Flash crash shows intrinsic vulnerability of cryptocurrencies

Mere rumors of a possible U.S. Treasury crackdown on money laundering carried out through cryptocurrencies on Sunday sparked a flash crash, wiping circa $300 billion off the total market capitalization of cryptocurrencies around the world  in less than 24 hours.

Supporters of digital coins tend to shrug off such government measures as “difficult if not impossible to enforce” due to the decentralized control or lack thereof as opposed to centralized fiat currency and central banking systems. Some would even argue that the government would fail or is too late to curb the proliferation of cryptocurrencies.

It is in fact not an overstatement to say the true value of blockchain technology lies in its ability to use a decentralized model of robust interaction at the protocol level.

Decentralized and autonomous, all cryptocurrencies (be bitcoin or altcoins/tokens) are governed by the defined method of consensus through a set of rules without a board or an authority, so theoretically independent from political influence and actions of monetary authorities.

As a side note, these highly appreciated virtues of cryptocurrencies also dignify them as an excellent facility to carry out money laundering, tax evasion, scams, drug trade and dodging international sanctions.

Although its decentralized and immutable ledger availability has made it popular for services in both financial and nonfinancial domains, cryptocurrencies intrinsically suffer from the arguably intractable governance, scalability and regulatory challenges associated with constructing  a fully decentralized network that can truly serve the interests of its users.

As a result, it is important to understand that most cryptocurrencies are not as privacy-enhancing as is commonly perceived.  Even more importantly, the primary deficiency of cryptocurrencies is that they are not as decentralized as is commonly believed.

At the moment, while the majority of countries do not make the usage of cryptocurrencies a serious offence, their status as money (or a commodity) varies, with differing regulatory implications and we can below look why the government control shouldn’t be understated.

The questions below also allow us to understand why such rumors of U.S. treasury crackdown do send shivers down the spine of even a devout digital coin supporter.

So, can a government actually ban cryptocurrencies?

In short, yes. If you are wondering how, here is an oversimplified view.

The word “decentralization” – the raison d’être of cryptocurrencies – is very idealistic in theory, and in the world of a blockchain enthusiast it is a cure for many, if not all, of the real world problems.

However, it is important to understand the challenge of decentralization and how it is intimately linked to the infrastructure and “centralized services” in our “overcentralized world”.

Technically, in a truly decentralized architecture it is hard if not impossible to discern a particular center. But..

A power-wielding government like the U.S. can not only instruct all institutions desist from handling, accepting, facilitating cryptocurrencies but also can apply an effective mechanism to disable the underlying service infrastructure such as domains, DNS, server/hosting, ATMs, payment terminal etc. to paralyze what we call a “decentralized system”. 

The Internet and World Wide Web were originally conceived as decentralized technologies too since technically there was no absolute central authority and still is not. Yes, technically but the reality is the things changed when it started to be widely adopted. 

From this, we can deduce that what appears more likely to happen is that the successful blockchain implementations won’t be fully decentralized – for example, it can be under government regulation where government-registered participants can transact. 

Can cryptocurrency replace fiat currency or become mainstream?

Blockchain is an impressive technology invented to serve as the public transaction ledger for the first digital currency bitcoin – to solve one of the digital money’s flaws – the double-spending problem without the need of a trusted authority or central server.  No word against the technology.

Consensus mechanisms allow for decentralizing the validation of transactions. They are crucial in arguments that cryptocurrencies could replace banks and function without trusted third parties safeguarding transaction ledgers.

Theoretically, cryptocurrencies  would become mainstream but it is not that simple in practice.

For example, let’s look at a few cases.

Scalability

If you know how the blockchain (if oversimplified, it is a long chain of records) works, it is easy to understand that over time the ledger grows substantially, making it unwieldy for recording everyday payments.

For example, a peer-to-peer network can not simply process the number of digital transactions currently handled by national retail payment systems, and would require a supercomputer at each node to keep up with verifying and validating transactions which is the core of consensus mechanisms and decentralization. 

Increasing the network’s transaction processing limit (network’s throughput) requires making changes to the technical workings of bitcoin or other cryptocurrencies, and various ideas and proposals have come forth on how to improve the efficiency and scalability, yet none is a silver bullet to provide a way out.  Different approaches of side chain/forks are also being explored to reduce processing time per transaction. 

The current centralized system works because banks can at low cost build the infrastructure in one place where everything is processed and handled smoothly without consensus mechanisms. 

So, growth of a decentralized blockchain is accompanied by the risk of centralization because the computer resources required to process larger amounts of data become more and more expensive. 

Stability

A currency is used as a medium of exchange and a mode of storage of value, and its value has to be stable. Large magnitude swings raging in the crypto world are not characteristics of a stable currency, and as many would agree, make them impractical for mainstream use. 

As a crypto enthusiast, you are perhaps after a surge in the price of the cryptocurrency you own although you never think about this when it comes to the money in your pocket or card. 

For example, currency stability, among many things, allows people to recognise changes in relative prices, minimizes unproductive activities to hedge against the negative impact of inflation or deflation, helps governments, you and businesses to plan savings and investments and provides the government with a machinery to manage the economy. 

Most importantly, you wouldn’t sell your car in a currency that might be worth nothing overnight and I wouldn’t give you my precious coins to get your car if they might be worth double tomorrow. 

Although there have been attempts to create a stable cryptocoin pegged to the worldly assets or fiat currencies, there is no proven feasible path towards a global central bank that would ensure the stability of a decentralised currency. 

 Regulatory challenges

 As above, cryptocurrencies do indeed pose serious challenges to governments and regulators, such as money laundering, tax evasion and terrorist financing concerns.

It is easy to understand why. Money laundering is the process by which the illegal sources of profits are disguised to obscure the link between the funds and the original criminal activity.

For example, illegally sourced money is used to buy cryptocurrencies and then the new balance is not linked to the original source.  Governments around the world has consistently raised concerns over this vulnerability provided by the decentralized nature of the digital currency technologies. 

This is, however, changing as the Web changed decades ago and fell under the government regulation and now specialised tech-companies provide blockchain tracking services, making crypto exchanges, law-enforcement and banks more aware of what is happening with crypto funds and fiat crypto exchanges.

However, this raises the risk of centralization as discussed above and undermines the true decentralization. 

Finally

If a huff and puff can down the currency system today, what would happen if the U.S. President Joe Biden signs an executive order tomorrow to ban cryptocurrencies?

Ultimately, our biggest challenge is ourselves. Right or wrong, we are too comfortable with relying on centralized authority to manage what is most valuable and dearest to us, may it be our personal data or asset possessions.

On a positive note, while technological utopians dream of the demise of any centralized institutions, it has been proven over centuries that a strong government is a necessary central point of coordination in society.

 

 

Risk Warning: Cryptocurrency is a unregulated virtual notoriously volatile asset with a high level of risk.  Any news, opinions, research, data, or other information contained within this website is provided for news reporting purposes as general market commentary and does not constitute investment or trading advice.