Money Reimagined: This Isn't Good for Bitcoin

No, blockchain does not fix this.

By “this” I don’t mean centrally controlled databases that are vulnerable to attack, the problem highlighted by this week’s massive Twitter hack.

I mean the meta problem of yet more bad publicity, with the word “bitcoin” again associated with fraud and unsavory behavior, a picture that cryptocurrency advocates will again struggle to avoid. That problem will indirectly but greatly contribute to ongoing public pressure for regulatory constraint on the cryptocurrency industry, which will impede innovation in the sector and its prospects to bring positive change to a broken financial system.

A related problem is that Crypto Twitter is an echo chamber. It is too smart for its own good. Within that nerdy hive mind, form doesn’t matter. It’s all about substance.

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“Bitcoin isn’t a crime, it’s just code.”

“The hack will open eyes to the failings of a centralized system.”

“Decentralization is now inevitable.”

Oh, how I wish those sentiments, expressed repeatedly over Twitter this week, were absorbed by “normies.” Sadly, it won’t be the case.

In two consecutive tweets, Blockstack CEO Muneeb Ali laid out the challenge between what should be and what, sadly, will be.

Might the spectacular breach of Twitter’s defenses eventually convince people to abandon the centralized internet platforms that control their data? Maybe. But many in the mainstream will share the views of New York Magazine’s Josh Barro, who argued, poorly, that the hack wouldn’t have happened if we banned cryptocurrencies.

Barro is a smart, influential columnist, respected on both sides of the political divide. It’s counterproductive to call him a would-be Communist “moron,” as this Crypto Twitter member did, alongside many others’ derogatory comments. It signals more about the critic than the criticism, helping perpetuate negative stereotypes of the crypto community.

A far better response came from Ideo CoLab’s Ian Lee, who highlighted Barro’s error in conflating technology with a crime.

But in the age of social media, constructive nuance like that gets lost in the noise of ad hominem attacks and invective.

That’s a problem because Twitter is a powerful factor in public debate. The performance of the conversation – the form, as much as the substance – matters for how public opinion develops.

And that matters because public opinion feeds into regulation, which in turn can impede innovation.

DeFi in the crosshairs?

This comes amid signs U.S. regulators are focusing on some of the more innovative crypto financial engineering projects.

On Monday, news broke that the Securities and Exchange Commission and the Commodity and Futures Trading Commission had forced two separate settlements, worth $150,000 each, out of Abra Global, the crypto-based provider of synthetic digital asset products.

Abra, which counts American Express and Indian billionaire Ratan Tata among its investors, has long been seen as one of the most innovative companies in the crypto industry. It launched in 2014 with what was then a radical idea for a crypto-collateralized synthetic stablecoin enabling peer-to-peer remittances from the U.S. to the Philippines. (Abra wasn’t providing an actual token to users, but a contract giving them rights to a fixed-dollar value worth of underlying bitcoin, a deal it achieved via some sophisticated hedging techniques and by using the intermediary-free Bitcoin blockchain as the settlement layer.)

More recently, Abra took the same synthetic assets model to offer non-custodial derivative-like investment exposure to a range of assets, including both crypto tokens and traditional financial instruments. In effect, it allowed anyone in the world to place bets of any size on the direction of U.S. stocks and bonds.

That’s what got Abra into trouble. The SEC determined it was offering “security-based swaps,” which precluded it from selling to U.S. customers not classified as accredited investors. Although Abra took steps to geofence the American market from its product, the regulators found it hadn’t done enough.

The fines won’t derail Abra, which has a growing global base of customers. But the action underscores the challenges for crypto companies doing innovative things in the U.S. against what continues to be a somewhat hostile posture from the SEC. (The CFTC has generally taken a more accommodating stance toward cryptocurrency innovation. Its former chairman, Christopher Giancarlo, is now driving the charge for the U.S. government to embrace a tokenized version of a digital dollar.)

In particular, there are risks for the Decentralized Finance, or DeFi, movement. Abra is not formally a DeFi provider, but its model – using underlying cryptocurrencies as collateral to assure stability and blockchains for an intermediary-free, low-friction settlement rail – shares similarities with this burgeoning industry.

There’s no reason to suggest DeFi leaders like MakerDAO and Compound are in breach of securities, derivatives or money transmission laws. But you can bet that Washington regulators now have their eyes on an industry that’s bringing services such as collateralized lending and interest rate benchmarking – traditionally the domain of highly regulated financial institutions – into a decentralized setting.

The DeFi industry was perhaps too small to matter to regulators before this. But, although the $2.6 billion in value now locked in DeFi contracts is still just a fraction of the trillions in traditional lending markets, it’s now big enough to get on regulators’ radars.

'Collateral' damage

This is why the Twitter fallout matters. If “cryptocurrency” continues to be a dirty word in Washington, political pressure will come to bear on the agencies seeking to regulate the industry.

DeFi is not immune from all that.

To be sure, the industry could benefit from more smart regulation. Legal clarity and reliable protection from scammers could help expand DeFi adoption and drive progress from a speculative ecosystem to one that generates valuable credit products and risk management tools.

But if the regulatory backlash is too blunt, it could do great harm to innovation. DeFi development can and will continue offshore. But as Abra’s experience shows, the global digital economy’s borderless nature makes it hard for companies to comply with regulations everywhere even when they want to. So the regulatory risk will continue to dangle over the heads of innovators.

That’s a pity, because while participants face real risks in the freewheeling, unregulated world of DeFi, the ideas generated there offer an exciting reimagining of the financial system. Whether it ends up looking anything like the current Ethereum-based DeFi ecosystem or something else, the prospect of reducing gatekeeper friction in finance is appealing in a world where exclusion from credit often defines the difference between rich and poor.

DeFi leaders have lawyered up in a bid to stay compliant. Some of the issues they face were discussed in a DeFi regulation workshop CoinDesk hosted during our virtual Consensus: Distributed event in May. There, Ropes & Grey attorney Marta Belcher eloquently argued that regulators may even be in breach of developers’ First Amendment constitutional rights if they constrain efforts to writing open-source code for decentralized communities.

But do not underestimate the power of Washington or the extent to which social media-infused hysteria can energize those who wield that power.

This is why the messaging around events like this Twitter attack matters. At times like this, crypto thought leaders should all try to take the high road.

CoinDesk Research covers quarterly data in crypto markets including volatility, correlation, volume and returns of the CoinDesk 20 list of crypto assets. In this report, we also cover derivatives markets, synthetic bitcoins, BTC versus ETH, central bank digital currencies and the return of aging bitcoin mining equipment; and look at the relationship (or lack thereof) between online sports betting and crypto markets. Sign up to download the free report.

A history lesson

A common theme here at Money Reimagined is the current financial system tends to serve those with access to financial assets while creating barriers for those on the lower rungs of society. This is a particularly important issue for assessing the impact of the Federal Reserve’s massive quantitative easing program in response to the COVID-19 crisis. I continue to believe the real risks from that program, at least for now, lie far more with asset price inflation, and its accompanying impact on income inequality, than with inflation. Global demand for dollars is just too big and the economic fallout from the pandemic too great for any monetary oversupply to unleash an accelerated increase in consumer prices.

So, it was quite impactful for me this week to discover the annotated historical charts on equality presented in a colorfully named site I’d never encountered before: WTFHappenedin1971. The reference to 1971 is, of course, the so-called “Nixon Shock,” the moment when the U.S. took the dollar off its peg to gold, abandoning the core anchor of the Bretton Woods global financial system established in 1944. It was also when the world’s central banks suddenly gained fiat monetary powers, an unimpeded capacity to create money, the very powers the Fed is now drawing on to fight the COVID-19 recession.

The classic hard money, anti-1971 argument is that central banks degrade people’s wealth by inflating the monetary base, though strong arguments are made on the other side that fiat monetary creation power enables them to better manage economic cycles, and that a contained amount of inflation is necessary to achieve that. That debate hasn’t been resolved for centuries and may never be. Perhaps it’s less controversial to talk about the unequal distribution of that monetary policy’s impact. This chart from WTFHappenedin1971 shows the effect on income equality since those monetary powers were given to central banks half a century ago.

Notably, the chart is from the Center on Budget and Policy Priorities, a think tank typically described as “progressive” and that earns a “Left” rating on the spectrum provided by AllSides.com. It’s not the only one from a left-leaning organization that’s included in The WTFHappenedin1971 site. Another from the Economic Policy Institute shows a striking divergence between productivity expansion and the relative stagnation of real wages since 1971.

In other words, a site that’s implicitly making the typically conservative argument for a return to the gold standard or to bitcoin-like hard money principles is cleverly drawing on the observations of the left to make its point. The American left typically favors government activism via money and fiscal policy to attack poverty, not strict constraints on monetary issuance.

Libertarians argue, with some validity, the left simply doesn’t see how fiat money inflation hurts the poor by eating into their buying power. But the left says that’s offset by the benefits of higher income from jobs created via monetary stimulus and easier credit.

Where might these positions align around this clear inequality divide? Around something that I see as a bigger reason to embrace decentralized, peer-to-peer cryptocurrencies than the strict scarcity function of bitcoin’s monetary policy: the excessive power of financial intermediaries. Inequality has gone hand in hand with the financialization of the American economy, where finance and financial groups have held increasing sway over the economy. That trend accelerated dramatically in the post-1971 era because of the political and economic clout that Wall Street earned for itself as the de facto agents of monetary and financial regulatory policy. Disintermediating that is where the real opportunities lie for crypto.

Global town hall

CHIMERICA. Before there were reserve-backed stablecoins like tether and USDC, there were currency boards. Under that rigid currency peg model, a country’s monetary authority commits to hold in reserve the full value of its currency in some other country’s currency and promises holders of the local currency to honor any redemption requests at a fixed exchange rate. Some currency boards have failed spectacularly – Argentina’s is the case par excellence – but some have been a force for stability and growth. Hong Kong’s “Linked Exchange Rate System,” which has pegged the Hong Kong dollar to the U.S. dollar since 1983, is mostly an example of success. That’s probably because, unlike Argentina’s agricultural export-driven economy, Hong Kong’s revolves around finance, which thrives on stability. Ending the peg would be extremely harmful to that economy, which is why hawks within the Trump Administration were reportedly keen to undermine it in retaliation for China’s increasing control over HK’s citizens. This week less trigger-happy souls apparently won the day as Trump ruled out taking such action.

Presumably, someone demonstrated to Trump the enormous harm such actions would have on American financial interests. The peg creates strong synchronicity between U.S. banks and the many foreign-owned banks (including U.S. subsidiaries) based in Hong Kong. Hurting them would diminish the United States’ global financial clout. It might also incentivize China to retaliate by dumping its giant holdings of U.S. Treasury bonds to accelerate the end of the dollar’s reserve currency status. However, as with U.S. interests in the Hong Kong peg, such actions by Beijing would be counter to China’s interests in financial stability. Whether they like it or not, both countries are joined at the hip by intertwined policy structures, forming what the financial historian Niall Ferguson and the economist Moritz Schularick described as “Chimerica.”

HOME SWEET BANK. If there’s a number from this past week that matters for the prospects of U.S. economic recovery, it’s 2.98 percent. That’s the record-low level to which U.S. mortgage rates dropped as the continued economic crisis and the Fed’s relentless monetary expansion efforts pushed benchmark bond yields ever lower. This powerful market shift has the potential to work as a countervailing force for economic recovery. Some 65 percent American households own their home, and there’s now an incentive for them to refinance their mortgages or take out a home equity loan, creating financial liquidity that’s much needed in these difficult times. Americans might not have direct access to the Fed stimulus dollars slushing around financial markets, but in this way they can turn the equity in their home into something of a bank.

MODELING VALUE. Valuing crypto assets has been a challenge for some time. How does one put a value on a token without an explicit return built into it, such as a promise of interest payments or dividends, or a real-world utility function such as oil or some other commodity? Well, analysts are still trying to figure that out, with multiple methodologies being applied. In this report, the first of two on crypto valuation by Coin Metrics, partners in our new Research Hub, Kevin Lu and other members of the team lay out a series of quite different approaches. All have some merit. But of course the lack of consistency makes it hard to settle on a commonly held market view. Should we be worried about that? How can something be considered valuable if there’s no consensus on how to measure that value? Never fear, says Coin Metrics, this is a process that takes time. And to back that up, they conclude with this statement: “The Dutch East India Company, founded in 1602, was the first corporate entity to issue bonds and shares to the public, and in doing so became the world’s first formally listed public company. It then took a period of over 300 years for the necessary foundational concepts to be developed until the formal discipline of equity valuation was established in the 1930s.”

Relevant reads

Everything We Know About the Bitcoin Scam Rocking Twitter’s Most Prominent Accounts. Among Crypto Twitter dwellers, for whom the meme flow of the cryptocurrency community is like a lifeblood, Wednesday’s massive hack against the social media platform felt profoundly disorientating. CoinDesk reporter Danny Nelson’s tick-tock breakdown makes for compelling reading on how the crisis rapidly mushroomed.

Hong Kong Citizens Turn to Stablecoins to Resist National Security Law. Hong Kongers may not yet need to fear the end of their currency’s dollar peg, but many are now fearing surveillance of their HK dollar transactions after the introduction of a new security law that aims to quell opposition to the Chinese Communist Party. Our reporter David Pan discovered that a number of them appear to have found a payment solution to avoid Beijing’s prying eyes: stablecoins.

Bank of England Considering a Central Bank Digital Currency, Governor Says. The Bank of England was one of the first major central banks to explore the prospect of a digital currency after bitcoin’s invention sparked interest in such ideas. The project then went into a kind of hiatus while former Governor Mark Carney started floating even bigger ideas with his proposal for a new digital international hegemonic currency to replace the dollar’s reserve role. Now, under new Governor Andrew Bailey, a British CBDC is back on the table, as CoinDesk’s Sebastian Sinclair reports.

Five Years On, Ethereum Really Is the ‘Minecraft of Crypto-Finance’. In the 2010s, the online world-building game Minecraft enjoyed surging popularity among pre-teens and teenagers – a generation that included a young Russian-Canadian called Vitalik Buterin. This opinion piece from Camila Russo, author of the new book “The Infinite Machine,” offers a reminder of just how young Buterin was (19 years old) when he invented Ethereum.

Russian Activists Use Bitcoin, and the Kremlin Doesn't Like It. In Russia, it often seems President Vladimir Putin controls everything – most importantly, national elections, in which he routinely earns overwhelming majorities in the popular vote. But as CoinDesk’s Anna Baydakova reports, he can’t control Bitcoin, which gives Putin’s opponents a type of freedom they otherwise struggle to obtain.

How a Digital Dollar Can Make the Financial System More Equitable. If we want digital dollars to foster a more equitable financial system, design is everything, say Patrick Murck and Linda Jeng, both lawyers at Transparent Systems. They offer a radical proposal for achieving such results: a cooperative model that puts community ownership and governance, rather than centralized or corporate control, at the core of the digital currency network.