The Case for Collaboration: Why the US Government and Crypto Ecosystem Must Work Together

Electric Capital

Published in

Electric Capital

20 min readSep 11, 2020

This is a modified version of the letter we sent investors in Electric Capital as part of our 2020 Q2 update.

The Case for Collaboration: Why the US Government and Crypto Ecosystem Must Work Together

Summary

China is set to roll out a digital renminbi settlement platform (“digital currency/electronic payment” or “DC/EP”). The US is the one country that could offer an alternative to a global Chinese DCEP. While there are meaningful roles for European and Asian governments to play, without the United States’s active involvement, these other regions can at best slow down the Chinese government’s initiatives.

We believe the U.S. government cannot outcompete the Chinese Government unilaterally on a CBDC or global DCEP settlement layer. It must follow a multi-pronged strategy of offering a viable alternative to the Chinese DCEP and competing asymmetrically via benefits the Chinese government structurally cannot offer: freedom of speech, privacy, due process, and protection from unreasonable search and seizure.

Similarly, the crypto ecosystem is unlikely to outcompete the Chinese government without significant support from the US Government. The crypto community must make the case to the US Government to work together against the Chinese Government’s efforts.

Our analysis is rooted in assessing the optimal strategies for the Chinese government, US government, and crypto community rather than any value judgements or ideologies.

In order to remain competitive, the US Government and the crypto community must:

Modernize USD settlement platforms as an alternative to the Digital RMB / DCEP — Invest in a USD settlement platform to modernize the Federal Reserve system.
Make cryptodollars broadly available by mid-2021 — Deploy cryptodollars by mid-2021 through public-private partnerships with USDC, Libra, Celo, Avanti Bank and other platforms targeted at the banking and payment sectors. Cryptodollars can reach emerging markets faster than the legacy banking system and faster than the DCEP.
Create regulatory clarity to unlock decentralized cryptocurrencies as an offensive tool and expand the reach of the USD — empower decentralized cryptonetworks that codify democractic values such as privacy and protection from extra-judicial seizure. This ensures the center of gravity of these rapidly growing decentralized ecosystems is primarily in US companies, denominated in USD, and able to extend the reach of the dollar to emerging markets and authoritarian regimes (where access to the USD is strictly regulated). The alternative is to cede that many multi-billion dollar companies on these platforms will have their center of gravity outside the US.

Optimal Strategies: The Game Theory of Digital Currencies

Given how far ahead the Chinese Government is of the US Government and the distribution advantages the DCEP has over crypto ecosystems, the US and crypto ecosystem must collaborate. A cryptocurrency ecosystem without the US Government’s support will quickly lose to an ecosystem built on the Chinese DCEP. If the US Government attempts to compete with the Chinese DCEP without using decentralized cryptonetworks, the US Government will lose.

Given: The Chinese Government aims to use DCEP as a global settlement layer

As in the case of paper money, the operation of the Chinese DCEP, including the issuance and distribution of the central bank digital currency (CBDC), will be based on a two-tiered system. The first tier consists of transactions between the PBoC and intermediaries, including China’s largest banks, wherein the PBoC issues digital renminbi first to these intermediaries. The second tier consists of transactions between intermediaries and retail market participants, including individuals and Chinese fintech companies such as Alibaba and Tencent. The second tier receives the CBDC so that it can circulate through the market and settle transactions back to the first tier. The two tier system allows for efficient control of money supply and due to the Chinese Government’s data visibility into companies, allows the government to have line-item level visibility into individuals and businesses spending money with institutions in tier two.

The Chinese government’s investments in DCEP and blockchain are a sign of three things:
1/ It recognizes the inevitability of blockchain technology applications and is investing in them. President Xi outlined in October 2019 that “[China must] increase investment, focus on a number of key core technologies, and accelerate the development of blockchain technology and industrial innovation.” The Blockchain Services Network that seeks to unify many internal government systems is also allowing the Chinese government to develop cryptography and distributed systems engineering expertise at scale.
2/ It desires a world with an RMB denominated settlement layer and financial services built on top of its settlement layer, where Chinese engineers and institutions have deep technical expertise while the U.S. fails to support these technologies. While users may have privacy from each other on the Chinese DCEP, because of transactions being shared from the second tier back with the Chinese government, any person or business using the DCEP or applications built on top of it would have all of their data accessible to the Chinese government.
3/ Plan B is to protect itself from the threat of cryptocurrencies and have influence over a cryptocurrency ecosystem that stands independent of the USD. For example, the Chinese government has focused on supporting the manufacturing underlying Bitcoin mining while limiting its citizens’ access to Bitcoin to prevent capital outflows and minimize social unrest.

The Chinese government’s ideal outcome is a world where cryptonetworks and the US government do not cooperate with each other, leaving the Chinese DCEP free to gain market share. This would allow the Chinese government to develop technical capabilities using its Blockchain Services Network, have increased significant asymmetric advantages internationally via the DCEP, deepened ties between China and Belt & Road countries, built defensive capabilities against the threat of cryptocurrencies, and have pushed companies in the crypto ecosystem to be non-USD denominated.

Cryptonetworks need support from the US Government to compete against the Chinese Government

Cryptonetworks present many challenges to the Chinese Government as they enable privacy, censorship resistance, and individual economic freedom. Unfortunately the crypto community is weak exactly where the Chinese DCEP and Blockchain Services Network are strong — distribution, capital investment, and regulatory clarity.

Although cryptocurrencies, cryptonetworks, and other decentralized technologies are under threat from, and are threatening to the Chinese government, they exist in a challenging regulatory environment in the US. The environment in the US creates significant friction, leads to entrepreneurs to waste millions of dollars on legal fees, and many entrepreneurs choose to not enter the space at all. Despite this, many of the best and the brightest in the US are moving quickly towards these greenfield opportunities with companies such as Coinbase now worth $8B and Square ($40B) being a critical on-ramp for USD to Bitcoin. Decentralized technologies appeal to many in the US on a philosophical basis and offer a new digital frontier where incumbents such as Google, Apple, and Amazon do not have structural advantages, for example because of privacy primitives that may prevent advertising based business models.

The crypto community has thus far focused on protecting cryptonetworks from the US Government. The community must now also educate regulators and policymakers on the positive role that cryptonetworks (both public-private partnerships and fully decentralized) can play geopolitically and in natural security.

The US needs support from the crypto community to outcompete the Chinese DCEP

The US Government has no comprehensive plans for a CBDC or USD settlement layer, has created regulatory uncertainty which slows blockchain based innovation, and has not strategically established influence over decentralized cryptocurrencies. The ideal US system would have the following properties:

Be available immediately to prevent the Chinese DCEP from capturing market share
Offer rapid settlement on par with the Chinese DCEP
Be backward compatible with the existing USD system — to reinforce the USD as a global settlement currency and to minimize transition costs for entities using USD settlement today.
Extend the reach of the USD in to Belt & Road countries where the banking system may be nascent but mobile phone penetration is high.
Offer due process and privacy guarantees that the Chinese DCEP would be unwilling to provide.
Have a robust entrepreneurial ecosystem to innovate on top of the platform.
Allow for the efficient and effective use of KYC/AML tooling for law enforcement.

There is no path for the US Government to accomplish all of these aims with only a CBDC effort. The recent history of the US Government attempting to build software is unpleasant. A US government driven CBDC will be slow to market and will almost certainly fail. An open, entrepreneurial approach can succeed because it takes advantage of the US’s unique advantages: the intellectual capital available in US-based crypto companies and the ability for decentralized cryptonetworks to quickly extend the reach of the USD.

The U.S. government can only accomplish its aims if it quickly deploys a three pronged approach:

Modernize USD settlement platforms as an alternative to the Digital RMB / DCEP — Invest in a USD settlement platform to modernize the Federal Reserve system.
Make cryptodollars broadly available by mid-2021 — Deploy cryptodollars by mid-2021 through public-private partnerships with USDC, Libra, Celo, Avanti Bank and other platforms targeted at the banking and payment sectors. Cryptodollars can reach emerging markets faster than the legacy banking system and faster than the DCEP.
Create regulatory clarity to unlock decentralized cryptocurrencies as an offensive tool and expand the reach of the USD — empower decentralized cryptonetworks that codify democractic values such as privacy and protection from extra-judicial seizure. This ensures the center of gravity of these rapidly growing decentralized ecosystems is primarily in US companies, denominated in USD, and able to extend the reach of the dollar to emerging markets and authoritarian regimes (where access to the USD is strictly regulated). The alternative is to cede that many multi-billion dollar companies on these platforms will have their center of gravity outside the US.

By employing a three pronged approach, the US govt can achieve all of its strategic aims:

Prong 1: A US CBDC Alternative to the Chinese DCEP (Table Stakes)

Advantages: A centralized US Central Bank Digital Currency can be designed to be efficient, backward compatible with the existing Fed banking system. By modernizing its infrastructure, the entire industry from the Federal Reserve out to retail banks would be made efficient. Instant, global settlement across banks that could be built on top of by credit cards, lending companies, and banks could be transformative in particular for those who are excluded from the existing banking system because of high fees. Existing tools for law enforcement such as KYC/AML compliance by the banking system would carry forward easily.

The expertise to build these sorts of secure distributed systems with modern cryptography is primarily in the crypto community today.

Challenges: Such a backwards compatible CBDC + Fedwire system would take years to implement and adopt throughout the global banking system. It would not be viable for the parts of the world where the USD is currently difficult to access or where banking infrastructure is nascent. This is table stakes and would come to market many years too late to be competitive.

Concrete recommendations:

Encourage broad adoption by US and international banks by involving them in testing of the US CBDC + updated Fedwire (a USD DCEP) settlement layer.
Adopt financial privacy into the requirements for a USD based DCEP such that the new US DCEP is considered a more trustworthy alternative to the Chinese DCEP.

Prong 2: Get to market in 12 months via public-private Cryptodollar DCEP (Defensive Tactic)

Advantages: The infrastructure for cryptodollars exists today and the crypto community is actively trying to engage in public-private partnerships. These private efforts bridge between regulated USD bank accounts and crypto networks that offer cutting edge technology designed for instant settlement, backwards compatibility with the USD banking system, tooling for law enforcement, and the ability to reach millions (or billions) of people, private companies, and NGOs. For example, USDC is a cryptodollar supported by Coinbase, backed by USD in American banks, and used by tens of thousands. The Libra USD (supported by the Libra Foundation) and Celo Dollars (supported by the Celo Foundation) could offer similar solutions and bring the cryptodollar to millions or billions of people globally in the coming years.

Crypto industry projects (Ethereum, Celo, NEAR, Libra, etc.) also offer the significant advantage of smart contracts in addition to fast settlement. These systems can serve as the basis for robust financial markets for global trade denominated in USD and settled instantly instead of weeks as in the legacy banking system. Banking, retail, supply chain, and other companies could build on top of these platforms, thus ensuring the continued success of the USD and of platforms whose success is aligned with the US.

A cryptodollar could achieve global scale in under 12 months. The blocker to mass adoption has been US policymakers who are concerned that such efforts may grant significant influence to a private company at the expense of the Federal Reserve. If instead, the US were to support multiple cryptodollar efforts where USD is held in US banks, and encourage American companies to participate in these ecosystems, cryptodollar platforms would proliferate, and competitive platforms could emerge, while keeping these ecosystems under US jurisdiction.

Challenges: The Chinese government has strategically deployed $1 trillion across its Belt and Road initiative, and the DCEP as a critical part of this initiative will be well resourced. Private companies will have a hard time competing against a state actor like the Chinese government.

Recommendations:

Support multiple consortia using cryptodollars to ensure financial, banking, and trade applications in emerging markets are built on the USD.
Encourage collaboration between law enforcement and companies working in these consortia.
Allow banks to hold custody crypto assets on behalf of customers (recently completed).

Prong 3: Employ cryptonetworks to offer what the Chinese DCEP cannot (Asymmetric, Offensive Tactic)

Advantages: As the third prong, the US must offer benefits the Chinese government is structurally unable to offer: freedom of speech, privacy, due process, and protection from unreasonable search and seizure. As they control social media, search, and have built the Great Firewall, the Chinese Government will pursue strict control over the digital RMB via the DCEP and will make efficient use of the data collected. Decentralized cryptonetworks offer individual protections such as privacy by design. These properties are desired by many, in particular by people in emerging markets with unstable governments and fiat systems. As a means to destabilize regimes that are actively trying to circumvent the USD, decentralized cryptocurrencies are an under-utilized offensive tool if used appropriately. By putting cryptocurrencies in the hands of individuals in these countries and allowing them to move out of their fiat systems, while retaining significant influence over the decentralized ecosystems themselves, and controlling fiat offramps in the rest of the world, the US Government can reinforce the strength of its position globally.

Challenges: By the same token, decentralized systems are intimidating for democractic governments. They are hard to control, could be used for nefarious purposes, and as a technology present novel challenges for securities, tax, and financial regulators. By focusing only on these challenges at the expense of the benefits of these new cryptonetworks, the US has left significant strategic value untapped. The US has also left the door open for the Chinese government to be the most influential actor in these ecosystems. Lack of participation in these networks has thus exposed the US to the risks that most concern US regulators.

Recommendations:

Enable crypto custodians to become federally qualified custodians. This would allow American companies to be the primary custodians for cryptoassets globally.
Encourage cryptocurrency mining and staking using renewable energy and excess energy in energy producing counties in the US. Subsidies to encourage data center construction would serve to create construction and new IT jobs in rural communities.
Clarify tax treatment of staking rewards to be the equivalent of dilution via new share issuance rather than dividends or new income at the time of receipt.
Approve of Bitcoin and Ethereum ETFs by the SEC. This would make US regulated markets the primary fiat inflow and outflow into the cryptocurrency ecosystems.
As initially proposed by current SEC Commissioner Hester Perce, create a safe harbor sandbox whereby new cryptonetworks can launch without fear and have a path to be sufficiently decentralized, such that their tokens are commodities. This encourages the best entrepreneurs to start businesses in the US and target US customers first, rather than avoiding the US and not offering novel products to US consumers and businesses.
A clear definition of what constitutes a “decentralized” network such that entrepreneurs can start cryptonetwork based businesses and stay compliant
A tax exemption on de minimis ($500) capital gains from cryptocurrencies to encourage spending these digital currencies which would drive merchant and business support. Merchant demand would create incentives for businesses in the US to innovate on top of crypto infrastructure and bring these innovations to their users around the world.

Conclusion

The need for collaboration between the US and the crypto community comes naturally from their own self interests, goals, and shared opportunities. The Chinese DCEP as a common rival for the US Government and the crypto ecosystem presents significant challenges for both, as well as a significant new opportunity to collaborate.

For the U.S., the geopolitical advantages of being the world’s medium of exchange and unit of account are at stake. Collaboration with the crypto community retains the benefits of being the world’s reserve currency and remaining the world’s center of technological innovation. Furthermore sensitive data that may be routed to the Chinese government in a Chinese DCEP system can be encrypted and remain private. By collaborating with the crypto ecosystem the US can more quickly and easily achieve its strategic initiatives.

For the crypto ecosystem, competing against the Chinese government’s DCEP and Blockchain Services Network initiatives becomes much easier with the US Government’s support. In many ways the US Government can unlock global adoption of cryptocurrencies.

While it will not be easy to foster real collaboration between various parts of the US Government and the decentralized crypto community, we believe it is the best path forward and the only path that does not result in a Chinese DCEP dominated future.

Appendix

Deep Dive: Motivations for the Chinese Govt, US Govt, & Crypto Community

In summary, the Chinese Government seeks to build an RMB settlement alternative to the USD denominated settlement layer used by most of the world. If this does not work, the next best outcome for the Chinese government is to have significantly more influence over the emerging, decentralized cryptocurrency ecosystem than the US. While the US and crypto community are philosophically aligned, they are not yet working together against their common competitor in the Chinese DCEP.

CHINA

The DCEP Wallet offered by participating platforms (e.g. Bank of China, Alipay) enables QR code payments, remittances, and P2P payments. Users can manage DCEP funds, and link the DCEP wallet to other accounts.

China is the front-runner in CBDC research and deployment. After six years of research, the People’s Bank of China (PBoC) has launched pilot programs of its digital RMB in four major cities in 2020 and is planning expansion into more regions. The DCEP system is a token-based digital currency running on a two-tiered centralized private network controlled by the PBoC. Chinese banks and third-party payment platforms act as intermediaries and settlement ultimately happens in RMB. The DCEP will initially be used across government institutions, then large Chinese companies, and then as a settlement layer across the Belt and Road.

The DCEP is now part of a broader strategic initiative to use blockchain technologies by the Chinese Government. In November 2019, President Xi Jinping reversed Chinese policy, launching a national campaign to make China a global leader in blockchain technologies. The Chinese government is investing in ways to influence decentralized crypto platforms, as they have successfully done through other platforms including social media, in order to use these technologies as an offensive weapon.

Most major Chinese companies have announced involvement in DCEP

Motivations of Chinese Government: A DCEP settlement system free of the USD

Increase efficiency, security, and speed of retail and cross-border payments and settlements.
Improve record-keeping and verification of financial transactions.
Increase government oversight of all aspects of the economy, including international capital flows and real-time macro and financial indicators (e.g. inflation).
Facilitate RMB internationalization in tandem with the Belt and Road Initiative and third-party payment platforms such as WeChat Pay and Alipay.
Bypass the U.S.-based SWIFT settlement system to avoid the threat of U.S. sanctions.

Threats posed by DCEP

Through a combination of DCEP and the Social Credit System, the Chinese government will be able to financially isolate and suppress critics and dissidents including journalists, intellectuals, minorities, and would-be political opponents.
The centralized ledger system could be used as a way to preferentially and unfairly benefit Chinese companies, as the great firewall of China has done domestically.
Data privacy and security risk to foreign entities since all financial data operated on by Chinese firms could be transferred to the Chinese government pursuant to the 2017 Cybersecurity Law and the new 2020 draft Data Security Law.

On the current path, the US will lose its significant strategic and national security advantages in having a global USD based payment and settlement platform. This is not a hypothetical situation. In just five years, Russia and China have shifted from 80% to 42% of their trade settled in USD. The DCEP can achieve a similar goal across the Belt and Road in coming five to ten years.

The Belt and Road initiative extends from Beijing to South Asia, Africa, and Western Europe. The Belt and Road gives the digital RMB global distribution to continue de-dollarization of Chinese trade.

United States of America

The U.S. has been resistant to CBDC experimentation. To date there are no concrete moves towards a digital dollar, despite calls for Federal Reserve accounts among certain legislators.

The Federal Reserve has avoided exploration of a digital dollar, instead focusing on very minor efficiency gains through the FedNow instant payments system that would bring the Fed’s financial infrastructure from the 1970s to the 1990s.
Any move toward a digital dollar would require Congressional action. However, banks in the West are making headway on real-time cross-border payments (e.g. J.P. Morgan’s JPM Coin and SWIFT gpi). U.S. regulators are supportive of these developments: On July 22, the Treasury Department’s Office of the Comptroller of the Currency (OCC) granted permission to banks to custody cryptocurrencies.
Meanwhile in Silicon Valley, the Libra stablecoin initiative, originally started by Facebook now seeks to work closely with incumbents, including global central banks, regulators, and financial institutions. Under the umbrella of the Swiss Financial Market Supervisory Authority (FINMA), Libra is seeking to issue multiple single-currency stablecoins rather than its initial concept of one stablecoin backed by multiple assets.
Celo, Mobilecoin, and others are launching their own consortia that enable crypto-fiat in addition to cryptocurrencies and digital assets (e.g. Celo Gold, Bitcoin, and Ethereum.)

US Government Motivations: Maintain a USD based global settlement system

Maintain the USD as the primary global reserve currency as a tool of national security.
Continued position of the USD as the primary unit of account for debt and primary medium of exchange to drive global demand for US Dollars.
Continued efficacy of the existing toolkit to prevent bad actors at fiat offramps and offramps including but not limited to forced KYC and AML by banks and financial sanctions.
Minimize disruption from alternative currencies and financial transaction platforms that circumvent the role of the USD and the US banking system.
Privacy of citizens’ data and protection against seizure of citizens’ assets by non-US governments
Sovereignty in financial decision making free from undue influence by non-US governments.

Cryptocurrency Community

Cryptocurrencies have gone from a fringe idea to a $200B asset class in a decade. What started as an experiment has spread to 30 million Americans, over 60M around the world, and acceptance by institutions such as Fidelity, Paul Tudor Jones, and university endowments, among others. Platforms such as Ethereum and NEAR allow us to reimagine financial primitives with greater transparency, and emerging token-enabled infrastructure allows us to reimagine the web without Amazon’s cloud and without going through the Google or Apple App Stores as intermediaries.

Motivations of cryptocurrency and decentralized technology community

Privacy of individual’s data and protection against extra-judicial seizure of assets by governments
Protect holders from fiat regimes that destroy value through poor monetary and fiscal decisions such as Venezuela and Zimbabwe.
Bottoms up innovation to empower individuals rather than mega corporations.

Europe

In Europe, while policy-makers have actively criticized American the Libra project’s stablecoin and cross-border payment ambitions, they are struggling to agree on a common EU digital finance and payments strategy. The initiatives that exist in Europe remain small-scale.

Only Sweden is making significant moves on CBDCs with its e-Krona, though its focus is domestic.
The Bank of International Settlements (BIS) is partnering with the Swiss National Bank to create a wholesale digital currency to be used between banks.
In April 2020, the Bank of France called for applications to experiment with CBDCs for interbank settlements. Bank of France Governor Francois Villeroy de Galhau has advocated the ECB move toward an e-Euro.
The Dutch Central Bank (DNB) has pitched itself as a viable R&D and testing ground for a European CBDC.
The focus in Europe is still on improving digital payment rails through existing European banks. For instance, 20 European banks are working on the Pan-European Payment System Initiative (PEPSI) to build a pan-European digital payment service.

Motivations of EU

Privacy of data and protection against seizure of assets by non-EU governments
Sovereignty in financial decision making free from undue influence by non-EU governments.
Some in the EU argue for a multipolar world where the US is not as dominant and the USD a less powerful tool for the US to exert influence over other countries.

Asia excluding China

By contrast, Asia is making rapid progress. With China on their doorstep, Asian countries are creating rival payment platforms and CBDCs to protect domestic markets and their sovereignty.

On April 6, the Bank of Korea announced it launched a pilot to research CBDCs.
In July, the Bank of Japan reversed its original position by announcing it would start experimenting with digital yen. The Japanese government is set to include CBDCs in its official economic plan. Given progress in China, there is now increasing pressure from Japanese legislators to pursue some form of digital currency. Japanese banks are already making inroads, launching J-Coin Pay — a QR-based digital wallet designed by Mizuho Bank in association with sixty other banks in Japan.
Central banks in Singapore, Thailand, Cambodia, and Hong Kong are moving towards issuing their own digital currencies.
Singapore has moved to regulate crypto businesses under the Payment Services Act and invest in blockchain technology at the government level.
While India has yet to make a decision on CBDC issuance, there are strong incentives for the Reserve Bank of India (RBI) to unite existing public and private systems in a country of 1.3BN where ballooning payments offer enormous opportunities and risks. India has moved towards digital payments and digital identity already and a digital CBDC would be a natural extension.
In India, as with all other Asian countries, the risk of Chinese payment platforms dominating domestic markets is great and we will doubtless see more government moves to support local fintech players and legislative pressure for CBDCs.

Motivations of Asian Countries

India

Increase financial inclusion and fast-track path to cashlessness for 1.3BN citizens; Crack down on money-laundering and fraud; Box out Chinese companies from the fintech space; Enhance data sovereignty; Interest in remittances; Preserve monetary and price stability

Japan

Compete with Chinese companies in the fintech space; Seek a stronger dollar and RMB (for exports); More receptive to stablecoins than USD or DCEP; Enhance data sovereignty

South Korea

Compete with Chinese companies in the fintech space; Seek a stronger dollar and RMB; Enhance data sovereignty; More receptive to stablecoins than USD or DCEP

Vietnam

Crack down on money-laundering and fraud; Box out Chinese companies from the fintech space; Enhance data sovereignty; Preserve monetary stability

Hong Kong

Make cross-border finance more efficient; Serve as a financial hub for crypto on- and off-ramps; Crack down on money-laundering and fraud; Interest in remittances

Singapore

Make cross-border finance more efficient; Serve as a financial hub for crypto on- and off-ramps; Crack down on money-laundering and fraud; Interest in remittances

Global Data