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Is There Social Value in Crypto Economics? by Mark Dempsey, Paula Oliver & Miguel Otero

crypto-social-value-2

The second paper of the Digital Revolution and New Social Contract series examines the contribution of crypto assets to our societies and advances policy recommendations for their effective regulation.

Before the 2008 financial crisis, the term “crypto assets” was primarily the preserve of a minority of computer scientists and engineers experimenting with new technologies as a means of decentralizing finance. With Bitcoin, Satoshi Nakamoto introduced crypto assets as an area of interest for investors and financial institutions with higher risk appetites. The wider public followed shortly afterward and, later, regulators.

Crypto assets reached a market capitalization of $3 trillion by the end of 2021. Their interrelationship with global financial markets is increasing (despite the recent market plunge), the profile of investors in crypto-asset markets is diversifying, and the applications and nature of the crypto-asset market are also expanding rapidly; from cryptocurrencies to decentralized finance (DeFi) ecosystems enabled by smart contracts to Non-Fungible Tokens (NFTs), the Metaverse and Web 3.0.

However, their contribution to social value is questionable and overdue for further investigation. The main proponents of crypto assets argue that their increasing interdependence with the real economy and partial substitution of some systems of the current financial and economic model has made them irreplaceable and therefore their long-term sustainability, inevitable. They contend that the crypto economy generates social value via four main principles: democratization through decentralization, transparency through open access, trust by avoiding human discretion, and economic inclusiveness. 

Our paper puts forward arguments in favour and against the crypto economy. We find that crypto has limited net positive social value because of the non-negligible negative externalities.

Firstly, the democratization of finance that crypto suggests depends on the elimination of intermediaries and central authorities (decentralization). However, the control of cryptocurrencies, transaction validation, platforms, protocols, and decisions are concentrated amongst only a few actors.

Additionally, the crypto economy is strongly linked to the traditional financial system, particularly in stablecoins and in its entry and exit legs (with sovereign money).

Lastly, decentralization has a huge environmental impact due to the high electricity consumption required for the predominant validation mechanism: Proof of Work. Even new validation systems like Proof of Stake have sustainability issues.

Transparency, which is allowed by publicly distributed ledgers, is trumped by the creation of new intermediaries in the crypto economy, who raise new barriers to transparency in addition to those in the legacy financial system. Technical knowledge is an additional barrier, as well as so-called tumbler services which allow for the obfuscation of identities and transactions, making the traceability of illicit activity much harder.

For crypto enthusiasts, new trust comes from the removal of human agency and discretion. Nevertheless, human involvement is still present in crypto. On the one hand, protocols are designed, maintained, governed, and updated by people, who are also in charge of solving the issues that arise out of code vulnerability. This gives reduced groups strong decision-making power over the broader crypto community. Security issues, such as theft and fraud, question the trustworthiness of crypto, as well as the lack of investor and consumer protection.

Lastly, economic inclusiveness is also questionable. The crypto economy creates new intermediaries, who charge for their services and have economic motivations. For example, validators have more incentives to process transactions that have higher fees associated with them, making those who can pay less unable to access finance. The promise of returns is also drawing financially uneducated groups to join crypto and take on risks without a proper understanding of market dynamics and a sound financial position that cushions losses.

Our analyses show that crypto has limited net positive social value.

However, blockchain and smart contracts can positively disrupt existing sectors and accelerate the development of new ones. Therefore, policymakers should be aware of the positive potential and not over-regulate to restrain innovation in the sector. Policymakers should come in with proportionate regulatory proposals. We suggest the following: 

– Implement crypto sprints and regulatory sandboxes to keep on testing the technology and involve all stakeholders in the regulatory process

– Consider the environmental impact of the crypto economy

– Strive for a formal agreement on global coordination

– Ensure the continuity of services in systemic blockchains, such as Ethereum, which concentrate a large part of the crypto economy

– Acknowledge that the popularity of crypto is symptomatic of the huge discontent that exists with the current economic and political system

 

Mark Dempsey, Hertie School

Paula Oliver, Center for the Governance of Change, IE University

Miguel Otero, Center for the Governance of Change, IE University

To read more about the topic and download the full paper, click here.