The Fundamental Rift in Fiat and Crypto Currencies

The fundamental control in the movement of value from person to person, or as we call it – accounting, may be the [second] oldest profession, but it is about to experience a transformation.

Governments exist and rule based on the primary ability to tax and control how value moves within society through fiat currency and regulations and taxation on its use.  This fundamental principal is in fact how all world governments come to and maintain power.

It is understandable therefore that the emergence of cryptocurrencies, like BitCoin, initially came to prominence by fundamentally bypassing these controls in what would otherwise be illicit or illegal transactions.  The truth behind the libertarian ethos is truly embedded into a currency system that is frictionless, without boundaries and without governmental oversight.

As we stand in the rift created by these two worlds, what are the opportunities and risks that will provide for the economic expansion that this opportunity presents?

The emergence of cryptocurrency has a similar birthright to that of the internet.  Born in a fierce independence of oversight, regulation and with a strong streak of digital anarchy, bitcoin has funded and inspired an industry of innovations.  The velocity and volatility of this community is truly the firey cauldron for which new ideas, industries and fortunes will be made.  The level of uncertainty and potential for those who embrace cryptocurrency will certainly produce a new generation of exceptions to the standard financial risk model.

But, as we move along the adoption curve and smart money turns into fast followers, they bring with them the desire to understand and price risk.  These fast followers bring with them the laggard regulation that will turn that uncertainty into measurable risk.  We see this today as the SEC and IRS are both providing guidance on the treatment of cryptocurrency as property.  With this comes attempts to monitor and tax the movement of digital asses.

In terms of velocity of change, the one that comes to mind are the different tax authorities looking at how an when to tax internet sales.  And while that took a few years to move from early adopters to measured and regulated business processes, we can expect that this change will follow the speed at which wealth is created.

This represents problems at different scales.  On the consumer level cryptocurrency has been represented as having a high level of anonymity.  This is, in fact, entirely false at any appreciable scale at which transactions become non-trivial.  Because every transaction is held in perpetuity and an irrevocable fashion, it is in fact, entirely attributable to the extent that you can match identity to a digital currency account.  In a way, this creates a perfectly solvable big data problem for forensics to look at where digital currency is a component in any transaction where either party is known.

This is why wallet companies, like coindesk, have strong Know Your Customer provisions built into their system.  The existing financial sector is well accustomed to regulatory requirements to prevent anonymous transactions, and they have applied this to their cryptocurrency operations.

For less pedestrian transactions, this becomes an exercise of mapping networks of cryptoaccounts into very predictable trees.  The emergence of cyber reputational scoring for accounts is either here or soon to come.  In this type of scenario, any account deemed ‘evil’ could taint any account which it did transactional volume with.  This transparency is entirely unavoidable in a public chain.

As a thought experiment, consider the US Government’s recent sanctions against North Korea where they have created a diplomatic policy that you can do business with the US Economy or North Korea, but not both.  As an example of the implementation of this type of policy, the government might attempt to block access to the SWIFT network.  This type of security control limits the exchange of value to paper fiat currency or other tangible goods.   Presumably, this type of policy would take a team of forensic accountants to track the flow of monies to determine if there were violations of policy.

In a large scale system of cryptocurrency, a reputational identity would flag accounts with these types of nationalistic or other ownership characteristics and could simply apply sanctions on any transactions they deem unapproved.

While the voracity of this approach will have to be worked out over time, throwing a big data challenge at intelligence agencies, taxing authorities or the government in general seems akin to giving a teenager keys to the car and a fifth of liquor.

On the enterprise level, this trackability should result in a conversion of uncertainty to knowable risk.  As regulation moves into the space, this should produce new forms of investment that will ultimately create new economic activity and ultimately opportunities to build wealth.

The recent Ethereum DAO, while unsuccessful in some measure, did produce an interesting outcome in terms of the SEC report defining it as a security.  Creating a more frictionless investment mechanism with proprietary DLT tokens has already taken off in other similar experiments.  In the FinTech side of things, creating an investment settlement capability with lower transaction cost has strong potential.  This is evident as we see fast followers, like R3 where purpose build blockchains provide financial settlements.

So this leaves a perpetual question; where is the next smart move.

In looking at the cryptocurrency ecosystem, there are two primary movers.  First are those who can operate at a very high technical level and with a high level of uncertainty.  For these players, we see emerging technologies, some of which are likely to create new industries and capabilities.  For most people, this high performance, high uncertainty environment is unattainable.  For those whom which this is appealing and achievable, the potential rewards are high.  For the larger market, there are strong plays in making the technologies and tools available to a larger set of industries.  These early adopters are beginning to focus on second tier industries where the application of this technology will create new opportunities within the existing lines of business.  There are primary examples of this in FinTech where financial institutions are adopting smart contracts to recreate existing products.  Large players like Citibank are envisioning themselves as technological service providers over financial institutions.  These types of changes have inherently less uncertainty and depending on the velocity of change, will have short term payoffs.

Watching the early movers and fast adopters can give you a sense of the velocity of the market, and in the case of cryptocurrency, should be highly informative.  The investments in ICO and follow on market cap gains demonstrate objectively that there is serious and lasting investment in the technologies and capabilities of crypto economics.  Again, the perpetual question, where is the next smart move.

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