Cryptocurrencies have an inequality problem: A growing wealth gap

Cryptocurrencies have an inequality problem: A growing wealth gap

As blockchain-based currencies face up to ESG scrutiny, the crypto community is coming up with ways to deal with climate concerns and governance issues. But the social aspects of a growing wealth gap still need tackling.

Jan 14, 2022

CRYPTOCURRENCIES may be widening the wealth gap. These supposedly decentralised digital currencies are owned, and their infrastructures supported, by a surprisingly small number of individuals and institutions. Even as they fall short of lofty ideals, they are also adding to systemic risk.

While crypto advocates have been paying attention to environmental concerns and crypto companies are beefing up on compliance hires amid regulatory scrutiny, the social concerns seem to be overshadowed.

A recent study by the United States’ National Bureau of Economic Research found the top 10,000 individual Bitcoin investors hold 5 million Bitcoins. That’s over a quarter of the 19 million Bitcoins in circulation.

The top 1,000 investors control about 3 million Bitcoins. These concentration measures exclude cold wallets held by exchanges, which typically combine the holdings of many individuals.

The same study, which was published in October, also found a concentration of between 60 and 80 per cent of mining capacity in China. Miners process and verify transactions on the Bitcoin blockchain, and are in turn rewarded for their work in Bitcoins. Furthermore, the top 10 per cent of miners control 90 per cent of mining capacity.

Finance professor Antoinette Schoar from the Sloan School of Management at Massachusetts Institute of Technology (MIT), who co-authored the study, told The Business Times (BT) these findings suggest Bitcoin benefits a few concentrated holders. The decentralised cryptocurrency also “has not led to a democratisation of financial institutions”.

“Any wider adoption of Bitcoin, which creates price pressure and drives up the price of Bitcoins, will only enrich a few anonymous holders that are unaccountable to the public, but undermine currencies like the (US) dollar, euro, yen by taking seigniorage benefits away from them,” she added. Seigniorage is the difference between a coin or note’s face value and its cost of production, and represents the profits of the governments producing the currency.

“The same is true when you look at the miner concentration we report. Here, again, the early hype or promise has not lived up to the reality that mining capacity is massively concentrated. In the case of mining, this also threatens the integrity of the blockchain itself, if a few colluding miners can launch a 51 per cent attack,” said Schoar. She co-authored the study with Igor Makarov from the London School of Economics.

A 51 per cent attack is when a group of miners controlling a majority of a blockchain network’s computing power manipulate data in the blockchain.

An insiders’ club

Schoar and Makarov’s study adds to a growing body of research showing that cryptocurrencies are not the great equalisers they promised to be.

Bitcoin was described by its creator Satoshi Nakamoto as a “peer-to-peer electronic cash system”. When the currency was launched in 2009, market participants hailed it as a means of eliminating central authority and streamlining the process of distributing currency.

More cryptocurrencies were introduced over the years that also relied on a decentralised blockchain, and proponents have suggested that cryptocurrencies might help pave the way to financial equality at an individual as well as national level.

But the evidence is accumulating for the opposing argument.

Researchers at the University of Limerick in Ireland studied 8 major cryptocurrencies: Bitcoin, Ethereum, Bitcoin Cash, Dash, Litecoin, ZCash, Dogecoin and Ethereum Classic. Their findings suggest wealth distribution in cryptocurrencies remains in line with that in real-world economies.

Researchers Ashish Rajendra Sai, Jim Buckley and Andrew Le Gear found that the Gini coefficients – typically a measure of the distribution of income across a population – for 7 of the cryptocurrencies had increased over time, with most now hovering between 0.6 and 0.8. Dash was the best-performing cryptocurrency with a Gini value of 0.28.

In traditional economies, the Gini coefficient ranges between 0 and 1, with a higher value denoting a wider income gap. For perspective, data from the Organisation for Economic Cooperation and Development put the Gini coefficient for Iceland at 0.25 in 2017 and 0.62 for South Africa that same year.

Meanwhile, research from blockchain data provider Chainalysis suggested that blockchainrelated applications, such as non-fungible tokens (NFTs) and decentralised finance (DeFi), are also controlled by a small group of insiders. The former are tokens associated with digital files, and are frequently used to represent digital works of art. The latter is a catch-all term for financial applications that use decentralised technology.

In its report on the 2021 NFT market, the Chainalysis team found that “a very small group of highly sophisticated investors rake in most of the profits from NFT collecting”. For instance, “whitelisted” investors, who have dedicated their resources to help promote an NFT project at the outset, often get to buy new NFTs at lower prices and therefore reap larger profits.

“Whitelisting isn’t just some nominal reward – it translates to dramatically better investing results,” the report said.

Data from OpenSea, the largest NFT marketplace, shows that 78 per cent of sales by whitelisted buyers are profitable, with 51 per cent resulting in a doubling, or more, of the initial investment. In contrast, 78 per cent of sales by un-whitelisted buyers later result in a loss on resale and 59 per cent result in a loss of at least half the initial investment.

In October 2021, Chainalysis introduced a DeFi Adoption Index. Its data shows DeFi activity has more large transactions than small ones – suggesting DeFi is “disproportionately popular for bigger investors compared to cryptocurrency as a whole”.

Large institutional transactions above US$10 million accounted for over 60 per cent of DeFi transactions in the second quarter of 2021, compared to under half for all cryptocurrency transactions. DeFi activity is also most concentrated in countries that have historically had the largest institutional and professional markets.

David Gogel, growth lead at dydx, a popular DeFi protocol centred on cryptocurrency derivatives, was quoted in the report acknowledging that large-scale traders, from individuals to professional crypto hedge funds, have been dominating DeFi adoption so far.

“Right now, DeFi is targeted towards crypto insiders,” he said. “It’s people who have been in the industry for a while and have enough funds to experiment with new assets.”
Gogel believes DeFi applications will become more accessible “in the long run”.

But David Golumbia, an English professor at the Virginia Commonwealth University (VCU) and a self-professed crypto critic, is far more sceptical.

“Concentration of wealth is not a bug in cryptocurrency, but its main feature,” he said, adding that blockchain advocates have very successfully managed to convince the masses of something that is quite the reverse of the truth.

“It’s a remarkable calling card of contemporary technological propaganda that this feature is routinely advertised and understood as its opposite – as promoting more equitable distribution of power and economic resources – when in fact, these are what the system is designed to prevent.”

Risks to the ecosystem

Does it matter that cryptocurrencies and the blockchain concentrate wealth and power, rather than redistribute it? After all, cryptocurrencies could still function as inflationary hedges or stores of value even if they run counter to principles of social equity.

But as with most other ESG principles, the effects of violation may not be felt till further down the road.

Sai from the University of Limerick said the widening body of research on crypto’s “perceived deviation from their democratic roots” points to the need for a more open discussion on the overall centralisation of the ecosystem.

In a note to policymakers shared with BT, Makarov, Schoar and her colleagues at MIT cautioned against allowing regulated financial institutions to speculate in Bitcoin and other cryptocurrencies due to national security concerns.

Large holders of cryptocurrencies have an incentive to influence regulators and those in authority to promote crypto investments, they argued.

“The opaqueness of most cryptocurrencies will make it much harder to enforce rules against market manipulation and self-dealing. With time, more effective regulatory frameworks and enforcement mechanisms may be developed, but the untraceable and borderless properties of crypto currencies, which are among their main draws, also make tax and general law enforcement very difficult.

“The immediate risk is that broad adoption of the cryptocurrencies will outpace our ability to put such safeguards in place. This would add to the social costs of large-scale adoption of cryptocurrencies as a store of value.”

They drew a contrast between broad adoption of crypto and the public listing of a company’s shares. While a company seeking to go public must satisfy listing requirements, including committing to regular audits and standard financial reporting requirements, Bitcoin is not subject to the same regulatory oversight. And yet, it is able to draw massive amounts of capital from institutional investors and households.

“The challenge posed by Bitcoin stems from its intrinsic properties – the opacity of its large holders and extreme concentration of mining power – which cannot be addressed through regulation of exchanges or financial institutions that facilitate public investments in Bitcoin,” the academics wrote.

VCU’s Golumbia added that in crypto, retail investors also take on far more risk than they can stomach. “Both the tokens themselves and the exchanges on which they trade are the constant target of frauds and scams, and are by design outside the system of guarantees that accompany other financial transactions, such as deposit insurance and credit card chargebacks,” he told BT.

While Schoar and her colleagues have not dismissed the possibility that crypto and its underlying blockchain technology could prove themselves useful sometime in the future, Golumbia takes a more sceptical view.

Much like an unregulated free market, he said, those who start out with the most resources in the crypto market will quickly be able to dominate any new system or subsystem and hoard resources for themselves.

The space for widespread use and experimentation with blockchain technology should be occupied by governments across the world, he said.

These are typically run on private and/or permissioned systems – different from the public, permissionless blockchain, as the crypto world understands it – and are typically developed through well-understood governmental and industrial processes.

If cryptocurrencies are to accomplish a public aim, they may need to be a more public good.

https://www.businesstimes.com.sg/bru...ing-wealth-gap