Issues and Concerns Related to Digital Currencies

(Disponible en français : Enjeux et préoccupations liés aux monnaies numériques)

This HillNote is the second of three on the topic of digital currencies. Part 1 of the series dealt with the taxation and regulation of digital currencies and part 3 will discuss blockchain technology and its various applications.

A.      The Hype

Recent media stories about individuals reaping enormous returns from investments in digital currencies have resulted in more money being invested in digital currencies, also known as cryptocurrencies.

Experts, institutions and governments have issued warnings to investors about the risks involved in digital currencies. In a January 2018 interview, Stephen Poloz, the Governor of the Bank of Canada, said that investing in cryptocurrencies is essentially gambling because they have no intrinsic value that one can analyze. The International Monetary Fund compared the excitement and unprecedented price increases of some digital currencies to historical speculative bubbles such as the tulip mania of the 1600s and the more recent dot-com bubble.

In March 2018, the Group of Twenty Communique stated that digital currencies “raise issues with respect to consumer and investor protection, market integrity, tax evasion, money laundering and terrorist financing,” and “they could have financial stability implications.”

Concerns related to digital currencies centre around their price volatility, links to criminal behaviour, and environmental impacts. However, many argue that digital currencies and their supporting technologies might also be used to reduce poverty.

B.      Price Volatility and Investment Risks

According to the World Bank, the price volatility of digital currencies hinders their ability to become legal tender. Figure 1 shows the daily price volatility of bitcoin compared to that of the Canadian dollar.

Figure 1: Daily Price Volatility of the Bitcoin and the Canadian Dollar, 4 January 2017 to 29 December 2017 (%)

Figure 1 is a line chart showing the daily price volatility of bitcoin and the Canadian dollar between 4 January 2017 and 29 December 2017. Bitcoin price volatility is higher than the Canadian dollar, with daily volatility reaching as high as 28% one day. On the other hand, the daily price volatility of the Canadian dollar was rarely more than 1% above or below zero.

Source: Blockchain and the Bank of Canada, Daily Exchange Rates Lookup.

Given the risks of digital currency investments, the International Monetary Fund is concerned that investors borrowing to invest in these markets may have difficulty repaying their loans.

Regulators are also concerned about initial coin offerings (ICOs) where investors purchase tokens redeemable in a new digital currency once – and if – it goes into circulation. Tokens can represent shares in a company, earnings streams, an entitlement to dividends, interest payments, or a company’s product or service.

According to the Ontario Securities Council, “[b]usinesses raised an estimated US$5.6 billion in 2017 (including over US$200 million reportedly raised by Canadian businesses) selling digital tokens,” but “46% of ICOs launched in 2017 had already failed by February 2018”. A recent investigation by the Wall Street Journal also found that nearly 1 in 5 ICOs “displayed red flags of fraud, including ‘plagiarized investor documents, promises of guaranteed returns and missing or fake executive teams.’”

C.      Criminal Links

Traditionally, cash was used by criminals for such illegal activities as trade in narcotics and weapons, money laundering, human trafficking and terrorist financing. Some of the characteristics that make cash attractive to criminals are also present in certain digital currencies: pseudo-anonymity, store of value and wide acceptance. With the emergence of digital currencies, criminals can digitally transfer value, allowing for anonymous online and cross-border illegal commerce.

According to a January 2018 study, approximately 24 million bitcoin market participants use bitcoin primarily for illegal purposes and almost half of bitcoin transactions are associated with illegal activity. These users reportedly conduct approximately 36 million transactions annually, worth $72 billion, and hold about $8 billion in bitcoin.

The first high-profile arrest related to illegal trade using digital currencies occurred on 1 October 2013, when the FBI arrested Ross Ulbright (aka Dread Pirate Roberts) for running Silk Road, a darknet marketplace on which illegal goods and services were bought and sold using bitcoins. The FBI confiscated 174,000 bitcoins and shut down the site.

Digital currencies are both susceptible to cyberattacks and can be used as tools for cyberattacks. For example, Mt. Gox, a Japanese digital currency platform, was hacked and lost approximately 750,000 bitcoins in 2014, and subsequently filed for bankruptcy. Digital currencies are also being demanded as ransom payments in cyberattacks.

As discussed in part 1, the federal government passed legislation in 2014 to help combat the use of digital currencies in money laundering and terrorist financing by requiring digital currency service providers to report transactions to the Financial Transactions and Reports Analysis Centre of Canada. The regulations bringing these changes into force were published on 9 June 2018.

D.      Environmental Impacts

Bitcoin uses a publicly available distributed ledger of all historical transactions called blockchain to validate transactions. Bitcoin miners perform complex calculations using computing power and specialized software to create new “blocks” and validate them.

The computing power required for this process continues to expand as the complexity of calculations necessary to validate new transactions continues to increase‎. Many bitcoin miners have joined mining pools or companies who purchase and run specialized computers. Ironically, the economies of scale involved in mining pools has led to a concentration of computing power, making the “distributed” ledger much more centralized.

As shown in figure 2, Bitcoin’s energy consumption was almost equal to that of the entire country of Ecuador in January 2018 and is projected to exceed Argentina’s by December 2018.

Figure 2: Estimated and Projected Energy Consumption of the Bitcoin as Compared to the 2015 Energy Consumption of Selected Countries

Figure 2 is a stacked bar graph comparing the estimated and projected energy consumption of Bitcoin to that of selected countries. It shows that at the beginning of 2018, Bitcoin’s energy consumption was between that of Azerbaijan and Ecuador. It also shows that, by the end of 2018, it is projected to consume approximately 6 times more energy, consuming slightly more, on an annual basis, than the entire country of Argentina.

Note: Countries selected based on their comparability with the estimated bitcoin consumption. Canada’s energy consumption in 2015 was 544,500 gigawatt hours.
Source: Table prepared by the author using data obtained from International Energy Agency, Key World Energy Statistics 2017, September 2017, pp. 60-68 and Morgan Stanley Research, Bitcoin ASIC production substantiates electricity use; points to coming jump, 3 January 2018.

Given the substantial energy requirement to run and cool digital currency computers, many companies choose to locate in regions with low energy costs and cooler climates. Several mining companies have submitted proposals to Hydro-Quebec, potentially making Quebec a “global hub” for cyptocurrency mining. Some have questioned the practical, ethical and ecological impact of allowing these companies to purchase electricity in Quebec.

E.      Poverty Reduction

While the price volatility, criminal links and environmental impacts of digital currencies concern regulators, some digital currency enthusiasts focus on the potential for digital currencies and related technology to improve the lives of the world’s underprivileged.

Financial inclusion, the access of people to the formal financial system, is a key factor in poverty reduction. However, 1.7 billion adults remain unbanked. Many proponents of cryptocurrencies argue that distributed ledger technology has the potential to increase financial inclusion since it does not require physical bank branch presence or expensive infrastructure to run.

In March 2018, the Group of Twenty Communique stated that “technological innovation, including that underlying cryptoassets, has the potential to improve the efficiency and inclusiveness of the financial system and the economy more broadly.”

Further Reading:

Author: Brett Stuckey, Library of Parliament