Crypto threatens financial stability says BoE banker

Jon Cunliffe, the Bank of England’s deputy governor for financial stability has recently given a speech where he tackled the question of whether or not, “the world of ‘crypto finance’ poses risks to financial stability.” Why and how does it do that?

Cunliffe pointed out that cryptoassets have grown by roughly 200% in 2021 ($2.3 tn), and from $16 billion just five years ago. The global financial system is worth $250 trillion, to give some context. He also mentioned that the sub-prime debt market was worth around $1.2 trillion in 2008, just before the financial crisis.

His point in using this comparison was that because the crypto industry is growing rapidly and beginning to connect to the traditional financial system, and there are leveraged players emerging in a mostly unregulated space, systemic risks, while limited now, could grow very quickly.

Referring back to 2008, he reminded his audience that in the case of the sub-prime market, “the knock-on effects of a price collapse in a relatively small market was amplified and reverberated through an un-resilient financial system causing huge and persistent economic damage.” We all remember the effects.

He called for financial stability regulators to take notice, to think very carefully about what could happen and whether they, or other regulatory authorities, needed to act. However, he cautioned against over-reaction. As he said, “We should not classify new approaches as ‘dangerous’ simply because they are different.”

Indeed, he said that innovation and technology, plus new players, could tackle longstanding frictions and inefficiencies and reduce barriers to entry, and that in the past they have been key to driving improvement and to increasing resilience in financial services.

Then, what started as a speech that may have sounded gloomy to the crypto markets, Cunliffe made an important and positive statement. He said, “Crypto technologies offer a prospect of radical improvements in financial services.” But he did add a caveat, “However, while the financial stability risks are still limited, their current applications are now a financial stability concern for a number of reasons.”

He then analysed the crypto market, breaking it down into unbacked cryptoassets used primarily as speculative investments and backed cryptoassets intended for use as a means of payment, pointing out that unbacked assets make up 95% of the market, and includes Bitcoin. His concern is that the main use of unbacked cryptoassets is for speculative investment and that fewer holders now say they see them as a gamble and more see them as an alternative or complement to mainstream investment. His greatest fear appears to be that while he doesn’t believe a collapse in the crypto retail investor sector would bring about instability, the large financial institutions with exposure to crypto are another matter, such as the many crypto hedge funds. He described one scenario: “For example, a severe fall in the value of cryptoassets could trigger margin calls on crypto positions forcing leveraged investors to find cash to meet them, leading to the sale of other assets and generating spillovers to other markets.”

Ultimately, Cunliffe called for faster action on regulating the market to manage risk, saying, “Although crypto finance operates in novel ways, well-designed standards and regulation could and should enable risks to be managed in the crypto world as they are managed in the world of traditional finance.”

While he sounds positive, as ever the demand is to bring crypto more in line with traditional finance, the very thing that caused the creation of crypto in the first place, due to ‘tradition’s’ failings.

The Pandora Papers expose a rotten system of privilege

Whilst there are many good, economic reasons why cryptocurrency and blockchain have grown since 2009, there is a more emotional reason underpinning it as well, and that is that people in power cannot be trusted. Just last week, we the people were given another file of documents – The Pandora Papers – which underlines why that distrust exists, and is growing.

The Pandora Papers consist of around 12 million leaked documents from law firms and other organisations worldwide. The documents unmask the previously unknown owners of 29,000 offshore companies hiding billions of dollars in assets from taxation or oversight. A good number of these ‘unknowns’ are actually terribly well known public figures in their countries, and some are global figures, such as singer Shakira.

David Z Morris in his thoughtful opinion piece for Coindesk, labels it “aggressive tax avoidance,” adding, “in some cases hidden funds seem linked to outright corruption, much of this activity is nominally legal – but the very existence of such structures almost guarantees they’re being used for deeply harmful ends well beyond dodging taxes.”

It is also estimated that a mind-boggling $32 trillion in assets are hidden in offshore tax havens, which is a figure “roughly 15 times the total value of all cryptocurrency in existence.”  Some of that money in reality belongs to the citizens of the 200 countries named in the papers, and should have been used for public infrastructure and services.

Morris rightly suggests that the Pandora revelations make a mockery of governments’ focus on cryptocurrency as a conduit for money laundering, tax evasion and criminal activity. Yes, there are some who may argue that crypto makes it easier for the average person to ‘enjoy’ the same tax evasion benefits as the users of offshore tax havens, but Morris says, not only is this a race to the bottom for crypto, it is a “false equivalency”, because “what world leaders have accomplished through offshore entities and shady banks simply can’t be replicated by average people using crypto.”

That’s because crypto cannot match the secrecy offered by offshore entities. And that is because the use of tax havens “is part of a much larger and more complex system of shadow influence that relies on institutional political power and generational wealth.” Furthermore, they are not just used for tax avoidance, they can hide “state-sponsored drug trafficking, murder and anti-democratic violence,” Morris points out.

Ultimately, what the Pandora Papers show us is something we’ve always known, but perhaps needed to be reminded of: the global banking system provides secrecy to only the wealthiest and most powerful. Cryptocurrency may not be the complete answer to this elitism, but it does explain some of the motivation behind crypto adoption, and that is the desire to escape a system that is rotten to the core.

DeFi will disrupt banks

Mark Cuban, the billionaire investor who is bullish on cryptocurrency and blockchain, has been telling CNBC that DeFi apps will challenge the traditional banks. Moreover, he believes that if banks weren’t so slow to embrace change, then they wouldn’t be facing this issue.

He particularly enthusiastic about the lending and borrowing aspects of DeFI. He said, “It’s a hassle to borrow money from a bank, and the foundational DeFi benefit is that it simplifies borrowing for personal purposes.” It also “allows anyone with funds to be a lender as well,” which is another plus.

As many of you will know, DeFi applications aim to recreate the traditional financial system and make it more accessible to a wider customer base. They are cryptocurrency based and the majority run on the Ethereum blockchain. Through DeFi lending, users can lend their cryptocurrency, just as a traditional bank does fiat currency, the difference being that the person lending the crypto earns interest on it.

In the traditional banking world, when a bank makes a loan, it is using the liquidity available from all the accounts it manages, yet none of the liquidity providers reap any rewards, only the bank does. DeFi changes that.

Furthermore, with DeFi, the barrier to entry is low for the borrower. The opposite is true for traditional banks. As CNBC says, “In most cases, the only requirement to take out a DeFi loan is the ability to provide collateral with other crypto assets.”

Cuban said, ″[B]usinesses, decentralized or otherwise, tend to benefit when they offer customers the path of least resistance to get what they want and/or need.” He added an important point: “DeFi is not monolithic. It’s competitive. It will evolve to meet customer needs.” Banks, it appears, are not doing that.

And yet they could have. On this subject, Cuban commented, “Banks could have simplified/automated to the point that DeFi wasn’t needed. They didn’t. They are so stuck in legacy [operations] they are disrupted by simple fintech.” 

Although banks are averse to change, DeFi will not wipe them from the face of the earth, but DeFi applications will still disrupt the traditional space.

Of course there is a downside with DeFI. For example, when you use a DeFi app, there’s no regulations or insurance in place, and “due to the volatile nature of cryptocurrency, investors would need to be comfortable with large swings in price.”

Looking ahead, Cuban predicts the “big players” in DeFi will “welcome regulation” since it will “allow the industry to grow and still have a Wild West aspect,” he said.

Fintech will win the battle for the future of financial services

The world has experienced a seismic shift over the last year and a bit, and the effects are about to become evident as we start to move into a post-pandemic future. Financial services are one sector where we are seeing major changes, especially in the role that fintechs play in the world of money.

In the Deloitte study ‘Fintech 2021’ a ‘second wave’ of fintech activity is predicted and the authors write: “Despite the Covid-19 pandemic we appear to have entered a new phase in the evolution of the financial technology sector.”

To start with the traditional financial institutions are pursuing partnerships with fintechs, or those identifying as technology companies, so that they can access new markets. The fact that more of these institutions are now engaging with digital assets is a clear sign of this. Visa’s CEO Al Kelly recently stated why his company is moving in this direction: “We’re trying to do two things. One is to enable the purchase of bitcoin on Visa credentials. And secondly, working with bitcoin wallets to allow the bitcoin to be translated into a fiat currency and therefore immediately be able to be used at any of the 70 million places around the world where Visa is accepted.”

Morgan Stanley is another giant that is moving in a crypto direction. It is  “eyeing up a $441m play for a stake in South Korea’s largest digital asset exchange, Bithumb,” writes Maxim Bederov, who then points out that Bithumb’s exchange volume “recently exceeded mainstream equity stock market volume.”

Morgan Stanley’s move came only days after its analysts published a report: “The Case for Cryptocurrency as an Investable Asset Class in a Diversified Portfolio” arguing for a 2.5% allocation for sophisticated investors. It also noted that cryptocurrencies as an asset class, “has crossed the critical thresholds of market liquidity, regulatory scrutiny and institutional acceptance.”

Who else is buying? Paypal has confirmed it is buying crypto-security firm, Curv, on top of providing a crypto buying service to its users. And we are likely to see many more mergers and acquisitions in this space “as power consolidates upwards from crypto-asset startups to institutional giants.” Bederov says.

And, after the Covid crisis we are also seeing a major shift to cashless societies: an outcome of the fear surrounding touching coins and bank notes which were seen as a source of spreading the virus. As a result, there was massive growth in the use of contactless payments. In the UK, the limit for contactless payments was elevated twice in the past year. The limit increased from £30 to £45 in March 2020 (a modest 50% hike) then by over 120% in March 2021 to £100.

Consumers are moving away from cash at record speed, according to a major new report by FIS Worldpay. The annual 2021 Global Payment Survey found that e-commerce exploded in 2020. The use of cash has declined by 42% since 2019, and the report says cash will be the least-used traditional payment method within four years. It also states, “by 2024, digital wallets, credit and debit cards will account for 84.5% of e-commerce spend.”

Bederov concludes by saying, “Whatever results in the near term, this powerbase tussle between cryptocurrency, cash and central banks will be the defining fintech battle of 2021 and beyond.” The signs are good for a fintech victory.