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What are the potential risks of digital currency?

In the previous two articles, we explored the questions ‘what is digital currency?’ and ‘what is the value of digital currency?’  In this article, we will examine the potential risks.  Why are some people hesitant about digital currency?  What could go wrong?

In outlining the potential risks of digital currency, we are not making predictions about the future. Risk means uncertainty, and so we will outline a shopping list of risks that could have a negative impact on individuals and society. By anticipating the future, we can make plans and take action today in order to increase the probability of a positive outcome.

In using a digital currency, individuals and investors are exposed to six specific risks:

  1. Price volatility
  2. Loss of confidence
  3. Breaches of cybersecurity
  4. Loss of individual freedom
  5. Mistaken transactions
  6. Regulatory risk

More broadly, digital currency exposes nations and civil society to six system wide risks:

  1. Loss of privacy
  2. Centralization of goods markets
  3. Consolidation in the banking industry
  4. Erosion of national sovereignty
  5. Cyberwarfare
  6. Acts of God

We will explore each of these risks in turn.

1. Price volatility

The biggest perceived risk of many digital currencies is price volatility.  This is a risk for investors in the short run, and makes it difficult for a digital currency to function as a means of payment.  For example, over the last three years, the price of Bitcoin has fluctuated from less than USD4,000 to more than USD19,000.

Bitcoin’s price volatility is caused by a range of factors. Large investors can materially impact Bitcoin’s price because it has a small market capitalization and less than 1% of Bitcoin addresses own more than 90% of all Bitcoin.  Investor sentiment can fluctuate wildly, especially following high profile cybersecurity breaches. Bitcoin has also attracted an active community of speculators who view Bitcoin’s volatile price as an opportunity to get rich quick.

As digital currency goes mainstream, it is possible that the perceived risk of price volatility will diminish. The price volatility of Bitcoin may simply reflect the activity of derivatives traders in a small illiquid market as well as volatility in the value of the US dollar.

If price volatility does turn out to be a problem in practice, then state backed digital currencies will be designed as ‘stable coins’. That is, digital currencies whose value is backed by another asset or pegged using an algorithm that controls the money supply.

2. Loss of confidence

The value of digital currency derives largely from confidence.

Central bank digital currencies (CBDCs) will be backed by nation states, which will make them useful as a means of payment.  However, confidence could be shaken if central banks print too much of them, or if user privacy is violated.

Unregulated digital currencies like Bitcoin gain their value from the size and enthusiasm of their community of active users.  As of September 2020, there were more than 3,400 cryptocurrencies. It is likely that many of them will not survive.  Confidence in a cryptocurrency could be shaken by the arrival of a superior alternative, the advent of a new technological paradigm, fears stoked by a high profile cybersecurity breach, or simply due to loss of interest.

3. Breaches of cybersecurity

Digital currency is exposed to the risk of cyber-attack, and cyber criminals have in recent years stolen digital currency worth billions of dollars.

The risk of cyber-attack affects cryptocurrency exchanges due to the large amount of digital currency concentrated in one place.  Governments may also have limited incentive to investigate and punish hackers, especially if they reside in foreign countries.

CBDCs face a much lower risk of cyber-attack since they will most likely be centrally controlled, which means transactions can always be reversed.

4. Loss of individual freedom

Cryptocurrencies like Bitcoin are attractive to people who want to opt out of the system. Only the person who has the private key can spend the relevant cryptocurrency, and a central authority cannot arbitrarily increase the money supply.

In contrast, CBDCs expose citizens to the risk that their digital currency could be frozen, debased, confiscated, or programmed.

Digital wallets could be frozen if a government agency determines that CBDCs are the proceeds of a crime, and individual freedom to control how ones money is spent could also be lost in four other ways:

  1. Tax – Central banks will likely be able to monitor transactions and withdraw taxes directly from digital wallets. Individuals who believe they have been overtaxed would need to seek a tax rebate.
  2. Inflation – If central banks can directly credit people’s digital wallets, they will be able to expand the money supply as much as they want. This will debase the currency and lead to higher prices.
  3. Negative interest rates – By eliminating cash from the system, digital currency will make it possible for banks to impose negative interest rates on deposit holders.
  4. Programmable money – One of the basic qualities of money is that it should be uniform or ‘fungible’. In other words, your $100 should be interchangeable with my $100. Digital currency could be combined with smart contracts to create programmable money. Receipt of such money could be made conditional on satisfying certain social criteria like visiting ones parents, and use of the money could be limited to approved vendors.

5. Mistaken transactions

Cryptocurrency payments are irreversible since they are settled on a peer-to-peer basis. Funds sent due to fraud or a mistaken transaction may not be returned.

In this respect, CBDCs will be much safer since transactions could always be reversed.

6. Regulatory risk

Unregulated digital currencies like Bitcoin and Ethereum face the risk of being regulated, restricted or banned.  They are not controlled by a central authority, have the potential to compete with fiat currencies, and may be designed to shield users from government surveillance.

The legal status of cryptocurrency is often uncertain and varies from one jurisdiction to the next.  The American Library of Congress has compiled a useful survey of the regulation of cryptocurrency around the world.

In many Western countries such as America, UK, and Australia, cryptocurrency is not directly regulated, not clearly defined, and tax treatment varies.

China was quick to identify the threat posed by cryptocurrency, and has adopted a more definitive approach. Bitcoin had the potential to subvert China’s capital controls. As early as December 2013, the People’s Bank of China issued a notice warning the public about the risks of bitcoin and prohibiting financial institutions from dealing in bitcoin, accepting it as a means of payment, or providing bitcoin related services. In 2017, initial coin offerings (ICOs) were also banned in China as a form of “public financing without approval”.

7. Loss of privacy

Digital currency raises serious privacy concerns.

Privacy is an important issue because protecting freedom of speech requires protecting private property and private contracts from the control of the state and political interference.  We have seen this issue show up repeatedly in recent years where activists have sought to silence people they disagree with by doxing them (that is, publishing their home address online) or by attacking their sources of revenue or commercial relationships.

Each digital currency protects privacy to a different degree.

Cash is the only form of currency that is completely private since a transaction need not be recorded in any way.

Bitcoin and Ethereum are sometimes described as being anonymous and totally private digital currencies.  However, in reality, they are pseudonymous. This means that users can send and receive cryptocurrency using a public address rather than their real name.  This prevents a user’s identity from being easily discovered. However, if the owner of a public address is identified, then every transaction belonging to the same owner could be traced.

Monero, a cryptocurrency launched in 2014, is considered to be a true ‘privacy coin’, which obfuscates the sender, receiver, and amount of each transaction.  By protecting the privacy of every transaction, Monero has attracted the attention of governments because it shields activity in the black economy. Although this is a problem for governments, it is worth remembering that transactions in the black economy may impose a net economic cost on society (e.g. sale of weapons) or confer a net economic benefit to society (e.g. avoiding excessive government regulation).  Monero provides people with a shield against government overreach, but it is unclear whether the technology is unhackable. CipherTrace, a crypto intelligence company, claims that it has developed a tool for tracking Monero transactions.

Christine Laggard, President of the European Central Bank, has argued that users of CBDCs should not be fully anonymous on the basis that this would facilitate money laundering, terrorism financing, tax evasion, and other criminal activity.  While fully protecting user privacy would shield this kind of activity from being easily tracked by governments, not protecting user privacy would expose the much larger population of law abiding citizens to the prospect of Orwellian mass surveillance.

Extensive public debate and deliberation should be undertaken before CBDCs are launched, and safeguards should be put in place. These might include encrypting transaction details, restricting government access to data, and subjecting requests for access to strict judicial oversight.

8. Centralization of goods markets

Many small businesses, like family owned restaurants, operate on a cash only basis.  This allows them to keep the lights on, provide goods that people value, and become an asset to their local communities.  Governments may view these businesses as tax evaders.

Digital currency will usher in a cashless society, which may expose businesses to increased government scrutiny and higher tax burdens.  If small businesses find it difficult to operate in this new environment, local communities may be hollowed out, and large tech savvy monoliths like Amazon will be quick to fill the void.

Highly centralised goods markets would give large tech firms a great deal of market power. Formerly industrious small business owners may see themselves transformed into low-skilled low-paid fulfilment centre workers with no equity stake in their local communities.

9. Consolidation in the banking industry

The advent of CBDCs may lead to consolidation in the banking industry.  According to McKinsey, global payments revenues reached $1.9 trillion in 2018 and around 37% of that revenue was captured by banks.  Digital currencies will offer lower transaction costs, and many transactions will be settled on a peer-to-peer basis or at the central bank level. This means commercial banks will see revenues fall as they capture a thinner slice of a shrinking market.

Consolidation in the banking industry may lead to increasing levels of financial instability.  Fewer banks will mean that the remaining banks are much larger, and may be considered not only ‘too big to fail’ but also ‘too big to bail out’. The failure of a giant mega bank could lead to a deep economic recession, or to the collapse of the global financial system.

10. Erosion of national sovereignty

Digital currency poses a threat to national sovereignty since it may lead individual nations to lose control over monetary policy.  As in the case of the EU, shared monetary policy goes hand in hand with closer trade ties and is often viewed as a stepping stone towards shared social programs and fiscal policy, which would need to be implemented by a supranational institution.

Given the importance of the US dollar, many countries have to some extent already lost control of their monetary policy.  For example, when America raises interest rates, Australia is forced to follow suit or suffer a weakened exchange rate.  However, since digital currency will be even more globally transferable, it will cause nations to lose control of their monetary policy to to an even greater extent.

Given the massive economies of scale involved in producing a digital currency, it is possible that a single player could dominate the entire global monetary system.  Its digital currency would then play the role of global reserve digital currency, similar to the role currently played by the US dollar.  This would most likely be the digital currency of a large country with significant productive capacity or proven gold reserves.  China and America are both contenders for this role, although both face various challenges.

America is already at the center of the financial universe, which means economic inertia is on its side. However, America’s dominant position also means that it has more to lose than to gain from disrupting the existing system.  In this context, America may invest too little and adapt too slowly.

China is an emerging power whose share of global GDP adjusted for purchasing power parity has already surpassed that of America. China’s large and growing share of global economic activity means that the Chinese yuan will have an increasingly important role to play in international transactions.  However, since the existing world order has been dominated by American and European powers for hundreds of years, China will face a steep uphill battle if it wants to build trust and secure a central role for itself in a new global monetary system.

11. Cyberwarfare

Cyber-attacks can come not only from criminals but also from hostile nations and non-state actors.  If an economy becomes dependent on digital currency, then a large scale cyberattack could lead to severe disruptions ranging from loss of data and supply shortages to destruction of property, social unrest, and political revolt.

The first and perhaps most famous example of cyberwarfare was Stuxnet, an American-Israeli software program that was designed to damage Iran’s nuclear program. The software infiltrated Iran’s nuclear facilities and caused the fast-spinning centrifuges used for separating nuclear material to tear themselves apart.  Although this was an act of industrial sabotage, similar software could be used to target a stock market or a digital currency.

12. Acts of God

Although embracing digital currency may allow economies to operate more efficiently and enjoy lower transaction costs, it also means building economies that are dependent on the Internet.  Any natural disaster that disrupts or neutralizes the Internet could cripple such an economy.  The list of possible threats is large: tsunami, earthquake, volcanic eruption, flood, wildfire, hurricane, solar flare, meteorite, lightning, or something completely unexpected.

Final thoughts

While digital currency may be the way of the future, the potential risks should be understood so that they can be avoided, reduced, or carefully managed.

In this article we identified twelve potential risks, six risks that could affect specific digital currencies, and six system wide risks that have the potential to affect civil society and the future of an entire nation.

Image: Pexels

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