Fintech In Crisis, Part II: From Alternative Payments To Alternative Money

In Part I of this series, I explored how the Covid-19 scare has highlighted some of the major challenges already facing the Fintech sector generally. But there is one area in which some thought it might be of some benefit; that is, in the market for an alternative money itself, rather than a mere means of alternative payment. With most of the world now emerging from lockdowns, however, it is far from clear that alternative money is gaining much traction. The opposite might even be true, as central banks explore ways in which to create their own digital currencies.

A Brief History of Alternative Digital Money

Though it started with bitcoin back in 2009, interest in digital cryptocurrencies really began to take off in 2014 as the blockchain technology and topic in general entered the mainstream financial press. By 2016, new coins were springing up regularly, each purporting to have its own share of niche, unique or in some cases more universal benefits. The initial coin offering (ICO) boom soon went into high gear, drawing the attention of many speculators and, following closely behind, regulators.

As the craze continued, there were occasional reports of frauds of various kinds. Coins would get lost on exchanges; proceeds from ICOs would mysteriously disappear, as would their principals; coins supposedly backed by something tangible were discovered to be backed by nothing but pure hype. But as the mania gradually subsided, it did serve a useful purpose: educating a huge number of both experienced and inexperienced investors in the underlying technology of blockchain. It also demonstrated that, through the years, the original cryptocurrency, bitcoin, had established a substantial first-mover advantage in the sector.

Bitcoin: Safe Haven or Speculation?

Several months ago, as lockdowns were being introduced and governments began announcing plans for aggressive monetary and fiscal measures to compensate for the expected collapse in economic activity, I wrote an article looking at recent developments with bitcoin, by far the largest alternative currency currently in use with a current total market capitalisation of $171bn.

In particular, I examined bitcoin’s core properties and how, due in large part to its fixed supply, it could be perceived as a safe haven relative to national currencies. In the event that negative rates and expanded QE, including purchases of risky assets, were to undermine central bank balance sheets, bitcoin could compare favourably. I also explored how the bitcoin ‘halving’, which took place in May, could be perceived as either positive or negative, depending on how one interpreted the supply and demand functions for the leading cryptocurrency.

I concluded in the negative, that the halving of bitcoin seignorage income would result in some of the less profitable miners charging higher transaction fees or exiting the market altogether. The result could be a general decline in volumes which could also depress the price. As it happens, bitcoin has indeed struggled since the halving, notwithstanding all the safe-haven hype. Average daily traded volumes have been only around $18bn/day over the past month, compared with an average over the prior year of around $30bn/day.

Even more disappointing for its supporters is that bitcoin has yet to find practical use cases as actual currency to purchase actual goods or services. Few vendors will accept it, in particular for large purchases. Consequently bitcoin, designed over a decade ago to function as an alternative currency, remains a speculation on possible future adoption for some as-of-yet unknown purpose.

Are Central Banks About to Get in on the Game?

Meanwhile, a new threat to bitcoin has emerged: central bank digital currency. Most major central banks and a few smaller ones have published papers indicating their interest in the topic of national, purely digital currencies. In some cases, the papers go so far as to recommend an eventual elimination of paper currency altogether.

In its recent Annual Report, the BIS writes on the topic of central bank digital currencies (CBDCs) and concludes thus:

“[C]entral banks play a key triple role as catalysts, operators and overseers. While most of the building blocks and policy imperatives for these roles have not changed, the new developments have changed their relative significance…

Central banks can and should stand at the cutting edge of innovation themselves, not least when directly providing services to the public. Central bank digital currencies (CBDCs) are a prime example. CBDCs could represent a new, safe, trusted and widely accessible means of payment. They could also spur continued innovation in payments, finance and commerce. For CBDCs to fulfil their potential and promise as a new means of payment, their design and implications deserve close consideration, especially as they could have far-reaching consequences for the structure of financial intermediation and the central bank’s footprint in the system.”

While it is entirely understandable that central banks would take an interest in these matters, those supportive of international, independent cryptocurrencies as a means of payment and store of value should take notice. Central banks are monetary authorities that do more than merely regulate their respective monetary systems. They create the actual money, with legal tender status and protection. That legal tender is the source of what amounts to seignorage income: in exchange for zero-yielding money (or reserves), central banks accumulate interest-bearing assets. Normally government bonds, in recent years, seeking to implement expanded QE, most developed-economy central banks have expanded the range of collateral they accept, in some cases into speculative-grade paper.

While those policies may be questionable in their intents and most certainly their possible future effects, including unintended consequences, central banks have repeatedly extended their mandates according to what they generally refer to as temporary, emergency conditions rather than anything permanent. This includes the imposition of negative interest rates, which encourage savers to hold physical cash, rather than accept negative interest on cash balances held in bank deposits.

CBDCs would get around this problem by making it impossible to hoard physical cash. If all legal tender were digital, and subject to negative interest rates, there would be no place left to hide. Savers would be forced to accept negative interest on their cash balances. The alternative would be to eschew cash in favour of assets, with the risks that doing so would entail. Absent capital controls, savers could perhaps hold other countries’ cash instead, or even gold; but were those currencies or gold to rise in value, then those gains would likely be taxable in the depreciating base currency.

But what if savers could acquire bitcoin as an entirely alternative, independent form of digital money, one that with sufficient cryptographic protection could be kept hidden from the authorities? Some argue that in a world of negative rates and QE-powered currency debasement bitcoin would almost certainly function as a safe-haven store of value, fixed in supply, and not subject to negative rates or confiscation.

Assuming that the authorities would not find a way to impose a form of capital controls to halt a flight into bitcoin, the problem with such thinking is that which I argued in my recent paper on the topic: the cost of maintaining the bitcoin network absent mining seignorage income is prohibitively high, and those costs need to be passed along to network participants, which is in effect a form of negative interest (or high fees if you prefer). Economically, from the perspective of the end user, the two work out the same. For all its technical elegance, the bitcoin algorithm suffers from this potentially fatal flaw.

The Ultimate Alternative Money: Gold

Another alternative to negative interest rates would be for investors to consider increasing their allocations to gold. Yes, gold pays zero interest, and high-security, safe-jurisdiction storage costs, while tiny, are still positive, but as low as 10bp/annum for large amounts. Moreover, gold is a highly liquid, global market, and one that had proved its worth through the ages in both good times and bad.

It is therefore encouraging to see multiple Fintech startups having a go at making gold more accessible to savers and, in some instances, as a payments medium. Several of these have already launched apps allowing customers to buy, sell and trade gold and use it as a means of payment within their networks. If the global economy remains on the road to negative interest rates, with or without CBDCs, these platforms will probably find there is growing demand for their services.

Conclusion

Fintech may indeed have a bright future. However, innovation across alternative lending and payments may have hit a wall given the downturn in the credit cycle, Wirecard’s recent failure and increasing regulatory scrutiny. Moreover, with banks (especially SIFIs) remaining first in line for crisis liquidity whenever trouble strikes (a huge implied subsidy), can nimble, entrepreneurial Fintech even survive? I believe that it will, but not without confronting these challenges. Indeed, as Uber and AirBnB have demonstrated in recent years, there are times when the single greatest challenge to tech is pushback from regulators. This may well be the case with Fintech for the foreseeable future. The ultimate challenge would be that of finding a way around legal tender laws, something that alternative, independent currencies are intended to do. Here, too, I wouldn’t hold my breath.