Since its introduction in a 2008 whitepaper, Bitcoin (BTCUSD) has generated controversy and news. Its enthusiasts herald the cryptocurrency’s launch as the advent of a new and equitable monetary system. Critics point to the cryptocurrency’s role in criminal activities and the absence of legal recognition as proof that it is “rat poison squared”. The reality, probably, lies somewhere in between.
Meanwhile, governments around the world are eyeing Bitcoin’s advance warily. Some, like El Salvador, have adopted it as currency. But major economies, including the United States, refuse to recognize it as legal tender. They have good reasons for doing so.
Among other things, Bitcoin enables the citizens of a country to undermine government authority by circumventing capital controls imposed by it. It also facilitates nefarious activities by helping criminals evade detection. Finally, by removing intermediaries, Bitcoin can potentially throw a wrench in the existing financial infrastructure system and destabilize it.
- Governments around the world are eyeing Bitcoin's advance warily because it has the potential to upend the existing financial system and undermine their role in it.
- In its current form, Bitcoin presents three challenges to government authority: it cannot be regulated, it is used by criminals, and it can help citizens circumvent capital controls.
- Until the time that Bitcoin's ecosystem matures, it will continue to be viewed with distrust by established authorities.
In What Do We Trust?
To understand why governments are circumspect about Bitcoin, it is important to understand the role that fiat currencies play in a country’s economy. Fiat refers to conventional currencies issued by governments. Fiat money is backed by the full faith and credit of a government. This means that governments promise to make the borrower of a currency whole, in case of a default.
The U.S. government relies on the Federal Reserve, a central bank on which Congress only has partial authority, to print or create money for its economy. The cycle of transactions in the US economy—one that involves borrowers, lenders, and consumers—relies on a chain of trust between transacting parties. The Federal Reserve, which is also known as a lender of the last resort, is the final leg of that chain.
Bitcoin advocates charge the Fed with creating money out of thin air i.e., the currency is not backed by tangible assets. By manipulating the supply of money in the US economy, the central bank also manufactures asset bubbles and crises, they say.
Governments facilitate the role of central banks in an economy. While central banks are involved in making policy related to money, they do not have authority to regulate its use. That responsibility lies with the government. Through a series of intermediaries, such as banks and financial institutions, governments distribute and regulate the flow and use of money in an economy. Thus, they can dictate how it is transferred, sectors where it is distributed, and trace its utility. They also earn revenue from it by taxing earnings of individuals and corporations.
Bitcoin Undermines the Cycle of Trust
Bitcoin’s decentralized system has the potential to dismantle the system described above. Its network does away with intermediaries and, by extension, the elements of a government’s system.
A central bank is no longer required because Bitcoin, the currency, can be produced by anyone running a full node. Peer-to-peer transfers between two parties on Bitcoin’s network means that intermediaries are no longer required to manage and distribute currency.
The chain of trust underpinning the current financial infrastructure becomes an algorithmic construct in Bitcoin’s network. A transaction is not included in the central ledger unless it is approved by all full nodes. Even a single disagreement or error in a transaction entry can result in its rejection.
Theoretically, at least, the streamlining of operations between individuals and between various actors on Bitcoin’s blockchain can rearrange the current system. The financial infrastructure is decentralized and the power to increase or decrease currency supply is not appointed with a single or group of authorities. Thus, in the new setup, the role of governments in managing and regulating economic policy through intermediaries may become superfluous.
Why Are Governments Wary of Bitcoin?
Whether the state- and regulation-less future envisaged by Bitcoin evangelists comes to pass is still an open question. Meanwhile, governments around the world are trying to understand the effect that the cryptocurrency might have on their economies in the near-term. Specifically, they are grappling with the following three problems presented by Bitcoin in its current form.
Bitcoin can circumvent government-imposed capital controls
Governments often institute capital controls to prevent outflows of a currency because exports could debase its value. For some, this is another form of control exerted by governments on economic and fiscal policy. In such instances, the state-less nature of bitcoin comes in handy to circumventing capital controls and exporting wealth.
One of the more well-known instances of capital flight using Bitcoin has occurred in China. The country’s citizens have an annual limit of $50,000 to purchase foreign currency. A report by Chainalysis, a crypto forensics firm, found that more than $50 billion moved from China-based bitcoin wallets to wallets in other countries in 2020, meaning Chinese citizens may have converted the local currency to Bitcoin and transferred it across borders to sidestep government regulation.
Bitcoin ties to illegal activity
The ability to bypass existing financial infrastructure for a country is a blessing in disguise for criminals because it enables them to camouflage their involvement in such activities. Bitcoin’s network is pseudonymous, meaning users are identified only by their addresses on the network. it is difficult to trace the provenance of a transaction or the identity of an individual or organization behind the address. Besides this, the algorithmic trust engendered by Bitcoin’s network obviates the need for trusted contacts at either end of an illegal transaction.
Not surprisingly, Bitcoin is a favored conduit for criminals for financial transactions. The most famous example of a crime involving bitcoin was the Silk Road case. Briefly, Silk Road was a marketplace for guns and illegal drugs, among other things, on the Dark Web. It allowed users to pay in bitcoins. The cryptocurrency was held in escrow until the buyer confirmed receipt of goods. It was difficult for law enforcement to trace parties involved in the transaction because they only had blockchain addresses as identification. Eventually, however, the FBI was able to take down the marketplace and seize 174,000 BTC.
In recent times, infecting popular applications with ransomware and demanding payment in bitcoin has also become popular with hackers. The 2021 Colonial Pipeline hack, which resulted in energy supply disruptions in various states, demonstrated the degree to which such attacks can become national security issues.
Bitcoin is not regulated
More than a decade after Bitcoin was introduced, governments around the world are still trying to figure out ways to regulate the cryptocurrency. There are multiple strands to bitcoin’s regulation problem.
For example, changing narratives about Bitcoin utility has complicated questions relating to the appropriate government agency to oversee the cryptocurrency, definitions to be used for lawmaking or, even, the approach for formulation of laws.
Is Bitcoin a currency to be used in daily transactions or a store of value that is primarily used for investment purposes? Is Bitcoin a safe haven asset during the times of global economic turmoil? Neither the so-called Bitcoin expert nor the average bitcoin investor seem to know.
It could be argued that the use of Bitcoin in investing products like futures is proof of its attractiveness to traders. However, the underlying markets for such derivatives are unregulated because none of the major cryptocurrency exchanges, used to set Bitcoin’s price for futures markets, are registered with the Securities and Exchange Commission (SEC).
An Opaque Ecosystem
While Bitcoin has the potential to upend established dynamics of the existing financial ecosystem, it is still plagued by several problems. Government wariness about the cryptocurrency can be partly attributed to fear and partly to the lack of transparency about its ecosystem. Those latter concerns are not misplaced.
Not much is known about the cause-and-effect relationship between Bitcoin price and global developments. That is an important sticking point in light of the cryptocurrency’s volatile price swings. Numerous scams have pervaded its development as an asset class. As the SEC outlined in a January 2018 letter, there are several issues, from an absence of transparency to the presence of bitcoin whales, related to the workings of cryptocurrency exchanges.
The Bottom Line
Bitcoin has become a touchstone for controversy since it was introduced to the world in the aftermath of the financial crisis. Governments have become wary, even fearful, of Bitcoin, and have alternated between criticizing the cryptocurrency and investigating its use for their ends.
While it has the potential to decentralize and change the workings of the existing financial infrastructure, the cryptocurrency’s ecosystem is still rife with scandals and criminals. Until the time that its ecosystem matures and a significant use case for it is found, Bitcoin will continue to provoke distrust and criticism from established authorities.