By Sanjiv Bhatia
In December 2013, a 25-year old, Gerald Cotton, launched QuadrigaCX, a cryptocurrency exchange in Canada where people could buy and trade virtual (or digital) currencies. Recently, while travelling in India, Cotton, who had Crohn’s disease, died unexpectedly at a hospital in Jaipur. He was 30 years old.
His death created an unexpected problem because he was the only one who knew the passwords to access almost $145 million in customer funds lying in these virtual currencies. The laptop from which Cotton controlled the business of the crypto-exchange was encrypted so even experts could not break through to access the funds. On February 5th, the company filed for bankruptcy protection.
This is clearly a setback for the cryptocurrency movement, but it will not derail their growth. Most cryptocurrency exchanges are mature with greater transparent practices than existed at QuadrigaCX. Backups and multiple centres of control are the norms, and industry insiders are shocked at the centralised control at QuadrigaCX. But clearly, the QuadrigaCX case will bring renewed calls for the strict regulation (and in some cases the complete elimination) of cryptocurrencies.
That would be extremely unfortunate. The idea of cryptocurrencies is extremely appealing to those of us who cherish liberty and economic freedom. A world with no controls on how people exchange their legally-earned money, with no global boundaries on where goods and services are produced and sold, and total freedom from the ‘big brother’ state watching over their financial activities, is an extremely powerful idea and the growth of cryptocurrencies is making these possibilities real.
Milton Friedman, arguably the most renowned Libertarian economist of the 20th century, predicted the development of such currencies back in 1990. “I think the internet is going to be one of the major forces for reducing the role of government. The one thing that’s missing, and that will soon be developed, is a reliable e-cash.”
Twenty years later cryptocurrencies like Bitcoin have become a reality, and their acceptance is increasing. The price of one Bitcoin, for example, rose from 6 cents in 2008 to more than $ 19,000 seven years later–an unprecedented rise in asset value. Why would anyone pay such a high amount for an imaginary currency that has no physical face and exists only as entries in digital ledgers?
The more pertinent question is whether these virtual currencies are a fad or the monetary future, and what, if any, regulations should be added to deal with their exchange.
First, a brief history of cryptocurrencies. In 2008, in the wake of the global financial crisis when government money was failing, a person acting under the pseudonym Satoshi Nakamoto published a white paper titled “Bitcoin: A Peer-to-Peer Electronic Cash System.” With that was created a system to transfer money digitally between willing participants without the need for a trusted third party like a bank. The developer of the Bitcoin system cleverly restricted the algorithm to supply only 21 million virtual bitcoins by the year 2140. Out of this total supply, 16.7 million bitcoins have already been issued. So, while its supply is restricted, demand keeps increasing, creating upward pressure on its price.
As would be expected in a free market, the success of Bitcoin encouraged savvy entrepreneurs to offer attractive substitute cryptocurrencies. There are very few barriers to entry so currently there are over 1500 such currencies. According to a recent study, more than 80% of these will eventually collapse, and only a few will survive. Despite many calling these virtual currencies a Ponzi scheme and a fad, investors, driven by the desire for high returns, keep pouring money into these currencies. Many, like the investors of QuadrigaCX, have been burnt but like with every other investment it is “buyer beware.”
Until now cryptocurrencies have been trading in unregulated markets. But in Dec 2018, two of the largest exchanges in the world, the Chicago Mercantile Exchange (CME) and the Chicago Board Options Exchange, started trading futures and options contracts on Bitcoins. These derivative contracts now allow investors to speculate on future price movements without needing to buy or sell these virtual currencies. This has dramatically reduced their price. The price of a Bitcoin, for example, peaked at $ 19,783 five days after the introduction of futures and options trading and has been declining continuously since then–the current price is around $3,650.. As always, the free market finds a way to moderate things without the need for state interference.
The value (and hence the price) of cryptocurrencies will ultimately depend on their acceptance as a medium of exchange. The more willing people are to use them in exchange for real goods and services the higher their acceptability and the higher their value. Hundreds of companies including global giants like Microsoft and eBay now accept Bitcoins as payment, and several countries, including most recently Japan, have legalised the use of Bitcoins.
Trust in these virtual currencies has increased dramatically in the last few years. As a result, governments worldwide are increasingly feeling threatened because their power to control money is slowly being eroded. Citizens in many countries are getting weary of government scrutiny of their financial activities and growing tax coercion and are embracing the freedom and anonymity offered by cryptocurrencies.
Also, most governments have an awful track record for managing currencies. Despite the rapid economic expansion over the last century, every single currency in the world has lost value over time–an aberration that can only be explained by the reckless printing of fiat money by governments. The Zimbabwean Dollar, for example, dropped over a billion per cent in one month. Cryptocurrencies represent a new chapter in the global monetary order –currencies with no borders, no exchange rates, and open and transparent valuation. The days of centralised government control over currencies could be coming to an end. And hopefully, it will be the start of the end of big governments everywhere.
Various governments around the world hold different views on regulating virtual currencies. The legal and policy framework fall in one of three categories: banned (China), open and strict (USA), and open and liberal (Switzerland). Many governments have issued notices on the pitfalls of investing in the cryptocurrencies and warned citizens that they invest in these currencies at their own risk with no legal recourse in the event of a loss.
The government of India does not recognise cryptocurrencies as legal tender, and currently, the creation, trading or usage of these currencies as a medium of payment is not authorised by the RBI or any other monetary authority in India. The RBI has cautioned holders and traders on the risk of these currencies and clarified that it had not authorised any entity or company to operate such schemes. Additionally, banks, and other regulated financial institutions are prohibited from dealing with virtual currencies and from providing services such as maintaining accounts, registering, trading, settling, clearing, giving loans against virtual tokens, accepting them as collateral, opening accounts of exchanges dealing with them and transfer / receipt of money in accounts relating to purchase/ sale of cryptocurrencies. That said, the RBI has recognised that the blockchain technology that drives virtual currencies has potential benefits for financial inclusion and enhancing the efficiency of the financial system.
Switzerland has perhaps the most liberal laws on cryptocurrencies because it recognises their potential and is eager to become a global hub for Fintech companies. The Swiss government is keen to create a means for companies to test innovative business ideas without having to comply with costly and time-consuming regulations. The country, therefore, allows the open exchange of cryptocurrencies and even their use to pay taxes (up to a certain limit). They are considered as assets (so no different than cash or stocks) and taxed as such. The authorities are also using existing anti-money laundering legislation (instead of writing new laws) to prevent money laundering in the trading and exchange of cryptocurrencies.
The case of QuadrigaCX is an outlier. Most crypto-exchanges have sophisticated technical controls including the existence of multiple keys, backup accounts, individual safekeeping—and the industry is advanced enough to come up with countless other ways to prevent the kind of situation that happened with QuadrigaCX. But it is essential that the industry be allowed to self-regulate itself—after all nobody has a greater incentive to devise appropriate controls than the industry itself. The last thing we need is more government interference and regulations.
There are enough existing regulations to control the financial services and investment industries. These regulations can easily be extended to investments in cryptocurrencies. No amount of laws will put an end to rogue behaviour. Despite the plethora of rules governing the investment industry, investors regularly lose money to corporate fraud and bankruptcies. But these losses have not prompted a ban on the trading of stocks and bonds. Why not apply the same standards to investing in cryptocurrencies–let the industry develop its own checks and balances and let investors beware? In a free world, every person should have the right to invest however they please. The role of the state is not to control the risk people take, but to require full disclosure of the potential risk of all investments, to have clear laws to prevent fraud and to prosecute rogue behaviour.