How Will Bitcoin Impact Banks and Finance Structures?

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 growth^6,7.

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 8^th 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 4^th,
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 29^th, 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 29^th 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.