White House Condemns Crypto-Sector in Chapter 8 of ‘Economic Report of the President’

The White House released the 2023 Economic Report of the President on Tuesday, and nestled among the usual topics—climate change, labor markets, international partnerships, children’s care, and education—there’s a delightful surprise: an entire Chapter 8 on digital assets.

But the report couldn’t wait for that long and started condemning the crypto sector in Chapter 1 itself, noting “blockchain technology has fueled the rise of financially innovative digital assets that have proven to be highly volatile and subject to fraud.”

Coming back to Chapter 8, titled ‘Digital Assets: Relearning Economic Principles,’ the Biden administration discusses the impact of digital assets on the broader economy and how it challenges existing business models and industries. It argues that while innovation in financial services brings both risks and opportunities, it cannot challenge fundamental economic principles, such as the effectiveness of an asset as money and the incentives that give rise to the run risk.

The report notes that while the underlying technology offers a clever solution for executing transactions without a trusted authority, they currently do not offer widespread economic benefits. Instead, they are largely speculative investment vehicles and are not a viable alternative to fiat currency. The report also stuck to the government’s classic take on innovation – always cautious, never too enthusiastic, as it called digital assets too risky to function as payment instruments or expand financial inclusion.

Despite directing a barrage of criticism at crypto, the report doesn’t do an excellent job of addressing the limitations or risks of crypto, given a lack of thorough research reflected in its data. This is exemplified by the top ten crypto derivative platforms listed by open interest, including the unknown BTCEX exchange at the top and other obscure names such as BTCC Futures, Deepcoin, and BingX occupying the top five positions.

The report, however, acknowledges that Distributed Ledger Technology (DLT) may still find productive uses in the future as companies and governments continue to experiment with it. In the meantime, regulators are expanding their capabilities to bring a large number of new entities under compliance and coordinate with various agencies to address the risks posed by crypto assets.

The report also notes that certain innovations, such as FedNow and a potential US Central Bank Digital Currency (CBDC), could help bring the US financial infrastructure into the digital era safely and securely without the risks or irrational exuberance brought by crypto assets.

The Perceived Appeal of Crypto Assets

The President’s report starts the discussion on the crypto sector by stating how financial crises in the US have been caused by institutions that function like banks but are not registered or regulated as banks. It then discusses how digital asset proponents aspire to create a decentralized financial system without relying on governments and their regulatory frameworks.

According to the report, crypto assets currently are largely speculative investment vehicles with no fundamental value, and their innovation has been mostly about creating artificial scarcity to support prices. “This raises the question of the role of regulation in protecting consumers, investors, and the rest of the financial system from panics, crashes, and fraud related to crypto assets,” it said.

In recent years, crypto assets, including stablecoins, have gained significant popularity among investors, particularly since the beginning of the COVID-19 pandemic in 2020. But despite their growing popularity, crypto remains a relatively new and untested investment class, and their risks and benefits are still being evaluated, it added.

The report said that it is crypto’s potential to transform industries and business models that have prompted the Biden administration to study the effects of these novel assets like Bitcoin.

The perceived benefits of crypto assets include their potential to offer fast, secure, and low-cost transactions, particularly for cross-border payments, and their potential to provide a decentralized and more accessible financial system.

While crypto proponents argue that crypto assets provide a hedge against inflation and can offer higher returns than traditional investments, the report said crypto poses significant risks, including their potential for price volatility, lack of regulation and oversight, and susceptibility to fraud and market manipulation.

The Reality of Crypto Assets

In its March 2023 report, the Biden administration details numerous claims brought forth by the rise of crypto assets about the benefits this novel technology brings to the financial sector.

These claims include crypto assets serving as a hedge against inflation and investment vehicles for individuals looking to make investment returns. Another potential benefit of crypto is its ability to offer money-like functions without relying on a single central authority.

Besides enabling fast and efficient digital payments via stablecoins, it can simplify cross-border transactions and remittances, increase financial inclusion for unbanked or underbanked populations, and improve the United States’ current financial technology infrastructure. In addition, it noted that recent developments have enabled new features and improved efficiency, such as smart contracts to automatically trigger particular actions without ongoing oversight.

But, of course, the Biden administration didn’t agree with these claims. It asserted that despite the claimed benefits of crypto assets, they are primarily speculative investment vehicles and highly volatile, making them risky investments said.

Through crypto, investors seek to make a profit through short-term trading. However, many of them do not have a fundamental value, in contrast to other types of assets like stocks and commodities, which it said involve claims on future profits or uses in manufacturing.

The lack of a fundamental value means that crypto assets are traded without real anchors, making their market prices reflect speculative demand and market sentiment. This lack of grounding also means that crypto assets are not effective hedges against inflation, said the report noting that when inflation rates increased globally in 2021 and 2022, the prices of crypto collapsed, proving that they were ineffective in protecting against inflation

While investigating the claimed benefits, the president’s economic report highlights that cryptocurrencies, such as Bitcoin, currently do not perform all the functions of money as effectively as sovereign money like the US dollar either. While cryptocurrencies serve as a unit of account, they are not as effective as the US dollar as a medium of exchange or a store of value.

Additionally, cryptocurrencies’ use to purchase goods and services is limited, and individuals would likely need to convert them to US dollars to understand relative values. The US dollar’s strength comes from the trust people have in government institutions and the legal system, something cryptocurrencies lack, it said.

While cryptocurrencies do not require a fundamental value to function as money, they lack the trust and stability provided by sovereign money, said the report, noting in advanced economies like the US, the profits from the issuance of sovereign currency benefit taxpayers by lowering tax needs, as central banks return these profits as government revenue.

Stablecoins, Scams, and Conflict of Interest

The report then discusses the risks associated with stablecoins, the primary being run risk, a fundamental problem known in the traditional banking sector for centuries. If stablecoin holders wish to redeem their stablecoins for $1 each, this will require the stablecoin issuer to liquidate some of its reserves, which may lead to disruptions in the markets for the reserve assets and reduce the market value of the issuer’s remaining reserves, reads the report.

However, as we saw in March 2023, the US saw its largest US bank collapse since 2008 when SVB collapsed following a bank run after revealing a financial shortfall resulting from the sale of its inflation-hit bond portfolio.

The Biden administration points out that stablecoins are not subject to the comprehensive set of regulatory and supervisory requirements that bank deposits are subject to in the US and gives the example of algorithmic stablecoin TerraUSD, which experienced a run that knocked it off its $1 peg.

Another key risk of stablecoins for US retail users mentioned in the report is that redemption may be a secondary concern for liquidity on crypto asset trading platforms. As such, US retail customers cannot directly redeem the two largest stablecoins (Tether and USD Coin) for dollars, reads the document.

And as a result, the report stated that stablecoins are not yet suitable for use as fast payment instruments.

It further highlights that the crypto asset industry needs proper consumer, investor, and market protections in place for consumers and investors to use crypto to access financial services safely.

According to the report, scams are the most common unlawful activity in the industry. It referred to a Federal Trade Commission (FTC) post from May 2021 that identified an increase in scams involving crypto since October 2020. Over 7,000 people reported losses during this period, amounting to more than $80 million, with a median loss of $1,900.

Also, lack of disclosure regarding crypto assets that are securities is one of the principal areas where there is mass noncompliance, which, the report said, prevents investors from recognizing that most crypto assets have no fundamental value. For this, the report cites an example from September 2021 when the SEC filed a case against BitConnect for allegedly committing $2 billion worth of fraud.

The report also covered FTX, a regulated crypto exchange that filed for bankruptcy protection in the US in Nov. 2022 under the conflicts of interest at crypto asset platforms — a practice the report said has long been prohibited in traditional markets due to the risks it poses to customers.

FTX transferred billions of dollars in customer accounts to its affiliated trading firm, Alameda Research, and made risky bets with customers’ funds, leading to massive losses, and it is unclear whether FTX customers and creditors will get their funds back, it stated.

Call to Avoid a “Minsky Moment”

While discussing the limited economic benefits of DLT technology, the report goes on to point out the misuse of blockchain technology by non-crypto-related businesses and the criticism of the practicality of blockchain-based applications.

The report mentions that while DLT is a notable computer science achievement, it is merely a database at its core, and not all DLT-based projects employ decentralization. The report also discusses the views of cybersecurity expert Bruce Schneier and computer scientist James Mickens, who argue that distributed ledgers are not particularly novel or useful and blockchains are a poor fit for their purported uses, respectively.

Moreover, the report mentions the proponents of blockchain technology who claim that it will be the backbone of a new Internet, Web3 but cites cryptographer Moxie Marlinspike’s argument that centralization in the current Internet is convenient and that a decentralized Internet would require individuals and firms to host their servers, which is much more costly than centralized hosting.

It further highlights Marlinspike’s concerns about Web3 trending toward a centralized structure, which could become the worst of both worlds, leading to a centralized control but still distributed enough to become mired in time.

The report also discusses the risks of financial innovation, citing economist Hyman Minsky’s hypothesis that financial crises often follow a similar cycle, where initially strong investments turn increasingly speculative until a bubble bursts. The report argues that the most effective financial regulation has been introduced only after a crisis has occurred.

“Fortunately, there has not yet been a systemic crisis caused by crypto assets, in part because they are not yet fully integrated with the rest of the financial system, giving policymakers time to act appropriately,” stated the report.

In the President’s report, several other risks associated with crypto assets were identified, which are not unique to crypto assets. They have reportedly posed challenges for regulators trying to minimize risks while encouraging responsible innovation. Some of these risks include excessive speculation, leverage risks, price volatility risks, environmental harm from crypto mining, fraudulent activities, and illicit finance risks.

“Because crypto assets appear to be here to stay, policymakers should consider these risks to avoid a “Minsky moment” caused by crypto assets,” said the report.

Investing in the Digital Financial Infrastructure: CBDC & FedNow

Besides discussing the growth and risk of the crypto sector, the report also mentions the need for a faster and more inclusive financial system in the US. It notes that while the vision of crypto assets has not been realized, other ways exist to progress toward a faster, cheaper, safer, and more inclusive financial system.

The Federal Reserve has a role in maintaining the integrity of the Nation’s payment systems and is designing and developing a faster payment system called the FedNow Service, it said. The FedNow Service, which will be operational 24/7, will allow businesses and individuals to send and receive payments conveniently and offer nearly instant access to funds.

The report noted that near-instant payments could yield real economic benefits for individuals and businesses by allowing them to make time-sensitive payments and providing them with more flexibility in managing their money. Additionally, a fast payment system such as FedNow could reduce fees and generate savings of more than $7 billion annually for American households.

Lower-income individuals could significantly benefit from these savings if FedNow is adopted widely. However, interoperability is crucial for the success of FedNow, and achieving this will require active partnership and collaboration with the financial industry, said the massive report.

Besides FedNow, the report mentions CBDC as a solution that functions as a liability of the central bank, similar to cash but exists on a digital platform that allows for real-time exchange and settlement.

The report covers wholesale CBDC and retail CBDC and notes that as of January 2023, 11 countries have launched CBDCs, with others exploring the possibility of issuing as well. According to the report, a trusted central authority would operate a potential US CBDC system rather than using a permissionless approach.

A digital fiat currency, it said, could offer a more efficient payment system, a foundation for technological innovation, faster cross-border transactions, environmental sustainability, and promote financial inclusion and equity. Additionally, a US CBDC could help support policy goals related to human rights, democratic values, and privacy, said the report.

The President’s report also mentions risks associated with CBDCs, noting they may pose credit availability risks by serving as a substitute for commercial bank deposits, which could reduce the aggregate amount of deposits in the banking system and increase bank funding expenses, potentially reducing credit availability or raising credit costs for households and businesses.

A widely accessible CBDC could also be particularly attractive to risk-averse users during times of financial stress, potentially increasing the likelihood or severity of systemic bank runs, said the report, adding CBDCs could also cause operational risks if the CBDC platform experiences system failure or cyberattacks.

The Biden Administration has developed “Policy Objectives for a US CBDC System” to reflect the Federal Government’s priorities for a potential US CBDC.

In conclusion, the report emphasizes that continued investments in the nation’s financial infrastructure have the potential to offer significant benefits to consumers and businesses. However, regulators must apply the lessons that civilization has learned and rely on economic principles when regulating crypto. This will help minimize the risks posed by digital assets and ensure that the broader economy continues to benefit from financial innovation.