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Can Cryptocurrency, Smart Contracts, and the State Peacefully Coexist?

Or for investors, is crypto un-investable, given regulatory risks?

Photo by Executium on Unsplash

Introduction

Cryptocurrency has taken the world by storm.

Since the publication of Satoshi Nakamoto’s now-famous whitepaper — “Bitcoin: A Peer-to-Peer Electronic Cash System,” the world has seen the power and appeal of modern digital methods to store and transfer value without the intervention of so-called “trusted third parties” — banks and other financial institutions that act as intermediaries in all aspects of value exchange and capital accumulation. With Bitcoin, like any cryptocurrency, users can send directly to and receive directly from a counterparty over the Internet without routing through a bank or similar. Value transfer is secured by cryptographic methods guaranteeing transaction integrity, solving the thorny issue of “trust” that is otherwise required in any exchange of value.

Advances in decentralized technology, obviating the need for trusted third-parties, haven’t stopped there. Enterprising engineers have since extended the technology at the heart of cryptocurrency — “distributed consensus” — to build digital platforms — “smart contract” platforms — capable of performing everything we’ve come to expect from modern computers today: peer-to-peer storage, computation, and networking writ large — in some cases at web speed.

The practical import of these digital breakthroughs in decentralization is that, now, the Internet as we know it no longer needs to rely upon the digital giants of the early 21st century — Amazon to provide cloud hosting, Google to provide search, Facebook to maintain our social graph, and the like. Now, internet services can be decentralized using smart contracts, so that the services provided by the likes of Amazon, Google, and Facebook can instead be served autonomously by code transparent to all users. Unlike their “web 2.0” forebears, these autonomous, decentralized “web 3.0” services cannot be abused by their creators to pry into our private data, censor or manipulate network responses served to clients, or arbitrarily revoke the APIs these services make available to third-party developers.

Cryptocurrencies, and smart contracts more generally, represent some of the early 21st-century’s greatest opportunities to imbue with new superpowers the institutions most dependent on public trust: finance, health, government services of all kinds, and many others besides.

But by the same token (pun unavoidable), and owing to the radical new capabilities it enables, crypto may also be seen to threaten the very financial and political controls that have in modern times guaranteed the stability of nations and global order more generally.

This begs a key question that governments may see in crypto today:

Can states survive in the face of widespread adoption of cryptocurrencies and smart contract platforms offering peer-to-peer financial and social-media services operating potentially beyond the bounds of government control?

This may not overstate the threat that governments may perceive in crypto; and governments’ answer to this question may well determine whether they’ll act to quash crypto, or embrace it with enthusiasm.

And since negative government sentiment and enforcement action (read: regulatory risk) is perhaps one of the most existential risks facing nascent crypto protocols, the answer to this question may also determine how investable crypto is as an asset class.

So supposing that governments will likely try to quash cryptocurrencies that they deem to be inimical to their own essential interests, this article:

  1. assesses how crypto may threaten governments’ essential interests;
  2. evaluates states’ ability to curb crypto’s most threatening aspects; and so
  3. addresses whether governments are likely to conclude that there is room for cryptocurrency, smart contracts, and the state to peacefully coexist.

Note: while the discussion that follows attempts to adopt the perspective of state leaders and government officials, it does not mean to imply agreement with that perspective. No matter what one’s own personal values, the thoughtful crypto analyst needs to consider how states, as one of the most important sets of strategic actors impacted by crypto, are likely to respond to its widespread adoption. It’s this matter-of-fact assessment that follows, with no intended normative judgment on whether potential government responses are “right” or “wrong.”

1. Government’s essential interests, and threats that crypto poses

We start from the premise that state leaders seek first to preserve the state’s power, which is a precondition for any effective government action besides. And in general, state power rests upon at least 3 pillars: (a) state stability, (b) state capacity (taxes!), and (c) effectiveness in the tools to exercise state power.

But awkwardly, government may see crypto as a threat to each of these 3 pillars — threatening to undermine political and financial stability, tax assessment/collection, and national currency controls. (Crypto raises other regulatory issues as well, e.g. privacy; but state leaders, being human, are probably most likely to react most aggressively to those issues that they view as most threatening to their own interests.) We’ll take these posited threats in turn.

(a) Governments may see crypto as a threat to political and financial stability.

Crypto promises to empower web visitor end-users by enabling services that their creators can’t later tamper with by limiting access or restricting content served. These digital guarantees free end-users (and developers too, in fact) from many of the limitations of traditional and proprietary “web 2.0” services. But, the fact that decentralized “web 3.0” digital services may be unblockable introduces what governments may view as systemic threats to the stability of the state.

For example, crypto enables the creation of social media communities that may be incapable of being moderated, which governments may worry could threaten political stability. While free speech generally deserves the greatest technical and constitutional protections, aggressive speech and viral misinformation can potentially incite violence and other harm that could threaten state stability — especially when facilitated by social media echo chambers such as Twitter, Facebook, and their kin.

Crypto also enables the creation of potentially unblockable decentralized finance (“DeFi”) applications; and if these services were to become widely adopted, governments may view these services as a threat to nations’ financial stability. Already today, for example, users can launch derivative contracts of practically arbitrary complexity (e.g., on the Ethereum blockchain), such that whatever can be coded can be traded. And as the 2008 global financial crisis demonstrated, mainstream trade in complex financial derivatives with unclear underlying value can result in acute financial losses for millions, the repercussions of which can ripple globally throughout an increasingly-interconnected financial establishment. After 2008, officials introduced regulation aimed at restricting the most systemically-threatening trade in derivatives — such as U.S. regulation like that embodied in the “Dodd-Frank” Act and its important “Volcker Rule;” but DeFi may be impervious to regulation like this, as decentralized contracts can be made immutable, or incapable of being changed.

So the key technical question, when it comes to governments’ evaluation of crypto’s threat to political and financial stability, might be whether the use of offending smart contract platforms (certain decentralized social media communities, DeFi services, etc.) could be somehow restricted by government officials. This will be addressed in section 2. below.

(b) Governments may see crypto as a threat to their ability to tax.

Modern tax collection relies upon tax bodies’ monitoring and reconciliation of flows of funds. In modern economies, tax authorities require employers to withhold taxes from workers’ paychecks. They require brokerage houses to provide trading records relevant to capital gains taxation. Presumably, cross-checks of individuals’ and businesses’ biggest tax deductions also take place based on records provided by big banks and payment processors, to ensure that ledgers balance, so that tax authorities get their full cuts due.

But crypto complicates things. Individuals and merchants in some places can already both receive payment in crypto, and then spend that crypto elsewhere, making it hard for tax authorities to track flows of funds — especially if persons use anonymous accounts, made possible by today’s crypto protocols. Already, PayPal in the U.S. has integrated Bitcoin purchases and sales into its services, and is rumored to be looking to integrate remittances in short order. Amazon has caused speculation that it may be looking into accepting crypto payments for goods it offers on its platform, with its posting for a digital currency and blockchain product lead. Doubtless many other payment processors and large merchants and merchant platforms are currently exploring how to support crypto exchange and payments.

That merchants and individuals soon may generally be able both to pay and be paid in crypto invites the birth of a parallel crypto economy hidden from regulators, and thus not amenable to transparent tax assessment. Were this to become sufficiently commonplace, and unless governments can find ways to shine light on crypto payments, the state may conclude that it would be unable to sustain a fair, legitimate, and generally-accepted tax regime, threatening the state’s ability to fund its own activities.

(c) Governments may see crypto as a threat to effective currency and economic control.

Finally, governments may see crypto as a threat to the effectiveness of state economic tools wielded in foreign diplomacy, national security, and domestic economy and money-supply-management. These perceived threats would be rooted in crypto’s ability to circumvent economic sanctions, anti-money-laundering/anti-terrorist-financing (“AML/ATF”) rules, and fiat currency controls.

Start with states’ economic tools for foreign diplomacy and national security. Sanctions and AML/ATF regulations use similar instruments in their aims to influence foreign actors and fight the financing of illicit activity. In essence, these regulations require financial institutions and money services businesses (“MSBs”) to block payments to sanctioned third-parties, to monitor suspicious customer and transaction activity, and to disclose this activity to regulatory oversight bodies. But crypto may open up avenues to circumvent this regulatory oversight, which today applies in the main to traditional finance institutions, like banks, payment processors, and MSBs. This is because crypto users intrinsically have the ability to pay third-parties in crypto, through non-custodial anonymous accounts (i.e., accounts not maintained by any business on which a government could impose controls), which officials may find hard to regulate.

Governments may see crypto posing similar challenges to the regulation of fiat currency controls, which states (via central banks) use to manage exchange rates, and/or interest rates and price inflation. To the extent that crypto users may be able to freely exchange digital equivalents of fiat currencies (i.e., “stablecoins”) across borders, crypto users could circumvent states’ official fixed exchange rates, for example (indeed, this concern is speculated to be in part responsible for China’s May 2021 crackdown on cryptocurrency in general). And to the extent that parallel crypto economies may eventually decouple from fiat-based economies — whose interest rate/money supplies are actively managed by central banks to achieve certain inflation and economic growth objectives — central banks’ money management methods’ could become correspondingly less potent.

So for all these reasons, governments may see crypto as a serious threat to the foundations of the state — threatening to undermine political and financial stability, tax powers, and currency/economic controls. And unless governments can address these threats, officials may conclude that they have no choice but to nip crypto in the bud, crimping its growth before it has a real chance to blossom.

2. Crypto controls’ potential to protect government interests

For the reasons outlined above, governments may view crypto as a serious threat to the state. But that said, a handful of targeted state interventions in crypto ecosystems could perhaps address 99% of perceived threats. And if so, governments may feel reassured that crypto does not necessarily jeopardize the state, and so may be more willing to support crypto’s accelerating adoption.

Setting state stability aside for a moment, coordinated regulatory intervention in crypto’s flow of funds could substantially preserve the state’s power to tax and administer global currency controls. For example, regulators may soon be able to lean on centralized stablecoins to monitor and manage flows-of-funds as banks are currently tasked to do — though users could still use other crypto to evade such controls.

But a more robust regulatory paradigm that has just recently started to develop in the E.U. would involve (a) ensuring that crypto funds flow through centralized exchanges (“CEXs”), and (b) restricting certain CEX activity, namely in converting crypto to fiat or sending and receiving crypto. This framework would enable officials to focus their regulatory efforts on discrete and known entities — individuals, corporations, and CEXs — on which officials could then impose legal and regulatory crypto controls.

And then to preserve state stability, regulators could lean on this framework further to (c) restrict certain activity on DeFi and decentralized social media platforms, to regulate the content they deem most threatening.

We explore these potential interventions in turn.

(a) Ensuring that crypto funds flow through CEXs.

Establishing measures that result in funds flowing through CEXs would provide funds-flow-transparency that regulators could use to tax and enforce currency controls effectively. Either or both of two sets of measures could ensure that crypto funds flow through CEXs:

  • (i) restricting the use of anonymous crypto accounts, and/or
  • (ii) prohibiting merchants from accepting crypto.

(i) Restricting the use of anonymous crypto accounts.

If all crypto accounts were attached to an identifiable legal person (natural or otherwise), then regulators could monitor “on-chain” crypto flows-of-funds, which would then take place legally only between known entities, each effectively necessarily attached to at least one CEX that performed “Know-Your-Customer” (“KYC”) checks in the setup of the account. This ability to link accounts to discrete and known persons would enable regulators to continue to assess taxes effectively, administer sanctions and AML/ATF restrictions, and keep tabs on crypto money supply dynamics.

And there are a few ways that regulators might be able to bring about these restrictions on the use of anonymous crypto accounts. Most simplistically, regulators could probably just create laws that prohibit persons from sending crypto from accounts unknown to a CEX (anonymous accounts); and require CEXs to file reports with regulators when crypto is received from anonymous accounts (maybe even freezing funds where possible).

The only crypto transactions left uncaught by such a regime would be those occurring between two anonymous accounts — but transactions between such account numbers could be easily identified by regulators (as these numbers would be absent from customer lists provided by CEXs). So implicated accounts would be immediately open to regulatory follow-up regarding source-of-funds, through proven methods of blockchain analysis (see the work of Chainalysis, for example).

(ii) Prohibiting merchants from accepting crypto.

That merchants may at some point in the near future be able to both receive payment in crypto, and then spend that crypto elsewhere, invites the birth of a parallel economy beyond the bounds of regulatory scrutiny. But, if governments were able to prevent merchants from accepting payments in crypto, then by and large, payments would still need to take place in fiat currency, as is the case today.

In this way, governments could keep the scope of their flow-of-funds’ monitoring limited to fiat currency channels (albeit looking anew at CEX crypto sources of funds), where traditional financial controls already exist today. And in order to bring about a ban on merchants from accepting crypto, regulators could probably just create laws to that effect (which laws are likely to be effective at least among the largest corporate entities with the most to lose).

Ensuring that funds flow through CEXs would allow regulators to focus the bulk of their monitoring and enforcement efforts on CEXs. And this brings us to the complementary second set of regulatory enforcement measures, also perhaps likely to come.

(b) Restricting certain CEX activity.

The state’s ability to monitor funds-flow and tax effectively in the face of widespread crypto adoption could be substantially preserved by the enactment of the 2.(a) measures above, ensuring that crypto funds flow through accounts known to CEXs.

But the effectiveness of state economic tools — namely, effective currency control administration — would require complementary measures besides, to:

  • ensure that funds flow only to whitelisted parties, to achieve the aims of sanctions and cross-border currency controls; and
  • ensure also that funds are free from resemblance to suspicious customer/transaction typologies, to achieve the aims of AML/ATF controls.

Furthermore, if, in order to force crypto funds to flow through CEXs, regulators choose only to prohibit merchants from accepting crypto (per 2.(a)(ii) above), then regulators would also need to:

  • impose CEX crypto off-ramp controls applying when crypto is converted into fiat, to ensure that CEXs can accurately identify sources of crypto funds being converted.

But in any event, if crypto funds flow, by and large, through accounts known to, and monitored by, CEXs, per the 2.(a) measures outlined above, then all of these complementary controls 2.(b) restricting certain CEX activity would likely be straightforward for regulators to implement. Indeed, regulators could probably, for the most part, copy-paste the regulation that currently applies to traditional finance regulated entities — applying this regulation also to CEXs, who would surely feel compelled to comply.

And using measures like these, government leaders could likely feel reassured that they are able to safeguard their powers both to tax effectively, and to continue to administer effective currency controls.

(c) Restricting activity on DeFi and decentralized social media platforms.

Having canvassed how governments might intervene in crypto flows-of-funds to preserve the state’s power to tax and administer global currency controls, we can now return to the question of state stability — namely, political stability and financial stability.

Recalling that crypto’s potential threats to stability are rooted in the fact that “web 3.0” digital services may be unblockable, regulatory interventions here would need to somehow restrict access to the decentralized social media and DeFi platforms that regulators deem to be most problematic.

Problematic DeFi services may be perhaps more easily addressed, as regulators could maybe simply scratch DeFi accounts off whitelists with which CEXs are permitted to transact, per the means described in 2.(a)(i) above. If users cannot send or receive funds from DeFi account addresses, then they cannot use these DeFi services.

But regulators may find it more difficult to regulate social media services that they deem problematic. Because crypto transactions aren’t integral to these services, restricting crypto funds-flow here likely wouldn’t limit these services’ use. Moreover, decentralized protocols are designed to be viewable and interactive by anyone, anywhere — aiming specifically to be censorship-resistant to centralized bodies.

Whether read/write access to decentralized services is susceptible to regulatory intervention of the technical kind is a technical question beyond the scope of this article. But to get a sense of what’s technically possible, one might explore how China, for example, is able to block certain Internet content within its borders, using the so-called “Great Firewall” — but then, for the leaders of free nations to bring themselves to resort to such measures would be highly contentious, in any event!

If it proves to be technically- and legislatively-infeasible, though, to regulate smart contracts underpinning social media communities that deal in misinformation or other destabilizing speech, then, as outlined earlier, these smart contract platforms could, as a matter of fact, be seen by governments to threaten the political stability of nations.

3. (In)compatibility between crypto, smart contracts, and the state

This discussion has suggested that whether cryptocurrency and related smart contract platforms may be viewed by governments as being irreconcilably inconsistent with government’s essential interests depends on two pivotal technical questions:

  • (1) Can officials ensure that cryptocurrency flows through CEXs?
  • (2) Can officials restrict access to decentralized social media platforms?

To this writer, the answer to number (1) seems to be “yes;” but the answer to number (2) is still unresolved, and requires further study. (If you have an answer to this question, please do feel free to note it in this post’s comments!)

At first blush, though, one might suppose that governments may generally conclude that they do possess the means to regulate crypto in a way that protects their own interests. And if so, states may just feel secure enough to support crypto’s accelerating adoption — and crypto investors would be reassured that crypto is indeed investable in the face of regulatory risk.

Conclusion

Crypto’s animating libertarian spirit elevates the freedom of the individual above that of the state.

So it’s ironic, then, that even the most idealistic crypto natives and crypto investors alike should maybe hope that governments do in fact possess the capabilities needed to regulate crypto according to some of the measures described.

Because if governments conclude that they are simply unable to curb the aspects of crypto that they find most threatening, then officials may feel they have no choice but to view crypto as an existential threat — one that simply cannot be allowed to stand. And that could portend a battle-to-the-death between nascent crypto protocols and state leaders worldwide — a showdown the likes of which the budding decentralized web may as yet be unprepared to survive.

Crypto offers the promise of a decentralized future boasting digital freedom and individual sovereignty unparalleled in human history. But the price of admission to this promised land may be the continued acceptance of certain — if more limited — curbs on peer-to-peer money transmission, risky financial undertakings, and destabilizing speech. For the sake of everyone — crypto developers, crypto investors, web users, governments, and society at large — one might hope that states worldwide can in fact find a way to enforce certain limited restrictions within the crypto-sphere, in order to reassure themselves of their own institutional integrity. Because perhaps only then, once government leaders feel safe, may the world be assured that crypto more generally may be set free to flourish.

Alex Mucalov is an observer of human social systems. He has had diverse and direct exposure to some of democratic society’s key economic and political institutions through varied strategy and governance work in financial services, government, and regulatory bodies. He holds a JD/MBA from the University of Toronto and a Master’s in Economics from the London School of Economics and Political Science.

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Alex Mucalov

Alex Mucalov

Founder of Atlas Coins || atlascoins.io || twitter.com/atlas_coins || discord.gg/Qm8Qwqeqa8 || Strategy professional, former regulator || MSc Econ (LSE), JD/MBA

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