Last week’s Senate hearing on cryptocurrency and blockchain highlighted many of the known issues in the sector. Economist Nouriel Roubini said, “crypto is the mother and father of all scams and bubbles”. But during the hearings, two key issues were omitted. While CoinCenter Lobbyist Peter van Valkenburgh welcomed institutional investment in the sector, there was no discussion about the specific risks of this trend.
Secondly, Roubini pointed to the centralization of public blockchains. But enterprise blockchains also present risks related to the concentration of business data on single blockchain platforms.
In his testimony, Roubini outlined that cryptocurrencies fail the key tests for money, consume huge amounts of energy, and the mining is largely centralized in China.
For the cryptocurrency sector, van Valkenburgh argued that the internet needs a public payments infrastructure. He acknowledged that the technology is still nascent and imperfect but stated it needs a light regulatory touch to encourage innovation.
I will be happy to debate @VitalikButerin any time in public, on impossible trinity, scalability or any other crypto subject. I already debated Joe Lubin in front of a crowd of 500 of his supporters and got 5X more applause than him. So be my guest any time. https://t.co/ofKOAPOh1E
— Nouriel Roubini (@Nouriel) October 12, 2018
Unsurprisingly Roubini is facing a backlash from the cryptocurrency community, and there are plans for a debate between Vitalik Buterin and Roubini.
“Crypto is the mother and father of all scams and bubbles, a bubble that has finally gone bust this year. Second, blockchain is the most over-hyped technology ever and is no better than a glorified database.”
“A recent study shows that 81% of all ICOs were scams to begin with. 11% of them have been failing or are dead. And only 8% are still trading on exchanges. Second, after a massive bubble in 2017 Bitcoin has fallen by 70% this year, other major cryptocurrencies have fallen by 80%, and thousands of other ones have fallen by 95%. This entire asset class is literally imploding now. Just yesterday major cryptocurrencies plunged another 10% in a day.”
“These assets are not currencies, calling them cryptocurrencies is nonsense. They’re not a unit of account, they’re not a means of payment, they’re not a stable store of value. Bitcoin can do only five transactions per second. VISA can do 25,000 per second. Nobody uses Bitcoin for transactions apart from criminals and terrorists. Crypto mining is also an environmental disaster as the system wastes masses amounts of energy.”
“They crypto idealogical utopia is a libertarian dream of full decentralization of all human transactions. No governments, no central banks, no corporations no banks, no trusted institutions. It’s totally utter nonsense.”
“Cryptoland is now subject to the opposite and dangerous trend. Massive centralization. Mining is centralized and controlled by oligopolies in totalitarian countries like China and Russia. Trading is centralized as 99% of all transactions occur on non-secure centralized exchanges that are being hacked on a daily basis. Development is centralized as a technological elite is police, prosecutor, and judge. They arbitrarily change the code and fork coins into new ones when things go wrong. And wealth is massively concentrated in cryptoland. The Genie coefficient of inequality in Bitcoin is worse than North Korea. It’s quite an achievement.”
“There is massive price manipulation in cryptoland. Widespread pump and dump schemes, spoofing, wash trading, insider trading, cons like Tether that are created by fiat and used to manipulate upward prices. Massive criminality.”
“ICOs associated with security tokens are non-compliant securities. They break all security laws. They are mostly scams, and even the SEC created a fake website to warn investors of such initial coin scams.”
“Utility tokens and widespread tokenization would mean the return to the stone age of barter. Even the Flintstones new better than crypto as they used clam shells as their own one currency.”
“Corporate blockchains or so-called enterprise DLT are glorified databases and have nothing to do with blockchain. They’re private rather than public. They’re permissioned rather than permissionless. They’re based on trusted authorities verifying transactions rather than being trustless. They’re not distributed on millions of computers but rather on a few selected controlled ledgers or databases. They don’t use cryptographic means to authenticate transactions but rather trusted permissioned authorities.”
“In summary, they claim to be blockchain but have nothing to do with blockchain. And 90% of all corporations experimenting with them have decided they are no better than traditional databases. And since they are more costly and less efficient than databases, they will not use them. Only 1% of all CIOs say there will be any adoption of DLTs in their organization. ANd 80% of all CIOs have no interest in this technology.”
“It’s no wonder as an organization, government, corporation or bank would ever want to put on a public permissionless distributed trustless ledger all these transactions with customers and suppliers. It doesn’t make sense, and it’s not going to happen. So blockchain is a lot of hype and almost no reality as an expert senior analyst recently concluded.”
“Unlike every other tool for sending money over the internet, it works without the need to trust a middleman. The lack of any corporation in between means that Bitcoin is the world’s first public digital payments infrastructure. And by public, I simply mean available to all and not owned by any single entity.”
“We have public infrastructure for information, for websites, for email. It’s called the internet. But the only public payments infrastructure that we have is cash. As in paper money. And it only works in face-to-face transactions. Before Bitcoin, if you wanted to pay someone remotely over the phone or the internet, then you could not use public infrastructure. You would rely on a private bank to open their books and add a ledger entry that debits you and credits the person you’re paying. And if you both don’t use the same bank, well then there will be multiple banks and multiple ledger entries in between.”
“With Bitcoin, the ledger is the public blockchain, and anyone can add an entry to that ledger transferring their Bitcoin to someone else. And anyone regardless of their nationality, race, religion, gender, sex or creditworthiness, can for absolutely no costs create a Bitcoin address in order to receive payments digitally.”
“Bitcoin is the world’s first globally accessible public money. Is it perfect? No. Neither was email when it was invented in 1972. Bitcoin’s not the best money on every margin. It’s not yet accepted everywhere, it’s not used often to quote prices, and it’s not always a stable store of value. But it is working. And the mere fact that it works without trusted intermediaries is amazing. It’s a computer science breakthrough. And it will be as significant for human flourishing as the birth of the internet. ”
“And Bitcoin is just the beginning. If we can replace private payments infrastructure, then we can replace other private choke points to human interaction as well.”
“Why should we want to build more public infrastructure? Why should we embrace blockchains over corporate intermediaries? Why should we tolerate their inefficiencies and work to make them better? Why should we want the pioneers of this technology here in the United States and not fleeing overseas? Because the corporate intermediaries today providing critical but privately owned infrastructure are becoming fewer larger and more powerful. And their failures are increasingly grave. So roughly half of all Americans, 143million people, had their social security numbers exposed to hackers because of a breach at Equifax. ”
“The SWIFT network has relayed hundreds of millions of dollars in fraudulent transactions because of hacked member banks in Bangladesh, Vietnam, Equador, and Russia. The FBI suspects now that the largest of these hacks was perpetrated by North Korea. Corrupt low-level employees at an Indian bank Punjab National were able to fraudulently certify SWIFT messages stealing $1.8 billion. It’s the largest electronic bank robbery in history. In fact, it’s the largest bank robbery in history.”
“Vulnerabilities are inescapable in systems that have single points of failure. It doesn’t matter if the point of failure is a corporation or if it’s a government. There shouldn’t be a single point of failure. Similar choke points existed before the internet. If you wanted to deliver a message you’d have to go through one of three television broadcasters or a handful of newspapers.”
“Private corporations are essential, but no critical infrastructure should rely on one or two. The internet removed single points of failure in communications infrastructure and ushered in a wave of competition among new media corporations building on top of its public rails.”
“Blockchains can similarly disintermediate critical payments and IoT infrastructure. The technology is not yet ready to answer all of those questions today, but it is our best hope. And as with the internet in the 1990s we need a light touch, pro-innovation policy to ensure that these innovations flourish in America for the benefit and security of all Americans.”
On the topic of institutional investment:
“Fortunately we are now seeing institutional investment coming online with respect to Bitcoin. And eventually other cryptocurrencies as well. We’ve got CFTC regulated Bitcoin derivative markets, and that means we’ll have I think better sell-side research from the institutional investment class and there will be the possibility for people to take short positions and rationalize the market.”
“Now key to this effort is more institutional grade products that are regulated by the proper authorities. So we have CFTC regulated derivatives. We could use ETFs regulated by the SEC where there is institutional grade custody and where there are known accounting standards and where purchasers know where they stand. We could also use better custodians in general. ….A nationally chartered bank that custodies cryptocurrency is something I think would bring more rationality to these markets.”
Outside of these discussions, what are the risks of broader cryptocurrency adoption by the regulated institutions?
To date, those exposed to cryptocurrency risks have made a choice, even if consumer protections could have been better. On the one hand, the entry of financial institutions should bring with it the professionalism and the regulatory oversight to which other markets adhere. On the other hand, there are broader implications for the economy as a whole.
The first impact is signaling. A February survey by finder.com found that less than 8% of Americans have invested in cryptocurrencies. This is despite negative public statements from respected figures such as Warren Buffett’s comment: “I can say with almost certainty that they will come to a bad ending”. JP Morgan’s Jamie Dimon famously called Bitcoin “a fraud”.
Adoption by brand name institutions provides legitimacy to the sector and encourages far greater consumer investment.
Institutions are already engaging, even if the profile is relatively low. According to the Financial Stability Board, a third of its G20 member jurisdictions reported that regulated financial institutions are participating. That includes investing, trading and dealing either in crytocurrencies or related derivatives.
While futures have been available on the CME and CBOE since December last year, the volumes are relatively low. On Friday 1,922 Bitcoin futures traded on the CME compared to 643,000 on the spot market. Coinbase launched an index fund targeted at institutions but reportedly failed to attract sufficient clients. That could in part be the result of NY Attorney General criticisms of the firm.
In August NYSE parent ICE announced it is setting a cryptocurrency exchange called BAKKT. ICE CEO Jeffrey C. Sprecher said: “We aim to build confidence in the asset class on a global scale.”
Yale’s $29.4 billion endowment has invested in two cryptocurrency funds. Goldman Sachs is exploring non-deliverable OTC forwards. Fidelity Investments has been experimenting in the sector for years and is expected to announce “something” later in the year. (UPDATE: Fidelity announcement)
Although Bitcoin has managed to survive numerous security issues to date, that doesn’t make it invulnerable. Just last month a bug was discovered in Bitcoin code that could have brought the entire system to its knees for the cost of $80,000.
There’s been much debate about the central bank involvement in the aftermath of the 2008 financial crisis. The question is what might have happened had there been no central bank intervention? Cryptocurrency proponents embrace a future without central banks. So what do the central banks think about cryptocurrencies?
Last week the Financial Stability Board (FSB) published a report entitled: “Crypto-asset markets: potential channels for future financial stability implications”. They use the crypto-asset term because of the absence of the three money features of unit of account, medium of exchange, and a reliable store of value.
The FSB doesn’t believe crypto-assets currently pose a risk because of the small size of the market and the limited exposure by regulated financial institutions.
The report noted that it’s possible that there could initially be an incident within one jurisdiction which may or may not spread. Separately it mentions that if it becomes straightforward to buy cryptocurrencies, there’s an increased risk of bank runs because funds could be transferred into cryptocurrencies very quickly.
Another concern relates to confidence. If cryptocurrencies are more widely traded and one of the risks materialize, consumers could lose confidence in the financial institutions and systems associated with them.
Should cryptocurrencies gain scale and financial institutions have exposure through trading, investment, or providing credit and other financial services, then a cryptocurrency implosion could have a ripple effect. Likewise for insurers covering cryptocurrency risks.
So far adoption for payments and settlements is limited. But if that changes and there was disruption, the question is how would you fix it?
In Roubini’s testimony, he pointed to the public blockchain centralization of mining, wealth, trading and development. He didn’t delve much into permissioned blockchains and classed them as “glorified databases and have nothing to do with blockchain.”
But they share the same leanings toward centralization at multiple levels. For the financial sector where there is already a significant degree of concentration, this may be less of an issue. However, the CLS / IBM LedgerConnect project has the potential to extend CLS’s systemically important position beyond its core forex settlement reach.
While there are enormous benefits to be gained from companies coming together to work on shared industry infrastructure, the risks need to be carefully considered.
The most obvious danger is limiting competition. The we.trade trade finance consortium avoids discussing pricing to prevent being viewed as a cartel.
However, competition isn’t just about prices. It also relates to the adoption of industry standards that favor certain players, or pricing consortium participation which excludes smaller players, even where that may be unintentional.
The concentration of hosting is a significant issue that impacts cloud computing beyond enterprise blockchain. In the early stages, it might be practical for all nodes to be hosted by a single cloud provider for simplicity. But as enterprise blockchains mature, if a cloud provider has an outage, it’s not just a few companies affected but potentially an entire industry.
Much like Bitcoin suffered a potentially catastrophic bug, so too could enterprise blockchains. Having large parts of an industry dependant on the same code carries obvious risks. In-depth third-party code reviews should become the norm. Currently, there’s a small pool of technical talent, and hence some reviews may not be sufficiently arm’s length. That needs to change.
Specialized enterprise blockchains
Based on network effects there’s a likelihood that there could be one or two blockchains per industry, which carries all the above risk factors. The alternative is to have one or two blockchains per industry function. The downside is a proliferation of groupings which seems less efficient. More networks require reliance on interoperability which also carries risks.
For insurance instead of one group that aims to do everything, one could have one that focuses on certain types of insurance, or on individual functions such as claims processing. In pharmaceuticals, a consortium focused on track and trace could be separate to the one that focuses on clinical trials.
Smaller groups could be more focused and are also likely to use more targeted technology as opposed to attempting one size fits all. This may or may not be the optimal route, but it should be debated.
While the Roubini spat with the cryptocurrency community promises to continue, the discussions about corporate issues such as institutional investment and enterprise blockchain centralization have barely started.
The irony is that a tool for decentralization encourages the opposite.