My thoughts on trust and cryptocurrencies

I was not even in my teens, when I visited a bank branch in a Delhi suburb to get the passbook updated for my Dad. After a long wait, when the bank teller finally updated the passbook, I asked him innocently if I could update the passbook with whatever amounts I wanted. He replied, explaining to me that the bank would accept only the amount that was in their ledger. I accepted what he said, but thought to myself, “What if he entered a wrong amount in their records, either unintentionally or deliberately? Why should I trust the bank?”

I did not realise then, but I was basically thinking about the most valuable commodity in the world of finance and commerce — Trust. This is what enables commerce across the world and provides for a stable economic environment where everyone can prosper.

If we go back in time, money (the medium of exchange that enables commerce) has always been something that has had value in itself. It could be a common commodity such as a cereal or grain, or a precious metal such as gold or silver. People could trust such a medium of exchange, as they were sure that they would be able to use it to get the things that they wanted. They were also confident that it would hold its value irrespective of economic collapses or social disorder. Later, representative money came into play (initially via tokens issued by trusted local goldsmiths against gold being held in their custody) that enabled local commerce to prosper. In due course, governments started issuing representative money backed by holdings of precious commodities and guaranteed exchange rates (similar to gold standard).

It is only in the last few decades that fiat currency — which is backed by nothing except a government promise — has seen widespread use by society at large. However, a few factors have led to some loss of trust in the current economic system among some sections of society-

• Decline in the value of most currencies — even the best performing USD has lost a significant part of its value since the beginning of the 20th century
• Hyperinflationary periods in several countries, most recently in Zimbabwe
• Economic crises at regular intervals, caused more often than not by financial intermediaries, followed by their taxpayer funded bailouts to prevent financial catastrophes

In all such cases, it is the common members of society who lose their hard-earned wealth and savings, while the banking elite seem to get away despite several wrongdoings. It is in this backdrop that we need to see the emergence of cryptocurrencies. The key reasons for their attractiveness — besides the obvious speculation — are enumerated below-

• They are based on a “trust-less architecture”, where the participants do not need to trust each other, but the platform ensures that all participants can verify any transaction and have confidence in its integrity
• The underlying technology has a completely decentralised peer to peer architecture. All users are equally important, and they have access to all the data. No one user can have undue influence on the platform, by having a way of controlling the supply of currency or setting interest rates, etc
• The peer to peer architecture also means that the system cannot be shut down or closed by a government fiat or due to social disorder.
• Even while the architecture ensures that you could trust the transactions that you are entering into, there is relative anonymity. You can transact directly with partners whom you do not know, without involving any intermediaries.

The first ten years of cryptocurrencies have been a roller coaster ride, swinging between euphoria and depths of despair. This is something to be expected given the amount of speculation involved. Moreover, cryptocurrencies have clearly not lived up to their initial promise of enabling digital micro payments. However, there is active ongoing development with changes proposed to the underlying architecture (see Ethereum 2.0 and Bitcoin taproot) that have the potential to make them viable as payment platforms in the future.

There has also been misuse of cryptocurrencies by criminals for drug trafficking and for ransomware extortions (see BBC News and NPR). This is not surprising considering the fact that the cryptocurrencies ecosystem is currently like the wild-west, with virtually no legal framework at all. The extent of misuse, however, is not clear. The transactions on a cryptocurrency blockchain are all open to everyone and can be traced back to the originator. As a result, despite the anonymity, it is possible with some effort to track down criminals (as can be seen in the takedown of Silk Road and the prosecution of two US law enforcement agents).

The emergence of cryptocurrencies (and the enabling technologies) is seen as a threat to financial intermediaries — as these platforms offer ways to eliminate the need for intermediaries for enabling trust in a transaction. The financial ecosystem has moved from initially ignoring such platforms, to blaming them for criminal activity (justifiably so, see Silk Road and ransomware), and further to making it difficult for them to operate (see China and India).

Meanwhile, BIS, in its latest Annual Economic Review, states that its plans for Central Bank Digital Currencies (CBDCs, will discuss these in a later note) are an opportunity for the global monetary system. Hopefully, this signals a move in the direction of a regulatory framework for cryptocurrencies.

In conclusion, I would summarise my thoughts as-

There is an underlying issue of loss of trust, and the misbehaviour of financial intermediaries, that needs to be addressed in an open and transparent manner by the financial ecosystem

It is not fruitful to fight against breakthrough technological advances. Instead, we must focus on putting in place the right economic and legal framework to ensure orderly development of such platforms, and to minimise fraud and criminal activities on them.

Moreover, the underlying technologies that have enabled the emergence of cryptocurrencies are extremely useful and their innovation/adoption needs to be encouraged.