February 14, 2020
Lev Menand, Columbia Law School
Eleven years ago an unknown person—or group of people—going by the name Satoshi Nakamoto launched Bitcoin, “a purely peer-to-peer version of electronic cash [that] allow[s] online payments to be sent directly from one party to another without going through a financial institution.” Nakamoto’s “electronic cash,” which users can transfer to each other with the right password, was followed by thousands of other “cryptocurrencies”—digital (or virtual) methods of payment that use cryptography for security—among them Litecoin, released by a Google employee in 2011 (“the cryptocurrency for payments”); Dogecoin, launched as a joke in 2013 and valued at over $250 million today (“the internet currency”); Ripple, created by a technology company to “instantly move money to all corners of the world”; and Ether, launched in 2015 as a “digital money” that can be used in “a global, open-source platform for decentralized applications.” Recently, established businesses have joined in, with Facebook announcing last summer its plans to launch a “global currency” called Libra, and J.P. Morgan Chase, the biggest bank in the U.S., debuting JPM Coin to settle payments with its clients around the world.
As these new “coins” have skyrocketed in value, briefly surpassing $700 billion in January 2018, the reaction in Washington has been ad-hoc. The Financial Crimes Enforcement Network has intervened at several points to address the use of cryptocurrency to launder dollars. Securities regulators have also gotten involved to protect investors from entrepreneurs looking to raise dollars through “initial coin offerings.” And commodities regulators have taken steps to protect people who trade virtual currencies on exchanges. (Relatedly, much attention has been directed to whether virtual currencies are securities or commodities.) But the country’s monetary authorities—the Comptroller of the Currency and the Federal Reserve—have been largely silent, leaving the question of whether virtual currencies are money unanswered. Congress too has watched from the sidelines, and commentators have said little about whether virtual currencies should be regulated as money or what would that mean.
This post considers virtual currency from a monetary perspective. It distinguishes between three types and argues that all three threaten serious monetary harms. Among them are reduced economic control, lost seigniorage, illegal transactions, regulatory arbitrage, and financial instability. To address these potential harms, it suggests that the government regulate virtual currencies as currencies—that the government require that people exchanging virtual currency comply with existing laws governing monetary transfers and that the government subject virtual currency issuance to regulation by the Comptroller and the Federal Reserve. It further recommends that the government blunt demand for virtual currencies by improving the existing dollar payment system.
A. What is Virtual Currency?
It’s helpful to begin by distinguishing between three types of virtual currency. Bitcoin and most of the other cryptocurrencies launched since 2009 are what I call utopian coins. They aspire to be what, in other work, I refer to as root money. Root money has its own “unit of account,” like the “dollar,” the “euro,” the “pound,” or the “yuan,” which a group of people use to measure the value of goods and services and other forms of tangible and intangible property. Root money can be distinguished from what I call synthetic money—money which uses an existing unit of account and is generally issued by a bank. (Bank deposits are the classic example.)
Unlike existing root moneys, utopian coins are not issued by states, or by any single entity. They are issued by their users through a set of rules codified in computer code (called distributed ledger technology). No single entity can control their supply. This is a core feature of utopian coins, as their creators see the ability of issuers to adjust the supply of dollars, yen, and euros as a bug (not a feature) of the existing monetary architecture. (Some like Ripple Labs are less ambitious. They retain some flexibility to alter the supply of Ripple, which currently exceeds $8 billion, and aim more modestly to offer their users a way to bypass, rather than replace, existing payment systems.)
A second and growing category of new moneys might be called corporate coins. Corporate coins resemble utopian coins in that they aspire to be root moneys (they do not use existing measures of value). But unlike utopian coins, corporate coins are issued by individual persons—corporations—who, much like states, can change the amount of money in circulation. Prominent examples of corporate coins include Saga, a money launched in December by a UK company, and Libra, the currency proposed by Facebook. Unlike utopian coins, these coins embed collateral: some other asset that people can fall back on. In the case of Saga and Libra, this asset is a claim on a basket of existing moneys. Such collateral is nothing new. For hundreds of years, states combined their moneys with precious metals to encourage people to accept them and to stabilize their value. Coins made of gold and silver functioned as money when they changed hands “by count.” But people could melt them down and sell them for scrap (for example, if their issuers were conquered by a neighboring power), shrinking the amount of money in the economy.
A third type of virtual currency—sometimes called a stablecoin—is also issued by corporations. Stablecoins are just synthetic money in new garb. Like bank deposits, stablecoins borrow an existing unit of account and attempt to trade at par with it. Stablecoin issuers, therefore, are nothing more (or less) than shadow banks. And like most shadow banks, stablecoin issuers embed collateral to encourage people to accept their coins. This collateral mainly takes the form of claims on pools of debt instruments denominated in state-issued root moneys. The most prominent stablecoin is Tether, issued by Tether Limited, a Hong Kong company. (There is $4 billion in Tether outstanding.) Tether Limited originally claimed that each Tether was backed by one dollar in bank deposits or other dollar assets. But Tether Limited recently conceded that there was substantially less collateral backing their coins, and that it “reserves the right” not to redeem tethers “on a case by case basis.” Other stablecoins, such as USD Coin, Paxos, Gemini, TrueUSD, TrueGBP, and TrueHKD seem to include stronger legal obligations. As do coins launched by existing financial institutions. (J.P. Morgan’s stablecoin is called JPM Coin and is collateralized by the bank’s promise to pay dollars.) More of these coins seemed poised to hit the market soon.
B. Why is Virtual Currency Dangerous?
Each of these virtual currencies threatens to damage our existing monetary architecture. Below, I consider several of the dangers they pose:
(1) Reduced Economic Control, Lost Seigniorage, Poor Price Discovery
To the extent that new root moneys succeed in displacing the dollar, the government would lose its ability to modulate the money supply. Although this is trumpeted as a feature of most utopian coins, groups of people who are unable to create new purchasing power to finance new productive projects generally are unable to grow their economies over time. And when faced with exogenous shocks, such economies tend to enter vicious cycles of default and decline. One of the twentieth century’s great achievements was monetary flexibility (the ability to break vicious cycles of default by expanding the amount of money in circulation). Even a partial shift to utopian coins would likely mean greater rigidity. And it would also bring monetary fragmentation. The use of multiple currencies in the same economy would increase transaction costs and incentivize arbitrage. There is a reason why the Yen, despite being a stable currency, is not used in Los Angeles.
Corporate coins appear to promise greater monetary flexibility. But existing monetary systems are subject to political control. The public, acting through governments, decides when to issue more money and who benefits, and the state receives the revenues that accrue from issuance (between $50 and $100 billion a year in the United States). Corporate coins would put monetary policy into the hands of private corporations, which would be able to decide how and to what extent to augment the money supply and who would benefit from monetary expansion. Corporate coins would privatize the returns from money issuance, transferring wealth from the government to corporations and their shareholders.
In addition, virtual currencies would hamper price discovery. The technology behind utopian coins is extremely costly to operate, so costly that it would be literally impossible to process the transactional volume of the U.S. economy in Bitcoin even if all the energy resources on earth were devoted to the effort. And none of the new units of accounts have robust transactional histories. People in the United States today value goods and services and tangible and intangible property in dollars and use vast stores of information about how much things are worth in dollars to order their economic lives. New units of account are completely unmoored by comparison.
(2) Illegal Transactions
Neither utopian coins nor corporate coins function today as real moneys. No one uses them to value things. But they do function as alternative payment systems, remonetizing illegal transactions. (They also function as speculative assets, diverting social resources from productive investment.) This is dangerous because one of the main ways that governments enforce their criminal laws, promote their interests abroad, and ensure payment of taxes is by regulating their payments systems. For example, the United States prevents criminals and terrorists from using digital dollars to buy goods and services and store up transaction reserves. (It attempts to do the same with physical dollars, but with much less success.) It also blocks foreign actors from using digital dollars, deterring military aggression, terrorist financing, and nuclear proliferation. And it monitors payment flows to keep taxpayers honest.
To date, utopian coins have been used by Russia to interfere in U.S. elections, Iranian hackers to attack American hospitals and government agencies, and North Korea to finance its nuclear missile programs. Iran is currently exploring ways to use Bitcoin to evade U.S. sanctions. Because utopian coins can be transferred easily and securely, drug traffickers use them, as do criminals and other participants in black markets. Further, income earned and retained in utopian coins is likely to evade tax authorities. Corporate issuers would presumably comply with tax laws and anti-money laundering reporting requirements. But the adoption of corporate coins would still make it harder for the United States, which cannot control foreign transactions in these currencies, to use sanctions to discipline adversaries.
(3) Regulatory Arbitrage and Financial Instability
Corporate coins and stablecoins would also impair financial stability. This is because moneys with embedded collateral carry the seeds of their own destruction. If their users lose confidence in them, they have a ready, nonmonetary alternative at hand. For example, people who have doubts about the value of deposits at Bank of America—about their ability to exchange their account balances with other people at par—can demand that Bank of America pay them coins and bills. This is called a bank run, and it can cause large amounts of synthetic money to vanish. All the people who had been using these moneys to buy and sell goods and services or store up purchasing power for future transactions suddenly aren’t able to anymore. Prices plummet, and incomes fall. Rapid economic contractions usually follow.
Governments have erected elaborate regulatory mechanisms to mitigate these problems. But stablecoins issued by entities outside this regulatory perimeter threaten to arbitrage these restrictions. Circle, which issues USD Coin, has a New York State license to deal in virtual currencies—but is not subject to bank regulations. The same is true for TrueUSD (issued by TrueCoin LLC), Paxos (which holds a trust charter from New York), and Gemini (which holds a New York virtual currency license). Tether has no U.S. regulatory recognition. Additional growth of these deposit substitutes will likely lead banks to lobby for decreased restrictions on their own activities. Each of the three most recent collapses—1929-1933, 1988-89, and 2007-09—were preceded by similar races to the bottom.
(What Would Currency Regulation Entail?
While utopian coins may die out on their own, absent a change in government policy, they are likely to survive as moneys for criminals, “rogue” nations, ideologues, and people in countries without functioning monetary systems. It is hard to predict whether corporate root moneys will succeed, although it would be foolish for Congress to wait and find out. And if the past is any guide, stablecoins, left alone, will expand. Regulated institutions will have every incentive to use these new synthetic moneys to avoid existing regulations, in much the same way that they turned to repurchase agreements and commercial paper prior to the 2008 crash.
So, what should policymakers do?
First, they should regulate all virtual currencies as currency. This would mean, for example, treating utopian and corporate coins as currency under the Bank Secrecy Act and using existing authorities to require individuals to report cross-border transactions exceeding $10,000. The federal government already has an elaborate regime governing monetary transfers designed to prevent illegal transactions. There is no respectable policy basis for exempting digital “tokens.”
Regulating virtual currencies as currency would also mean treating virtual currency issuers as banks. A bank is an entity that creates money. One type of money that banks create is called bank notes. During the Civil War, the federal government created a national banking system, giving “national banks” an effective monopoly on note issuance by imposing a prohibitive tax on all other issuers. The notes created by national banks were printed by the government and regulated by the Comptroller. In the 1930s, the government pulled the plug on national bank notes, and today only the twelve Federal Reserve Banks (FRBs) are permitted to issue physical money.
But national banks, national credit unions, and other entities chartered by states still issue another type of money called deposits or account money. Account money is a type of digital currency—it is a ledger entry that can be transferred online. Account money makes up the vast bulk of the money people use every day, an order of magnitude more than notes issued by the FRBs. When denominated in dollars, virtual currencies are, in many respects, indistinguishable from account money issued by banks. When denominated in other units, they are a lot like account money in a foreign currency, especially if they use dollars or other currencies to back their issuances. We have a regulatory regime for ensuring that this sort of money is “sound”—that it maintains a stable value over time. It makes little sense to allow new entrants to copy this business but evade the regulatory regime designed to ensure its stability.
Accordingly, the government should require virtual currency issuers to apply for bank charters from the Comptroller. It should also subject stablecoin issuers to regulation by the Federal Reserve, the government agency charged with modulating the supply of dollars and setting reserve requirements for entities that maintain accounts denominated in dollars. And it should prevent states from erecting competing regulatory regimes for virtual currency issuers by restoring and extending the tax on state bank notes to cover corporate coins and stablecoins issued by entities without national charters.
Second, policymakers should improve our existing monetary architecture. Efforts by the Fed to build faster rails for regulated synthetic moneys issued by banks are a step in the right direction. But the Fed already has FedWire, which settles immediately, and so it could also expand access to this system by allowing households and business to open accounts at the Fed. This would permit households, nonprofits, and businesses to easily hold digital dollars in large quantities, likely dulling demand for stablecoins and other corporate coins. A FedAccount program would also have an array of other benefits, including a more inclusive financial system, better consumer protection, greater financial and macroeconomic stability, improved monetary policy transmission, reduced payment tolls (interchange fees), streamlined regulation and regulatory structures, and increased fiscal revenue.
New technology is transforming the way we pay for goods and services, store value, and settle debts. While the back end is different, the functions are not. We already have a regulatory framework for money and payments. We should apply it to virtual currencies.
 This post draws on unpublished work: Why Private Money is Bad (And What To Do About It).