May 23, 2023
Introduction to Cryptocurrency
Cryptocurrencies (or crypto) are digital financial
Off-chain transactions are any transactions that occur
instruments exchanged and recorded on public ledgers
outside of the main blockchains. Instead, they are generally
(known as blockchains) that do not require central
facilitated, processed, and recorded by online platforms,
intermediaries (e.g., commercial banks, central banks) for
such as crypto exchanges (e.g., Binance, Coinbase), which
clearing and settlement. Users and transactions are public
host users’ custodial or hosted wallets. Exchanges allow
but pseudonymous, which means users’ identities may be
users to exchange fiat currency into crypto and vice versa.
obscured. Initially introduced as payments tools,
These platforms allow users to trade digital assets, make
cryptocurrencies are mostly used as a form of investment.
markets for various assets, and offer other services.
This In Focus introduces crypto market structure, regulatory
frameworks, and policy issues. For more, see CRS Report
Types of Cryptocurrencies
R47425, Cryptocurrency: Selected Policy Issues, and CRS
The two most widely used cryptocurrencies are Bitcoin and
Report R47064, Blockchain: Novel Provenance
Ether, which, as of May 2023, represent more than 60% of
Applications.
the crypto market capitalization. Bitcoin was the first
cryptocurrency to gain widespread adoption. Bitcoin
Cryptocurrencies: An Overview
functions as a unit of account and medium of exchange. In
Once used by a small subset of computer scientists, crypto
Bitcoin, decentralized consensus mechanisms encourage
has gone global. Crypto has been characterized by continual
some network participants (called miners) to secure the
and rapid price increases and decreases. Recently, after
system for financial gain. Bitcoin relies on a proof of work
experiencing dramatic growth that propelled it to a record
(PoW) consensus mechanism that rewards miners who
high of around $3 trillion in November 2021, the market
possess greater computational resources and energy
capitalization fell to less than $800 billion in November
demands.
2022 in what has been referred to as a “crypto winter.” As
of May 2023, it is valued at around $1.1 trillion.
Ether is the cryptocurrency native to the Ethereum
blockchain. Unlike Bitcoin, Ether uses proof of stake (PoS),
Crypto attempts to replace the current financial system, of
a less energy-intensive consensus mechanism than PoW. In
which a central tenet is trust, with one that does not require
PoS, computational effort of PoW is replaced with
trust. A variety of safeguards are built into traditional
collateral: Validators lock or “stake” at least 32 Ether to
banking and payments systems to foster trust, such as
enter a pool to be given a chance to validate the next block.
chartering procedures, capital requirements, ongoing
The network may seize collateral for malicious activity or
supervision, and deposit insurance. In place of trust, the
other offenses. Ethereum also enables smart contracts,
cryptocurrency system leverages a series of separate but
which are applications that self-execute when participants
concurrent incentives for different system participants.
meet some predetermined set of criteria. Because of the
enhanced programmability, Ethereum is widely used for
In recent years, large financial intermediaries—the very
decentralized finance (or DeFi) projects that aim to mimic
type of institutions crypto wanted to make unnecessary—
traditional finance but without intermediaries.
have displaced the decentralized, trustless ideal. For
example, crypto was originally accessible via less-than-
Stablecoins
user-friendly blockchains, but companies and applications
Cryptocurrencies such as Bitcoin and Ether fluctuate in
created more user-friendly and familiar systems that allow
value based on market supply and demand. By contrast,
individuals and firms to “custody” their crypto in accounts
stablecoins are digital assets “designed to maintain a stable
or wallets at institutions. An entire ecosystem has
value relative to a national currency or other reference
developed that supports cryptocurrencies, including the
assets.” For example, the Tether and USD Coin (USDC)
custody or hosting services known as wallets, as well as
stablecoins are set equal in value to $1. Total market
exchanges, payment platforms that support crypto,
capitalization for stablecoins is greater than $130 billion.
decentralized finance platforms, and dozens more.
As with cryptocurrencies, stablecoins are not generally
accepted for payment and are primarily used when trading
Transacting with Crypto
crypto. Stablecoins may attempt to match their value to
On-chain transactions are transactions processed over the
equivalent fiat currencies in different ways but have been
blockchain, the network of nodes that maintain the system.
known to lose their stable values. For more, see CRS In
Users send and receive cryptocurrency on-chain using
Focus IF11968, Stablecoins: Background and Policy Issues.
unhosted wallets that store the keys that secure ownership
of and permit transaction of crypto. Assets on a blockchain
Central Bank Digital Currency
are protected by asymmetric key cryptography, which uses
The premise of central bank digital currencies (CBDCs) is
a public key to encrypt and a private key to decrypt data.
that issuing and managing a digital currency by a central
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Introduction to Cryptocurrency
bank may realize at least some of the anticipated benefits of
framework for MSBs is largely a state-based licensing
cryptocurrencies but with greater efficiency and fewer risks.
regime and applies to many nonbank institutions, including
For example, CBDCs could be used for payments, much the
several crypto-related companies, such as trading platforms,
way crypto was intended. However, CBDCs would be legal
payment platforms, and crypto automated teller machines.
tender and exist as dollars themselves instead of having
At the federal level, these various crypto firms are
values designed to be linked to dollars. For more, see CRS
considered MSBs and must register with the Financial
In Focus IF11471, Central Bank Digital Currencies.
Crimes Enforcement Network and comply with the Bank
Secrecy Act and implement anti-money laundering (AML)
Crypto Regulation
and know your customer (KYC) programs. For more, see
Currently, there is no comprehensive regulatory framework
CRS Report R46486, Telegraphs, Steamships, and Virtual
for crypto, but regulators may apply existing regulatory
Currency: An Analysis of Money Transmitter Regulation.
frameworks when applicable to crypto.
Selected Policy Issues
Applicable SEC Framework
The relative novelty of how cryptocurrency transactions
In an April 2022 speech, Gary Gensler, chair of the
occur introduces a host of policy issues.
Securities and Exchange Commission (SEC), stated that
“
Privacy vs. illicit activity: The same characteristics that
many of the tokens trading on these [crypto trading and
make crypto a favorite of users with a legitimate desire for
lending platforms] may well meet the definition of
‘
privacy also provides secrecy that may make it useful for
securities.’” If so, both the tokens and platforms are
engaging in illicit activity. Balancing the potential privacy
required to register with the SEC and become subject to
provided by crypto’s pseudonymity with the requirement
SEC regulation. Traditionally, the SEC has used the Howey
that financial firms comply AML/KYC programs is as a
Test to determine whether any investment contract—not
key policy issue.
just cryptocurrencies—is a security. According to the
Howey Test, an investment contract is defined by four key
Energy and the environment: The PoW consensus
features: (1) the investment of money (2) in a common
mechanism used by some cryptocurrencies requires use of
enterprise (3) with a reasonable expectation of profits and
sophisticated computers and significant amounts of energy
(4) to be derived from the efforts of others. For more, see
to power and cool the equipment. Recent estimates of the
CRS Report R46208, Digital Assets and SEC Regulation.
Bitcoin network’s annual energy consumption put the
amount at about 147 terawatt hours, or roughly equivalent
Applicable CFTC Framework
to the amount of energy used by Malaysia. In light of this
The Commodity Futures Trading Commission (CFTC)
issue, some market participants have shifted to the less
administers the Commodity Exchange Act, which defines
energy-intensive PoS consensus protocol. Moreover,
commodities as various agricultural products—such as
various federal agencies are examining the impacts these
wheat and cotton, among others—as well as services and
technologies have on the environment. For more, see CRS
rights in which futures may be dealt. Using this definition,
Report R45863, Bitcoin, Blockchain, and the Energy
in 2015 the agency brought an enforcement action against a
Sector.
Bitcoin options and futures platform, concluding that
Bitcoin and other virtual currencies are “commodities.”
Future of regulation: Traditional financial institutions are
Various federal court decisions have since supported the
subject to an array of regulations, such as prudential
CFTC’s position that the Commodity Exchange Act’s
standards or disclosures requirements. In the crypto
definition of the term commodity encompasses virtual
industry, on the other hand, non-compliance with and
currency. Entities offering trading of crypto futures and
uneven enforcement of applicable frameworks has created
options must register with the CFTC, whose authority in
the impression that the industry is not subject to those rules
spot (cash) markets is limited to enforcing prohibitions on
or is breaking them. Potential future crypto regulation may
fraud and manipulation.
choose to require disclosure, segregation of customer funds,
and limitations on platforms’ tendency to play multiple
Applicable Banking Framework
roles simultaneously that some say lead to conflicts of
Various states, including New York and Wyoming, have
interest—all of which are required in traditional finance.
established frameworks in which crypto firms may obtain
The regulatory policy debate has focused on whether a
special state banking charters. At the federal level, national
regulatory regime that is tailored for crypto is necessary.
banks can seek approval from the Office of the Comptroller
Other key policy issues can be summed up in three
of the Currency to provide limited crypto services, such as
unanswered questions: Is the current authority sufficient, or
crypto custody services, holding reserves, and using node
is congressional action required? If new regulatory
verification networks and stablecoin for payments. In
authority is required, who should be the primary regulator?
addition, a crypto firm may seek a national bank trust
Is it better to create a new, overarching structure, or is a
charter, which limits the holder to “fiduciary capacity”
refinement of the existing framework sufficient?
operations permitted by federal statute and laws in the trust
bank or company’s home state. Firms with bank charters
Consumer and investor protection: Some argue that
become subject to federal bank regulation. For more, see
numerous scams and frauds—recently embodied by the
CRS In Focus IF12320, Crypto and Banking: Policy Issues.
collapse of FTX—highlight a lack of investment and
consumer protections in the industry.
Applicable Money Services Business Framework
Cryptocurrency exchanges often register as money services
Paul Tierno, Analyst in Financial Economics
businesses (MSBs) in order to operate. The regulatory
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Introduction to Cryptocurrency

IF12405


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