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I find it useful to think about risk in cryptocurrencies across three dimensions: market, technology, and regulation. Like dimensions in space and time, they do not exist independently; they intersect.
The market risk dimension is the adoption risk that any new technology faces. It is represented less by cryptocurrency critics than by people who don’t care. The technological risk dimension is the risk of the underlying technology breaking down. This is perhaps the most often overlooked. How many can tell they understand why Bitcoin’s SHA-256 hash function is unbreakable? The regulatory risk dimension receives the most attention, but its nuances are often misunderstood. These nuances and the market’s slow progress towards understanding them were on display in this week’s series of news cycles.
This week was devoted to regulatory and technological risks. It’s been fun to watch commentators go from wringing their hands over the centralization of Bitcoin mining in China to wringing their hands over the Chinese government’s crackdown on Bitcoin mining.
This column originally appeared in Crypto Long & Short, CoinDesk Research’s weekly newsletter for professional investors.
Both risks are overestimated. Mining is, along with validation, Bitcoin’s governance system. And Bitcoin trivializes governance: It takes the corrupting power of governance and turns it into a “toothless commodity,” which anyone with an internet connection can provide. The only advantages in this race are cheaper power and faster processors. North American miners have shown that they can compete on both fronts.
Right now, any Chinese “crackdown” on cryptocurrency mining is a golden digital opportunity for North American miners. And if Senator Elizabeth Warrens’ comments represent Washington’s intentions toward mining in North America, it will be someone else’s opportunity. (A Paraguayan lawmaker made friendly regulatory overtures this week. Notably, Paraguay controls 45% of the capacity of Earth’s second largest hydroelectric dam and uses very little of it.)
This week, the cryptocurrency markets demonstrated a more sophisticated understanding of regulatory and technological risk: ignoring the mining thunder from Washington and Beijing, and stunned to learn that U.S. federal law enforcement had found a way to seize bitcoin from Darkside, the criminal collective that held Colonial Pipeline systems for ransom.
It was the largest seizure of its kind ever made by a single (presumably) sophisticated organization. Did the FBI crack Bitcoin’s crypto? The market reacted as if it had. A three-letter agency finding a way to solve tough crypto problems would indeed remove the legs from Bitcoin and all cryptocurrencies (among others). But that’s not what happened.
Hours after revealing it had recovered bitcoins sent to Colonial Pipeline attackers, the FBI was named in a Europol press release describing a multinational operation in which law enforcement has set up a service encrypted messaging and marketed it to criminals as a Trojan horse. Inexplicably, these masters of deception seem to have entrusted this stool pigeon with their private Bitcoin keys.
The increasingly crypto-curious world has a thing or two to learn about how it works. The New York Times and The Wall Street Journal published articles this week noting that bitcoin is “truly traceable” and citing “the reputation of cryptocurrencies as difficult to trace.” Law enforcement has long understood that cryptography is not only traceable, but permanently traceable. Some wacky feds have called bitcoin “pursuit futures,” journalist Nathaniel Popper noted in his 2016 book, “Digital Gold.”
The distinction between the U.S. government cracking SHA-256 (which it created) and setting up a sting through an off-chain service provider illustrates perfectly where regulatory risk in cryptocurrency really exists. The market’s reaction to the news of the seizure and its non-reaction to a mid-week drop in Bitcoin’s hashrate or to the (some bogus) news of Bitcoin bans in two Chinese provinces (Qinghai and Yunnan) shows a better understanding of this distinction.
Washington and Beijing would struggle to stop Bitcoin mining, at least by legislating it directly. As long as at least one computer is “running Bitcoin”, Bitcoin will work. If the price of bitcoin rises, more miners will ignite, motivated by rewards and offering security commensurate with the value of the network. Close the entrance to his den and the honey badger will be seen in another part of the forest.
Greater regulatory risk exists in the government’s power to control crypto exchanges and other off-chain service providers. Crypto’s weird and fragmented liquidity performed admirably on May 19th. This might not be the case in the next draw, depending on how trading is regulated. There is also a risk of slow progress in crypto-friendly regulation, such as banking supervision and Bitcoin ETF approval.
It’s not that mining is untouchable. Regulatory risk at entry and exit can have a negative effect on mining, driving down the price. It’s important to distinguish between this and a regulatory risk that affects the security of Bitcoin itself.
The market seems to better understand this distinction between technological risk and regulatory risk in cryptocurrencies. This is a sign of improved efficiency, at least for now. In the wobble between retail and institutional market cycles, this dynamic could change quickly.
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