How Will Bitcoin Impact Banks and Finance Structures?

3129 words (13 pages) Essay in Finance

22/02/19 Finance Reference this

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What is finance, and how does cryptocurrency fit in to our current understanding of it:

At the start of the unit, one of the first concepts we were asked to consider was a point that is highly contended – a philosophical question which has never borne more significance than it does today, with the recent emergence and explosive growth of cryptocurrencies. We were asked to consider what finance was, and how it fit into society. Now it would be prudent to ask what finance is, and how cryptocurrencies fit in to our current understanding of it. Let me start to answer this with a brief description of ‘fiat’ currencies, or legal tenders, with no material value or value redeemable for commodities.

Historically, the value of a nation’s currency was pegged against a commodity with well-established value, such as gold or silver. This was the case for the majority of currencies up until 1971, when Richard Nixon decoupled the US dollar from gold. Supply and demand determines the value of fiat currency. Governments can control how much is in circulation and control the value of money as well as inflation. One of the biggest downfalls of cryptocurrency according to its critics, is the inability of more tokens to enter circulation when demand is high. The total amount of Bitcoin, is limited by a digital production process analogous to precious metal mining, which can stop its value from being eroded by systematic over-production and debasement as has been the case with numerous fiat currencies historically.18 This inability to react to demand causes sharp volatility in the value of cryptocurrency, making them unreliable stores of value. This has been most evident with the steep spikes in Bitcoin value since the beginning of the year. Conversely, as fiat currencies are not linked to physical reserves, they risk becoming worthless due to hyperinflation. If people lose faith in a nation’s paper currency, the money will no longer hold value.

Fiat money serves as a good currency if it can handle the roles that an economy needs of its monetary unit: storing value, providing a numerical account and facilitating exchange. Because fiat money is not a scarce or fixed resource like gold, central banks have much greater control over its supply, which gives them the power to manage economic variables such as credit supply, liquidity, interest rates and money velocity.

Cryptocurrencies on the other hand do not serve as a currency for one particular nation, and are not controlled by any government body either. Instead they employ what is known as blockchain technology, which is a form of digital ledger that is maintained by all the users of the network. An on-going record of all transactions is kept and added to, each time a new transaction occurs. Despite this however there is an inherently high level of anonymity, given that bitcoin, tezos etc. addresses are not linked directly to any person or entity. This also gives way to several problems for governments which are unable to control inflation or the amount of cryptocurrency in circulation, declaration of earnings and tax, prohibition of trading illegal goods and money laundering. There are several safe-guards in place to ensure against ‘double-spending’ and other fraudulent activities however which are built in to the blockchain technology. Further, as a result of this peer-to-peer network in which cryptocurrencies operate, there is no single point of failure, making it very difficult for the system to collapse.17

What potential effects will the use of cryptocurrency and decentralising of currency have, particularly on banks?

The total value of all cryptocurrency in circulation is now ~$200 billion USD3. Even though this is almost double the value it was in July, it is still trumped by the value of paper USD issued by the U.S. Federal Reserve, which alone amounts to about $1.4 trillion. We are therefore nowhere near the point yet where cryptocurrencies pose a credible threat of supplanting central-bank-issued money. Nonetheless it is worth thinking through some of the implications if something like Bitcoin (which has about a 45% market share of all cryptocurrencies) were to wholly or even partially supplant central bank fiat currency.

The agreed protocols that govern Bitcoin, Tezos and other cryptocurrencies, are effectively their monetary policy. In exchange for mining blocks of bitcoins and consuming computing power to verify the legitimacy of transactions, Bitcoin “miners” get paid in Bitcoin. These rewards increase the supply of Bitcoin, though the increase in Bitcoin money supply is inhibited by the increasing difficulty of verifying transactions. Increasing computational power is required to verify each transaction and mine new blocks to create new Bitcoins, meaning that the total supply of coins is gradually approaching the limit of ~ 21 million coins (currently there are ~16.5 million in circulation).

Fiat money has its own protocols that stabilise inflation using interest rates and bond-buying, and the money supply that results from this is generally ignored. With cryptocurrencies however, money supply does not respond to shifts in money demand and with a relatively fixed supply, large fluctuations in value and prices result (in the preceding 11 months the price of bitcoin has soared almost 8 fold5). This some argue, is specifically the reason Bitcoin and other cryptocurrencies will not take over2 and makes Bitcoin impractical as a money. Cryptocurrencies however have proven to be a useful alternative to traditional reserve currencies in places with poor monetary policy and weak banks. In Kenya for example, 1 in 3 people own a bitcoin wallet1, while in India, where recently there has been a significant shortage in cash supply, greater numbers of people have converted to the use of bitcoin.4

If a particular country were to adopt Bitcoin to replace its currency, the effects of doing so would likely be felt by others in a knock-on effect. A larger credit cycle in one country would mean larger booms and busts for its trading partners. Foreigners outside the country that adopted the cryptocurrency, may also opt to deposit directly within that country and desert their own country’s banks in doing so – this could affect the flow of capital into and out of a their home country, further amplifying the credit cycle. The latest difficulties with Bitcoin make the prospect of a crypto currency takeover seem fanciful at the moment, but if solutions to these problems were found or a new currency were devised with better protocols, central banks would have to resolve these dilemmas one way or another.

Financial history – what can we learn from historical bubbles and is it reasonable to foresee the current growth as sustainable?:

An economic or asset bubble, is trade in an asset at a price or price range that strongly exceeds the asset’s intrinsic value. It could also be described as a situation in which asset prices appear to be based on implausible or inconsistent views about the future19. The general consensus among industry professionals, is that the current cryptocurrency market is in an unsustainable phase of bubble growth6,7.

There were 30 ICOs each launching new cryptocurrencies in July, then more than 50 in August. Part of this mania is based on speculation. But it’s also clear that there has been departure from a fundamental assumption of what a cryptocurrency originally was – a scarce digital commodity where the value derived from its scarcity. To be frank, if more than one hundred new sources of this digital commodity have been launched since June, then the concept of scarcity, and therefore the supposed inherent value, begins to erode. In fact, many of these newer cryptocurrencies will need to fail in order to maintain the value and viability of the most widely used currencies, bitcoin and ether. These look to remain viable over the intermediate and perhaps long-term, though not necessarily at the current prices. History has shown us that the majority of cryptocurrencies fail dismally at some point soon after their conception16. Only a select handful have shown consistent growth over the last few years. Bitcoin itself has crashed significantly several times. Even so, though the core blockchain technology left behind others, will provide value as a hidden infrastructure underlying future applications.

Though bitcoin has seen astronomical growth over the last year one of the major problems in its use is the extreme volatility in its value. On April 8th 2013 for example, Bitcoin was valued at $215 USD, eight days later this figure dropped to $63 USD then seven months after this its price soared to $1,200 USD. This volatility was in hindsight partly a consequence of strong speculative demand from buyers for a new and unknown technology.  There are however, more fundamental problems that cause the value of Bitcoin to fluctuate. The algorithm that controls supply prevents the amount of Bitcoin from expanding to meet increases in demand. This inelasticity in supply leads to price variations and also encourages speculation and excessive volatility, all of which render it unreliable as a store of value.7

The cryptocurrency market is new and being filled with new currencies almost daily. As competition develops however and with little history, few can value them correctly, forecast which currencies will succeed, and whether they are all part of a larger bubble that will eventually burst. History has shown however that new financial instruments are the authors of financial bubbles – be they options for tulip bulbs in the 1630s, fiat money in the Mississippi bubble of the 1700s, stock in the South Sea bubble, leverage in 1929 or collateralised debt instruments in the credit crunch of 2007, the problem was the world was behind the knowledge curve of the instrument and the power of greed drove the market wild and finally into collapse.8 It would therefore not be unusual to see a similar crash with cryptocurrencies in the near future.

Cryptocurrency regulation – How is it possible to regulate an online currency based globally?:

In short, it isn’t. The whole premise of cryptocurrencies is that they are decentralized and ungoverned by any one government, but rather managed by a peer-to-peer network of users worldwide. The focus has thus shifted to the soundness and legality of investing in them through means such as ICOs and derivatives markets.

In the largely unregulated world off cryptocurrencies, one issue remains at the forefront of the attention of regulators such as the SEC (in the U.S.) and ASIC (in Australia), and that is in the nature of ICOs, whether they are seeking genuine donations for the development of software, or whether they are in fact shares in a company or other investment, which contributors hope to redeem at a future date for financial benefit – an illegal and unregulated speculative investment.

Initial coin offerings have raised $3.6 billion USD so far this year15 with several currency developers generating vast amount of capital in a matter of hours with little more than a website and a promise of a revolutionary new product. This unchecked source of crowd-funding has been banned by several governments, as other countries’ regulatory bodies such as the SEC and ASIC, have developed their own policies regarding these offerings.

On September 4th, China banned investment in ICOs citing breaches of securities laws and “disruption to economic and financial order”13, and moved to shut down cryptocurrency exchanges also.13 In July, the U.S. Securities and Exchange Commission required companies to register ICOs in the same fashion as IPOs14. Following this ruling on September 29th, the SEC charged two companies with fraud and selling unregistered securities after running successful ICOs that collected more than $300,000 USD14.

Substantial efforts have been made to legitimise cryptocurrency offerings by law firms such as Cooley in New York and others with vested interests in making ICOs work. Cooley attests that it has developed a “simple agreement for future tokens” (SAFT) framework that will allow token sales to be compliant with US securities laws. This is important given that several major ICOs had excluded US individuals from participating given the then-standing issues with the SEC. If by applying the SAFT framework the SEC is satisfied, then US investors would have access to more ICOs providing a major source of capital to them. The basic premise of the Simple Agreement of Future Tokens (SAFT) is that the cryptotoken fail the Howey test, a measure of whether a financial instrument is in fact a security. In order for tokens to fail the test and not be considered securities, they must be delivered to investors only after a functioning product or service is in place. “The network and the token must be genuinely useful such that they are actually used on a functional network,” according to Cooley’s framework. To date ICOs have delivered tokens to investors before the launch of the underlying currency, meaning that the only real function tokens could have use for would be in trading in secondary markets, blatantly classifying them as securities. 

In the case of Tezos, investors bought into the project hoping that the Tezos platform would be built successfully, and that by owning the tokens, also yet to be created, they would become stakeholders able to shape the final platform. One particular case highlights the blatant regulatory arbitrage which is plain for all to see, and which the founders of Tezos attempted to disguise by consistently referring to their ICO contributions as “non-refundable donations”, in order to make ambiguous the nature of the security they were offering. Tim Draper, one of the main venture capital backers, when asked by Reuters how much he had donated replied “You mean how much I bought? A lot.”

In Australia, ASIC released a decisive factsheet on ICOs and their position, stipulating that ICOs must be conducted in a manner that “promotes investor trust and confidence, and complies with the relevant laws”11. ASIC has also warned that the Corporations Act may apply to an ICO depending on the rights that attach to the coin from the ICO itself, rights to underlying coins or rights on tokens used in the ICO. Likewise, ASIC has also made it clear that if an ICO is conducted to fund a company, then the rights attached to the coins issued by the ICO may fall within the definition of a share. Where it appears that an issuer of an ICO is actually making an offer of a share, the issuer will need to prepare a prospectus as for any other IPO11, which will allows investors the safeguard to withdraw their investment before the shares are issued should there be misleading or deceptive information in the prospectus.  

Lastly it is worth noting that some ICOs have been described by their initiators as a form of crowd funding. In Australia, ASIC has made a clear distinction between crowd funding using an ICO and ‘crowd-sourced funding’ (CSF) that has been regulated by the Corporations Act since 29th September 201711. Under the new laws, CSF will be a financial service where start-ups and small businesses raise funds, generally from a large number of investors that invest small amounts of capital. There will be specific rules for conducting CSF with fewer regulatory requirements than ICOs, while maintaining investor protection measures. This is particularly of importance in the case of Tezos, where the developers sought “donations” to fund the development of their network, a deliberate misrepresentation which would now be both illegal and arguably unethical in Australia.

REFERENCES:

  1. https://www.huffingtonpost.com/ameer-rosic-/7-incredible-benefits-of-_1_b_13160110.html
  2. https://ftalphaville.ft.com/2017/06/07/2189849/guest-post-the-consequences-of-allowing-a-cryptocurrency-takeover-or-trying-to-head-one-off/
  3. https://coinmarketcap.com/all/views/all/
  4. https://news.bitcoin.com/bitcoin-demand-rise-cash-run-dry-india/
  5. https://au.investing.com/currencies/btc-aud-historical-data
  6. https://www.coindesk.com/comes-cryptocurrency-bubble/
  7. http://www.cityam.com/1408388669/why-bitcoin-won-t-be-money-future-cryptocurrencies-might-be
  8. https://www.forbes.com/sites/investor/2017/05/31/cryptocurrency-is-a-bubble/#4501c7dc33b1
  9. https://www.bloomberg.com/news/articles/2017-09-27/cryptocurrency-derivatives-you-bet-this-trader-has-295-return
  10. https://ftalphaville.ft.com/2017/10/19/2195028/trouble-in-ico-paradise/
  11. http://asic.gov.au/regulatory-resources/digital-transformation/initial-coin-offerings/
  12. https://qz.com/1091812/the-secs-ico-crackdown-may-be-avoided-by-the-saft-legal-framework/
  13. https://techcrunch.com/2017/09/04/chinas-central-bank-has-banned-icos/
  14. https://coinidol.com/icos-to-be-regulated-as-ipos-in-the-us/
  15. https://www.coinschedule.com/stats.php
  16. https://bitcoinexchangeguide.com/deadcoins/
  17. https://bitcoin.org/en/how-it-works
  18. https://3decuj2tc6bl1oljdt3zfwbb-wpengine.netdna-ssl.com/wp-content/uploads/Currency-Debasement.pdf
  19. https://en.wikipedia.org/wiki/Economic_bubble

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