Could Credible Cryptocurrencies Silently Take Over the U.S Financial System?

Hannah Kinsey, Apr 30, 2022

Cryptocurrency is considered by many to be yet another esoteric fad reserved for a select group of people. Like the dot-com bubble of the 1990’s, many expect cryptocurrency’s time in the spotlight to end and for tech risk-takers to lose their wealth as quickly as they amassed it. The shiny array of buzzwords such as “Web3”, “NFT”, “Bitcoin”, “Dogecoin”, “Blockchain”, “Ethereum”, and countless others clog news headlines, advertisements, and make the world of cryptocurrency feel more and more inaccessible and fictitious. Articles decrying cryptocurrencies as ponzi schemes [1] and the stories of rags-to-riches-to-rags-again crypto billionaires [2] further weaken the credibility of the burgeoning technology. By contrast, the get-rich-quick and “fortune favors the brave” narrative that cryptocurrency companies are selling in billboards and Super Bowl advertisements is equally sensationalized and farcical [3] [4] [5]. However, underneath the chaotic veneer of cryptocurrency messaging lies true potential for economic disruption and a revision of how we understand the financial system.


To understand how cryptocurrency can become more credible and mainstream is to first understand stablecoins. Five years after the introduction of Bitcoin —the first cryptocurrency to popularize the technology— the first stablecoin, Tether, was created. Stablecoins resemble other cryptocurrencies in most ways —they can be traded on an exchange and their transactions are facilitated by blockchain technology— except that they are backed by an underlying asset such as a national currency or the price of gold. Stablecoins are “stable” because they attempt to peg their price to an asset of choice. The most popular stablecoins today, Tether and USD Coin, are backed by the US Dollar. Consumers and investors who are concerned with the extreme volatility of other cryptocurrencies such as Bitcoin and Ethereum can find their solution in stablecoins, which can be traded out for real-world assets and are guaranteed some degree of safety. They are also particularly helpful in facilitating the purchase of other types of cryptocurrencies and can bridge the gap between traditional finance and the cryptocurrency environment while promising stability, transparency, and low trading fees. With stablecoins, a consumer can easily access their money within the cryptocurrency ecosystem and have that money exist as dollars, for example [6]. It is for these reasons that stablecoins have become immensely popular. As of February of this year, the world supply of stablecoins equaled roughly $174 billion, or approximately one-fifth of all Wells Fargo consumer deposits in the last fiscal quarter [7].


Stablecoin providers function like banks. When a person purchases a stablecoin, they provide a dollar loan. Providers, then, must hold enough assets to redeem a stablecoin for a US dollar on demand. This enters stablecoin providers into the same risk that banks bear: they are “runnable” and risk collapse if consumers decide to take their dollars back all at the same time. The US government does not currently have the power to regulate all stablecoin reserves, but it may begin to do so. The Treasury department issued a report on stablecoins in November of 2021, recommending that Congress require oversight of stablecoin wallet providers and more transparency of stablecoin reserves [8]. Senator Sherrod Brown (D-OH), Chair of the Senate Banking Committee, spoke of stablecoins, confirming that they are “not going to remain unregulated.” [9]. In the first two weeks of February, the House and Senate both held hearings with witness Nellie Liang, the Treasury’s undersecretary for domestic finance, to discuss stablecoin regulation. The hearings highlighted a growing Congressional divide over whether to regulate stablecoins by the FDIC [10]. Following such scrutiny, it is likely that stablecoin companies will come to be increasingly regulated by the US government. In the meantime, the government is showing signs of attempting to crack down on the exchanges on which these coins are traded in an effort to increase the transparency and relative safety of these currencies [11]. Admittedly, increased government regulation can be viewed as a way to bolster the credibility of cryptocurrencies and further legitimize them. Yet the vast majority of cryptocurrency enthusiasts view government involvement with suspicion, alleging that legislative heavy-handedness will stifle innovation. The “wild west” that is the cryptocurrency space, they argue, should remain truly decentralized, unregulated, and anarchic [12].


Even after they come under regulation, stablecoins present a somewhat compelling innovation. First, they mark an important shift in the world of cryptocurrency because they represent the capacity for digital assets to have real value and to evolve and develop more uses with time. More and more often the world of crypto is treated like the stock market, where investors purchase coins when prices are low and sell when their value goes up. Stablecoins, by contrast, underscore the importance of the “currency” part of the word “cryptocurrency” because they are not speculative. Additionally, as issuers provide consumers with more options to manage their money, stablecoins have the potential to create competition for the banking sector. In an economy where the five largest banks control approximately 47% of the market share, stablecoins represent a promising force to stimulate competition in the banking sector [13]. Since cryptocurrencies are all managed digitally, stablecoins represent a potentially cheaper and faster way to exchange, invest, and manage money. They represent a more accessible and transparent alternative for those who feel disenfranchised by the conventional banking system.


The rise of stablecoins and the subsequent rush to regulate them is emblematic of a much more crucial issue at hand: the rapid development of digital currencies and the US government’s inability to keep up. Because the technology that cryptocurrencies are grounded in is so abstruse, members of Congress must spend lots of time understanding these concepts before they can even begin to regulate them. Not only is the technology hard to grasp, but the pace of legislating is so slow that cryptocurrency companies and exchanges have the potential to cause irreversible harm before they even begin to be regulated by the US government. The House Financial Services Committee hearing on Financial Innovation and Digital Currency in December of 2021 showed just that. It was the first ever congressional hearing on the cryptocurrency industry and was the first time members of Congress had spoken with top cryptocurrency executives. Ranking member Patrick McHenry (R-NC) quite shrewdly asked his fellow lawmakers, “Do you know enough about this technology to have a serious debate?” [14] The nearly five hours of discussion that followed revealed that most members, in fact, did not. Just one month after the entire cryptocurrency market’s worth hit $3 trillion [15], members of Congress exposed their grossly inadequate knowledge of the subject they were dealing with.


Wherever Congress is, it seems that the cryptocurrency industry tends to be two steps ahead. While members of the Financial Services Committee wrestle with the concept of stablecoins, a type of cryptocurrency more threatening to the economy, known as algorithmic stablecoins, are entering the mainstream. Like stablecoins, these coins are pegged to a given asset and try to maintain their value at the value of that asset. For example, the most popular algorithmic stablecoin, Dai, is pegged to the value of the US Dollar [16]. However, its key feature is that it is not backed by physical, bank-held USD. Instead, algorithmic stablecoins use algorithms to regulate a coin’s value. In simple terms, the algorithms mimic the functions of the central bank, pumping out coins into the internet when the coin’s value goes above its target (for example, $1) and reducing supply when the value goes below. There are a number of other mechanisms that programmers include in these cryptocurrencies so that they can maintain the price of their coins at the exact target price, each adding a level of security to the coin [17]. The utility of these coins is that they provide the reliability that stablecoins offer while not depending on a supply of collateral. In order to add a level of safety and confidence to their coins, in most cases, the “collateral” these companies use will be other cryptocurrencies. In this way, the engineers of cryptocurrencies are able to layer their currencies on top of each other by pegging and collateralizing them via different mechanisms and intricate processes. This effectively eliminates the risk of  “running” the coin in the way that consumers can run banks or stablecoins during an economic crisis. In theory, algorithmic stablecoins should only be as vulnerable as that which they are pegged to. This means that the vast majority of algorithmic stablecoins, which are pegged to the US dollar, should only fail if the dollar itself fails.


Blockchain, the technology that allows computers all over the world to essentially “agree” on the validity of transactions between people, provides the consumer confidence that allows coins like this to exist. In theory, as long as someone has faith in the technology, they need not worry about losing their money if they decide to put it in such coins. For example if a consumer puts $100 USD into Dai today, their holdings will still be worth $100 USD ten years from now. And since the providers of algorithmic stablecoins are not responsible for supplying any sort of physical assets, they eliminate the need for tellers, customer service offices, and the other bureaucratic trappings of banks. Proponents of algorithmic stablecoins and other similar types of cryptocurrencies argue that they are pioneering the system of decentralized finance, or what is commonly referred to as “DeFi”. While all cryptocurrencies are part of the DeFi space, algorithmic stablecoins represent the most decentralized type of currency to ever exist. Behind each algorithmic stablecoin is no company, no clear ownership structure, nor bank account. Most likely, the ownership structure is a relatively small group of programmers and several thousand lines of code. The quite radical implication of this is that the government has no ability to tax or regulate the providers of these coins even if it wanted to. Additionally, accessing financial services on decentralized networks like these does not require that users reveal their identities. While this creates a huge risk for crime, it also opens up financial systems to the two billion people worldwide who cannot access formal financial services because they don’t have access to documents such as a government-issued ID or social security number [18][19].


Despite its bold promises, decentralized finance is far from perfect. Stories of major hacks, scams, and dubious activity within crypto companies enter the news with just enough frequency to cause doubt about the long-term viability of these digital assets. On February 8th, 2022, the Department of Justice announced its seizure of $3.5 billion in cryptocurrency from a couple responsible for the 2016 hack of a Hong Kong cryptocurrency exchange [20]. By November of 2021, DeFi companies had lost $10.5 billion via fraud and theft in that year alone. Critics argue that such is to be expected from a technology that, in its nature, removes accountability and facilitates anonymity. Among fraud and theft, critics list money laundering, sanction evasions, and terrorism among decentralized finance-related concerns [21]. However, advocates point out that the “wild west” is not meant to be entirely safe. And, like our own economy, consumers should be given the liberty to discern the safest ways to spend their money and determine the security of where they keep it. Still, proponents point out that the largest cryptocurrency companies which have been in the market the longest have had the chance to be well-vetted and have shored up their code to be infallible to hacking. (This is perhaps why nearly 8 million U.S. adults feel comfortable sending remittances to family abroad using at least one or more kinds of cryptocurrencies to save on bank fees and exchange rate costs [22]).


As decentralized finance continues to improve, multiply, and become accepted by a wider demographic, it shows tremendous potential to uproot our current systems of finance. Fortunately, algorithmic stablecoins are just the tip of the iceberg. There are dozens of other protocols, systems, and tokens within the crypto-sphere that put making and managing money back into the hands of regular people. The truly revolutionary part about it is that all of the workings behind the cryptocurrency environment are open-source, public information. The financial tools that used to be reserved for banks and governments are now permissionless and accessible to anyone with enough enthusiasm and an internet connection. Moreover, DeFi represents a subversive political and social movement to remove power from large, central banks and replace the middleman with computer networks. The cryptocurrency space entertains a somewhat utopian fantasy of finance that is equitable, accessible, transparent, and boundless. This ideology is particularly appealing to Gen Z, a generation that consistently markets itself as anti-establishment, socially conscious, and tech-savvy [23]. As more continue to become involved in programming and owning these currencies, the decentralized finance movement could take on a life of its own and become the financial system of choice for the new generation. With all this said, the general public’s lack of understanding about decentralized finance and cryptocurrency is its biggest weakness. If the survival of new coins depends on increased participation in purchasing and holding them, then they will fizzle out or remain a second-tier investment choice if they are not accepted into the mainstream. As it stands now, the average American is not predisposed to take the risks that he or she believes most crypto entails. When more attention is paid to improving company transparency and emphasizing the non-speculative uses of crypto, then will the concept of DeFi become attractive to the general public. Companies must stop making hyperbolic ads comparing cryptocurrencies to the moon landing or the invention of the wheel and should instead allocate their resources toward educating the public about its practical purposes [24]. Only then will decentralized finance truly have the power to topple the current financial paradigm and leave the government once again scrambling to keep up.


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