Roadmap To Utopia

Research May 10, 2022

Or How Crypto-anarchists Will  Learn To Love Regulation

Key take-aways

  • Government regulation in the crypto-space is set to increase markedly over the next few years – it is unavoidable.
  • In addition, central bank digital currencies (CBDCs), public versions of electronic money currently under development by numerous countries around the world, are coming. It is a matter of when, not if.
  • Many crypto-enthusiasts are deeply troubled by these developments. These worries are misplaced. Regulation should be warmly embraced not feared, but for reasons you may not have come across before.
  • Indeed, government regulation and CBDCs may turn out to be the very catalyst that gets crypto-anarchists to their long-hoped for dream of technological utopia where money is (largely) freed from government bondage.

Government Entanglement

Regulation, both proposed and announced, is coming thick and fast. Indeed, often it is hard to keep up with the pace of announcements. Worries about the use of cryptocurrencies for sanctions avoidance by Russia and/or their use in facilitating trade with other personae non gratae around the globe is just the latest accelerant to regulation implementation.

For crypto die-hards and privacy advocates the increasing entanglement of government in the crypto world is unambiguously bad. It is completely at odds with why cryptocurrencies were conceived in the first place i.e., a new form of private digital money and by private I mean in both senses of the word. That is, public entities (governments) neither issue them nor are they able to track financial transactions at the level of the individual because pseudo-anonymity provides a degree of privacy.

Worst of all from their perspective are central bank digital currencies (CBDCs), public versions of electronic money currently under development by numerous countries around the world. When widely introduced - likely over the next several years - they will give governments control over money in a way that has never before been possible. Not only will the government be responsible for issuance and distribution of digital money to the non-bank private sector (the central bank acting as its agent), but they will also have the ability to track and monitor all financial transactions.

Financial privacy will be a thing of the past. You do not have to be Edward Snowden to find this prospect scary and many crypto fans are vehemently against their introduction, but for central planners they are a dream come true.

This is not the only reason why I am fully convinced that CBDCs will be widely introduced. In a fully cashless society, which is very clearly the direction of travel in most countries, without a public form of digital money the central bank would be unable to provide a monetary anchor to the financial system. This undermines one of its key objectives, maintaining financial stability.

The reason for this is relatively straightforward. At present, the only money that can be held in digital form by the non-bank private sector – aside, that is, from cryptocurrencies – is deposits in the commercial banking system. These deposits are privately-created money but they are considered perfect substitutes for public money because of the ability of depositors to convert their balances into bank notes and coins at parity on demand. If bank notes and coins are no longer widely accepted by the providers of goods and services, ie. because society is cashless, then this conversion becomes moot. The public issuer – the central bank – would no longer be able to guarantee parity between public money and privately-issued commercial bank deposits. In short, even though bank notes and coins form an ever dwindling part of the financial payments landscape, they constitute the very foundation upon which modern monetary systems are based.  

So to recap, regulators are coming for privately-issued cryptocurrencies and CBDCs will be rolled out in the not too-distant future. This is something the crypto-community cannot ignore. And while, as mentioned, many are concerned - even fearful - of such developments actually it should be viewed as a positive trend and welcomed, even for die-hard crypto-anarchists (as odd as that may sound).

Let me explain.

Internet-Like Growth

Bitcoin – the world’s first cryptocurrency - was born just over 13 years ago and since then cryptocurrencies have risen to be worth on aggregate $2tr give-or-take. While it is not possible to directly measure ownership from wallet addresses for obvious reasons (pseudo-anonymity), surveys suggest up to 300 million people own cryptocurrencies or approximately 3% of the global population. This pace of adoption is fast, even slightly faster than the rate of internet adoption 15 years prior – see chart – something widely reported in crypto circles. Assuming the relationship holds then crypto ownership is set to hit the one billion mark within the next several years. That would be quite an achievement.

Internet vs. Crypto Adoption

Internet vs. Crypto Adoption Source: World Bank and Crypto.com

Crypto’s Adoption Curve

Anyone who has worked in a start-up, in marketing, or has looked at how technology gets adopted will be familiar with the product/technology adoption curve. It’s normally drawn as a bell-shaped curve - see below. Innovators are the first group of users (“Wow, shiny new toy!”), then come the early adopters (“This is cool. Gimme!”), followed by the early majority (“Ok. it seems to work I’ll give it a go now.”), the late majority (“Better safe and late.”) and then finally the laggards (“What’s this interweb thingy I keep hearing about?”).

Stylized Technology Adoption Curve

Source: Author

Crypto has clearly already passed the tech-enthusiastic innovator stage. Indeed, as discussed in a recent article on the evolution of Bitcoin narratives, the proof-of-concept narrative faded by late 2014/15. Since then, the predominant narrative for Bitcoin, at least, is as censorship-resistent gold, which is very much a “visionary” narrative - a characteristic of early adopters.

Given this, and combined with all the chatter about the imminent institutionalization of crypto investment, the best guess as to where crypto is on the product adoption curve is the threshold between early adopters and the early majority.

Transitioning to the next phase of the adoption curve, which is what commentators generally mean when they use the phrase “going mainstream”, the crypto sector will need to appeal to the early majority cohort. For this to happen some obstacles will have to be overcome, but which ones?

Adoption Impediments

According to a recent survey by Natixis Investment Managers, the top reasons given by investment fund selectors for not recommending investing in cryptocurrencies were the need for better regulation (82%), more transparency (82%) and greater education (65%). Other surveys looking at crypto usage amongst the general public report similar results. In layman’s terms, crypto needs to become less “scary”.

As the survey evidence suggests, government regulation has a role to play. The simple truth is people, especially the pragmatists and conservatives in the early and late majorities, feel more comfortable investing in something which is overseen by the government. It is one of the reasons why the traditional financial sector is regulated – the majority of people demand it. Regulation brings with it the perception of legitimacy.

Increased government regulation will make crypto less “scary” for these majorities, but it is only a necessary not sufficient condition for greater adoption of crypto. There also needs to be an incentive for greater numbers of people to want to hold crypto over fiat money.

In an earlier research note, I outlined what this incentive is. Essentially, it arises from the fact that across the globe monetary and fiscal policy settings are currently “extreme” and bringing them back to historic norms requires sustained negative real interest rates, which will

“… encourage ongoing public interest and money flows into cryptocurrencies because fiat money’s purchasing power will continue to steadily decline.”

Combined with increased perceptions of safety, as a result of increased regulation, this will be a potentially powerful driver for bringing the early majority, and eventually the late majority, into crypto.

Obviously, crypto anarchists have no objections to rising crypto-adoption. It is, after all, the only way to achieve the long hoped for technological utopia. Their objection is that if increased regulation of crypto is what brings this about, money may never be able to break free from government bondage. This is where they are wrong.

No Laffing Matter

One of the most famous curves in economics is the Laffer curve, which defines the relationship between tax rates and tax revenues. It is, essentially, a model of government entanglement in the economy via the tax system. As shown in the chart below, the Laffer curve has a humped shape.

Laffer Curve

Source: Investopedia

Starting at the bottom left of the chart, when both tax rates and tax revenues are close to zero, raising the tax rate generates higher tax revenues for the government. This positive relationship holds until the tax rate hits a tipping point denoted in the chart as point T*. Beyond this point, further increases in the tax rate actually results in lower tax revenues. The intuition behind this change is that when tax rates are perceived by the public as too high or onerous (that is above the level defined by T*) they either increase tax avoidance measures, such as under reporting income, and/or they are discouraged from doing additional taxable work. After all, no one is going to work if the tax rate is 100% - what would be the point.

For economists the usefulness of the Laffer Curve is that it provides a framework for thinking about what the optimal level of taxation in an economy should be. But what is important to recognize is that while governments can set the tax rate at any level they wish, T* is not determined by them. It is, instead, determined by the preferences of the general public. The humped shape arises because society as a whole will only tolerate government entanglement (via the tax system in this instance) up to a certain level before it prompts a change in behaviour.

What has this got to do with crypto? In my view, everything. A modest amount of government regulation should be good for crypto adoption, for the aforementioned reasons, just as modest tax rates are good for raising government revenue. However, as with the Laffer Curve, there is some level of government entanglement in crypto where society will deem it to be too high or onerous. CBDCs, for example, could easily turn out to be a step too far. The right to privacy is a fundamental right enshrined in the UN Deceleration of Human Rights (Article 12) and very few people, I would strongly argue, are prepared to give up their right to financial privacy if avoidable, and avoid it they can.

Regulation Limits

When government bodies implement crypto regulation, the target is almost exclusively the on-off ramp where the conversion between fiat and crypto occurs. This not accidental, it’s practical because the only place regulation can really “bite” is where crypto touches traditional finance.

Under threat of being excluded from the traditional financial system, governments can impose regulations - such a KYC, AML or so-called travel rules – on exchanges offering conversion from crypto back to fiat and vice-versa. They can also regulate cryptocurrencies whose valuation is referenced by fiat money, namely fiat-backed stablecoins, by blocking access to the underlying assets held in traditional financial institutions.

Cryptocurrencies that do not touch the traditional financial system in any way are essentially out-of-reach of the regulators. This is one of the reasons why recent UK crypto regulation on stablecoins intentionally excluded algorithm stablecoins, which do not have to be backed by holdings of fiat assets and hence are able to remain (theoretically at least) segregated from the traditional financial system. It is also why the US Treasury department, which co-published a white paper looking at stablecoins back in November, focused almost exclusively on fiat-backed stablecoins; algorithmic stablecoins received barely a mention. The omission of algorithmic stablecoins is an implicit admission by governments that there is a limit to what crypto activities can be regulated.

The implications of this are significant. It means governments will never be able to issue a blanket ban on holding or transacting in all cryptocurrencies, only some. It also follows, therefore, that people will be able, if they so choose, to keep their cryptocurrencies shielded from the government. Conversion back to fiat in these cryptocurrencies will be impossible, and transacting with them on centralized exchanges that allow any of their users to convert back to fiat will be off-limits, but it is do-able.

A Crypto Version Of The Laffer Curve

Substituting regulation for tax rates and on-off ramp activity (the focal point for regulation) for tax revenue we can draw an analogy to the Laffer Curve for crypto – see below. From low levels, increasing regulation is a positive for crypto adoption as mentioned. This generates rising on-off ramp activity as people convert fiat to crypto. During this accumulation phase, holdings of private cryptocurrencies rise (the dark blue line – RHS).

Let’s call R* the regulation tipping point (equivalent to T* in the Laffer Curve). Beyond this point, increasing regulation results in declining on-off ramp activity as people are discouraged from switching between fiat and crypto because of the increased bureaucratic burden of conducting such transactions. Holdings of private cryptocurrencies continue to rise but at a slower pace, eventually reaching a plateau. (NB: On-off ramp activity is a flow variable, holdings of cryptocurrencies is a stock variable.)

Stylized Relationship Between Regulation vs. Crypto Usage

Source: Author

Faced with a strong rise in the market cap of cryptocurrencies, ironically facilitated by increased regulation, and with significant financing needs of their own due to high levels of indebtedness, it is not hard to imagine a scenario where governments become increasingly concerned about the challenge cryptocurrencies present. Their most likely response will be more, not less, regulation in an attempt to underpin demand for fiat currencies.

In extremis the government could shut the on-off ramp (equivalent to 100% tax rate in the Laffer Curve). This would sever the link between fiat currencies and cryptocurrencies. For all intents and purposes cryptocurrencies outside the reach of the regulators will become effectively locked in cyber-space.

Such draconian action may appear effective, but this is not at all certain because of the simple fact that governments cannot dictate what people deem to be money. It is not in their mandate. Societal preferences determine what is money, as recognized by former BoE governor Carney, who in a speech given in 2021 at the BIS noted,

“When it comes to money, the consent and trust of the public must be nurtured and continually maintained.”

It is true that government legislation forces people to make tax payments in fiat currency, essentially coercing them to have to hold some fiat money, but that is the extent of it. Loss of privacy, due to the introduction of CBDCs, and the erosion of purchasing power, due to negative real interest rates, will see public trust in fiat currencies severely tested. Conversely, the technological infrastructure associated with cryptocurrencies will become increasingly familiar and this will diminish their “scariness”.

Cryptocurrency sceptics (the laggards in the production adoption curve) will no doubt argue that private cryptocurrencies will never be unable to supplant public forms of money to a significant degree even if they offer a better store-of-value because they are unable to satisfy the other two prerequisite functions of money, namely medium-of-exchange or unit-of-account.

However, a great deal of work is being done to increase the scalability of cryptocurrencies, either by shifting to more efficient consensus protocols or overlaying layer 2 payment protocols like Lightning on the Bitcoin blockchain. These efforts enhance cryptocurrencies’ ability to act as a medium-of-exchange.

As for the unit-of-account prerequisite think about this. Assuming governments do push the crypto “nuclear button” and block the on-off ramp the only way people will be able to get hold of cryptocurrencies will be by exchanging goods or services for them. Only a short mental hop is required for them to be used as a unit-of account eg. “I’ll paint your house for three ETH”.

Give Regs Some Love

Fiat currencies will continue to exist because governments will always need to raise taxes, but there is no reason why the populace has to use them exclusively, or for even the majority of their financial transactions. If governments can’t ban cryptocurrencies, and they can’t dictate what society considers money, there is not much they can do to stop cryptocurrencies being widely owed, especially if they offer greater privacy and a better store of value than fiat.

To the extent that government action in the form of increased regulation and the introduction of CBDCs, encourages - even accelerates - greater crypto adoption they should be seen as catalysts for crypto-anarchists to achieve their long hoped for dream of technological utopia where money is (largely) freed from government bondage.

So, perhaps, it really is time to stop fearing government regulation of crypto and learn to love it.

Until next time.

Ryan Shea, crypto economist at Trakx


Footnotes

[1]    In the sense that the blockchain allows wallet addresses to be tracked, but they do not have to be associated with personally identifiable information the way an account held in the commercial banking system has to be.

[2]    I do mean when not if for reasons I will allude to shortly.

[3]    The majority of money issuance and distribution at present is done via private commercial banks.

[4]    This will apply even if governments do not adopt blockchain technology but instead stick with the incumbent centralized database model. NB: From a surveillance perspective bank notes and coins, currently the only form of public money that the non-bank populous can hold, is terrible as they allow transactions to be conducted completely anonymously. That is why governments require additional personally identifiable information for large cash transaction or they ban them outright.

[5]    Something I have mentioned before - see: https://blog.trakx.io/crypto-in-the-spotlight-hacks/ and https://blog.trakx.io/crypto-in-the-spotlight-attacks/

[6]    See: https://coinmarketcap.com/

[7]    See: https://triple-a.io/crypto-ownership/

[8]    My dad being a prime example.

[9]    See: https://blog.trakx.io/bitcoin-the-inside-out-narrative/

[10]  Proof-of-concept refers to the tech community kicking the tyres of the Bitcoin code and protocols to see if they functioned as expected.

[11]  Visionary in the sense that this narrative tends to be favoured most by proponents who see Bitcoin as a superior to the present fiat system and hence a worthy successor.

[12] Larry Fink the CEO of Black Rock, the world’s largest asset manager in the world, recently stated that they were  studying digital currencies and their underlying technologies on the back of increasing interest from their clients – see: https://www.blackrock.com/corporate/investor-relations/larry-fink-chairmans-letter

[13]  In marketing this is known as the chasm.

[14]  They survey covered 141 US investment executives that manage $2.7tr in client assets - see: https://www.im.natixis.com/uk/research/2022-fund-selector-outlook

[15]  See: https://www.ziglu.io/uk-crypto-report-2021.pdf

[16]  It should also go a long way to de-stigmatizing crypto as a criminal safe haven, a narrative that is long past its sell-by date but which continues to be perpetuated , something I covered in a recent article – see: https://blog.trakx.io/crypto-in-the-spotlight-hacks/

[17]  See: https://blog.trakx.io/fed-fears/

[18]  I am being optimistic - this is the best-case scenario. Failure to bring fiscal and monetary policy back to more normal settings increases the risk of either accelerating inflation, possibly hyperinflation, or a bone-crunching deflationary depression.

[19]  The article was entitled Fed Fears. As well as outlining the just mentioned incentive, I also explained why more hawkish signals emanating from the Fed would undermine crypto prices, but only in the short-term. For anyone underwater in long crypto positions I suggest you have a read – it will provide some succour.

[20]  Named after the economist Art Laffer, even though the concept was first recognized centuries prior.

[21]  Economists love curves that have minimums and maximums. Using mathematical differentiation to derive results means economists can overcome their physics envy by pretending to be a hard science.

[22]  See: https://www.un.org/en/about-us/universal-declaration-of-human-rights

[23]  For more details on stablecoins – see: https://blog.trakx.io/cbdcs-crypto-killers-1/ and https://blog.trakx.io/cbdcs-crypto-killers-2/

[24] In their recent proposals the EU (I told you regulations were coming thick and fast!) requires crypto service providers to ensure asset transfers from self-custodied, or unhosted wallets, be made individually identified. There is no technology available to force such disclosures, so the upshot of this legislation is that unhosted wallets will be excluded from exchanges operating in the region, who offer on-off ramp services. It won’t stop transactions between unhosted wallets all it will do is put a geographic ring fence round them.

[25]  Fiat-backed stablecoins, which are really only a crypto appendage to the traditional financial system are one of the most accessible coins for regulators. They are eminently bannable. Indeed, with the introduction of CBDCs, their purpose becomes much less obvious. For reasons I outlined in the articles referenced in footnote 23 above, in my judgment they will morph into payment interface providers (privately run companies to facilitate access to CBDCs).

[26]  In much the same way as cryptocurrency wallets identified as being associated with criminality are locked in cyber space as demonstrated by the fact that the vast majority of the proceeds from the 2016 Bitfinex hack remained in the original hackers wallet – see link in footnote 16.

[27]  See: https://www.bis.org/events/acrockett_2021_speech.pdf

[28]  Often this also makes them less energy intensive – a green bonus if you will – see: https://blog.trakx.io/crypto-power-plays/

[29]  Let’s hope for all our sakes they don’t push the actual nuclear button, the probability of which may be low but is, unfortunately, rising.

[30]  Pulling the plug on the internet is infeasible in the modern world.

Carole Laizet

Senior marketing manager with 15+ years of experience in the Financial Industry (traditional Banking as well as Crypto Assets). Responsible for market research @trakx.io