With the digitization of currency, come both dangers and opportunities.
Cryptocurrencies are challenging the U.S. dollar's long-standing dominance of world finance.
The war on currencies is intensifying: for the first time in a century, the dominance of the dollar has been challenged. The rise of cryptocurrencies and "stable currencies" has prompted people to rethink what currency is, who is the regulator of currency, and what it means when currency is not controlled by a national government. The U.S. dollar itself may need to be completely reformed and transformed into a digital currency that can move instantaneously to rival Bitcoin or any other token.
Affected by the rise of cryptocurrency, the old front of the national currency is being redrawn. These privately issued currencies are dividing the monetary system, banks, and payments. This scene reminds people of the "Wildcat" currency period in the mid-nineteenth century, when many banks issued their own currencies, prompting the Federal Reserve to issue national currencies. If there is no "no doubt" currency, the efficiency of business operations will become lower. If there is competition among multiple currencies in economic activities, the government runs the risk of losing control of fiscal and monetary policies.
What kind of storm will the new currency set off? Nobody knows. On the blockchain network, there are many cases of cryptocurrency and applications. But this technology is so disruptive that it is spurring a wave of new regulatory measures. Governments all over the world have an incentive to consider digitizing currencies, at least to maintain competitiveness and maintain their control over economic interests. The Fed itself will also release related reports in the near future.
"The birth of digital currency may enable people and businesses to bypass banks," said Thomas Hoenig, former president of the Federal Reserve Bank of Kansas City. "If cryptocurrencies become an alternative to the U.S. dollar, they will create an independent monetary environment and make monetary policy more difficult to implement."
The market value of cryptocurrencies has doubled this year alone, and now reaches $2.1 trillion. With a total value of nearly US$900 billion, Bitcoin was recently selected as legal tender by El Salvador. This is a controversial currency shift, but it may pave the way for other developing countries. Capital is pouring into the trading platforms and exchanges of new digital assets such as NFT (non-homogeneous token) like a tide. Investors also conduct token transactions on decentralized exchanges such as Uniswap. They also staking tokens to network operators to obtain high yields.
Cryptocurrencies and tokens have not yet (temporarily) been able to shake the US$19.4 trillion US money supply, or 50% of international trade denominated in US dollars. As one of the measures of dollar hegemony, the dollar’s share of central bank reserves has continued to drop to 60% in the past 25 years, but it is still three times that of its closely followed rival, the euro. Most markets for global commodities are priced in U.S. dollars. Trillions of sovereign debt and commercial debt are pegged to the Fed's "risk-free" interest rate.
But the threat of blockchain technology to the US dollar cannot be easily eliminated.
Cryptocurrencies, stablecoins and NFTs are becoming local tokens for gaming and e-commerce platforms. The design of the virtual reality platform also accommodates NFT or other private currencies. As economic behavior shifts to these hidden gardens, banks and government-backed currencies may come to the wall.
01 Challenge the incumbent
Especially for banks and other companies that actually charge "rents" to mobile dollars, the size of the affected funds is very large. North American banks, bank card networks, and non-bank "finan-tech" companies make a lot of revenue in payment and credit card services. According to the data of consulting firm McKinsey, related revenue is as high as 500 billion US dollars. According to estimates, this accounts for 2% of US GDP, most of which are credit card processing fees.
Many banks and financial companies, such as Visa and JPMorgan Chase, are working hard to be compatible with cryptocurrencies and stable currencies, hoping to capture commissions in brokerage, custody, and payment services. But the technology they face will threaten their income and, more importantly, will obtain data.
For example, Solana is a latecomer in the field of cryptocurrency. The network was developed by former Qualcomm software engineers and is said to be able to process 65,000 transactions per second at a cost of US$0.00025 per transaction, which is faster and cheaper than larger rivals such as Ethereum. The network's stablecoin and NFT (new data art, video, music, and other playthings) businesses have skyrocketed. Solana's blockchain network is also attracting the attention of high-frequency trading companies and is seen as a platform for ultra-fast data transmission and trading applications of cryptocurrencies, stocks and other securities.
BTIG analyst Mark Palmer called Solana "the biggest breakthrough in blockchain in 2021", claiming that it is driving a meta-universe game called Star Atlas that uses NFT as a built-in asset. "Solana's architecture-driven speed is a real rule changer in the world of NFT games," he wrote in the latest report. Last week, due to a surge in usage, the network collapsed, causing its token prices to fall. But this also reflects the profitable selling behavior to a certain extent. This year, the Solana token has risen from 1.5 US dollars to 139 US dollars, and the total market value is as high as 41 billion US dollars.
02 The battle of the digital dollar
The biggest financial policy battle shaping Washington now is the digitization of the U.S. dollar, which is to turn the U.S. dollar into a token that can be issued directly to consumers by the central bank. The Federal Reserve is about to release a world-renowned report stating its views on central bank digital currency (CBDC). Other countries such as China have already launched CBDC pilot projects, which has put pressure on the Federal Reserve.
The digital dollar can take many forms. The basic idea is that the central bank will issue new digital tools for transactions and deposits in addition to banknotes and bank account bookkeeping (essentially deposits). Proponents say that CBDC payments will be settled in real time, and because the central bank has no profit motive, fees will also drop significantly. This is a great thing for the unbanked people who account for 6% of the population and those who pay higher fees for cash checks. Those who send money abroad will also bypass middlemen such as Western Union and MoneyGram, and will be able to pay lower "exchange" fees.
As other countries take the lead in the CBDC field, international pressure is accumulating. "The time for the central bank to start related work has passed," Benoit Coeure, head of the innovation department of the Bank for International Settlements, said in a September speech: "We should roll up our sleeves and accelerate the design of important details of CBDC."
However, Fed officials seem to be divided in philosophy, let alone the details. Director Lael Brainard, who is expected to take over Jerome Powell as chairman of the Federal Reserve next year, has hinted at supporting CBDC. But Director Christopher Waller expressed doubts about this, describing the digital dollar as "looking for a solution to the problem." In his view, commercial banks and the Federal Reserve are already developing real-time settlement. He argued that stablecoins will put pressure on bank fees, and according to the results of the questionnaire, most people who have not opened an account in a bank do not want to open an account at all. In his speech last month, he said: “The government should only compete with the private sector when it solves market failures... I think CBDC should not be a special case.”
Compared with Fed officials, politicians are more likely to make a final decision. In the bill supported by the Democratic Senate Sherrod Brown in Ohio, it is envisaged that the Federal Reserve will provide an "electronic dollar wallet." The commercial bank will maintain the wallet so that the owner is entitled to a share of the bank's reserves at the Federal Reserve. For consumers who cannot go to bank branches, he believes that the postal service can be transformed into a digital dollar bank.
Of course, these are not attractive to bankers, who worry that the Fed will take away their deposits and damage its ability to lend. Rob Morgan, senior vice chairman of the American Bankers Association, said: "At least in the United States, the disadvantages seem to be more obvious than the benefits."
According to a recent report by Joshua Younger, director of fixed income strategy in the United States, JPMorgan Chase Bank has called for the launch of "the least aggressive CBDC." He believes that if CBDC deposits can be limited to less than $2500, it will reduce the possibility of the Fed "swallowing" deposits. He also said that 15% of Bank of America’s assets are stored in the Federal Reserve’s reserves and purchased Treasury bonds, which has been “partially nationalized”. If the Fed enters the field of commercial banking, the ratio may increase further.
03 Conquer the wild west of cryptocurrency
When the digital currency took root, regulators did not stand by. Federal and state regulatory agencies are formulating rules to regulate the industry. In the Senate hearing last week, the new chairman of the US Securities and Exchange Commission Gary Gensler developed a detailed schedule that will supervise encrypted tokens, trading and lending platforms. He said: "Most areas of encryption operate outside the regulatory framework, not within it." The scrutiny of automated exchanges may be strengthened, and there is also the possibility that investors like BlockFi can deposit cryptocurrencies to earn high returns. The same will be true for lending platforms.
Parliament also found a great opportunity to increase revenue through taxation of cryptocurrencies. Democrats in the House of Representatives have added "digital assets" to the $3.5 trillion coordination bill, which includes provisions governed by the Wash Sale rule, that is, if investors buy back within 30 days before and after the sale If you are using cryptocurrency, you will not be able to apply for tax relief. This provision alone may increase taxes by $16 billion in ten years.
Of course, it is not easy for regulators to tax or manage the entire industry. The cryptocurrency brokerage business outside the United States accounts for the vast majority of trading volume. Exchanges such as Uniswap use agreements and "smart contracts" to process transactions and operate independently of all centralized institutions such as banks or brokerage companies. "The unspoken rule is that through independent operation, users can ignore the Securities and Exchange Commission and still continue to trade assets," said Innovating Capital's cryptocurrency investor Anthony Georgiades. "Decentralization is already sufficient, even if they want to prohibit certain asset transactions, they can't do it."
Washington is still unable to agree on whether cryptocurrencies should be used as currencies, securities or commodities. The U.S. Internal Revenue Service regards cryptocurrency as "property", and the U.S. Commodity Futures Trading Commission has the authority to supervise the cryptocurrency futures market, as well as a series of agencies to supervise banks and exchanges.
Some states can't wait for federal regulations. BlockFi ran into trouble with regulators in New Jersey and Texas, and soon investors in these two states would no longer be able to legally open accounts with the company. BlockFi CEO Zack Prince said that it is necessary to develop unified federal banking regulations. At a meeting last week, he said that "it is ultimately up to federal regulators to create a path for these business practices."
Stablecoins may be the biggest dilemma faced by regulation. This token has a fixed value of $1, and is generally pegged to the U.S. dollar. There are currently 110 billion U.S. dollars in stable coins in circulation, mainly Tether and USD coins. These coins are used by investors as a substitute for the U.S. dollar in exchange transactions, and their applications in international payments and P2P transactions are becoming more and more widespread.
Diem, a partnership of 26 companies, may become a game-changing stablecoin, which was first initiated by Facebook. According to Christian Catalini, chief economist of the Diem Association, Diem is trying to release a "regulatory friendly" version. The operating network will be supported by companies such as Uber, Coinbase, and Spotify, and is expected to only charge a handling fee of 0.1% of each transaction, which is far lower than the current charging standards of banks and card companies.
Diem may become a hot item, and its token may quickly increase its appeal in applications such as Uber's fare, Farfetch's Gucci bag, and Spotify's subscription, bypassing payment intermediaries with low transaction rates. The network is also designed for P2P transactions including currency exchange, and the underlying blockchain technology may be able to move programmable digital assets in the future. However, if the digital dollar is released, the Diem coin itself may be short-lived. "We promise to gradually withdraw the token after the emergence of the digital dollar," Catalini said.
Diem promises to hold high-quality assets as currency reserves, backed by at least one-to-one cash or the Federal Reserve. It also has no more options: regulators have begun to view stablecoins as a source of financial instability, and they will issue new regulations on issuers’ capital and reserves in the near future.
What is worrying is that the issuer did not use 100% of the cash reserves to support the token, but instead used alternatives such as commercial paper, bank repurchase agreements, and other securities. This may be fine under normal market conditions, but it will cause instability in a crisis. Money market funds have experienced a run, and eventually spilled into other areas, forcing the Fed to stabilize the market. The most recent one occurred in March 2020. Morgan Ricks, a law professor at Vanderbilt University and a former fiscal official, said: "When the Fed is concerned from a stability perspective, this becomes a core issue."
Tether, the largest stablecoin, had encountered legal difficulties due to its reserves, and reached an agreement with the New York State Attorney in February last year, agreeing to make more information disclosures. However, the composition of its reserves is still opaque. According to the latest disclosure, the reserve assets of Tether currency supported by Bitfinex exchange are only 3.9% cash and 2.9% Treasury bills, while commercial paper is as high as 65%. Tether once claimed that its token is “always 100% backed by our reserves”.
The U.S. Treasury Department recently established a working group to develop a stablecoin regulatory framework. Some top economists think this should have been done long ago. "Policy makers may view stablecoins as promising financial innovations that do not pose any systemic risks," wrote a recent paper by Yale University economist Gary Gorton in collaboration with federal lawyer Jeffery Zhang. "That would be a mistake, because this is precisely when policymakers should act."
04 Dollars will not leave
The dollar will not easily admit defeat. Since President Nixon ended his peg of gold in 1971 and turned it into a freely floating "legal" currency, the U.S. dollar has lifted many threats. The onset of inflation in the 1970s, the appreciation of the yen in the 1980s, and the rise of the euro in the early 2000s all failed to bring down the dollar.
For Bitcoin, the largest cryptocurrency, a common marketing technique is to call it "digital gold" with a fixed supply of 21 million tokens. Compared with the fact that the supply of Bitcoin cannot be increased by design, fiat currency may be depreciated by the government for political or economic purposes. The central bank has begun a money-printing frenzy-the Fed’s balance sheet has increased from US$1 trillion in 2008 to US$8.3 trillion. Proponents of cryptocurrency believe that because the central bank tolerates inflation, the purchasing power of the U.S. dollar will be weakened, and cryptocurrency will be more valuable.
However, despite a lot of nitpicking about currency "drops" or the erosion of the dollar's purchasing power, economics is much more complicated than this. Since the early 1980s, inflation has not become a serious problem in North America. The inflation rate before the epidemic was so low that policymakers even began to worry about deflation. Rising labor costs and the disruption of the global supply chain have brought the threat of recent inflation, but its sustainability is still difficult to say. Those forces that suppress inflation-including the aging population of advanced economies and the productivity gains brought about by technology-will continue to exist.
History is also on the side of the dollar, because the US government has never allowed a competing currency to subvert its authority. Technology will increase the difficulty of work, but it is not impossible to overcome. The more successful currencies such as Bitcoin, the more the government may want to kill it.
05 Implications for investors
What is the impact on investors in terms of crypto infrastructure stocks and currencies? At present, the impact is not significant. Despite tightening regulations, the prices of crypto-related stocks and digital currencies have been rising for several months. With the expansion of application cases such as cryptocurrency, stable currency, and decentralized financial networks, capital is pouring into the industry. It will take months or even years for regulators to write and implement new regulations. The digital dollar may be stranded in parliament due to the fighting between the two parties.
People want regulators to release clear messages, which may open the floodgates for investment in products and services. The market has been expanded through the introduction of consultants and industrial fund managers who manage trillions of dollars in global assets. Banks also want a level playing field that eliminates existing regulatory arbitrage that provides advantages to proprietary crypto companies.
The encryption industry itself is also becoming a lobbying force. In August, when lawmakers added crypto company tax reporting requirements to the Senate infrastructure bill, the industry lobbied to exert influence. Although the lobbying blitz failed, the battle is not over—then it may be transferred to the legislature.
As for the U.S. dollar, the currencies that trouble it may provide protection instead. In the crisis, investors sell desperately whenever there is trouble. Cryptocurrencies and other tokens have not yet experienced such a test. In a panic, the most risky currencies fall the most, and cryptocurrencies may be no exception. "If there is a crisis, all these similar currencies will rush towards the sovereign currency," Hoenig predicts. Regardless of whether it is digitized or not, the dollar will continue to fight.
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