established law.