To regulate or not to regulate? Cryptocurrencies beg question

As cryptocurrencies like bitcoin gain in popularity, investors and policymakers alike are asking if cryptocurrencies should be regulated. Government regulation is heresy for libertarian investors attracted by the promise that cryptocurrencies will end the tyranny of the inflation tax and government’s fiat money monopoly. Then there are those who prefer the anonymity of cryptocurrency for illegal transactions. But with every new blockchain glitch and exchange hack, pragmatic cryptocurrency investors see a need for investor protections that may only be possible with greater government oversight.

The most important characteristic of cryptocurrency is its ability to be accepted as payment for the purchase of goods and services. Regardless of whether the transaction requires an intermediate step of converting cryptocurrency into a national currency, there must be a mechanism that allows cryptocurrency to be traded for goods, services or national currencies.

{mosads}Blockchain is one part of this mechanism. It is a public ledger system that transfers ownership of cryptocurrency claims from one computer address to another. The transfer is facilitated by the efforts of many independent agents, commonly known as “miners,” who add transaction records to the ledger. Each miner attempts to be the first to solve a complex cryptography problem to earn transactions fees and other rewards. In the process of reaching a solution, the blockchain record of cryptocurrency ownership is updated on a permanent public record that can be viewed on the internet using free open-source software.

Blockchain has been advertised as a reliable algorithm that is immune to manipulation. The outcome of the mining race is alleged to produce a permanent and irreversible record of cryptocurrency ownership. Importantly, the algorithm is supposed to ensure that a cryptocurrency account can spend its currency only once. Eliminating the possibility of cryptocurrency double spending is equivalent of counterfeit protections for paper money issued by governments.

The promise of transfer finality and security from counterfeiting without the need to entrust cryptocurrency with a financial intermediary has been hailed as a breakthrough by advocates of bitcoin and other cryptocurrencies. Unfortunately, the safety and finality of the cryptocurrency payments system has turned out to be less certain than advertised.

Collusion among cryptocurrency miners can disrupt the safe and timely transfer of cryptocurrency. If independent miners pool their resources and control enough processing power, they can increase the odds that they are the first to solve the cryptography puzzle and extract higher profits by manipulating the order in which cryptocurrency transfers are recognized on the blockchain.

This power can allow miners to front run transactions and even double spend a single unit of cryptocurrency. Because it takes some time for transactions to be recorded on the blockchain, the double spending problem is potentially most serious in “fast pay” transactions where a cryptocurrency is exchanged for immediate delivery of a good or service, like exchanging cryptocurrency for a pizza.

The exchange of cryptocurrency for national currency, or goods and services, requires a willing counterparty. Since cryptocurrency is not universally accepted as payment, this requires finding a trade counterparty, in essence, finding a coincidence of wants. This effort required to arrange a trade tarnishes the shine of cryptocurrency with the search costs that makes barter systems so inefficient.

Cryptocurrency exchanges have been created to reduce the cost of finding a willing trade counterparty. For a fee, these unregulated intermediaries will match customer orders to buy and sell cryptocurrencies, trading them for national currencies. While exchanges reduce search costs, they create new risks for cryptocurrency owners who must transfer their private ownership keys to the exchange.

The necessity of entrusting an intermediary with a private cryptocurrency key creates many of the security risks that cryptocurrencies were supposed to eliminate. The recent “hack” of the Japanese Coincheck exchange yielded cyberthieves the equivalent of $530 million of cryptocurrency held by its customers. This incident is only one of numerous exchange hacks that have cost investors the equivalent of hundreds of millions of dollars in cryptocurrencies.

Notwithstanding the success of many cryptocurrencies, events have shown that virtual currencies are just as susceptible to fraud and manipulation as are “old school” financial products. As new flaws and hacks are revealed, cryptocurrency computer experts redouble their efforts to fix blockchain computer code and strengthen the security of cryptocurrency exchanges. Still, computer code improvements alone may not diminish the potential abuse of monopoly power, nor can they recover and return fraudulent gains, or pursue and punish perpetrators.

There are compelling reasons why cryptocurrency investors might prefer a little more government oversight. Old school financial products benefit from government programs that protect investors against market manipulation schemes and fraudulent losses. While imperfect, few mainstream investors would jettison government safeguards that protect them against the abuse of monopoly power or the regulations that make investor protections possible. Are legitimate cryptocurrency investors so different?

Paul Kupiec is a resident scholar at the American Enterprise Institute, where he studies systemic risk and banking regulation. He previously served as a director at the Federal Deposit Insurance Corporation and a task force chairman for the Basel Committee on Banking Supervision.