Blinded by the light: 7 red flags about cryptocurrencies we completely missed

Whether it’s gold, silver, wildcat bank notes, greenbacks, checks, Federal Reserve notes, credit cards, money market funds, electronic funds transfers, smart cards or digital dollars, there is a revolution in the creation and movement of money every several decades that turns traditional markets upside down. More than 19,000 cryptocurrencies and dozens of crypto asset exchanges created in just the last 13 years represent the latest shiny new financial objects in that continuing saga.

Interestingly, however, the general euphoria that often accompanies technological advancements seemingly blinded investors, legislators and policymakers to the red flags that accompanied the explosion of the crypto industry. Investors and markets are now paying the price. Consider seven of those red flags that should have prompted greater scrutiny, regulation or at least someone to throw a caution flag.

Red flag #1 — Most money products and financial delivery systems are anchored in confidence in a government, central bank or highly regulated financial intermediaries. 

But since whoever “Satoshi Nakamoto” is posted a message embedding a link to a white paper and mined bitcoin’s genesis block on Jan. 3, 2009, its value has grown from a quarter of a penny in 2010 to a high of $68,000 in November 2021. All of that occurred understanding that bitcoin has no underlying intrinsic value, lacks government backing of any type and experienced no intervening economic event that could rationally explain any increase in value. 

Red flag # 2 — When inflation and interest rates reached 13.5 percent and 21 percent, respectively in the early 1980s, securities firms created uninsured money market funds (MMFs), paying double-digit interest rates to give consumers an alternative to the 5.5 percent they could get at regulated banks and S&Ls. As MMFs sucked deposits out of them, growing by nearly half a trillion dollars over the next decade, a laundry list of banking, securities and money laundering laws were interposed as preventing MMFs from offering such products.

Section 21 of the Glass-Steagall Act, for example, got everyone’s attention because it made it a federal crime for a securities firm to engage in the business of receiving deposits. A legislative and regulatory compromise was forged. Similarly in the 1990s, there was much debate about the legal status of digital currencies like Mondex and Digicash, which attracted the attention and opposition of agencies such as the Financial Crimes Enforcement Network. Cryptocurrencies seemed to have gotten a pass and largely avoided such scrutiny.

Red flag # 3 — The government earns a profit from seigniorage when it mints money.  It is the difference between the cost of minting money and its value when it is distributed into the economy. The cost to consumers is zero. In comparison, cryptocurrencies such as bitcoin are expensive to mine, and the cost only increases as more miners compete and reduce each other’s chances of mining a coin without continuously acquiring additional specialized computing power and reliable energy sources. All this makes the average five-year cost of mining one bitcoin, according to one report, approximately $32,000. Someone has to pick up that cost somewhere in the chain of ownership, making it a ridiculously expensive substitute for money or investments.

Red flag #4 — Solving complex mathematical puzzles (the proof-of-work model) is the key to mining a crypto coin. Ironically, mathematical complexity is also the backbone of the encryption that forms the basis for digital signatures and just about every form of online security that we rely on. A hacker’s ability to penetrate computer networks is in direct proportion to the time, computing power and knowledge available to do so.  Wouldn’t it be logical to carefully consider the implications of a business that relies on penetrating the kinds of mathematical puzzles that also protect our data? 

Red flag #5 — According to a recent report that demonstrates the scale of the energy challenge created by crypto mining, the average U.S. household consumes electricity of about 900 kWh per month compared to the roughly 155,000 kWh it takes to mine a bitcoin. While policymakers appear not to have understood how proof-of-work cryptocurrencies would add significantly to global energy and environmental challenges, they have finally caught on.

A July 15, 2022, letter to the heads of the Environmental Protection Agency and Department of Energy by four U.S. senators and two U.S. representatives cites recent studies that suggest the power demands of crypto miners in upstate New York increased annual electric bills by hundreds of millions of dollars.

Data also suggest that mining of the two biggest cryptocurrencies, bitcoin and ethereum, consumed electricity at an annual rate last year that exceeded that of the entire United Kingdom and created nearly 80 million tons of carbon dioxide emissions.

Red flag #6 — The story of bitcoin and its founder, Satoshi Nakamoto, is peculiar enough to raise its own set of cautions. But once the industry began to produce Dogecoins and Jesus Coins, it is hard to imagine how policymakers who understand how money, banking and commerce work would not have called a time out. Dogecoin was reportedly created by software engineers as a “joke.” That joke now has a market value of $9 billion. Jesus Coin sought to displace morally bereft cryptocurrencies with the unique advantage of providing global access to Jesus as well as sin forgiveness through outsourcing. Although the founders may have been kidding, the market seemed to have missed the joke.

Red flag # 7 — Crypto is about money and investing — in short, it is the care and feeding of other people’s money. The oversight and centralization of financial services and payments systems as well as the identity of who may engage in or own a bank, for instance, is scrupulously controlled by law. But the creation, clearing and settlement of crypto assets is entirely unregulated. Even more problematic, those businesses are concentrated and controlled by people in various locations around the world that are required to pass no litmus test to earn the privilege of safekeeping other peoples’ money. That has always been a recipe for disaster.

The 1960s rock band Manfred Mann sung about being blinded by the light. In the case of crypto, that appears to have been what happened. Everyone was attracted to the sizzle and forgot to rationally analyze the steak. 

An evaluation of what crypto is and how it should be regulated to maximize security and stability seems finally to be underway. Warren Buffet famously noted that “only when the tide goes out do you discover who’s been swimming naked.” It is not too late for policymakers to put on sunglasses, identify those swimming naked and channel the most beneficial elements of the crypto business and its delivery systems into safe products and networks that advance financial systems and benefit consumers.

Thomas P. Vartanian is the author of “200 Years of American Financial Panics: Crashes, Recessions, Depressions and the Technology that Will Change it All” and executive director of the Financial Technology & Cybersecurity Center. His new book, to be published in February 2023, is “The Unhackable Internet.”