Decentralized Money At The Crossroads
Blockchain technology is set to challenge the State for control over money
Since the first coin left the mints of Lydia in the 7th century BC, issuance of money has remained squarely within the purview of the state. The power to unilaterally redistribute society’s claim on economic resources has become an indispensable tool of government, whether deployed towards a positive social outcome or to extend the life of a failing regime.
The advent of electronic money added a new dimension to the state’s already formidable grip on the financial system — the ability to control money it already issued. Physical cash was replaced with an entry in a ledger of a state-regulated institution, and seizing funds became a matter of a few pen- or keystrokes. No more need to enter homes or places of business, to break into strongboxes. Indeed, the tables have turned so completely that every time we use electronic money, it is with the government’s tacit approval.
The trend of ever-increasing state control over money has gone largely uncontested, until now. The emergence of blockchain technology has raised the possibility of a different world — one where an individual’s ability to assert property rights over money is not contingent on consent from a central authority. Now, just over a decade since Bitcoin’s genesis block, the technology is starting to catch up with its early promises, and the prospect of truly usable decentralized money is beginning to materialize. If progress continues unobstructed, the money paradigm will shift. Powers that governments have long taken for granted will return into the hands of the individual, and the ripple effects of this change will be felt across the fabric of modern society. To no one’s surprise, the state is not looking like it will stay on the side-lines. Decentralized money is now a prominent feature on regulatory agendas, and the first steps are being taken in what is shaping up to be a long war. Below, we try to sketch a roadmap for what is to come.
What Is At Stake?
Picture a world where decentralized money plays a prominent role in the real economy. Prices are denominated both in fiat and crypto, transaction volumes are significant in both. Consensus protocols that underpin decentralized money are secure, fast and scalable. Privacy is the default and disclosure is a choice. Who are the winners? Who are the losers? What are their likely courses of action?
The State
Suppose decentralized money is adopted overnight, and governments wake up to a new reality without a chance to prepare and adapt. What would be the first question on their agenda? Or perhaps the second one after “whose fault is it?”. I am going to go out on a limb and say “can we still levy taxes?”.
On the face of it, this new reality looks like a fiscal nightmare and, for once, from the state’s perspective. Individuals and businesses can transact without the government’s knowledge, and only selectively disclose financial flows. True prices paid for goods and services are difficult to establish, verifying profit and income calculations near impossible. Undisclosed crypto addresses are the tax havens of the decentralized age. Cryptography stands in the way of enforcement action, and settlement of a tax bill requires the explicit consent of the payer. If this were to come true, would anyone bother paying taxes at all? Are we one step away from anarchy?
A deeper dive reveals a less dramatic picture. Opportunities for illicit behavior are unlikely to expand far beyond what physical cash and the fiat system already cater for. Offering customers to transact off the books still runs almost the same risk of being reported. Flows of goods and services continue to be as visible and measurable. Any decrease in risk associated with illicit behavior can likely be counterbalanced by an increase in severity of punishment under the law.
Perhaps most importantly, authorities would naturally amass a database of “compliant” crypto addresses, where users have agreed to a level of ongoing disclosure sufficient for government’s comfort. Those addresses would then likely be declared the only ones eligible to transact within its economy. Whether you want to buy a coffee or a house, you would need the money that is demonstrably compliant.
In effect, the money supply would become segmented into “white” and “grey” domains, with the latter relegated to marginal use cases and thus penalized in terms of value. “Grey” does not necessarily mean “illegal”, but merely reflects the fact that provenance has not been established to the satisfaction of a particular authority. Indeed, the same address could be considered compliant in one jurisdiction, but not in another. All in all, we look to have ended up in a system where untaxed gains accrue in the form of second-rate decentralized money and bringing them back into the compliant domain is difficult and/or expensive. Sound familiar?
The powers that the state initially lost seem to have been granted straight back, and it all looks like business as usual for the economy. Has nothing really changed then?
Not quite. The outcome may look similar, but not the mechanism that underpins it. The state no longer operates a proprietary monetary system. Instead, individuals continually reaffirm their consent to grant the state certain powers within a decentralized construct. When the state performs its duties to the society’s general satisfaction, it is indeed business as usual. In times of social discontent, however, things could get interesting.
Imagine that a number of individuals and businesses, as an act of protest, withdraw their capital, in whole or in part, from the compliant domain of money supply. In an act not dissimilar to voting out a government, they would instead defund it. A small group can be labeled tax evaders and jailed. Not so with a sufficiently popular movement, and neither can it be ignored. The state would be operating on increasingly short rations, and printing fiat is unlikely to be an effective countermeasure — flight to the decentralized alternative could immensely amplify the resulting devaluation. Short of a brutal regulatory clampdown and use of force, the only realistic option for the government is to engage with the protesters to re-establish social consensus. In the longer term, the desire to steer clear of such confrontations could mean a more balanced approach to policy and improved government accountability.
Is this threat of non-compliance a credible one? Would protesters have to subsist on contraband cigarettes, or would a self-regulated sub-economy quickly emerge? The required technology would be readily available and barriers to implementation would be few. The answer thus depends on the depth of support for the issues being protested. Beyond doubt, however, is the fact that the adoption of decentralized money would shift the balance of power within the social contract from the state to the individual.
The Individual
Despite all its inequity and inefficiency, it is hard to deny that the current monetary system, in developed economies at least, has done a very difficult job reasonably well. Then, is there any real appetite for the benefits of decentralized money? Will the empowerment theme resonate? Will consumers get a better deal?
Let’s tackle the consumer angle first. Even at this early stage, it is clear that decentralized money will bring about lower transaction costs across the board and increase competition in many if not all areas of financial services. As a result, some of the financial flows previously destined for corporate profits would instead turn into additional spending power for consumers. The global payments industry alone boasts close to $2 trillion in revenue, so benefits should be sizeable. On top of that, consumers can expect a myriad of adoption incentives coming their way, with some data privacy on the side. Sounds like a great deal by all accounts, but keep in mind that we are still operating in the hypothetical endgame.
What of the empowerment angle, does it have much relevance? Firstly, it links directly into the age-old private property narrative — the direct power you have to defend your home and physical assets can now be extended to electronic money (in fact, cryptography would give you a degree of control that you are never likely to achieve over physical property). In most developed democracies at least, neither your home nor your electronic money is under daily siege. Yet, the desire to be in control of what is yours is an ever-recurring theme. It is cropping up in an increasing number of contexts, from various aspects of data privacy today to personal mobility in the near future. Practically on all fronts, the individual is rapidly losing ground. What is more, an increasing number of people are starting to realize what they have lost, and the resulting frustration is only likely to keep rising. Arguably, decentralized money provides the individual with the single biggest opportunity for a win, for a chance to regain control over their claim on the economy they helped build.
The Financial Industry
As things stand, private banking institutions play a uniquely privileged role in the monetary system. In a fractional banking model, liquidity in the hands of businesses and individuals is in fact “commercial bank money”, issued by institutions acting as exclusive intermediaries between central banks and the real economy.
This exclusive arrangement has two major consequences. First, monopolistic access to central bank money comes with exclusive opportunities to make a profit. Examples of this privilege range from banks’ use of near-free liquidity provided in the course of quantitative easing to make speculative market bets, and to the simple fact that commercial bank deposits available to consumers pay a lower interest rate, under most circumstances than central bank deposits only available to banks themselves. Second, banks get to force their credit risk onto depositors and, in times of crises, onto taxpayers. In simple terms, if you hold a deposit in a bank that has issued too many bad loans, then your money is at risk. The only way you can avoid this exposure altogether is by not using electronic money at all, which is not a realistic proposition for most of us.
By definition, this position of privilege would not be replicated within the decentralized monetary system. New leaders will emerge in the space, making it unlikely that current market shares would be carried over into the new regime intact. In other words, decentralization will likely both shrink the financial sector profit pool and decrease the legacy institutions’ share of it.
Faced with this prospect, what strategy can we expect the financial industry to adopt? Seems unlikely it would willingly evolve to the detriment of its own profitability, especially when the new reality does not yet look inevitable. A more rational course of action would be to deploy resources towards preserving the current state of affairs. Decentralized money does not exactly fit into most existing regulatory frameworks, and lobbying for an adversarial approach of prohibitive legislation and aggressive enforcement seems like an obvious and a well-trodden path.
State of Technology
We are in the early days of decentralized money. Both the concept itself and its constituent technologies are still under development and far from their mature form. Yet the adversarial environment that will be its natural habitat dictates that even the early choices may prove critical. We will highlight one particular design decision, popular among many current industry leaders, that may present itself as low-hanging regulatory fruit and set the tone for things to come.
One of the widely accepted requirements for decentralized money is price stability. Without going into excessive detail, proposed solutions to this problem can be divided into two categories — those that rely on the fiat financial system, and those that do not.
Recipe followed by the first category is simple — place fiat and/or highly liquid and stable financial assets (e.g. government bonds) with a regulated financial institution and issue blockchain-based units of value (stablecoins) that represent a claim on the underlying assets. In case of purely fiat collateral, stability is achieved almost by definition, since the underlying asset and the reference for stability are one and the same. Use of a wider range of instruments necessitates certain design adjustments, but the ultimate price stability is not really in question. Theoretically, combining this approach with a truly decentralized blockchain protocol gives you an instrument that ticks most boxes for what decentralized money should be. Indeed, such instruments are already widely used on crypto exchanges and are actively being considered for wider applications.
Except, what you actually get is an enhanced electronic version of the bearer bond — an instrument of choice for money laundering that has long been phased out. It is difficult to imagine that any regulator would countenance bringing it back. On top of that, imagine that a bank agrees to hold the fiat deposit that underpins such an instrument. What if the instrument is then used as a means of payment in a drug deal and is seized by law enforcement? Is the drug dealer a customer of the bank? Is the bank facilitating the crime? Whatever the interpretation, this situation is untenable from today’s regulatory perspective, and something has to give.
In an ideal world, a decentralized self-regulation framework would be phased in, perhaps making the coin even less attractive for illegal activity than its fiat counterpart. In practice, the shortest path to a satisfactory regulatory outcome is to extend the current framework to cover the new asset. That means every participant of the ecosystem would have to be KYC’ed and AML’ed by a central authority, and regulators would gain the power to unilaterally seize funds considered to be in breach of the law. In other words, enforcing existing regulations means breaking decentralization.
Whether or not this outcome materializes is a question of bargaining power. Does the fiat-backed construct have sufficient immunity from regulatory pressure to buy time and push for a compromise?
As its name suggests, the fiat deposit that underpins it is under the effective control of the regulator. Seizing it in response to non-compliance would immediately collapse the whole system. Arguments have been made that spreading collateral across a wide range of jurisdictions could decrease exposure. In reality, regulatory regimes in the majority of developed economies are highly aligned and often act in synchrony (e.g. FATF). As it happens, these are the very jurisdictions where most of the assets suitable as collateral originate. Indeed, even if only one of the many jurisdictions acts to seize or encumber its share of assets, the result may well be mass panic among users and a game of financial musical chairs, where the one standing is left with the collateral shortfall.
Given this balance of power, the conversation between fiat-backed coins and regulators is not likely to be anything but a one-way street. Signs point to an outcome where the model is brought fully into the regulatory fold, and the technology is co-opted by the banking sector to serve as an extension of the fiat system.
Can other approaches fare any better? Does removing dependence on the fiat system shift the balance of power enough?
Given the current trajectory of technological development, it is not unreasonable to expect a workable and largely uncompromised design for decentralized money to emerge in the near future. Albeit as yet unproven, there is a number of approaches to price stabilization that do not rely on the fiat system, removing the associated attack surface either substantially or entirely. In combination with resilient consensus and privacy, we would arguably be approaching a situation where attacking the decentralized money construct as a whole is less effective than going after its users. The question then circles back to our earlier discussion — will users care to put up a fight?
Which Way Now?
Decentralization is on a collision course with a long-established order backed by significant political and commercial interests. It offers glimpses of a better world, but its ultimate impact will be shaped by the regulatory response that it elicits. A restrictive regulatory agenda would cause the decentralized space to split: one part would become fully compliant, but offer decentralization in name only; the other would remain loyal to its original values, but would be forced to adopt an adversarial attitude to their implementation. This situation is unlikely to yield the best social outcome. Resources deployed within the compliant space would primarily seek to benefit the same interests that brought about the restrictive regulatory agenda in the first place. The “rebels”, on the other hand, would be forced to focus on building up defenses against state-sponsored attacks, rather than on implementing the vision of a more balanced society. Yet, as things stand, this adversarial future is exactly where the industry seems to be drifting. Can something be done to shift the course?
Regulatory agenda with respect to decentralization is driven by two factors — the duty to prevent significant risks to the economy and the rule of law, and the need to accommodate the political pressures involved.
Given the magnitude of changes that decentralization could bring about, it is more than reasonable for regulators to step in. The problem, however, lies in the fact that existing regulatory toolkits do not have the instruments to deal with decentralized systems without breaking them. In order to avoid the prospect of a chainsaw being employed where a scalpel is called for, the decentralized industry has little choice but to co-opt the narrative of social responsibility, articulate the risks involved and offer decentralized solutions to address them before regulators can act.
The willingness of regulators to accept this dynamic, however, comes down to the question of political pressure. As things stand, that pressure comes primarily from the financial industry and state institutions that are the very symbol of centralization. The only way to shift the balance is to get the public on board. Changing the popular perception of crypto from that of a financial gamble to the instrument of social empowerment is not an easy task, but one that needs to be tackled urgently for the benefit of all.
