Introduction

The Economic and Monetary Affairs Committee of the European Parliament has requested to its Directorate General for Internal Policies (DGIP) an in-depth analysis of "virtual currencies".

The Policy Dept. "A" of the DGIP has sourced this analysis from the Kiel Institute for the World Economy, a German think-tank.

The report has been provided for the "Monetary Dialogue July 2018" of the European Parliament.

As a document which is expected to influence public policies, I wanted to analyze its content, comment and try to foresee its potential impact.

It is worth noting that its publication has already spurred commentary. While the authors themselves boil its conclusions down to the headline "Bitcoin & Co. Unsuitable for the Mass Market" (see picture above), the "crypto press" has offered various other "takeaways" on this report, such as these:

A worthwhile read

As a general comment, the report is extensively researched and very professional, with a long list of solid references.

To keep pace with crypto, your "engine" needs to run on passion!

However, it suffers where many other such otherwise thorough efforts suffer too: the pace of innovation in this area is so rapid that "cold" academic observers cannot keep up, regardless of whether they draw a "competitive, private sector" or a "stable, civil service" salary. The report focuses mostly on Bitcoin and Ethereum (for ICOs). When considering that its conclusions could be used in political decision-making, there is a risk that such a narrow view may lead to ill-informed conclusions.

The only way to keep pace with crypto is to follow it with passion, or you'll perpetually be discussing yesterdays' technology.

The second comment has to do with the generally "sliced" approach to the "Cryptoverse" that is on display here as well.

Should this be solely about "money"?

I increasingly believe we are in a middle of something much bigger than just financial innovation. The blockchain phenomenon has the potential to impact society in more ways than offering alternative money. Most analyses look at this or that aspect in isolation. It's also the case with this report which has been specifically requested to look at the monetary aspect of the "blockchain products". Yet again, the same risk arises: by offering only a partial view regulators might be led to take insufficiently informed decisions.

Unique perspectives

After an introductory chapter, the report discusses the nature of money. It posits that, among the generally accepted three principal characteristics, it is the "medium of exchange" (MoX) one that is prominent and should be considered the main feature of money. "Serving as a unit of account" (UoA) it is said, "follows from the use of money but it does not constitute money in the first place because the unit of account [...] need not be generally accepted".

Custom units of account

An important point the report makes is that "[d]igital currencies even bear the potential to dramatically facilitate the use of multiple units of accounts (sic!) as prices may be displayed in any unit (i.e. currency) that the individual user prefers".

This is an important remark - "currency exchange" in general is a source of economic added value; offering to an economic agent the possibility to pay in the currency it finds most convenient (easier to earn for him) thus decreases friction, stimulates economic activity, increases overall prosperity and well-being.

I've tried to make this point as well: Sing -> Earn SBD -> Buy beer -> Get inspiration -> Repeat! in my latest witness update. Imagine one has a rather painful and ill-paid job that allows him to earn euros or dollars but is also a passionate singer or photographer posting to the steem blockchain and earning STEEM and SBD for sharing what he creates and shares. Offering him either goods or services in exchange for his STEEM / SBD or a convenient way to exchange the latter for euros increases his well-being.

Stablecoins

The report also states what many other have tried to underscore: high volatility is an important barrier to adoption of cryptocurrencies as MoX. People have a general idea of what their time and effort should buy. If the currency they are handed in exchange is suddenly worth only half that value two weeks or one month later, they are not happy. The existence of the built-in SBD and the blockchain mechanisms for anchoring it around $1 make steem easily the most advanced blockchain economy, as acknowledged by "The Economist"

Smart (but inflexible) contracts

The report acknowledges that the self-executing "smart contracts" of Ethereum "can reduce certain kinds of transaction costs and counterparty risks" but also points out that they lack flexibility and can hardly respond to fundamental changes in context.

Limitations

One of the limitations of a purely intellectual exploration of the domain, absent actual practical cases, emerges in the last paragraph of the 3^rd chapter. The authors note that what has most people fascinated under the "blockchain" name is the result of a quasi-magic combination of features including decentralisation, open access, consensus mechanism and unprejudiced verification.

In truth, while these are important characteristics, neither are all necessary, nor are they sufficient. I contend that the most important feature of blockchain systems is that they mediate and make possible and economical outcomes that were unattainable in their absence. They achieve this feat by influencing human behavior and actions through human nature's most powerful and reliable lever: INCENTIVES!

The perfect illustration is the "European Financial Transparency Gateway" project, whose outcome had remained elusive and out of reach for European policymakers for several years.

Despite issuing legislation to mandate national designated actors called "OAMs" to allow investors untrammeled access to regulatory information, the EC has failed to get these OAMs to share and provide for free to investors what listed companies are providing for free to them.

The reason is that the only technical solutions available till now were centralized systems that are challenging the economic models of these national OAMs. When confronted with the risk of losing their income streams, the OAMs always managed to find subtle ways of resisting change, including enlisting the help of a market-friendly regulatory body.

Blockchain architecture allows imagining a novel, unexpected solution which leverages decentralisation and consensus mechanisms but can be configured for only partly-open access and only discerning, peer-based and "need-to-know" verification.

Yet what is truly crucial in this specific design is the system which allows tracking value transfers using a fine-grained, blockchain native "unit of account" (UoA). The UoA aspect is the key ingredient that can align the incentives of the various parties in this rather subtle story of European integration.

The moral? When it comes to convincing humans to behave in a certain way, incentives (promising an upside) are more powerful than the law (threatening a downside)!

As an aside, that UoA is a STEEM clone renamed "EFTG" for the occasion and the underlying blockchain technology is a clone of steem, a blockchain not as widely known as bitcoin and ethereum.

Crypto fascination

Back to the report, the 4^th chapter notes that the power of blockchain technologies to underpin "money creation" fascinates and the first resulting "killer app" is financial speculation.

Blockchain-based crypto assets have indeed a cost advantage over the existing international plumbing for cross-border money transfers (especially outside the SEPA space).

They are also offering a higher degree of privacy and thus enable tax evasion, money laundering and trade in illicit goods. But the authors correctly choose to stress the positive: they offer financial freedom in countries with strict capital controls and cash shortages and they can serve as an alternative form of investment.

The focus shifts then to ICOs which, the authors reckon, allows sidestepping high regulatory costs associated with traditional means of raising funds (thus lowering the barrier for capital allocation and financing innovation).

However they choose to stress the risk "retail investors" are exposed to, without taking the time to distinguish between those ICO participants which got their BTC, LTC, ETH via a minimum investment in computer "hashing power" and "hacking time" between 2009 and 2015 and latecomers who paid their crypto investment vehicles (BTC, LTC, ETC) using hard-earned fiat money.

I believe this is one of the biggest oversights of the report, especially since in a previous chapter, as mentioned above, the authors note the power of cryptocurrencies to establish subjective accounting systems.

Should the regulators apply the same yardstick when attempting to protect these two "ICO investors":

a young adult who, as a 14-17 year old kid in late 2009 got 100 BTC because his gaming computer managed to sign 2 blocks on the bitcoin blockchain and, having followed the blockchain space ever since, wants now to turn his "half million" (on paper) into more?
a middle-aged latecomer who bought 10 BTC on an exchange with 50 000 hard earned euros or dollars for which he worked maybe 2 years?

I am convinced the answer is an emphatic "No!". Because converting crypto to fiat is not yet very straightforward, they shouldn't be treated as functional equivalents for regulatory purposes. Some cryptocurrencies can be earned with much less effort than fiat, while performing leisure activities.

One has only to look at the rewards someone like @acidyo receives while streaming video-gaming to a steem blockchain-connected website. If he decides to exchange some of the STEEM thus earned in ETH in order to participate in an ICO he deems promising, how much gratitude can regulators expect for trying to "protect" his investment through cumbersome investment restrictions? More importantly, what if the resulting "caution" ends up discouraging investment and denying vital capital to innovative projects?

Partial conclusions

I decided to split this analysis in two parts to allow and encourage reflection. Reports such as the one presented here are highly-synthetic, condensed pieces that challenge readers. They need to be slowly "digested" and integrated with first-hand observations from the real world and with accounts from different sources.

In Part 2 I'll look into the last three chapters of the report, about the "crypto-financial ecosystem" and the envisioned "central bank digital currencies" (as well as the overall conclusions of the authors).

Meanwhile, I'd like to invite readers to ponder the following: "Bitcoin & co" might not be suitable for the mass market for reasons linked to their design goal and specific technical decisions. What about second- and third-generation, much more sophisticated cryptocurrency systems such as STEEM? Would the authors headline apply as well? My hunch is that it does not apply: the steem blockchain is as ready as it gets for mass market adoption.

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Virtual Currencies - an EP report July 2018 - Part 1