Why Governments Are Wary of Bitcoin

Since its introduction in a 2008 white paper, Bitcoin (BTCUSD) has generated controversy and headlines. Its enthusiasts herald the introduction of the cryptocurrency as the arrival of a new and fair monetary system. Critics point to the cryptocurrency’s role in criminal activity and the absence of legal recognition as evidence that it is “rat poison squared.” The reality probably lies somewhere in between.

Meanwhile, governments around the world are watching Bitcoin’s progress and taking action when they can. Some, such as El Salvador, have adopted it as currency. Others refuse to recognize it as legal tender, treat it as a commodity or property, or even ban it altogether. In 2023, the European Union adopted a framework for the regulation of cryptocurrency.

Among other things, Bitcoin enables the citizens of a country to subvert government authority by circumventing capital controls imposed by it. It also facilitates nefarious activities by helping criminals evade detection. Finally, by removing intermediaries, Bitcoin could potentially throw a wrench into the existing financial infrastructure system and destabilize it.

Effective governments require trust

To understand why governments are wary of Bitcoin, it is important to understand the role that fiat currencies play in a country’s economy. Fiat refers to conventional currencies issued by governments. Fiat money is backed by the full faith and credit of a government. This means that governments promise to make a currency borrower whole in the event of a default.

The US government relies on the Federal Reserve, a central bank over which Congress has only partial authority, to manage the supply of circulating money. The cycle of transactions in the American economy—one involving lenders, borrowers, and consumers—relies on a chain of trust between transacting parties. The Federal Reserve, the lender of last resort, is the last leg of that chain, lending only to depository institutions.

Bitcoin proponents claim that the Fed creates money out of thin air (ie the currency is not backed by tangible assets). By manipulating the supply of money in the US economy, they say, the central bank also manufactures asset bubbles and crises.

Governments facilitate the role of central banks in an economy. While central banks are involved in making policy related to money, they do not have the authority to regulate its use. That responsibility lies with the government. Through a series of intermediaries, such as banks and financial institutions, governments distribute and regulate the flow and use of money in an economy. They can therefore determine how it is transmitted, sectors where it is distributed, and track its utility. They also earn revenue from it by taxing the earnings of individuals and businesses.

Bitcoin undermines the cycle of trust

Bitcoin’s decentralized system has the potential to dismantle the system described above. Its network does away with intermediaries and, by extension, the elements of a government’s system.

When using cryptocurrency, a central bank is no longer needed. This is because it can be produced by anyone running a full node. Peer-to-peer automated transfers between two parties on Bitcoin’s network mean that intermediaries are no longer needed to manage and distribute currency.

The chain of trust that underpins the current financial infrastructure becomes an algorithmic construct in Bitcoin’s network. A transaction is generally not included in the central ledger unless a specified majority of nodes approve it.

Theoretically, at least, streamlining operations between individuals and various actors on Bitcoin’s blockchain could reorder the current system. The financial infrastructure is decentralized, and the power to increase or decrease currency supply is not assigned to a single or group of authorities. In the new configuration, the role of governments in the management and regulation of economic policy by means of intermediaries may therefore become redundant.

Reasons why governments are cautious

Whether the government- and regulation-less future envisioned by Bitcoin evangelists will happen is still an open question. Meanwhile, governments around the world are trying to understand the effect cryptocurrency could have on their economies in the near term. Specifically, they grapple with the following three problems that Bitcoin and cryptocurrency present in their current forms.

Bitcoin can bypass government-imposed capital controls

Governments often impose capital controls to prevent currency outflows because exports can depreciate their currency’s value. For some, it is another form of control exercised by governments over economic and fiscal policy. In such cases, the stateless nature of Bitcoin comes in handy to bypass capital controls and export wealth.

One of the more famous cases of capital flight with Bitcoin occurred in China. The country’s citizens have an annual limit of $50,000 to buy foreign currency. A report by Chainalysis, a crypto-forensic firm, found that more than $50 billion moved from East Asia-based Bitcoin wallets to wallets in other countries in 2020, meaning Chinese citizens may have converted local currency to Bitcoin and transferred it across borders to sidestep. government regulation. Not all $50 billion is believed to be from China or capital flight, but it does show an increase in capital movement in the form of cryptocurrencies from previous years.

Bitcoin linked to illegal activity

The ability to bypass existing financial infrastructure for a country is a blessing in disguise for criminals because it allows them to camouflage their involvement in such activities. Bitcoin’s network is pseudonymous, meaning that users are identified only by their addresses on the network. It is not easy to trace the origin of a transaction or the identity of an individual or organization behind the address. In addition, the algorithmic trust created by Bitcoin’s network avoids the need for trusted contacts on either side of an illegal transaction.

Not surprisingly, Bitcoin is a favorite channel by criminals for financial transactions. The most famous example of a crime involving bitcoin was the Silk Road case. In short, Silk Road was a marketplace for, among other things, guns and illegal drugs on the Dark Web. It allowed users to pay in bitcoins. The cryptocurrency was held in escrow until the buyer confirmed receipt of the goods. It was difficult for law enforcement to track down parties involved in the transaction because they only had blockchain addresses as identification. Eventually, however, the FBI was able to take down the market and seize 174,000 BTC.

Recently, infecting popular apps with ransomware and demanding payment in bitcoin has also become popular among hackers. The 2021 Colonial Pipeline hack, which led to energy outages in several states, demonstrated the extent to which such attacks can become national security issues.

Bitcoin is not regulated

More than a decade after Bitcoin was introduced, governments around the world are still trying to figure out ways to regulate the cryptocurrency. There are several aspects to Bitcoin’s regulatory problem.

Is Bitcoin a currency to be used in daily transactions or a store of value used primarily for investment purposes? Is Bitcoin a safe haven asset during times of global economic turmoil? Neither the so-called Bitcoin experts nor the average bitcoin investor agree – it’s possible that all are true.

It can be argued that the use of bitcoin in investing products such as futures is a testament to its attractiveness to traders. Government-sanctioned marketplaces such as the CME Group and the Cboe offer regulated cryptocurrency futures contracts, and exchanges in more developed countries must register with the appropriate authority, such as the Securities and Exchange Commission (SEC). But in other countries, it is not as tightly regulated, so concerns about investor and user safety arise because cryptocurrency has a global reach and potentially influence.

Cryptocurrencies are opaque ecosystems

While Bitcoin has the potential to improve established dynamics of the existing financial ecosystem, it is still plagued by several problems. Government caution about the cryptocurrency can be attributed in part to fear and in part to the lack of transparency about its ecosystem. The latter concern is not misplaced.

Little is known about the cause-and-effect relationship between Bitcoin’s influence and global developments – it has not yet reached a scale equivalent to that of the dollar. This is a crucial sticking point given the cryptocurrency’s volatile price swings; if it were to gain the influence of the dollar, it could have serious consequences worldwide.

The Bottom Line

Bitcoin has become a touchstone for controversy since it was introduced to the world in the aftermath of the financial crisis. Governments have become wary of Bitcoin and have alternated between criticizing the cryptocurrency and using it for their own purposes.

Although it has the potential to decentralize and change the existing financial infrastructure, the cryptocurrency’s ecosystem is still full of abuses, scandals and criminals. Bitcoin will likely continue to attract mistrust and criticism from established authorities. With this in mind, government-backed cryptocurrencies called central bank digital currencies (CBDCs) based on blockchain technology are more likely to be accepted by governments than decentralized ones.

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