Building Virtue Into Virtual Assets

The illicit use of crypto-currencies—with billions lost, stolen, or exploited by criminals, hackers, rogue states, and bad actors—has cast an understandable cloud over the industry. And both virtual asset providers as well as supportive innovative banks (e.g. Silvergate, Signature), are facing constraints that have impacts far beyond crypto itself, but nonetheless effect its reputation and promise. If virtual assets, like cryptocurrencies, are to realize their creators’ aspiration to foster more inclusive, equitable, and verifiable means of exchange, they must demonstrate their engagement with the global financial system rules necessary to keep both users and society safe.

Virtual assets have the potential to abide by democratic norms and regulatory guardrails, as well as promote U.S. capital markets abroad, but Americans won’t reap the benefits without our government drafting clear rules and code, including robust Know Your Customer requirements, addressing rampant anonymity, and preventing the easy washing of illicit funds. Unless we design for democratic integrity, the decentralized finance (DeFi) sector will continue to be exploited by malign actors, autocrats, and kleptocrats intent on undermining democracies, flouting laws, and upending the stability of the global financial system.

The creators of blockchain and cryptocurrency designed these technologies to address fundamental challenges and inequities within traditional banking, many of which were revealed by the 2008 global financial crisis. For example, why should citizens be relegated to anointed intermediaries like banks? Why can’t counterparties transact directly with each other? How can citizens protect themselves from future global financial shocks? DeFi was intended to be a partial answer.

But recent crypto scandals and meltdowns are making DeFi look less like a financial innovation and more like a dangerous bug—ready for exploitation by al-Qaeda in Syria and neo-Nazis in Syracuse. The technology underpinning crypto can facilitate traceability, auditability, identity proofing, and inclusion, but the proliferation of unregulated cryptocurrencies and anonymity is moving the industry in the opposite direction, devolving DeFi into a haven for money laundering, illicit finance, terrorist financing, and corruption—despite the technology’s ability to create a 24/7/365-always on financial system.

Rogue states are mobilizing crypto as well. North Korean state-sponsored hackers have used crypto-exchanges to process hundreds of millions of dollars in stolen cash, while cryptocurrencies have been used by Russia to evade military export controls and to steal millions from U.S. consumers.

On top of that, hackers have stolen billions from easily targeted wallets, and criminals hold companies and governments hostage with crypto-demanding ransomware attacks. Proliferating cryptocurrencies that lack basic regulatory guardrails are a danger to owners of their tokens (think FTX, TerraUSD), companies (think JBS, Colonial Pipeline), and society at large.  Moreover, unregulated crypto threatens U.S. capacity to impose sanctions, control corruption, or influence global trade dynamics—weakening American economic security and emboldening adversaries.

Virtual assets will not go away, but we cannot collectively close our eyes to the risks they pose. The flow of cryptocurrencies is already stressing our antiquated state financial crime regulations—most of which are now 50 years old and premised on a different era of brick-and-mortar banks and paper money.

DeFi is a good illustration that our financial system is effectively borderless, but our current regulatory system is not. Perhaps we are less in need of innovative products, and more in need of innovative regulation—for both DeFi and the traditional banking sector.

The question of how to regulate, however, is complex.

One approach is for the U.S. government to join the fray and issue its own digital currency. These digital dollars or regulated stablecoins could be offered through a digital wallet that effectively extends the reach of ‘open’ capital markets like the U.S. to individuals and organizations anywhere from women-owned businesses in Afghanistan to NGOs in South Sudan, bypassing corrupt central banks and kleptocrats. This could simultaneously help citizens around the world while also benefiting the America’s national economic and foreign policy objectives. In this way, decentralized finance might become a critical extension of the power of U.S. capital markets and the dollar itself, rather than anonymous tools for criminals.

Similarly, digital finance could be a platform for reinforcing alliances for economic security more generally. As we consider new forms of multilateral coordination to strengthen democracy, there is also a powerful argument to enable a group of democratically aligned digital currencies in tandem. Building upon and improving the strength and traceability of the dollar, euro, yen and pound—the top four global reserve currencies—would support a fairer, cleaner system while disabling bad actors. Aligning rules and building a seamless digital infrastructure would promote international trade and financial connectivity by allowing transactions between corporations and governments to be settled instantaneously.

There is hope that we can still harness the power of DeFi to build a well-regulated and valuable virtual currency marketplace that supports a free and equitable financial system. There is urgency for both operators and regulators to propose innovative new guidelines to build a compelling vision of our digital financial future. However, that will require more government engagement in designing a democratically driven architecture, flexibility from finance gatekeepers, and a renewed commitment to integrity from crypto champions and the infrastructure they promote.

Amit Sharma is founder and CEO of Finclusive Capital, and a member of the Board of Advisors of FDD’s Center on Economic and Financial Power. Elaine Dezenski is the senior director and head of FDD’s Center on Economic and Financial Power. Follow her on Twitter @ElaineDezenski. FDD is a Washington, DC-based, nonpartisan research institute focusing on national security and foreign policy.