Whether it’s Australia, Singapore, Russia, or Venezuela, more and more countries seem to be jumping on the cryptocurrency and virtual currency bandwagon. What some may consider a fringe financial concept isn’t so outlandish anymore. The Bank of England, People’s Bank of China and Russia’s Sberbank have all recently announced they are investing in the technology behind cryptocurrency. Analysts say part of this trend is simply due to the rising popularity of blockchain technologies in general—whether it’s public cryptocurrencies like bitcoin or whether it’s blockchain-based solutions implemented for making supply chains more efficient. But what are these new digital currencies? And why are many non-U.S. allies so eager to invest in potentially launching state backed versions?
First, a primer. Both virtual currency and cryptocurrency are forms of digital currency. Digital currency is a denomination of currency that is issued by a party or issuer who is responsible for redeeming digital money for cash. Cryptocurrency is a more secure form of this because every transaction creates a code or hash that is logged into that currency. The process of hashing is a type of blockchain technology. The hashing process is one in which each currency records the code from the current and previous transaction (in a chain). This type of coding is a form of cryptography which is used for security. “A cryptocurrency is difficult to counterfeit because of this security feature. A defining feature of a cryptocurrency, and arguably its most endearing allure, is its organic nature; it is not issued by any central authority, rendering it theoretically immune to government interference or manipulation.” Here is an excellent quick explainer on bitcoin, which is a type of cryptocurrency.
Like the U.S. dollar and other global currencies, virtual currencies are backed by faith in the institutions that issue them. The biggest difference between the U.S. dollar and virtual currencies however, is that these new currencies are all about decentralization. A virtual currency side-sweeps regulators and U.S. financial institutions or infrastructure, making it pretty appealing to countries on the U.S. sanctions list. This is why Russian and Venezuelan officials have been reportedly looking to create state-sponsored cryptocurrencies. But Luke McNamara, a Senior Analyst at the cybersecurity company FireEye, says the reality of how this plays out has yet to be seen. McNamara helps FireEye conduct strategic forecasting in an effort to anticipate risks posed by emerging technologies and geopolitical developments.
“Virtual currencies offer a means of exchange and payment channels outside the U.S. dominated and U.S. dollar financial sector,” says McNamara. So, for countries under U.S. sanctions, this appears to be a possible solution.
Brian O’Toole is a nonresident senior fellow at the Atlantic Council. He has worked in the U.S. Treasury Department and is an expert on economic and sanction policy in the private sector. O’Toole says that “while U.S. sanctions don’t specifically apply to the dollar, for all practical purposes, use of the dollar in a transaction (wherever in the world) means you’re almost certainly going to traverse the U.S. financial system, where the transaction will be blocked or rejected. Countries subject to sanctions may think that going outside the dollar into a virtual or cryptocurrency would help them avoid U.S. jurisdiction.”
Luke McNamara remains skeptical about whether state-issued digital currency will truly be an effective means of evading U.S. sanctions as they have yet to be put into practice, and sometimes buzz isn’t backed by substance. “In the case of Venezuela—where the currency is continuing to plummet in value and to some degree that speaks to the trust the people have in the government. If the government is also now issuing a new form of money—how well will it be adopted if there’s already this potential distrust in the monetary system there?” says McNamara.
O’Toole says of the countries who have publicly suggested state backed cryptocurrency “none have truly convertible currencies of their own already; some are purely undesirable (Venezuela, DPRK, and Russia to some degree) while others have currency controls (China). If their own state backed currencies don’t have traction, why would a crypto-currency?”
McNamara believes it’s potentially possible for a nation-state cryptocurrency to eventually increase in popularity in the distant future but there are a lot of nuances that would need to be worked out first. For example, how would the nation enforce monetary policy? How would it work in conjunction with the fiat money already in circulation? “But either way a state issued cryptocurrency is going to be inherently more centralized than Bitcoin, which contradicts the advantage it has, which is that bitcoin is more open-source—meaning you don’t have to trust a central authority with it. The state sponsored model is sort of flipping that on its head. And it remains to be seen whether that will make people more skittish or not.” says McNamara.
What if, a non-U.S. allied country were to create a state backed cryptocurrency that was widely adopted? And what if several countries that considered the U.S. a threat banded together and supported this one form of cryptocurrency? What if they planned to weaponize cryptocurrency as a means of replacing the U.S. dollar and bypassing U.S. financial institutions in an effort to hurt them?
McNamara says such a threat would be far in the future, if at all. And in fact, he says he doesn’t see it hurting the dollar in any way. O’Toole agrees: “crypto currencies are little more than a popular commodity that some people may use as a currency (like gold used to be). China and Russia have plenty of gold now, but it’s not as if they can facilitate trade with it. The driver of the post Bretton-Woods global financial architecture was and remains the strength, centrality, and relative stability of the U.S. economy. And because the world is so much more globally integrated now, anything trying to threaten the dollar would have to replace its presence, which cryptocurrencies are not in any serious position to do.”
But what if non-U.S. allied countries sold the dollar and tried to replace it with a cryptocurrency? O’Toole says none of the non-U.S. allied countries could totally forego the dollar except for possibly North Korea, but that is so small it does not matter. O’Toole explains: “Venezuela and Russia are energy exporters, and those exports are dollar denominated. China is a significant energy importer—again, dollar denominated. If such significant sectors of those economies are reliant on international trade and dollar-denominated goods, there’s not enough displacement to make it work, especially at the losses they’d take on volatility. (How does one arrange a significant shipment in Bitcoin eight months from now if the currency might be 40% lower? Who could afford to take on or hedge that risk? No one really, because it would be so expensive for an FI to do).”
It’s true the international financial markets are hugely reliant on the dollar. And while the glory days may be over, trillions of dollars are still being exchanged every day in the financial markets. O’Toole points out that Bitcoins market cap is in the millions. “The prevalence of the dollar in financial transactions means that any cryptocurrency’s relative size is basically a blip, if that,” says O’Toole. “Again, some small sectors could use it as a way around the dollar or the U.S. market, but without an actual substitute for U.S. services and market access, it’s not really a threat. Cryptocurrency is left to nibble around the edges of the U.S. dollar, at best, not to exist as a threat to the U.S. financial system,” he added.
McNamara says the threat is more likely to come from public cryptocurrencies like Bitcoin if they become more widely adopted. “North Korea conducts a lot of illicit financial activities and theft to help fund and bring currency to the regime. They engage in gold smuggling and counterfeiting currencies. And theft of cryptocurrencies appears to be another tool.”
Last week, South Korea accused North Korea of stealing cryptocurrency worth billions from the South in 2017. Seoul said that the North was still trying to hack into its exchanges. McNamara says FireEye’s research backs this claim and he has seen theft and targeting of bitcoin by North Korean cyber espionage operators as a means of getting around U.S. sanctions.
If cryptocurrency is so secure how is North Korea able to steal virtual currency? McNamara says “cybercriminals or nation state actors as in the case of North Korea are not actually targeting the blockchain technology itself. They are hacking exchanges—essentially targeting the points where people are buying and selling. They are targeting users who have left money on an exchange—which isn’t the most secure way to store it. It’s the same thing as if someone were to target someone’s email account and hack into their account and forward the money left on exchanges somewhere else.” For example, let’s say you leave cash in your PayPal account and someone were to hack into your email—they could forward that money elsewhere. McNamara says the blockchain technology and hashing remains intact. “The criminals are not hacking into the blockchain itself or altering the hash. They are simply compromising someone’s account the same way someone can compromise someone’s email account password.” But when it comes to Bitcoin or Ethereum, once a transaction is made it’s immutable says McNamara. “Charges cannot be reversed the way they can be on a credit card so it is harder to reclaim funds if they’ve already been sent somewhere else.”
While cryptocurrency can be hypothesized and predicted, only the future will truly determine its popularity or fate. Regardless, blockchain technology itself is leaving a footprint and appears to be here to stay—along with the U.S. dollar and financial institutions say the analysts.