Nothing to sell but dreams

Today's key crypto-related regulatory questions reveal how it is not fulfilling its promised potential

Nine years ago, this column warned that electronic currencies would soon be a matter of concern for governments and monetary authorities. How precisely, I asked (‘Two scary steps forward’, April 8, 2013), would the tax authorities track down Bitcoin transactions? How would we have to modify foreign exchange and other regulations to prevent hidden capital flows using cryptocurrencies? Would Bitcoin make it easier to evade taxes, and undermine the government's fiscal policies? And I worried also that crypto would be “a hard monetarist’s dream come true”, given that it was a tech-intensive attempt to kill off monetary policy.

In the years since, crypto assets have embedded themselves into our financial environment, but without actually living up to their potential as currencies. Perhaps the crucial turning point here was the relatively successful attempt by the People’s Republic of China in 2017 to crack down on local cryptocurrency exchanges and coins’ equivalent of initial public offerings following months of capital flight; almost $725 billion left China’s shores in 2016, and the regulators noted that wide availability of cryptocurrencies would hobble any attempts at capital controls.

Even in countries where cryptocurrencies continue to exist in a regulatory grey area or are considered legal, the fact is that they aren’t quite currencies. You can’t depend on them for purchases, and thus as a medium of exchange. It isn’t as if Amazon.com accepts Bitcoin directly. And attempts to create bridges between individuals’ stores of cryptocurrency —their “wallets” —and the regular financial system have not panned out effectively. Debit cards linked to your crypto assets on major exchanges exist in the United States, but they have a higher failure rate for transactions than is comfortable for regular people and have higher fees. The number of transactions in Bitcoin has actually shown a decreasing trend; it reached a peak in 2017 that has not been scaled since.

There are three uses for a currency: As a medium of exchange, as a store of value, and as a unit of account. Cryptocurrencies are not useful as a medium of exchange; but if anything, they are even worse as a unit of account, meant to assign a relatively stable number to track the worth of goods and services. The wild fluctuations in their own value mean that the statement, “This house is worth 10 Bitcoin,” is effectively meaningless over time, as compared to the statement, “this house is worth US$400,000.”

It is the third function of currencies, as a store of value, that is the reason that cryptocurrencies have not yet disappeared. Goldman Sachs, for example, famously announced in January that Bitcoin is now competing with gold as a store of value, and that it already has a fifth of the “store of value” market. Given the enormous expansion of central bank balance sheets and the air of irresponsibility about monetary policy and money printing that is exuded by major central bankers today, the search for alternative stores of value is understandable.

Illustration: Ajay Mohanty

Yet even here volatility is a problem; the price of Bitcoin, the most stable cryptocurrency, is five times as volatile as the price of gold and it actually becomes more volatile when equities do. JP Morgan analysts believe that, if Bitcoin were exactly as volatile as gold, one Bitcoin would be worth three and a half times its current price in dollars. A less volatile store of value would be picked up as part of more savings portfolios and by institutional investors. We seem a long way from that, though. JP Morgan private banking’s Chairman of Investment Strategy, Michael Cembalest, released a report this month that poked big holes in the store-of-value argument. For one, we don’t even have the beginnings of a pricing model for cryptocurrency the way we have for bonds, commodities, equities or real estate. Quoting Humphrey Bogart’s character in a movie about the fight over a valueless ‘Maltese Falcon’, Mr Cembalest concludes: “The most widely discussed use cases [for cryptocurrencies] and the valuations at which they’re trading are still the ‘stuff that dreams are made of’.”

There is only one way to read this: As of right now, everything crypto-related is speculation pure and simple with very little real underlying utility and pricing logic.

Unsurprisingly, therefore, the key regulatory questions for cryptocurrencies have now become: First, how do we minimise the impact on broader financial markets of the risk embedded in such speculation; second, how do we protect retail consumers from a market founded entirely on speculation; and third, how should we treat the gains that some speculators will inevitably make.

This is the global context in which we should see recent moves in India. For example, concern about the blitzkrieg of crypto-related advertising that overran this country’s airwaves last year is neither inexplicable nor unprecedented. Singaporean and Spanish authorities are also considering regulations for such advertising, in order to minimise fraud and the exposure of retail investors.

Then there is the question of macro stability. Last October, the International Monetary Fund’s Global Financial Stability Report warned that, in the words of a summary on its website, that “widespread and rapid adoption [of cryptocurrencies] can pose significant challenges by reinforcing dollarisation forces in the economy —or in this case cryptoisation —where residents start using crypto assets instead of the local currency… It could also create financial stability risks, for example through funding and solvency risks arising from currency mismatches.” The Reserve Bank of India, which is perpetually behind the technological curve, may not have thought through these problems yet, but other emerging-nation banks are doing so.

Finally, there’s the question of taxes. The recent Union Budget references the taxation of “virtual digital assets” as capital gains. That clearly includes gains made from putting money in cryptocurrencies, which clearly should now be called crypto assets. Various shady tech evangelists from the sector, including some well-known voices from Silicon Valley, declared that this was “India regularising/legalising Bitcoin”; others said it was a “win” for the crypto ecosystem. It is nothing of the sort. Income from illegal ventures is still taxable in most jurisdictions. Publication 17 of the US Internal Revenue Service reminds taxpayers that “if you steal property, you must report its fair market value in your income in the year you steal it” and that “income from illegal activities, such as money from dealing illegal drugs, must be included in your income on Schedule 1 (Form 1040), line 8z, or on Schedule C (Form 1040) if from your self-employment activity”. The Internal Revenue Service (IRS) is not legalising these activities by telling taxpayers how income from them must be declared.

The prime minister, addressing the recent World Economic Forum, argued that the solution to crypto regulation will have to be global. This is probably the right answer, given the implications for global financial stability, for tax base erosion, and for capital flight. Yet it is hard to say what, when the world’s leaders address this issue, the crypto ecosystem will have to argue in its favour. Blockchain-based tech can grow without needing publicly traded crypto as an appendage. So what is crypto’s developmental argument? How does it promote efficiency, growth or financial inclusion? It is precisely because there are so few convincing answers to this question that hardliners who view crypto as being little more than scams and speculation are winning the argument today.

The writer is head of the Economy and Growth Progreamme at the Observer Research Forundation, New Delhi