The pros and cons of crypto markets (vs. regulated markets)

Keeping-your-balance-from-highFew people saw it, but Bitcoin dropped 87% to $8,200 on Coinbase last week. The sudden drop was due to an erroneous trade entry from a trading algorithm, and it didn’t last long. The asset quickly recovered.

Operational issues like this one are not that rare in the regular markets, but it begs the question of how often operational issues happen, and which world (crypto or regulated) is most exposed.

A bit of research on the pros and cons of crypto markets vs regulated markets lead to the general view below.

 

pros-and-cons

Google-search the pro’s and con’s of cryptocurrencies, and you find articles like this one or that one. Let’s start with these well-recognized statements.

 

Advantages

The stated advantages are repositioned in their wider dimension, before being particular issues are pointed out:

Advantages Issue at stake Comment
Freedom of payment: crypto spells the end of the “tyranny of governments“. Someone’s freedom fighter is a someone else’s terrorist. Who gets to decide? Can we agree that some authority is needed?

Cryptos are a benediction for bad actors. Rogue states and international pariahs use Cryptos to flout international sanctions. Do we want to help the North Korea’s government?

Wallets are anonymous and protect from identity thefts

Anonymity also hides bad actors and hinders enforcement authorities.

Identity-theft

It is naïve to think that there’s only a few bad apples.

Ransomware actors commit enormous damage.

The whataboutism of saying that there are much more fraud in fiat currencies may be true, but probably not after adjustment by the sizes of the two monetary masses or transaction volumes. Anyway fraud is fraud, and it should not be facilitated. 

  Good luck getting your lifetime savings if you lose your key.

That’s an enormous amount.

This would never happen at a regulated institutions, which would always be able to return your money to you.

 

We don’t know who owns the majority of cryptos. 

question-identity

Natoshi Nakamoto, the creator of BTC, owns probably 1 million BTC, worth dozens of $ billions at the current level. Natoshi Nakamoto is a pseudonym.

Contrarily to stated democratization objectives, 80% of cryptos are currently held by only 20 wallets (exchanges). DeFi has created its own new giants.

What power would these individuals and private entities hold on all of us if we convert, say, 20% of the world’s economy to crypto?

A complex algo cannot be manipulated.

They are not full-proof.

They also consumes an enormous amount of resources.

 

The day a quantum computer breaks the code, a miner can hack the blockchain. BTC will be worth nothing after that. It will happen in the next decade.

Cryptocurrencies have a large negative environmental impact.

 

A transaction is validated in 10 minutes. True. But most regulated assets settle T+1 these days. Is the gain worth that much?

A lot of transactions could be moved to virtually instantaneous settlement.

 

No third party involvement. Your repository IS a third-party.

An exchange or a repository of crypto like Coinbase IS a third party. You are still exposed to third party risk with cryptocurrencies.

If anything, your counterparty risk is actually much higher than in the regulated world.

Needless to say, regulated providers have a much better resilience. More on this in the exchange section below.

Free/very cheap transactions

Low-price

If the transactions themselves are free to operate, the exchanges are not.

The fee structure is actually opaque, and certainly not free.

  • Fee structures are complicated, involving fixed fees, AUM-based fees and transaction fees.

Worse, transaction fee is only one element of transaction costs. The other are:

  • Transaction spreads: the most liquid cryptos have spreads typically of 5-25 bps, while BTC has a spread of 1.5-20 bps, which are in line with the major currencies. But most crypto currencies are way less liquid.
  • And liquidity: the slippage in BTC is a few bps for $100k$. It is orders of magnitude higher than for major currencies (you could trade dozens of millions of EUR/USD without impacting the pair’s price).
  • The rumor is that some platforms (advertising free trades), have a tendency to move their spreads when you come for trading… It’s another cost.
No inflation, since there is no government involved.

Yes, governments can issue new dollars.

But cryptos are structurally inflationist – their number is limited and the cost of mining them increases over time.

The recent exponential growth price of BTC matches the rhetoric that it can ‘only go up’.

  • The number of bitcoin is limited, and mining efficiency decreases every 4 years automatically (and the computational cost increases inversely).
  • If you think the crypto is not inflationary, then at least it is deflationary, since the price of any asset, expressed in BTC, will go down.
  • You may not create more of a given crypto currency, but you can endlessly create different crypto currencies.
  • There is an estimated 6,000 cryptocurrencies at this stage. Most of these currencies will never have any value.

Which is the most stable and reliable? A fiat currency like the dollar in existence for centuries and backed by the power of taxation, or ‘something’ (see the regulatory question) that has no intrinsic value, is not a store of value, is not well defined and whose prices is highly volatile?

 

Fright

Disadvantages

Those were the advantages. Here are the known disadvantages now.

Disadvantages Issue at stake Comment
Lack of awareness / the techniques are complex Awareness is growing fast, but the complexity as well.

Not knowing what sustains the Thai baht currency, or the geopolitical complexity of the Turkish lira, is irrelevant to most individuals – they don’t use those currencies. It is the same for cryptocurrencies.

As a result most people will never use such complex assets as a mean of payment, especially when they are evolving faster and faster.

Highly volatile in nature

roller-coaster-looping

BTC, probably the benchmark in crypto currencies, has 80% volatility. Can it be a store of value?

A store of value must meet several criteria, like being durable, fungible, verifiable, storable, portable, and divisible.

Cryptocurrencies meet many of those. Where it becomes difficult is that a store of value must “retain purchasing power into the future“.

  • Gold is perceived as such. Most fiat currencies are to some extent.
  • Cryptocurrencies instead have no ‘intrinsic value”, and will never have any, to the exception of the mining cost (precious metals are worth at least their general extraction cost)
  • Cryptocurrencies are generally not backed by anything of value (like the USD is backed by the full faith and power of the US government & its economy)
  • They must also be perceived as such.
  • Because of the lack of history and their high volatilities, it will take years / decades / generations before they could be accepted as such.

Also, a store of value should be usable for exchange. Just walk around town, your supermarket to start with, and it is pretty obvious. Most of the world’s assets cannot be purchased with Crypto currencies (at this stage).

This being said, cryptocurrencies offer other unique characteristics like

  • being seizure resistant (for now). Who is looking for this again?

Not accepted everywhere

atm-keyboard

To a few rare exceptions, cryptocurrencies are not accepted means of exchanges. Will they every be?

A few countries have accepted BTC as a national currency or borrowed in cryptos, but it is more to escape international sanctions than by structural benefit (see our previous note here)

  • El Salvador’s attempt to avoid sanctions turned into a fiasco.
  • Venezuela tried to create a Petro-currency pegged against its reserves, mostly to circumvent international sanctions. It also went nowhere.

So will cryptocurrencies ever be accepted as means of payment? Elon Musk thinks so, but

  • Cryptos would have to be authorized by governments first.
  • For that, Cryptos would have to become less volatile first.
  • Government would consider that they would not hinder on their responsibilities and powers. You really have to be naïve to think that the US government will ever relinquish the international power and the responsibilities coming from being the world’s top reserve currency.
  • And for what? To let commercial entities make profits? To support speculation? The Fed has prevented banks to issue their own currencies in the past.
  • The Fed will support any form of economy and will likely let crypto exists, but never to the point of a challenge. Most central banks follow the same guideline. China just forbade them, as a preparation for their own CBDC.

Companies may use them, but it will be marginal. At this stage, crypto are not even secure and their legal nature not well defined.

There are many theft and scams.

Pickpocket

OMG, where do we start?

FTC-Reported-Cryptocurrency-Scams

Maybe just some official statics from the Federal Trade Commission.

These numbers are based on self-reporting and are way below reality.

No reverse payment or recovery

You have no recourse against another participant.

More importantly, the regulatory environment is so weak, that there’s nothing you can do when your money is gone.

 See the regulatory section below.

It is a pandemic issue, according to fraud, compliance professionals and litigation attorneys.

Black market: dark web, fraudulent identities, ransomware… Self-evident  You have to be blind not to see it.
Scaling issue As the number of transactions increases, the computing power needed to confirm transactions become unmanageable

The world’s computer infrastructure is limited. Energy resources are limited. The more energy you consume, the more you pollute. Simply said, the computational needs to handle cryptocurrencies are already unmanageable.

Not exchangeable with fiat currencies. Governments can restrict conversions.

Or they can tax transactions. The IRS is actually the best positioned agency to regulate cryptocurrencies in the US.

 

 

No-jumping-or-diving

Regulatory issues

There are several areas, where cryptocurrencies are deficient, and certainly less safe than ‘regulated markets’. Let’s start with the regulatory issues.

Cryptocurrencies are not always securities.
  • BTC and Ether are not, according to the Howey Test (the criteria confirmed by the Supreme Court to define what is an investment contract).
  • But an Initial Coin Offering (ICO) is a sale to the public and the SEC considers it its responsibility.
  • Also the SEC’s gods disagree, and they may simply change the rule at some point.
  • Right now, the SEC is being finger-pointed for the lack of a clear policy, and for playing whac-a-mole on everything crypto (aka ruling by enforcements).
  • Gary Gensler, the SEC’s new Chairman and an MIT professor on cryptocurrencies, has a clear intent to regulate cryptos.
  • A minima, a lot of exchanges better be registered (since some cryptos are definitely securities), and sooner than later.

As a result, the SEC is limited in its rights & competencies to intervene in cryptocurrencies.

Cryptocurrencies are not commodities.

Commodities

  • Because Cryptocurrencies are not used to create other goods, they are not commodities.
  • But futures are, and so the CFTC has oversight on a segment of the crytpo market – those having futures.

So the CFTC is also limited in how they can intervene in cryptocurrencies

Cryptocurrencies are not currencies.

They are at best means of payments.

Which means the OCC (Office of the comptroller of the currency) has little jurisdiction.

The IRS has some oversight
  • The IRS can determine how it will treat cryptocurrencies and how it will tax their transactions.
  • It can also force individual to report transactions, even on foreign exchanges, as well as their transaction prices.
  • The IRS considers cryptos as capital assets, whose profits are subject to capital gain taxes.
  • You can tax what you don’t like and therefore the IRS could become the best regulator.

What is needed

Congress

It is Congress’s job to determine what a cryptocurrency is, and how cryptocurrencies should be handled by the United States.

  • Although many bills are supposedly in progress, Congress has still not decided how it will define cryptos.
  • with a bit of cynicism, the old men in DC may not be the most competent in the newest technologies, so don’t hope for anything soon.

 

 

LimboThe legal limbo

The lack of regulatory rules, and a fortiori the lack of a regulator, makes guidance, implementation and corrections difficult. The lack of both rules and jurisprudence makes defining what is right or wrong (aka legal) particularly difficult for all the law professionals.

You will find among the many issues that they face (Freeman Law, World Financial Review):

Contractual issues ‘Smart contracts’ rules that are automatically applied when parties transact in a given rule-based cryptocurrency do not fit when in legal framework for contracts. Contract laws also differ from state to state. As a result, any disagreement results in lengthy litigation.

Jurisdictional / accountability issues

Globe

The blockchains are located nowhere and everywhere. Any miner keeps a copy of it. as a reuslt,

  • Which agency has jurisdiction to investigate an issue?
  • Who do you sue when there is a loss?
  • Which law from which jurisdiction apply to blockchain, so where do you sue? Most disagreements become cross-border.
  • Worse, many explicit participants (exchanges) are located in far jurisdictions, for which no international treaty works or handles cryptocurrencies. Good luck collecting your crypto-monies from a Gibraltar-based exchange that refuses to pay you back or goes bust. Let’s not even mention mention that some exchanges have chosen to be country-less.
Theft and fraud

Cryptocurrencies promises anonymity to its account holders. Thieves could not hope for a better way to manage their finances.

But data also is stolen. When Ledger’s database was hacked, 1 million emails and the entire information from 9,500 customers were stolen. If you are one of those, you have no recourse against the company – there are no laws.

If someone hacks your bank account, banks are forced to cooperate with the police. There is no equivalent in cryptocurrency. Demonstrating that an individual committed a crime is much harder in an anonymous world.

Privacy issues

Privacy-man-silence

Anonymity is a problem for law enforcement. But it is not even guaranteed by the blockchain technology. The technology company Chainalysis can already identify the owners of multiple crypto currencies.

Also, blockchain’s distributed peer-to-peer technology may be infringing on confidentiality rules like HIPAA and CCPA.

Money laundering Anonymous accounts are ideal for money laundering. But there are actually techniques (like mixing) to make money tracing even harder or offer deniability to criminals. Interestingly, the mixers themselves also leave traces, leading to famous arrests.

Intellectual Property

mechanical-brain

Industries exposed to counterfeits are interested in the traceability of transactions. It raises concerns of ownerships, enforceability of smart contracts, as well as difficulties with licensing, distribution and exclusivity.

NFTs are a quagmire of issues of their own. See our previous piece.

No recourse

Most interestingly, if your bank loses the money you have deposited in your account. You can trace it or force the bank to get your money back. There is absolutely no equivalent in a decentralized system. If a hacker depletes your wallet, you are alone.

Needless to say, wallet hacking is now a big business, notably through the ubiquitous smart phone – and apparently both common and relatively easy to do.

 

 

NYSEExchanges

Exchanges like the New York Stock Exchanges, the CBOE or the Chicago Mercantile Exchange are well established. They offer safe environment for transacting, raising capital, or for ensuring resilience of the financial markets.

Exchanges in the crypto space, not so much:

 

 

 

skeletons-no-hear-no-say-no-seeThere are good sides in the crypto space, like the benefits of the distributed ledger, aka an efficient outsourcing mechanism. Miners need to be rewarded for this service, and the token needs to have value for this.

But it’s pretty obvious to me that regulated market participants hold themselves to much higher standards than the crypto participants, and that there are some serious drawbacks in the overall crypto concept. Not to you?

And it is the general public that suffers from these low standards, not the professionals.

 

 

 

 

References

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Written by Gontran de Quillacq

Gontran de Quillacq is an expert witness and a legal consultant. He is a recognized authority in options, trading, derivatives, structured products, portfolio management, hedge funds, mathematical finance, quantitative investment, strategy research and financial markets in general.

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