To bring down cryptocurrency, hold the exchanges accountable

Cryptocurrencies are valued at around 300 billion euro. This is an absurd figure, but if you study cryptocurrencies carefully, you’ll find yourself growing used to absurd figures. Consider the electricity use of Bitcoin, currently estimated at 0.3% of global electricity use. Add another 0.1% for Ethereum, take the rest of the market as well as the various other coins that have pumped and dumped over the years into consideration and you’ll conclude we’re currently using anywhere up to one percent of all global electricity merely for the purpose of mining cryptocurrencies.

Cryptocurrency enthusiasts will insist you need to compare cryptocurrencies to the legacy financial industry they’re supposed to replace. In that case, it’s fair to take into consideration the mining machines that need to be built to use cryptocurrency, the hardware wallets that “hodlers” use to store their digital assets,  the conferences held in a desperate effort to form consensus and the small army of tech support workers needed to guide its users through the process. Coinbase, Kraken and Circle, three big companies in the industry are planning on increasing their cumulative headcount to 2,500 people by the end of this year. For comparison, Mastercard currently has 13,000 employees.

Explaining the most absurd figure of all

How is it possible cryptocurrencies are worth 300 billion euro, if they’re not a good solution to the problem they’re supposed to solve? Well, to understand this mystery, you need to understand that cryptocurrencies benefit from two factors: The first boon to cryptocurrencies is that the people who invest in cryptocurrencies do not behave like rational actors. The second boon is that there is almost no accountability whatsoever, for the negative externalities imposed upon the rest of society. This second factor is not unique to cryptocurrencies. If the world was filled with rational actors, the tobacco industry would not exist either. Cryptocurrencies are treated in a similar matter by many to the lottery: They hear anecdotes of people who struck it big and decide to take a gamble too, disregarding the low probability of success.

The first factor however, is more sinister and the main focus of this essay. When someone pollutes our environment and someone else suffers sickness as a result, we’re dealing with a negative externality. Those who are not directly involved in the activity, suffer the harmful consequence. One of the roles of our government, is to hold businesses accountable for negative externalities. Cigarettes cause health problems, even in those who are merely indirectly exposed to the smoke. Governments thus respond to this by placing punitive taxes on cigarettes, with the proceeds used to discourage smoking.

What are the negative externalities of cryptocurrencies? Well, they’re too many to count. If my CPU is damaged because someone installed mining software on my computer, I’m suffering a negative externality. If the environment I live in is degraded because of wasteful energy use for pump and dump schemes, I’m suffering a negative externality. If my company can’t function because someone is holding our files for ransom until they receive a payment through cryptocurrency, I’m suffering a negative externality. This also applies when I’m blackmailed. Sadly, it now even applies when children are kidnapped.

The decentralized evasion of expensive responsibilities

The environmental pollution speaks for itself, but the other issues deserve further scrutiny. The big innovation cryptocurrency introduced, was the ability for people to receive money in an anonymous manner. There are a small number of obscure situations where this might be considered a proper use case, but in general we benefit from living in a society where it was until recently not very easy to receive money anonymously. Banks are required to follow strict rules, to know the identity of the customer they’re dealing with. Before you open a bank account, someone had to establish your identity. If vast sums of money change hands through people’s bank accounts, banks are required to notify authorities. With Bitcoin, there is nobody who is held responsible when a million dollar arrive at a particular address.  In this manner, cryptocurrencies impose a negative externality on our society, by creating a financial incentive for criminal activities.

One of the major reasons cryptocurrencies are worth 300 billion dollar today, is because the laws and regulations we impose on other companies, are not properly applied to cryptocurrency companies. It’s labor intensive, to verify the identity of your customer. Most traditional banks require you to visit their office, before you can open a bank account. The banks that don’t, tend to be preferentially used by scammers.  Cryptocurrency companies thus function like banks, without being subject to the laws imposed upon banks. In a similar manner, there are laws that require companies to check whether investors know what they’re doing. In many countries, regular people are not allowed to invest in small startups, to protect them from scammers. In the cryptocurrency casino, you’re free to invest in ICO’s, which are like small startups, except for the fact that you don’t receive any legal rights and don’t know the identity of the people behind the company. The cryptocurrency companies can thus function like stock brokers, without carrying the same responsibilities.

Bitcoin exchanges and other cryptocurrency companies are not held responsible for the various forms of fraud and theft that occur. People who are not up to date with all the latest scams still need to be able to own a bank account to participate in society. Banks have a responsibility, to ensure the safety of their customers’ deposits. When your credit card details are stolen and someone orders goods on your name, you’re going to be reimbursed. When your account at a cryptocurrency exchange is hacked, you’re screwed.

Similarly, as soon as you withdraw your coins from a cryptocurrency platform, the platform will deflect all responsibility for what might happen to your purchase. The decentralized nature of cryptocurrency, allows everyone to point at each other. If your coins are lost, it’s not the responsibility of the currency developers, who made a system that’s irreversible by design. It’s not the fault of the wallet developers either, who might have screwed up. Users of cryptocurrencies have responsibilities placed upon them by commercial entities, that would normally be held by said commercial entities. The users are insufficiently made aware of these responsibilities, which would be sufficient to dissuade a lot of them from participating in the scheme.

The unscrutinized money laundering of crypto exchanges

The biggest problem however is as following: Cryptocurrency companies benefit tremendously from the fact that they don’t know the source of the money they’re dealing with. If you buy a painting that was originally stolen from Jews during the second world war, there’s a good chance you’ll have to give the painting back to the heirs, without receiving any reimbursement. If you deal with stolen property, you generally have no rights to said property in most places, especially if you had reason to know the property was likely stolen. Cryptocurrencies like Bitcoin are designed in a manner, that allows companies to claim plausible deniability: “Sure, this guy showed up on our exchange and sold us a million dollar worth of Bitcoins in a period of two weeks, but there are plenty of people out there who made good investments in the right currency.” Crypto companies need these type of shady customers, because of the Pareto distribution: The vast majority of users have very little invested in crypto. A small minority is responsible for the majority of the volume on an exchange, but this small minority is largely composed of criminals.

To address the problems intrinsic to crypto, exchanges need to be held responsible when they’re used for money laundering. Currently, exchanges have no incentive whatsoever to address money laundering. For this reason, the exchanges tend to ask no questions and deny no customers. If I show up to any big exchange, sell a million dollar worth of Bitcoin and claim to have bought them using physical cash on the street a few years ago, the exchange won’t interfere. They have no financial incentive to deny me their service. If an exchange says no, I’ll head to their competitor and they’ll lose the profit margin. If it turns out years later that I kidnapped someone to receive my Bitcoins, the exchange is not ordered to return the proceeds to the family who paid the ransom. If it turns out the coins were stolen from another hacked exchange, they won’t be obliged to give the coins back to said exchange. The exchanges of course, make sure to pass such coins rapidly onto their customers. The customers in turn, are taught to treat the coins as if they are fungible, even though they’re not.

It happens on a regular basis that banks are given big fines for their failure in addressing money laundering. When it comes to cryptocurrency, no such standards seem to exist for the exchanges. Exchanges regularly handle customers with volumes of millions of dollars, without bothering to ask or check whether the money happens to come from questionable sources. To check your customers is labor intensive and causes customers to leave for competitors. What we see in practice is thus a race to the bottom, with the most successful companies placing the lowest demands upon their customers.

Crypto exchanges have record profits year after year, while cryptocurrencies skyrocket in value. This is very unsurprising, when seen in light of the fact that this economic sector is used for money laundering without being held to the same standards as banks are. What is surprising however, is the complacency of governments. Why do governments watch passively, as money laundering shifts from the regular banking system, towards the crypto-economy? Government officials seem to stare themselves blind at the fact that these currencies are designed to be anonymous and decentralized. This doesn’t matter however, because the weak link in the system is found in the exchange between actual money to cryptocurrencies. It doesn’t really matter whether a cryptocurrency is designed to be anonymous or not, if an exchange is required to know how you got your currency. In fact, it could be argued that the exchanges are the currency. The protocol is not decided on Gitlab, the miners and exchange operators decide together through consensus what should be thought of as a bitcoin.

You might argue that users would still be able to spend their illegally obtained cryptocurrency within the ecosystem. However, the cryptocurrencies are highly volatile, thus merchants tend to rely on third parties to process payments for them. It’s self-evident that these third parties would have to be held accountable, if they find themselves accepting payment in cryptocurrencies obtained through illegal means. If they accept a payment in Monero, they have every reason to believe the money was unethically obtained. When it comes to coins like Bitcoin, the payment processor would choose to give preferential treatment to coins that have been white-listed, which would in due time lead towards Bitcoin becoming a Rube Goldberg machine for payments, rather than a means of laundering money.

The laws needed to address this problem already exist. It’s now merely time for governments to enforce them.

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