Bitcoin: Seizing Ground in Weak and Failing States

Amid economic turmoil, the Venezuelan government has taken a collection of actions to stabilize their currency, most of which have backfired leaving the country spiraling into greater despair. Most recently President Maduro threatened to yank 100 bolivar notes from circulation, causing panic and businesses to stop accepting the note. It is unfortunately not uncommon for weak and failing states to tamper with currency controls in feeble attempts to resolve problems that have no easy solutions. The fallout usually results in citizens scrambling to find ways to carry on their business, resorting to black markets and other measures. One new feature of the modern world is the emergence of digital cryptocurrencies like bitcoin, which offer a potential alternative to failing local currency.

Bitcoin will play a dynamic role in weak and failing states, both stabilizing trade and potentially undermining government influence over their sovereign economic domain.

States that are weak and failing are characterized by the collapse of domestic institutions, the inability to maintain security within the bounds of their sovereign territory, and economic instability from conditions that inhibit low friction sanctioned commerce. Once a state becomes destabilized, aggravating economic factors such as high inflation and a declining exchange rate with hard currencies, can further degrade the functioning of a regime. States like Syria, that are in the throes of civil war, see their domestic production of needed goods plummet, which increases demand for imports of consumer staples. The hard currencies needed to acquire imports become prohibitively expensive. From 2011 to 2015 the Syrian pound declined by almost 400% against the dollar in official exchange. More than 80% of Syrians live below the poverty line, and are not able to secure basic needs. States in turmoil institute currency controls to stem such declines. These controls usually reduce or eliminate the sanctioned ability to exchange local currency with other foreign notes. The typical result is a flourishing black market for currencies like the dollar or euro. Black markets for currencies thrive by providing these notes at a sizable premium to the official rate. While the black market may provide mechanisms to convert, and move money abroad, it is typically expensive using multiple middlemen to circumvent government obstructions. In civil wars, insurgents and their supporters desire to not only maneuver around central authority, but to also mask transactions behind anonymous trades. Traditionally this would be accomplished via the movement of cash, or front-organizations that operate under a guise of state sanctioned activity. This is where digital currencies like bitcoin have begun operating, within unstable regions where demand for backchannel capital presents an opening for cryptocurrency that does not depend on the authorization of central bank clearing. This article will examine two mechanisms that digital currencies facilitate within weak and failing states; capital flight, and black market currency.

Capital flight is defined as the mass movement of money or other assets out of a country as a response to an economic or political event. This well documented phenomenon has many historical examples. The most recent instances include flight from Iceland’s krona during and after the 2008 crisis, and from the Chinese Renminbi to the dollar in 2013. At its most basic level, organizations or individuals will seek to move funds denominated in an increasingly volatile or sinking currency into a more stable investment. This can be obvious as large monetary transfers on international exchanges, or more subtle trade nuances where goods and services are provided for hard currency that is held indefinitely offshore. Capital flight can have detrimental effects on a state that is already weathering weakness and destabilization. Fear of economic uncertainty can drive money out of a country or region, further devaluing a local currency and crashing markets. Once funds are moved abroad, the government loses control of these assets which further reduces balancing options for the regime.

To prevent this, states have typically wielded their secret weapon, the central banking system.

Central banks have been designed with the specific capability of controlling monetary flows. A quick change in central banking policy can stop all those with assets in domestic banking institutions from moving their funds abroad or exchanging their local currency for foreign. This typically accomplishes its intent because of ubiquitous use of traditional banks and investment firms that must abide by the rules and guidelines of their host state. Digital currencies, such as Bitcoin, are only guided and controlled by mathematical algorithms and by those that trade it. As such, central banks do not have direct control over bitcoin and where it can or cannot be transferred. There is some empirical evidence that Bitcoin has been used to facilitate capital flight in places like China, where observations of the exchange rate between Bitcoin and the US dollar/Bitcoin and Renminbi show positive discounts between the two, pointing to sales occurring outside of the official exchange rates at the time (Ju & Tu, 2016). Central banks, can and have attempted to stymie the ability of individuals to buy digital currencies on established exchanges, which require capital transfers from traditional banking institutions to execute purchases of Bitcoins. This has proven effective in more developed nations such as Iceland and China in preventing Capital Flight through bitcoin exchanges. Though such controls have no effect on purchases of bitcoin with cash, or through trade of goods and services. What can be said is that government attempts to hinder access to bitcoin, relies on current realities that bitcoin has not yet been widely adopted.

If large percentages of the public were in possession and were regularly using bitcoin for everyday commerce, it would be more challenging for central banks to stop capital flight.

Informal banking institutions that utilize bitcoin could work alongside the traditional banking model, if there were enough clients to support overhead. Although, without wide-spread adoption prior to a destabilizing event, states can prevent easy access into bitcoin post-crisis and limit the ability to use digital currencies as a middle agent to access dollars/euros or other alternatives.

One of bitcoin’s most controversial and unique characteristics is its ability to move funds digitally from owner to owner anonymously. While the underlying technology makes every transaction open to the public view, the transaction includes no information about the sender or the receiver other than a unique set of numbers that identifies the bitcoin “wallets” and the “coins” that are involved in the transaction. This has made bitcoin popular for those that peddle illicit products, for funding of terror organizations, and other black market activities. There are some limitations to the anonymity of bitcoin. While bitcoin itself is anonymous, bitcoin transactions that touch traditional banking will effectively leave a trail that investigative agencies can use to track the source of funds. Since each coin is given a unique identification number that perseveres as it moves from wallet to wallet, the story of each coin can be linked to other financial observations where coins are used for the purchase or sale of other assets. Various services attempt to mask some of these inherent privacy weaknesses by shuffling and redistributing bitcoins, and hiding funds in dark wallets that can’t be easily traced. Those attempting to be funded by bitcoins can setup new wallets with no history and no identity, and those with bitcoins can use services popular with criminal networks to exchange for hard currencies or mask their coins for later use.

While cash is still and shall be king of black market exchanges, bitcoin has some advantages. Cash must either be physically moved or deposited into a traceable and identifiable banking account to be transferred to other individuals. Bitcoin can be transferred within minutes, to anywhere in the world without any identification needed. Digital currency if protected with encryption, physically stolen it would be worthless to a bandit. Weak states with poor security and infrastructure make handling large amounts of cash risky, and bitcoin offers some solutions to these problems for black marketers. In that bitcoin may operate as a go-around for currency controls, it also presents opportunities for filling humanitarian needs. In Venezuela, currency controls require substantial bureaucratic hurdles for acquiring foreign currency, often meaning that hospitals and clinics running short of basic supplies are not able to import what they need*. In future scenarios, individuals and organizations may be able to overcome some of these barriers with access to bitcoin. NGOs could use bitcoin rather than pay hefty fees and taxes, which can range between 10–20% on international transfers (Krause, 2016).

Bitcoin is designed to be decentralized, but there are numerous bottlenecks in the distribution and processing environment that exists today. While anyone can download the software that “mines” bitcoins by running computation hungry calculations, massive mining operations in China are using datacenter scale systems to dominate this activity. It is no longer viable to use personal computers to efficiently mine new coins and authenticate bitcoin transactions. This means these coins must be purchased from large exchanges that are usually the recipients of newly minted coins. Exchanges work by cooperating with global financial institutions. Bitcoin has yet to be widely adopted as a means of exchange for most products, common uses have been relegated to a savings/investment mechanism, or a means of acquiring illicit products or services. This will change over time, as we are clearly in the beginning of process, and it could certainly take years for substantial adoption.

The developing world will be a likely candidate for more diversified use. There is increasing evidence that bitcoin, with its high-volatility, is more tolerable in developing nations that suffer from persistent and high inflation (Krause, 2016).

Bitcoin can be used to diversify savings within weak and failing states, and will take a more prominent role in compensating for imbalances that occur due to currency controls. This could impact the ability of weak states to stabilize their currencies on the foreign exchange. Bitcoin will also continue to fill gaps in black markets, providing a new source of capital that can bypass state obstructions and surveillance. In the near term, effects of Bitcoins presence will remain limited by its still minimal adoption, and the constraints created by bottlenecked mining and dominance of relatively few exchanges.

References

Ju, L., Lu, T. J., & Tu, Z. (2015). Capital Flight and Bitcoin Regulation. International Review of Finance.

Krause, M. (2016). Bitcoin: Implications for the Developing World.