Responding to the growth of “cryptocurrencies” has shot up the list of priorities for policymakers and regulators in recent months.
Given the intense confusion surrounding this topic, we present here a primer that explores the topic from a public policy viewpoint, starting with the most basic points. We constructed this in Q&A format to make it easy to read and to jump to the points of greatest interest. It is intended for an intelligent non-specialist and therefore required a fair amount of simplification, for which we apologize to any technical experts who would have explained things differently.
Cryptocurrencies overlap with key parts of the global monetary and financial system. The rapid growth of cryptocurrencies demands that policymakers and regulators consider whether or how to fit them into their existing systems or revise those systems for the new world.
Cryptocurrency prices have been extremely volatile. According to Coindesk, Bitcoin rose by over 15 times in 2017, and fell by more than 25% in the first month of 2018 (See exhibit below). Cryptocurrency volatility may likely continue, as many cryptocurrencies limit their monetary supply. When supply is limited, prices will swing with changes in demand. As Bitcoin has shown, demand for cryptocurrencies can be highly variable leading to extreme price volatility.
BITCOIN PRICE IN US DOLLARS
1HOW COULD CRYPTOCURRENCIES AFFECT ECONOMIC EFFICIENCY AND GROWTH?
Many cryptocurrencies are set up at least in part to make payments or other processes faster and more efficient. To what extent would these advantages improve the economy? Are there other effects that would increase the benefits or offset them? Are there alternative technologies that offer the same improvements with lower risks? The answers vary significantly with the specifics of the cryptocurrencies and their design and use.
2WHAT WOULD BE THE POTENTIAL IMPACTS ON FINANCIAL STABILITY IF CRYPTOCURRENCIES WERE ADOPTED WIDELY?
Cryptocurrencies could impact financial stability either directly, as payments and investments denominated in Bitcoin or other virtual currencies become sizable, or indirectly by changing the size, profitability, and stability of existing financial institutions and markets.
3HOW MIGHT MONETARY POLICY BE AFFECTED BY CRYPTOCURRENCIES?
Monetary policy primarily operates by affecting the amount of a nation’s money and the interest rates charged in the economy for using that money. At the extreme, the more people use cryptocurrencies for their monetary needs, the less important a country’s own money becomes, except for any secondary effects on cryptocurrencies. How much substitution will occur for conventional currencies? Would central banks be able to find alternative approaches to achieve their monetary policy objectives? How much would it matter if their monetary policy tools become less useful?
4HOW COULD FISCAL POLICY BE AFFECTED BY CRYPTOCURRENCIES?
There are two first-order effects on fiscal policy. First, by decreasing a government’s benefits from creating money instead of borrowing to make payments. Second, cryptocurrency transactions can generate tax revenue, which may be higher or lower than equivalent conventional transactions would produce. Looking beyond the tax rules themselves, some fear that cryptocurrencies could aid in tax evasion, reducing government revenues.
5WHAT ARE THE OPTIONS FOR TAXING CRYPTOCURRENCIES?
Depending on whether cryptocurrencies are viewed as currencies, investment assets, fixed assets, or something else, there are a variety of different potential tax treatments. The distributed nature of cryptocurrencies, without a central home, also challenges traditional frameworks that treat money earned domestically differently from foreign earnings.
6TO WHAT EXTENT MAY CRYPTOCURRENCIES FACILITATE ILLICIT ACTIVITIES?
Law enforcement officials are concerned that cryptocurrencies, with their greater anonymity, could encourage money laundering and abet a wide range of illegal activities.
7WHAT COULD BE THE EFFECT OF CRYPTOCURRENCIES ON PRIVACY PROTECTION?
Many advocates of cryptocurrencies believe that their use protects personal privacy more than existing systems and institutions do. For example, Bitcoin transactions are tied to account “addresses”, not directly to names. This does not provide absolute protection, however, as linkages can be established between addresses and personal identities, with varying degrees of difficulty.
8WHAT CONSUMER/INVESTOR PROTECTIONS MAY BE NEEDED IN REGARD TO CRYPTOCURRENCIES?
As with many other innovations, cryptocurrencies can be used in fraudulent transactions or suffer from market manipulation. Beyond outright fraud, there is a risk that consumers or investors may act without sufficient information or understanding.
9WHAT TOOLS DO POLICYMAKERS HAVE AT THEIR DISPOSAL?
As governments weigh the pros and cons of cryptocurrencies, they often reach different conclusions. Policymakers are in the early stages of determining how best to interact with cryptocurrencies, with current responses ranging from declaring them illegal all the way to actively fostering their development. There are a wide range of tools at the disposal of the authorities, but also some unconventional constraints created by the distributed, somewhat anonymized and global nature of cryptocurrencies. Given the decentralized nature of most cryptocurrencies, there would be benefits from global coordination of legal and regulatory treatment, but there is clearly not a global consensus among policymakers.