My evidence to the UK Treasury’s Digital Currencies Inquiry

The written evidence I submitted to UK Parliament, as requested by the Treasury’s Digital Currencies Inquiry, is finally up!

For all the written evidence, click here and hit “View all” — there were forty-eight submissions. Blockchain skeptics will particularly enjoy Jorge Stolfi’s.

There will be a second oral evidence session — Martin Walker was amazing at the first — though it probably won’t feature me, sadly.

 

Round Gold-colored Bitcoin by David McBee, CC-0 — the stock image favoured by the Treasury.

 

Evidence submitted by David Gerard (DGC0052)

Digital Currencies Inquiry: written evidence submitted by David Gerard

I am David Gerard, author of Attack of the 50 Foot Blockchain, a critical book on cryptocurrency and blockchains. I write a news blog of the same name on the crypto space, and speak and consult on the topic. I have been asked to submit evidence to this inquiry.

Executive summary:

• Bitcoin and similar cryptocurrencies are inefficient payment systems, because they were constructed to fulfil fringe political aims.
• Blockchain and Distributed Ledger Technology are terms used to market mundane technologies as fulfilling the spectacular promises of Bitcoin — promises at which it has already failed.
• The cryptocurrency and blockchain space is rife with at best unrealised claims, and at worst outright fraud.
• The present Know Your Customer/anti-money-laundering regulation is appropriate.
• Cryptocurrency products should not be marketed to consumers or retail investors.
• US regulatory agencies are tightening regulation, in an appropriate manner.

Are digital currencies ultimately capable of replacing traditional means of payment?

1. I will assume “digital currencies” here to mean decentralised cryptocurrencies, such as Bitcoin, and possibly centrally-controlled cryptocurrencies such as Ripple.

2. The problem with Bitcoin as a payment system is that it was never designed to be a good payment system, one that could outperform present digital payment systems — it was constructed as a political project, and political considerations overrode any concerns of efficiency.

3. The political aims of Bitcoin were as a project to advocate anarcho-capitalist and Austrian School economic ideals and a digital gold standard. The requirements were a system with strictly regulated issuance — rather than monetary policy — with Bitcoin’s creator, the pseudonymous “Satoshi Nakamoto,” explicitly comparing it to gold, and condemning the financial system and the fact that central banks can issue money without backing. The online subculture Bitcoin was created and nurtured in was explicit in its anarcho-capitalist politics, and it attracted many people of these leanings.

4. (The political history of Bitcoin’s origins is best documented in The Politics of Bitcoin: Software as Right-Wing Extremism (2016) by David Golumbia, a professor at Virginia Commonwealth University in the US.^[1])

5. This means that Bitcoin was founded on political ideas that had already shown themselves to be inadequate to the function of a modern economy. This means it had a number of problems from the outset.

6. Nakamoto required decentralisation — that there was no central controlling body that any user of the system had to trust. The problem is that decentralised systems are vastly less efficient than centrally controlled ones. This is reflected in the stupendous waste of power involved in Bitcoin’s “proof of work” mining system, where it uses 0.1% of the world’s total electricity consumption, or an amount comparable to the entire Republic of Ireland.^[2] This is to achieve a transaction rate of approximately 7 transactions per second, total worldwide across all of Bitcoin.

7. The purpose of decentralisation is to ensure that Bitcoin transactions are irreversible — so that no transaction may be censored, and no Bitcoins may be taken from someone without their cryptographic consent. This has the side-effect that the system is extremely brittle to errors and thefts, which cannot be reversed — if you make a mistake, you lose your Bitcoins; if someone hacks your Bitcoins, you can’t get them back. Irreversibility is marketed to merchants as “no chargebacks” — but, while merchants dislike the possibility of chargebacks, they dislike more payment methods that customers won’t use; and customers overwhelmingly prefer electronic payment methods to have the possibility of chargebacks.

8. Deflation was explicitly designed into Bitcoin — Nakamoto put forward as a positive for Bitcoin that it would go up in price, with greater demand and use. This did indeed happen — although the price rise was from speculation — but the problem was that deflation disincentivises use of a currency; if your money is worth more tomorrow, you won’t spend it today. This was observed in practice — when merchants did add Bitcoin as a payment method, it mostly wasn’t used, as even Bitcoin advocates prefer to hold rather than spend, and the general public were not attracted to Bitcoins when they could use conventional currency over a channel that allowed chargebacks.

9. Bitcoin transactions were fast and free until mid-2015, when it hit capacity, and transactions suddenly went up in price and were subject to delays. By December 2017, the average fee for one Bitcoin transaction was $55. This shook off most of the remaining legitimate merchants.

10. The one successful merchant use case for Bitcoin was on black markets, and particularly the darknet drug markets. As well as the uncensorability of transactions, there was a widespread (if erroneous) perception that Bitcoin was anonymous. It is instructive to note that even the drug market doesn’t like using Bitcoin — apart from transactions being expensive and slow, the price of Bitcoin is sufficiently volatile, at 5%-10% a day, that a deal could be messed up by price changes by the time it finally went through. The darknet drug markets have increasingly moved to other cryptocurrencies.

11. Since Bitcoin was open source code, anyone could copy it to make their own cryptocurrency, and so there are thousands of Bitcoin copies, or “altcoins.” While these are usable as long as they don’t suffer a similar transaction clog, they have not solved the problems of a decentralised cryptocurrency. The second most popular cryptocurrency, Ethereum, is having intermittent transaction clogs similar to those that befell Bitcoin.

12. Bitcoin has also lost its decentralisation — since proof of work mining has economies of scale, the natural tendency is to recentralise. By early 2014, most mining had formed into a few large mining pools. Bitcoin is now mostly mined by four or five large pools. Altcoins tend to be even more centralised. Miners with a sufficient percentage of the mining power have the power to stop transactions going through — which affects the uncensorability of transactions.

13. ICOs, offering tokens marketed as private currency but in practice being objects of speculation, typically run on top of a decentralised blockchain platform such as Ethereum, but are centrally-controlled by the issuer. These are most usefully treated as securities or investment vehicles.

14. There is a great deal of work in computer science on mathematical constructs that can deliver the promises of Bitcoin — mostly decentralisation — without its problems with efficiency and transaction speed. So far none of these have delivered a robust working system fulfilling these promises — and many have been “six months away” for years. For the most part, their offerings in practice tend to be marketing their tokens, in the manner of ICOs.

15. Given all of this, Bitcoin-style decentralised currencies are unlikely to outdo conventional payment systems in the foreseeable future.

16. Centrally-administered currencies such as Ripple do not suffer Bitcoin’s inefficiencies or transaction speed problems, but (of course) are simply private payment systems that can be regulated appropriately. Similar systems are mooted for use in such proposals as central bank cryptocurrencies, e.g., distributing pounds sterling via a centrally-administered blockchain-like construct.

To what extent could digital currencies disrupt the economy and the workings of the public sector?

17. Bitcoin’s main use case was illegal payments — financial crimes and money laundering. This has the possibility of social disruption. This has mostly been dealt with by firm control over the gateways between cryptocurrencies and conventional currencies — Know Your Customer laws at the exchanges, and banks requiring detailed information from customers on the provenance of cash deposits.

What risks and benefits could digital currencies generate for consumers, businesses and governments?

18. It is important to note that all of Bitcoin’s promises have already failed in Bitcoin, and other cryptocurrencies will only fulfil these promises while they are little-used.

19. As such, the main consumer risk is that the space is rife with fraud, scams and criminals — as it is perceived as a get-rich scheme.

20. This also carries the risk of retail-level investors losing all their money in extremely questionable investments. I consider it misselling to allow cryptocurrency marketing as an investment to retail-level investors; it is a profoundly risky trading environment.

21. The main concerns with a central bank cryptocurrency are economics, rather than technology or fraud considerations — no more so than with any other form of cash, as it would be a different system for pounds as we know them.

22. Cryptocurrency and blockchain enterprises tend to make spectacular promises, claiming that work is underway that will give results in a matter of months or a few years. These almost never eventuate. The sector is notorious for its high hype-to-production ratio.

23. Blockchain marketing frequently puts forward future technological possibilities as if they are present-day systems you could buy off the shelf — the sector routinely confuses “could” and “is.” One IBM marketing brochure from 2016, Making Blockchain Ready for Business,^[3] includes the following claims:

24. “an enterprise-class, cross-industry open standard for distributed ledgers that can transform the way business transactions are conducted globally”

25. “highly secure blockchain services and frameworks that address regulatory compliance across financial services, government, and healthcare”

26. Note how both of these are phrased as if the systems offering this functionality exist now. No blockchain-based systems doing all of these things at once exist in 2018, let alone in 2016. All technological claims made by blockchain marketers require close and detailed questioning as to whether the technology in question even exists in production form in present time.

How is distributed ledger technology being applied in the financial services sector, and how might it be applied in future?

27. The marketing of Bitcoin-related technologies to business started in earnest around late 2013 and early 2014 — and, because the word “Bitcoin” was tainted due to its associations with drug markets and its 2013 asset bubble, the technology was promoted using the word “blockchain.” This was further euphemised in its marketing to the term “distributed ledger technology” — a term which the earliest use I can find of is from 2013, referring specifically to Bitcoin.^[4]

28. It is important to note here that at every stage, the thing being marketed is Bitcoin promises, such as decentralisation, censorship resistance, the unalterable transaction record, spectacular effects on social organisation and so forth. One would think from the words that “distributed ledger” could include shared Excel spreadsheets or Google Docs — but the term is used as a method of making outlandish-sounding Bitcoin promises without saying the word “Bitcoin”. This is even as those very promises had already failed in Bitcoin.

29. The useful aspect of Bitcoin is the blockchain data structure — an append-only ledger, made tamper-evident through cryptography. This is a construct known as a Merkle tree, first used in 1979, and widely used in computing since — nothing about it is new with Bitcoin.

30. An append-only ledger, that anyone can check the integrity of, is obviously useful; as such, we now see “blockchain” or “distributed ledger technology” used as marketing terms for such ledgers. Many of these are genuinely useful products — but, of course, a data structure does not produce the nigh-magical promises of Bitcoin. However, the spread of append-only ledgers — for those particular and specific applications in which they have a use case — is potentially good and useful.

31. A prominent example is Guardtime’s KSI Blockchain, the backbone of Estonia’s “blockchain” efforts, which is not a blockchain at all — the software was first created in 2007, and the name was changed to “blockchain” in 2012 as part of Guardtime’s marketing efforts, to great success. The power of the Bitcoin promises is such that KSI Blockchain is frequently put forward by advocates as good news for blockchains, and even good news for cryptocurrency — even though the software supplies only the tamper-evident timestamped data ledger.

What work has the Government (and its associated bodies) done to understand, prepare for and, where relevant, encourage changes that may be brought about by increased adoption of digital currencies?

How might the Government’s processes adapt should digital currencies be adopted more widely (e.g. tax implications, anti-money laundering measures)?

32. The currencies themselves are not useful payment systems, except for black market purposes. As such, present efforts to properly regulate the gateways to and from conventional currency are appropriate.

33. It would be appropriate to put into place strong consumer protection against misselling cryptocurrency enterprises as investments to retail-level investors. We presently see Tube advertisements for cryptocurrency exchanges — these should be banned as misselling, in the same manner as bans on Contracts for Difference, rolling spot forex, financial spread betting, binary options and similar financial instruments that are inappropriate for consumers and retail investors.

34. It is possible that the efforts at new computer science, to create systems that fulfil the promises of Bitcoin without its severe technical limitations, might succeed to some degree. In such a circumstance, a cryptocurrency might be adopted more widely. However, the economic problems with the lack of a central issuing bank would remain; thus, they may not be very functional as currencies. The problems with fraudsters in such new and ill-regulated areas of finance would be similar to those we observe presently in the cryptocurrency world.

Is the government striking the right balance between regulating digital currencies to provide adequate protection for consumers and businesses whilst not stifling innovation?

35. There needs to be more protection for retail investors against fraudulent schemes related to cryptocurrency.

36. The main innovations cryptocurrency enterprises offer are end-runs around regulation. While this can lead to useful innovation in finance, financial novelty is historically greatly attractive to fraudsters.

37. ICOs are much touted as a new method of enterprise fundraising with great possibilities. While I concur on the future possibilities of a hypothetical properly-regulated ICO sector, the problem at present is that almost all ICOs are functionally just highly manipulated and unregulated investment vehicles with near-fraudulent prospectuses. Fraud is rife in the sector.

38. Cryptocurrency exchanges are all but unregulated. The Commodity Futures Trading Commission in the US has noted previously that common market frauds — wash trading, spoofing, painting the tape and so forth — are qualitatively worse on cryptocurrency exchanges than on conventional regulated commodities, futures and securities exchanges:^[5]

39. “Beyond their practical and speculative functions, the emergence of these nascent markets has also been negatively marked by a variety of retail customer harm that warrants the Commission’s attention, including, among other things, flash crashes and other market disruptions, delayed settlements, alleged spoofing, hacks, alleged internal theft, alleged manipulation, smart contract coding vulnerabilities, bucket shop arrangements and other conflicts of interest. These types of activities perpetrated by bad actors can inhibit market-enhancing innovation, undermine market integrity, and stunt further market development.”

Could regulation benefit digital currency start-ups by improving consumer trust?

40. This would be useful and appropriate. Innovation in finance is useful, but regulations exist for good reason, and particularly for consumers and retail investors.

How are governments and regulators in other countries approaching digital currencies and what lessons can the UK learn from overseas?

41. FinCEN in the US has so far supplied useful guidance on regulation of gateways to and from conventional currencies, which has been broadly adopted in other countries.^[6]

42. The US Securities and Exchange Commission and the Commodity Futures Trading Commission have taken a light touch with regulation so far — they have stated the rules that apply, increasingly so since mid-2017 and the crypto market bubble and boom in ICOs.^[7] They have only recently moved to action, including administrative orders, fines and, in egregious cases, arrests. Many consider they should have acted sooner.

43. The New York State Attorney General’s Office has recently started an inquiry into cryptocurrency exchanges — asking for basic details such as their banking arrangements, compliance arrangements and how they deal with common modes of fraudulent trading.^[8] This is information regulators should have, and it is concerning that they generally do not. Exchanges such as Coinbase/GDAX and Gemini — who both market themselves as regulated and trustworthy exchanges — have welcomed the inquiry, whereas Kraken (also US-based) has stated that the cryptocurrency sector does not want regulation, even to this level.

May 2018

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[1] David Golumbia. The Politics of Bitcoin: Software as Right-Wing Extremism. University of Minnesota Press, 2016.

[2] “Bitcoin Power Consumption Index.” Digiconomist. https://digiconomist.net/bitcoin-energy-consumption

[3] Jeremy Cuomo. “Making Blockchain Ready for Business: Increase trust, accountability, and transparency across your business networks”. IBM, 2016. https://www-01.ibm.com/common/ssi/cgi-bin/ssialias?htmlfid=XIM12353USEN&

[4] JP Koning. “Why the Fed is more likely to adopt bitcoin technology than kill it off”. 14 April 2013. http://jpkoning.blogspot.co.uk/2013/04/why-fed-is-more-likely-to-adopt-bitcoin.html

[5] Commodity Futures Trading Commission. “Retail Commodity Transactions Involving Virtual Currency.” Federal Register Volume 82, Number 243, Wednesday, December 20, 2017. https://www.cftc.gov/LawRegulation/FederalRegister/proposedrules/2017-27421.html

[6] e.g., Financial Crimes Enforcement Network. “Application of FinCEN’s Regulations to Persons Administering, Exchanging, or Using Virtual Currencies.” March 18, 2013. https://www.fincen.gov/resources/statutes-regulations/guidance/application-fincens-regulations-persons-administering

[7] US Securities and Exchange Commission. “SEC Issues Investigative Report Concluding DAO Tokens, a Digital Asset, Were Securities: U.S. Securities Laws May Apply to Offers, Sales, and Trading of Interests in Virtual Organizations.” July 25, 2017. https://www.sec.gov/news/press-release/2017-131

[8] New York State Office of the Attorney General. “A.G. Schneiderman Launches Inquiry Into Cryptocurrency ‘Exchanges’.” April 17, 2018. https://ag.ny.gov/press-release/ag-schneiderman-launches-inquiry-cryptocurrency-exchanges