A common argument from skeptics of bitcoin and other cryptocurrencies is that governments will eventually move to control the digital cash to limit competition with the U.S. dollar and other fiat currencies. This has been JPMorgan Chase CEO Jamie Dimon's stance on bitcoin for a number of years, and Bridgewater Associates founder Ray Dalio reiterated this risk in a prerecorded interview first broadcast during a bitcoin industry conference on May 24 (although he also revealed that he owns some of the crypto asset).
Despite some high-profile commentary calling for a cryptocurrency ban, we seem to be a long way off from President Joe Biden signing an executive order that bans the private ownership of bitcoin (as President Franklin D. Roosevelt did with gold). But there has been increased discussion of tracking and regulating what's going on in the bitcoin ecosystem. Of course, the state of bitcoin regulation could always change in the future, but here's where things stand now.
The developed world already operates in a sort of financial surveillance state. Most people hold their spending money, savings, and investments in centralized banks and other financial institutions, and this financial data is available to various government agencies in a variety of forms, usually via a subpoena or regulations that require financial institutions to automatically report specific types of transactions. In the U.S., much of this surveillance dates back to the Bank Secrecy Act of 1970.
Apparently, this setup is not good enough for the Biden administration, which would like to take things one step further by allowing the Internal Revenue Service to hire tens of thousands of new employees to track the flows of money in and out of financial institutions directly. This includes custodians of virtual currencies, such as crypto exchanges. These plans have been outlined in the Treasury Department's recently released American Families Plan Tax Compliance Agenda.
One of the key reasons why people use bitcoin is as a hedge against the financial surveillance state. The decentralization of the bitcoin network enables a degree of censorship resistance, which in turn promotes more private financial activity in the digital realm (though there is still plenty of work to be done when it comes to improving privacy and anonymity in bitcoin).
Regulating the bitcoin network itself would be a practically impossible task. Sending a bitcoin transaction amounts to not much more than broadcasting a message over the internet or some other communications channel. As illustrated by the ongoing crypto wars, the use of encryption technologies like bitcoin are protected on free speech grounds. Trading a cryptocurrency doesn't just involve sending someone money, it involves sending a machine a written message to carry out a task—a message that's protected by the First Amendment.
However, lawmakers and regulators can much more easily target the additional layers of activity that are built on top of the base bitcoin network, such as centralized crypto asset exchanges. These more centralized systems will likely be central to any potential regulatory crackdowns on the crypto asset market. For example, the Financial Crimes Enforcement Network has already proposed dropping the $3,000 threshold requirement for financial institutions to collect, retain, and transmit information related to international value transfers down to $250.
In addition to crypto exchanges, stablecoins (digital assets pegged to the dollar) are another potential target for regulators. Stablecoins are issued on public blockchains like Ethereum and Tron and do not gain much interest from regulators because they're still backed by centralized financial institutions. The large amount of stablecoin-denominated activity occurring in the decentralized finance (DeFi) space could be outlawed with the stroke of a pen. Then again, the level of privacy offered by Ethereum, where much of this activity takes place, is pretty awful, and blockchain surveillance companies like Chainalysis are able to help regulators figure out who is using these systems for illicit or unregulated financial activity.
There's also a gray area between the decentralized bitcoin network and the centralized exchanges. This is where alternative networks like sidechains, the Lightning Network, and other so-called layer-two protocols operate. On systems like these, smart contracts on the base bitcoin blockchain are used to construct new networks. They make tradeoffs in terms of being less resistant to censorship than the bitcoin blockchain in exchange for enabling other features such as faster payments, cheaper transactions, better privacy, DeFi applications, and much more.
This will be a key area to watch in the regulatory space going forward. These systems are not as resistant to control and regulation as bitcoin itself. For example, could regulators decide that a node operating on the Lightning Network is a financial intermediary? Could a number of governments come together to target a geographically diverse sidechain like Liquid or RSK? Bitcoin obtains its censorship resistance through the use of proof-of-work miners (PoW) as its mechanism for coming to consensus on the order of transactions. Two critical components of this consensus mechanism are that the miners are both dynamic and potentially anonymous. Bitcoin sidechains currently replace these miners with federations of known entities (or a subset of a group of known entities), but Lightning Network nodes are still able to operate pseudonymously.
Then again, the centralized, bitcoin-backed derivatives trading platform BitMEX was able to keep operating normally after a regulatory attack last year, and a potentially key building block against censorship was a treasury system that decentralized ownership of bitcoin deposits to multiple parties through the use of a bitcoin smart contract known as multi-signature. Additionally, bitcoin's layer-two systems are also evolving, and they can become more resistant to government control over time.
Bitcoin mining is also commonly brought up as a potential area for regulation, but miners don't actually have much control over what happens on the network. As illustrated by the SegWit2x debacle (where the larger bitcoin community rejected an upgrade agreed to by the vast majority of bitcoin miners, in addition to large exchanges and wallet providers), miners can't unilaterally change the rules of bitcoin, and their main role is deciding the order in which transactions are made. Furthermore, the upcoming Taproot upgrade will enable different types of transactions (from a single-signature bitcoin transaction to the opening of a Lightning Network channel) to look indistinguishable from each other on the blockchain, which makes it more difficult to censor specific types of transactions on a networkwide basis. Additionally, a censorship policy by miners would need support from at least 51 percent of the network hashrate to be effective, and users could still move to a new system for consensus as a last resort.
Over the near term, exchanges, stablecoins, and other points of centralization will be the areas to watch for increased regulation of the crypto market. Therefore, it may be time for bitcoin users to think about moving away from centralized custodians and toward more decentralized options. This may be the only way for bitcoin to retain its underlying value over the long term.