America’s encryption conundrum: How to protect security without stifling innovation?

Author: Former U.S. Deputy Treasury Secretary Justin Muzinich

Source: Foreign Affairs

Compiled and edited by Amy Liu

Over the past year, digital currencies have gone mainstream. In just three months last spring, China tested its first digital currency in some of its largest cities. Hackers broke into a major U.S. oil pipeline and extorted more than $4 million in Bitcoin . Cryptocurrencies have surged to record levels, with a total market value of more than $2 trillion. Federal Reserve Chairman Jerome Powell warned that cryptocurrencies are extremely volatile and could pose potential risks.

For years, many in Washington have viewed cryptocurrency as a darling of techies and West Coast liberals, but it has suddenly become one of the most important policy issues on the Biden administration's agenda. Digital currencies are driving tremendous innovation and have the potential to increase efficiency across entire sectors of the economy. But they also pose a variety of national security and financial threats, and could even undermine U.S. influence overseas.

One reason digital currencies are so potentially transformative is that their software design often reflects a particular policy view — that governments should have less control over money. Early adopters often ascribe political and philosophical significance to their use of digital currencies. Reducing government control over money has potential benefits, such as lowering the cost of payments. But it could also undermine the ability of authorities to respond to economic crises or combat cyber and financial crime.

The huge upside and downside potential has pushed the policy debate around digital currencies to extremes. On one side are opponents of digital currencies who believe they are primarily a tool for illicit financing and have called on governments to curb their spread, in some cases even advocating for a ban on private sector tokens. On the other side are evangelists who see digital currencies as revolutionary;

But what the United States needs is a public policy framework that takes a balanced approach, preserving the market’s ability to innovate without sacrificing the government’s ability to perform its basic functions. In other words, policymakers need both the humility to recognize that markets are best at distinguishing useful innovation from hype, and the confidence to put in place key safeguards. To that end, a Biden administration should erect guardrails in areas where these currencies pose the greatest collateral risks. At the same time, the United States should lay the groundwork for launching a digital dollar or provide private sector support to ensure that the dollar plays a preeminent role in international payments. This approach would forge a path between the two extremes of banning digital currencies and allowing markets to flow unimpeded.

U.S. policymakers should act quickly. China and other countries are moving forward with sovereign digital currencies. Uncertainty about what the U.S. will do adds to the cloud of regulatory risk hanging over the industry. The sooner the U.S. takes steps to provide policy clarity, the sooner innovation can flourish.

Cheaper, faster, more risky

There are public and private sectors for digital currencies. Sovereign digital currencies, such as China's digital yuan, are issued by the government and holders can request them directly from the central bank. Like ordinary currency transactions, sovereign digital currency transactions are verified by the central bank. In other words, these currencies are just digital extensions of regular currencies - except that they can make central banks look more like retail banks. Depending on their design, sovereign digital currencies could even enable ordinary depositors to open accounts directly with the central bank and could increase rather than reduce government control over money.

In contrast, private-sector digital currencies typically rely on decentralized blockchain technology to settle between users. These currencies include cryptocurrencies such as Bitcoin and Ethereum , whose value fluctuates relative to the U.S. dollar, and stablecoins, such as USDC . They are pegged to fiat currencies. There are many types of blockchain technology that underpin these currencies, but it generally allows a community of users to verify transactions on a ledger rather than relying on a central authority such as the Federal Reserve.

For example, before a token can be transferred from one user to another, a certain number of token holders might have to validate a transaction, or a token holder might have to confirm a cryptographic key. One consequence of moving transactions outside the banking system is that transaction fees might be reduced. Since 2018, the average cost of sending bitcoin from one digital wallet to another has been about $4. The largest U.S. banks charge consumers much more for transactions of similar speed: about $28 for domestic wires and about $40 for international wires. But decentralized systems are not inherently cheaper than centralized ones. A centralized ledger can operate just as efficiently as a decentralized ledger. One reason it’s cheaper to send bitcoin than dollars is that bitcoin avoids much of the infrastructure of the traditional central banking system and the associated fees. Some of that infrastructure, such as anti-money laundering systems, plays a vital role. So to the extent that the lower cost of transferring bitcoin and other cryptocurrencies reflects lower regulatory and compliance costs, that may not last. But other costs associated with the traditional payment system stem from inefficiencies that could be eliminated through competition. If the challenges posed by cryptocurrencies force the traditional payment system to cut costs, that’s clearly good for the U.S. as a whole.

In addition to offering lower fees, cryptocurrencies have also spawned a new generation of decentralized business models. For example, blockchain-enabled file storage businesses allow anyone who joins the network to rent spare hard drive capacity directly from others on the network, rather than relying on Dropbox or Amazon Web Services. In so-called "decentralized finance," blockchains can facilitate lending without banks.

Yet, as some cryptocurrency evangelists have argued, decentralization is not just another example of a new technology upending incumbents. True, companies threatened by blockchain technology will have to adapt. But cryptocurrencies don’t just promise to replace private sector incumbents; they could undermine some important government functions that both parties value, and that presents a risk that a limited public policy framework should address.

Who controls the money supply?

One of the biggest risks posed by cryptocurrencies is that they could undermine the Fed’s ability to set monetary policy. While this scenario is unlikely, it is conceivable that cryptocurrencies like Bitcoin could become a common enough medium of exchange that a significant portion of the money supply is beyond the Fed’s control.

Until now, this has been a theoretical question. Despite being labeled “currency,” Bitcoin and other cryptocurrencies are mostly held in the U.S. as investment assets. Goods and services are not denominated in Bitcoin, so most holders use it as a substitute for assets like gold or stocks, and sometimes as a hedge against inflation. One reason Bitcoin hasn’t become a medium of exchange is that the IRS says any transaction involving the digital currency is a taxable “realization event” — meaning users pay taxes on the gain in value of the bitcoins between the time they buy them and the time they use them to buy goods. In other words, Bitcoin is treated as a stock for tax purposes, which makes it impractical to use as currency.

But even if the IRS changes its view, Bitcoin and similar cryptocurrencies will not be widely used as a medium of exchange for a more fundamental reason: their price volatility relative to the U.S. dollar. Just in the last year, the price of Bitcoin has varied widely—from a low of less than $15,000 per coin to a high of more than $60,000. Therefore, anyone who prices goods and services in Bitcoin must accept this volatility risk.

In a world where it is difficult to predict how technology will develop, policymakers should take proactive steps to prevent private-sector digital currencies from eroding the Fed’s control over monetary policy. In particular, they should strengthen enforcement of tax rules, including those requiring capital gains taxes on cryptocurrency transactions, to make non-stablecoins more attractive as an asset rather than as a medium of exchange. Congressional efforts to include appropriate cryptocurrency tax reporting language in recent legislation are a good step in this direction. Policymakers should also require stablecoins to maintain fixed reserve requirements at all times so that even as they become widely used, they do not hamper the Fed’s ability to set monetary policy.

Unclear rules, uncertain power

In addition to complicating monetary policy, cryptocurrencies could create risks within the financial system, as Powell warned earlier. They are traded in secondary markets, both over-the-counter and through exchanges widely used by the public, but the regulatory regime surrounding them is unclear. One point of confusion is whether cryptocurrencies are securities, which fall under the jurisdiction of the Securities and Exchange Commission (SEC), or commodities, which fall under the jurisdiction of the Commodity Futures Trading Commission (CFTC). Lawyers are divided on the issue, and there is considerable uncertainty within the industry about which regulatory regime applies to which currency.

Even if cryptocurrencies clearly fall under the CFTC’s jurisdiction, there’s still a second divide. The CFTC can regulate futures markets for cryptocurrencies like Bitcoin, but its authority is more limited when it comes to spot markets — just the ability to punish fraud and manipulation. For example, the same exchange might facilitate trading in both Bitcoin futures and spot markets, but the CFTC would have regulatory authority only over the former. In the absence of a federal regulator, spot markets could be regulated differently in all 50 states, which would both confuse consumers and hurt U.S. competitiveness. Entrepreneurs would do less business in the U.S. if they had to comply with 50 different legal regimes in the U.S. and just one in other countries.

In addition to jurisdictional issues, cryptocurrencies also raise questions about financial stability. For example, there are few rules governing the reserve or liquidity management of stablecoins. As a result, token holders may have difficulty exchanging tokens for dollars, and they may be exposed to more risk than they realize. For example, the popular stablecoin Tether initially claimed that its tokens were backed by the U.S. dollar, but later disclosed that it had invested its reserves in various risky assets, surprising many token holders.

As long as these currencies are not widely held, such risks will be borne only by individual holders. However, if the collateral of a systemically important stablecoin is compromised, a run on the currency could occur and affect the stability of multiple markets - something that is more likely to happen when the economy is already in trouble. These are issues that policymakers are discussing, and existing regulatory frameworks, such as those governing money markets, may be partially applicable to cryptocurrencies.

The way forward

As digital currencies continue to gain traction, the debate over how to regulate them will only intensify. Finding a middle path won’t be easy in Washington. Because digital currencies touch on so many policy areas, they span the U.S. government’s normal decision-making silos and risk an uncoordinated, patchwork approach. Within the executive branch, multiple agencies have a stake in the issue, including the Treasury Department, the SEC, the CFTC, the Federal Reserve, the Justice Department, and the State Department. In Congress, multiple committees have an interest in digital currencies, including the Committees on Banking, Finance, Agriculture, and Foreign Relations.

To forge a cross-sector path forward, the Biden administration should regularly convene a high-level group similar to the President’s Working Group on Financial Markets, which would include the Treasury Secretary, the Fed Chair, the SEC Chair, and the CFTC Chair. Congress could also create a bipartisan task force to seek consensus across committees.

Most Americans want their government to respond to economic downturns, prevent widespread financial instability, and combat terrorism and other types of crime. But most also want to benefit from the innovative potential of new technologies like digital currencies. Decisions about government control of money must be made not only by software developers but also by elected representatives who are accountable to the American people.