CRYPTOCURRENCY? A SOLUTION WITHOUT A BURNING PROBLEM? THE ASSET CLASS WE WANT BUT DON’T NEED?
I have conflicting views on crypto and given how much it’s in the news these days, I decided to challenge my views again with a mini deep dive into the latest developments.
I preface this by admitting I am a “no coiner” meaning I hold no crypto, a position I have regretted a few times. I have a close friend who made a small fortune trading Bitcoin, he has now retired and travels the world dancing tango competitions. Jealous, yes.
However, thinking about cryptocurrency analytically and strategically – what can it do?
Core technology
Cryptocurrency was born out of a distrust of established financial systems and their oversight, with the distributed ledger being a technology that could register ownership of an asset through a chain of data that was verified and stored across a group of privately owned computer systems. The chain of data is held secure by cryptography, or a hard to crack code that requires extensive run time to compute. When transactions are registered, multiple companies will compete to formulate the new accepted ledger.
Hence transactions are recorded, the new owner of the token is accepted across multiple ledgers, and this owner can be registered by a private key, which creates a bit of risk in the shape of various potentially urban myths around lost computers and keys, or at the extreme armed robbery to steal someone’s keys, but also means the owner can own assets outside the regular financial system (without Know Your Customer disclosures). Hence we find Benefit 1 – Anonymity.
We also find Benefit 2 – Freedom from real assets. Ownership can be transferred in a matter of minutes, no physical transfer of an asset needs to occur, and no credit relationships between banking networks needs to be involved.
At the moment many of us feel that international payments are not really an issue, it may take a couple of days and cost a small amount of money, but not a big deal. What we don’t see is the plumbing behind the curtain. Payments go through established banking networks, even if these networks credit their customers accounts quickly, someone is taking a credit exposure to another institution across complex multi-bank netting arrangements.
I saw this rather a lot on the trading floor, when large swap payments between banks would need to be made on a daily basis and occasionally our back-office staff became heated if payments were late. Removing some of this friction could likely be useful and remove some cost? Leading us on to….
The cost and limitations of the technology
As discussed, to hold assets securely outside the financial system requires multiple companies to compete with extensive run time. This has a non zero energy and $ cost. Servers can be located in cold regions with access to low cost power e.g. Siberia near a coal fired power plant – but if you grow too much and start causing blackouts the locals may get annoyed.
Similarly, this system of operation has a limit to the number of transactions it can process per second. Not a problem at current levels, but if there are ambitions to take over all global retail payments? Visa and MasterCard process an enormous amount of transactions a second, and most consumers aren’t going to slow down their tapping rate for a bit of anonymity.
So, if you care about anonymity, its going to cost some $ and limit your transactions, what use cases will this serve? Hmm.
If you don’t care about anonymity, you don’t need a distributed ledger outside the financial system so something held inside the system, by a bank or a government will do. This can deliver the benefits 2 – tokenisation and immediate settlement within an established system. Is there a use for this?
Uses for Tokenisation
This is a potentially powerful use case. Global banks could remove their settlement / credit exposure to other banks with the immediate transfer of cash ownership, through a cryptocurrency or a stable coin – an asset backed by a real currency holding. Banks may want to remove the friction of established payments networks, however as these are by definition, established, will enough spend the Investment $ to set up a marginally better payments system to create the network effects necessary for the marginal benefits on the table? This I cannot predict. Several large banks (such as JP Morgan) have been trialling systems and the new act in the US are set to promote stable coin usage.
Countries could also create their own central bank digital currency or CBDC. This is potentially a useful way to track the cash you are distributing as benefits and either monitor or restrict its usage. It also reconfirms the strangle hold central banks have on currency and provides some of the use cases of a cryptocurrency while remaining under the control of the central bank, but it does create complexity and the potential increased risk of financial instability by creating two items the central bank has to stabilise in a downside scenario. Here it is likely that central banks (such as the Bank of England) may respond to each other’s actions, to avoid being left behind.
For example, China created an e-CNY CDBC in an effort to encourage retail usage and pan Asia trade settlement in CNY rather than USD via SWIFT, meeting their long term aim of disrupting USD hegemony. However, the devil is in the details with payments systems, if the creation of the alternative payments rail isn’t perfect, people wont move from established payments methods, and it seems that China may be meeting this aim more gradually through stronger trading relationships and a gradual increase in their prominence as a trading partner.
Similarly in Australia, a CBDC piloted successfully in 2023 (wholesale usage only) and Project Acacia is looking at a variety of institutional use cases including, rather excitingly the tokenisation of real assets not just cash. This could enable tokenisation of privately held assets such as commercial property, which if broken down into smaller bite size units could introduce smaller buyers to these markets, potentially increasing the frequency of trading private assets, breaking down both the illiquidity and lack of transparency of such. Given the global trend towards private assets for all investors this is interesting, but not without risk.
Leaving the final and to me most contentious use case
Is Cryptocurrency a legitimate asset class?
I really don’t like this question, my immediate answer is a knee jerk no. All kinds of things have been “assets” before including railroad bonds and tulip bulbs. Forcing myself to step back, what is an asset? Something you store wealth in that you expect to at least retain or go up in value and can be used to buy other things when you need them or passed down to family.
Assets can have all kind of characteristics; they are more useful if easy to hold / small / safe to store / do not perish / hard to steal / fungible / transportable / easy to sell etc.
Why is gold valuable? Diamonds? Yes, they have use cases but even De Beers is being challenged at the moment as the price differential between lab grown diamonds and the real thing extends. Physical gold was used a lot in colonial times as a small item that did not degrade, could be moved about by boat, defended by men with muskets, then used to buy food and guns in pretty much any port if the buyer had working teeth to bite coins for quality and a weighing scale.
Cryptocurrency ticks many boxes around storability and fungibility, if we can fix the potential risk of bad actors and fraud in the system, it could be a solid store of value, if enough of society accepted that is what it is.
Gold is also useful, via limited supply, as a hedge to standard currency inflation, since central banks can always print more currency but rarely dig more as yet undiscovered gold. Many crypto converts will tell you that crypto, via the mechanism of limited issuance, can be this too. Maybe, but evidence suggests it doesn’t always trade this way yet, with bitcoin trading emotionally / positively correlated with tech stocks.
So my conclusion. Cryptocurrencies could become an asset class, but the road to acceptance is a long one. It is not certain which of the many “coins” will create lasting value and if these coins will be fungible with each other. This opens the market to speculation, which will create profits for some, but in a zero sum game some people will take losses. My personal feeling is that unless you are the smartest person in the room, the losses may be yours to take. Leading me to conclude…Crypto – the asset class we want but don’t need.
Julia Patterson
Partner, Financial Services