Lambert here: Given how common fraud is in these financialized Americas, it’s no surprise that Bitcoin is popular and increasingly normalized. Not that I’m in favor of central bankers; “strictly” does more work than a bad adverb should do in the introduction below. But it’s always possible to make things worse!

By Ulrich Bindseil, ECB Director General for Market Infrastructures and Payments, Patrick Papsdorf and Jürgen Schaaf, Heads of ECB Payments Surveillance. Senior Management Advisor, Market Infrastructure and Payments, ECB.

Bitcoin’s market cap hits a new high in November 2021. This column shows that it is difficult to find arguments to support the cryptocurrency’s current valuation. Even if the financial stability risks of a Bitcoin crash can be contained, the bursting of the bubble will result in painful losses for many retail investors and society as a whole. The authors concluded that public authorities should refrain from taking steps to support additional investment flows into Bitcoin and should treat it as rigorously as the traditional financial industry to combat illegal payments, money laundering, and terrorist financing.

Durability, Stability, and Scalability of the Bitcoin Network¹ impressive. The potential of blockchain outside of digital assets and finance is still under-exploited. Still, several authors have questioned the underlying technology and concepts of Bitcoin (e.g. Avoca 2021, Acemoglu 2021, Bindseil et al. 2022). The concept of “Proof of Work” is a constitutive feature of the Bitcoin system. It has scalable difficulty levels designed to incentivize miners to keep the system running. The stronger the computing power, the faster the verification process, and the more secure the entire system. Still, the technology’s ability to keep pace in a quantum computing environment has been questioned, and governance of the necessary deep changes is deliberately made difficult. Furthermore, the proof-of-work concept, a necessity for system security, wastes electricity and is an unparalleled environmental polluter: Bitcoin may consume as much energy as all data centers around the world (Digiconomist 2021).

Bitcoin is not a currency and unlikely to be sustainable as an investment

There is a consensus that Bitcoin has failed to achieve its original purpose as a currency. It is too unstable to fulfill the classical functions of money (unit of account, means of payment and store of value). Furthermore, incentivizing maintenance of the system without a central authority is cumbersome and expensive. The number of transactions per second the Bitcoin network can process is low and fees are high (currently between $2.50 and $4 per transaction; Avoca 2021). It is difficult for merchants and customers to embrace it outside the niche.

One of the most popular arguments among Bitcoin proponents is that Bitcoin’s limited supply will make it an inflation-proof asset, while fiat currencies, which can be multiplied at will, will increasingly depreciate. However, even if Bitcoin could become the new global currency, its technically fixed “money supply” could cause the world to fall into a deflationary trap, as growing economies need additional liquidity.

Likewise, comparisons to gold fail. As Taleb (2021) argues, gold was used both in industry and as jewelry for centuries before it became an investment asset or reserve currency. Furthermore, gold does not degrade over time and easily retains its value even in extreme situations such as natural disasters.

It follows that Bitcoin’s market valuation is purely speculative: its market rally will only continue as long as the Bitcoin community’s belief in Bitcoin’s alleged dominance can be maintained. But enthusiasm alone is not enough in the long run, because Bitcoin is ultimately just a digital chain, and technology is replaced by better technology—and the new will soon replace the new.

High private and social costs of the Bitcoin network

The longer the boom lasts, the higher the valuation of Bitcoin, and ultimately the higher the cost to society. Investing out of fear of missing out and ignoring risk. Bitcoin comes with huge private energy and hardware costs to run the network. Since Bitcoin does not create value for society beyond the hope of speculative gains, these private costs will represent a net loss to society when the music stops.

Take the problem of environmental pollution as an example. Even though in many countries the negative externalities of energy consumption are priced through taxes, geographic arbitrage can lead to further concentration of mining where taxes are the lowest. Some argue for positioning bitcoin mining in places where energy is quasi-free (such as Iceland, which has abundant geothermal energy, or the proximity of volcanoes in El Salvador). But why haven’t these locations previously attracted other energy-intensive activities with limited geographic constraints?

Furthermore, over the years, the Bitcoin network has been known to facilitate criminal activity by providing illegal means of payment. There is a long list of shady operators and market manipulations that have marked Bitcoin’s history on the supply side (e.g. Dunn 2021). Additionally, Bitcoin is popular for funding criminal activities under the radar of law enforcement and regulators. Drug trafficking, money laundering, terrorist financing, ransom and extortion are popular areas of use.

Regulatory mentality is changing

Bitcoin’s widespread use in illicit activities was recognized early on. The closure of the darknet marketplace Silkroad in 2013 (2013) revealed the widespread illicit use of Bitcoin. In 2014, money laundering and terrorist financing related to crypto assets became the focus of the Financial Action Task Force (FATF), which in 2019 issued guidance requiring national implementation and enforcement. If fully implemented, crypto asset service providers will have to adopt AML/CFT measures such as customer due diligence and suspicious transaction checking and reporting. Illicit use of bitcoin will become more difficult, especially when exchanging for fiat currency or purchasing goods and services.

There are several reasons why, despite the scale of the problem, the overall implementation of effective measures to combat the illicit use of Bitcoin has been somewhat slow. First, the potential societal risk may be underestimated because the cryptocurrency market is relatively small and assumed to be unleveraged; at least, no fundamental threat to global financial stability has been diagnosed. Second, Bitcoin’s responsibility appears to be decentralized, as it raises multiple threats. For example, first concerns were primarily related to money laundering and terrorist financing, only to later realize that it was often used to pay ransoms, and only recently to focus on environmental, consumer and investor protection issues. Third, many aspects of Bitcoin are fundamentally new and do not fit into existing regulation, thus presenting challenges. Fourth, the vested interests of large bitcoin holders and financial service providers could lead to increased lobbying.

Nonetheless, some jurisdictions have taken or are preparing to take steps to regulate Bitcoin and other cryptoassets. Approaches, however, range from a complete ban on crypto-asset businesses to a more inclusive approach to licensing and oversight intermediaries. The latter aims to bring cryptoassets “into regulation” to address risks, while supporting the benefits that innovation may bring (e.g. Cunliffe 2021).

Despite progress towards consistent and effective regulation of crypto assets, Bitcoin’s market capitalization reached a new peak in November 2021. Some measures by public authorities may have contributed to these peaks. For example, authorities have not blocked the first-ever launch of a futures-based bitcoin ETF in the US (whereas bitcoin spot market ETFs were rejected), while a German law allows investment funds of institutional investors to invest 20% of their assets in the cryptocurrency. For investors, such public measures or inactions signal future policy stances and appear to legitimize Bitcoin. Furthermore, they facilitate the integration of Bitcoin with the traditional financial system. Overall, the net impact of the authorities’ recent measures against Bitcoin is therefore ambiguous. They may add to the total cost Bitcoin ultimately brings to society, not just for illicit payments.

in conclusion

As others have said (Taleb 2021, Dunn 2021, Roubini 2021), we think Bitcoin’s sustainability is questionable. If Bitcoin eventually collapses, the net social cost of its lifetime will be enormous. Without any positive contribution from Bitcoin to society, its total social cost and net social cost would be equal: adding up energy consumption, network hardware usage, human and technological capital investment – ??all of which would have to be written off entirely. Additionally, the social fabric will be disrupted when retail investors find their savings lost, and early investors who exit before the music stops will enrich themselves at the expense of themselves.

Public policy makers have been too slow to address all the issues related to Bitcoin. At the same time, Bitcoin is becoming a pseudo-normal asset class for everyone, and its risks are not yet understood. While regulators have taken steps to crack down on reliance on Bitcoin for illicit purposes, disintermediation of the Bitcoin network remains largely beyond the reach of regulators. Further regulatory efforts are needed to effectively address various illicit payments made through Bitcoin. The principle of “same function, same risk, same rules” is to be applied consistently.

Several supportive moves have emerged in 2021, such as the approval (or at least not banning) trading of futures-based bitcoin ETFs. This could be an important driver of Bitcoin’s price surge in the fall. Authorities need to be careful not to facilitate new investment flows into Bitcoin that would increase its market capitalization and thus the scale of its eventual cumulative social cost.

Author’s Note: The views expressed in this column are those of the author and not necessarily those of the ECB. We would like to thank Fiona van Echelpoel, Jean-Francois Jamet, Anton van der Kraaij, Mirjam Plooij and Pedro Miguel Bento Pereira Da Silva for helpful comments. All remaining bugs are ours.

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