In this second installment in our two-part blog series on cryptocurrency, we discuss the current push for regulation and how crypto might impact traditional currencies in the long run.

Cryptocurrency, also referred to as “crypto,” is any currency that exists digitally or virtually, as opposed to more traditional forms of currency that come in the form of a physical unit such as paper or metal coinage. The first cryptocurrency, Bitcoin, was founded in 2009 and remains the best known today, though thousands of cryptocurrencies now exist, including Ethereum, Litecoin, and Ripple, to name just a few.

Should cryptocurrency be regulated?

In recent years, wide cryptocurrency price swings – caused mainly by the use of cryptocurrencies as a tool for speculation rather than as a currency, combined with alleged mismanagement and abuse of cryptocurrency exchange networks – have prompted calls for increased regulation of both.

The cryptocurrency market, valued at roughly $3 trillion in mid-2021, had an approximate value of $900 billion in early December 2022. Calls for regulation increased significantly around the globe after the November 2022 collapse of FTX, one of the world’s largest cryptocurrency exchanges. Once valued at $32 billion, FTX filed for bankruptcy protection, and founder Sam Bankman-Fried resigned as its CEO after reports alleged that the company had loaned billions of dollars in customer funds to his own trading firm, Alameda Research, without informing the customers. Bankman-Fried has since been arrested and charged with a number of financial crimes.

John J. Ray, the new CEO of FTX, said that he’s never seen such a complete failure of corporate controls, and it was unclear in early December 2022 if customers of the exchange would be able to recover their funds. The bankruptcy declaration by FTX triggered significant price decreases for many cryptocurrencies, and the viability of some cryptocurrency exchanges has been seriously impacted as a result.

Regulators say that current oversight of cryptocurrency is uneven because what little regulation exists is split between federal and state agencies and is rife with gaps. Supporters of regulation argue that nonexistent control systems and decision-making that is limited to a small inner circle create a black box that provides no method to verify that investors and their holdings are protected. They also say that the decentralization and anonymity that are the founding principles of many cryptocurrencies make them and the exchanges especially attractive for illicit activity, money laundering, and sanction evasion.

What form would cryptocurrency regulation take?

Many experts say that U.S. regulation of cryptocurrencies and exchanges is a virtual certainty, but it was unclear in late 2022 what form such regulation would take. A key issue to be resolved is the criteria that will be used to determine if a cryptocurrency falls under the regulatory framework of a security, subject to Securities and Exchange Commission (SEC) regulations, or if it should be regulated as an asset or commodity.

Cryptocurrency advocates — including some members of Congress — have pushed for any regulation to come from the U.S. Commodity Futures Trading Commission (CFTC) rather than the SEC.

“In part, it’s because the securities regulatory regime is so prescriptive,” said Daniel Kahan, a lawyer in King & Spalding’s cryptocurrency and blockchain group. “There’s a focus on all of these technical elements of the regime around reporting and trading and other things that are not directly tied to fraud.” According to Kahan, the belief in the cryptocurrency sector is that the CFTC “would be much more appropriate to focus on investor protection, anti-fraud, and anti-market manipulation-type issues rather than on these very technical prescriptive elements of the current securities law regime.”

Some experts argue that neither the SEC nor the CFTS should have exclusive power to regulate cryptocurrency because the design of a cryptocurrency can result in the coins generated by the cryptocurrency software having characteristics of an asset, a commodity, or both.

The SEC already has made a move toward regulating the sector with its widely publicized 2020 lawsuit against Ripple that alleges it raised more than $1.3 billion by selling its native token, XRP, in unregistered securities transactions. More recently, the SEC has been targeting exchanges such as Coinbase and Binance over their crypto products. The regulator’s chairman, Gary Gensler, has been vocal about the cryptocurrency sector and has referred to it as “a Wild West.”

The cryptocurrency sector has stepped up lobbying efforts, including hiring former top officials from Democratic and Republican presidential administrations, in an effort to shape laws and regulators in their sector. Final authority to determine how cryptocurrency is regulated at the federal level is held by the U.S. Congress.

Could a digital dollar replace cryptocurrencies?

Some federal officials and banking regulators see “significant benefits” from creating a central bank digital currency (CBDC), which would be a digital form of the U.S. dollar. A CBDC would be similar to cryptocurrencies because it would exist as virtual banknotes or coins held in a digital wallet. The difference between a CBDC and a cryptocurrency, however, is that the value of the CBDC is backed by the U.S., just like traditional fiat currency.

Federal Reserve Chairman Jerome Powell said the key reason to release a CBDC would be to eliminate the need for alternative coin use in the country. “You wouldn’t need stablecoins; you wouldn’t need cryptocurrencies if you had a digital U.S. currency,” Powell said in congressional testimony. “I think that’s one of the stronger arguments in its favor.”

Many experts say the threat of a CBDC launched by another country replacing the U.S. dollar as the default currency for use around the world is another key reason that a U.S. CBDC is under consideration. Countries – including China – have already created a CBDC. Other potential benefits of a U.S. CDBC include cheaper, faster, and more accessible payment systems without the risks that come with decentralized, anonymous cryptocurrency systems, according to some experts.

The development of a CBDC would likely take years if the U.S. chooses to create one, according to U.S. Treasury Secretary Janet Yellen. Experts add that the Federal Reserve is unlikely to launch a CBDC except under the explicit authority of the U.S. Congress.

Meanwhile, in November 2022, the New York Federal Reserve’s Innovation Center (NYIC) launched a 12-week pilot project with major banks to examine the viability of a CBDC. The pilot program will use digital “tokens” that represent bank deposits. Institutions involved in the program will engage in simulated transactions to test the viability of the system. The participating banks include BNY Mellon, Citi, HSBC, Mastercard, PNC Bank, T.D. Bank, Truist, U.S. Bank, and Wells Fargo. The bank transfer messaging service, Swift, also will be a participant in this project.

Will digital currencies replace traditional currencies?

Digital currencies, whether they are decentralized cryptocurrencies or digital fiat currencies, are considered by some to be the future of currency, but others say that there is little evidence supporting this.

Over 97 percent of the currency in circulation in the U.S. today is from checking deposits – dollars deposited online and converted into a string of digital code by a commercial bank. The digitization of credit and debit card transactions and the development of banking apps have moved many traditionally cash-based transactions into digital space, thus preserving – and, in many cases, extending – the use of traditional fiat currencies.

New payment intermediaries like Paypal still rely on customers linking the service to their bank debit and credit cards. Advocates of digital currency argue that these forms of payment via traditional fiat currency are too slow and expensive and are unavailable to the unbanked.

Intermediaries that provide traditional fiat currency-based services counter that they are steadily improving their services to increase efficiency and reduce costs and that fees charged to customers of cryptocurrency exchanges have risen over time. They also note that many cryptocurrency platforms (such as exchanges) typically require a bank account to use cryptocurrencies, which limits their ability to serve the unbanked.

U.S. Treasury Secretary Yellen and several Federal Reserve members have repeatedly touted the coming creation of FedNow, a system that will allow bill payments, paychecks, and other common consumer or business transfers made with traditional currency to be available instantly and around-the-clock. Scheduled to go live in 2023, FedNow is a change from the current system that is closed on weekends and can require days to settle a transaction.

A significant number of prominent currency stakeholders argue that continuing development of traditional fiat currency payment processes and the rollout of new services like FedNow are likely to erode the advantages of cryptocurrencies and any CBDC under development while preserving existing safeguards.

The crypto long game

The long-term role of cryptocurrency and digital currencies in national and global economies has yet to be determined. Use of cryptocurrency primarily as a tool for unbridled financial speculation is unlikely to continue, however.

The behavior of key cryptocurrency sector players, the nature of likely future regulation, the possible introduction of a digital U.S. dollar, the level of support for use of cryptocurrencies as actual currencies, and continuing development of traditional fiat currency payment processes are likely to be the key determinants of future digital currency development and use.

>> For more insights on how cryptocurrencies affect different industries, contact us to learn more and see a list of the industries we cover.

Image credit: Alesia Kozik via Pexels

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