The meteoric fall of Sam Bankman-Frid, the discredited founder of cryptocurrency exchange FTX who was recently convicted in New York of fraud and money laundering, casts this largely unregulated market in an unflattering light. While miracles were expected from the blockchain technology powering cryptocurrencies, events over the past few years suggest the industry is in serious trouble.
In addition to the criminal activity that, in 2020, brought the FTX stock market to a shocking crash, and the Bankman-Frid verdict in early November, there is also a lawsuit by American regulators against the world's largest crypto exchange Binance, which is accused of creating a "network of deception". Doomsday is clearly approaching for this industry. Will cryptocurrencies always be a magnet for fraud and economic crime or will they eventually transform and democratize the financial sector?
A paradoxical situation becomes apparent. Satoshi Nakamoto (the pseudonym of the creator of Bitcoin) came up with the idea of a purely peer-to-peer version of electronic money after the global financial crisis of 2008, when trust in governments and central banks was at an all-time low. Shortly after the launch of Bitcoin in 2009, Nakamoto wrote that "the main problem with traditional currencies is that they require maximum trust to function properly". But the system that was supposed to eliminate the need for trust between people and trust in traditional financial institutions, today is experiencing its own crisis of trust.
Cryptocurrencies such as Bitcoin or Ethereum are built on computer codes and networks that are not controlled or managed by any central authority. It's pretty impressive that this kind of decentralization actually works. Transactions can be made securely without going through banks, credit card companies or other financial institutions. In principle, such a system would make financial systems less susceptible to the risk of fraud and manipulation.
Unfortunately, fraudsters and unscrupulous companies use clients and investors in love with new technologies for their own interests. In doing so, they are sidelining the most important cryptocurrency innovation - blockchain-based tools that can increase transparency and strengthen trust in the financial sector. Stored on computers around the world and publicly available to anyone with an internet connection, blockchains are digital "ledgers" that are an immutable record of all transactions made in the system. Relying on algorithms rather than human interaction creates a reliable trail of money that traditional financial infrastructure cannot provide.
How did we end up with a crypto industry that often contradicts its original principles? One possible answer: any innovation is inevitably accompanied by speculation and fraud, especially in the early stages of its development. In the 19th century, banks deceived inspectors by filling their gold reserves with nails. More recently, in the dot-com era we saw the Enron scandal, and the biotech boom brought Elizabeth Holmes and her company Theranos.
Another problem is that the crypto industry's consumer-oriented platforms are implementing old ways of doing business through technology that was invented to end them. For example, FTX was an "exchange", that is, a gateway to blockchain-based cryptocurrencies, but was not fundamentally concerned with the use of decentralized technologies. There is some irony in the fact that most owners of cryptocurrencies keep their assets in exchanges, because they require a high level of trust and have many of the risks of traditional financial institutions.
Behind the scenes, the crypto industry has already started using technology to tip the scales back towards innovation. One example of this is the development of "Proof of Reserves" technology, a mathematical method that allows institutions to verify their crypto assets. Such tools can help prevent fiascos like the FTX collapse, where a lack of transparency allowed Bankman-Frid to hide his financial fraud.
Importantly, Proff of Reserves technology and similar tools are best suited for cryptocurrencies, not conventional financial assets, including the US dollar. As a result, these technical innovations encouraged traditional financial institutions (the same ones that Bitcoin was supposed to replace) to support cryptocurrencies. For example, JPMorgan plans to move trillions of dollars worth of assets to the blockchain, and monetary authorities are considering the idea of central bank digital currencies that would use blockchain technology to issue digital versions of fiat currencies.
Yes, the crypto industry has faced a whole series of extremely difficult problems: the high impact on the environment due to "mining", the use of bitcoins for illegal transactions, the lack of privacy and much more. However, as Proof of Reserves technology demonstrates, the crypto community is now inventing powerful new ways to leverage the inherent transparency and trustworthiness of blockchain technology to create a safer and more flexible financial ecosystem.
While this innovative work is underway, governments around the world are exploring ways to protect consumers from the excesses of the crypto industry. But they should look beyond the headlines: a balanced approach must be sought to enable this remarkable technology to become truly successful.
Juels is a professor at Cornell Tech, co-director of the Initiative for Cryptocurrencies and Contracts (IC3)
Prasad is Professor of Economics at Cornell University's Dyson School
Copyright: Project Syndicate, 2023. (translation: NR)