Is Traditional Finance Doomed? Part I

Summary

• Crypto and DeFi offer an alternative, de-regulated system for banking and finance.
• But despite the crypto boom, many believe fiat currencies will remain dominant and are more reliable for investors.
• Meanwhile, G7 central banks have responded to the emergence of digital currencies and are exploring CBDCs.
• Should CBDCs take precedence, commercial banks are unlikely to disappear and will act as the ‘middlemen’.

The End of Traditional Finance?

Crypto and the concept of decentralized finance (DeFi) are taking traditional finance by storm. And it is easy to see why: they offer alternative, more accessible means of investing and banking compared with the heavily regulated, centralised system of banks and financial institutions. For some, DeFi and crypto will eventually replace such official entities and democratise the movement of money.

We spoke to CEO and Co-Founder of FRNT Financial Stéphane Ouellette to find out more:

‘I think it’s quite clear what the most popular use case for cryptocurrency is – essentially being used as an alternative currency, alternative investment, so people are either getting into bitcoin to spend it eventually, or they’re viewing it as a potential alternative currency that will continue to grow, and the infrastructure around payments will grow.’

Beyond offering a deregulated system, crypto can also help distribute universal basic income by ensuring more efficient and automatic delivery of payments. Additionally, crypto enables quick and cheap cross-border payments that are not hindered by high exchange rates and regulations, and it offers more secure forms of payment.  

But will crypto completely take over traditional methods of payment?

From Fiat to Crypto

Despite the crypto boom and an estimated 22% of Americans owning bitcoin, it is still highly volatile and tied to broader market fluctuations and investor sentiment. For example, the recent price fluctuations for crypto have been a result of the Fed’s commitment to lower inflation and the market’s response to the dreary macro outlook. That volatility means some investors consider crypto too risky and speculative, preferring to stick with fiat currencies and traditional investment vehicles.

Senior economist at Deutsche Bank Marion Labour gives her take on crypto’s competition with traditional finance:

‘I wouldn’t say that crypto has a very high competitive advantage compared to what finance is offering. The main difference is with issuing the money. When you talk about fiat currencies, it’s issued by your central bank, where with crypto it’s decentralised. But apart from that, I wouldn’t consider crypto as a means of payment.’

Can Crypto Challenge the Dollar?

But not everyone agrees. Morgan Stanley’s former Chief Global Strategist Ruchir Sharma argued that bitcoin may end the dollar, and a sinister report from the Financial Times suggested that bitcoin’s rise reflects America’s decline.

However, what the dollar has that crypto lacks is government backing. That is by design, of course: crypto sells itself as deregulated and decentralized. But it means investors – especially institutional – are more likely to trust the dollar than crypto. And it remains the world’s reserve currency, with 59% of all foreign bank reserves denominated in USD.

Even most stablecoins, which as the name implies target stability, derive such stability through pegs to government-issued currencies like the dollar. That means the importance of the US dollar as a store of value will persist.

Moreso, the role of central banks are unlikely to fade soon. As Laboure says,

‘…what we are seeing is central banks have the last word. They are the institution rescuing many institutions when you have a crisis… [cryptocurrencies] are very volatile, and they are not regulated. So, regulation is coming; volatility, I don’t think it’s going to end anytime soon.’

Central banks are unwilling to relinquish their pre-eminence. And faced with the rapid evolution of DeFi and digital currencies, many are experimenting with central bank digital currencies (CBDC).

CBDCs: The Next Disruptor

With the onset of digital currencies, central banks worldwide are showing an interest in CBDCs. Currently, 105 countries are exploring them, and 10 countries have already launched a digital currency. China was the first to pilot a CBDC. At the end of October 2021, 140 million people had reportedly opened wallets for eCNY. And Nigeria was the first to launch a CBDC (the eNaira) in Africa. Despite crypto’s current woes, clearly the underlying concepts are alluring; G7 central banks have now expressed interest, too.

The Fed has issued a white paper contemplating its own CBDC, noting it would be a safer digital asset for the general public and incur greater financial inclusion for vulnerable households. However, demand for bank notes has been rising in the US and euro area, which could induce hesitancy around a complete transition to CBDC. Demand for cash in other advanced economies such as Sweden, however, has been declining, which could have the reverse effect (Chart 1).  

In the UK alone, only 23% of payments in 2019 were cash, and the COVID pandemic accelerated this decline even further by 35% in 2020.

One clear benefit of a retail CBDC is that central banks can issue it directly to the wallets on ordinary people’s smartphones, increasing accessibility for those who cannot access private banking.

So is there a chance CBDCs will replace cash? Laboure says,

‘It’s not aimed to completely replace cash, and most central banks made it clear that cash, physical cash, and CBDC will coexist in parallel. So, I don’t think there is any idea to replace cash suddenly, but obviously the use of bank notes has decreased on the long-term basis, and the pandemic has really accelerated the decline of cash as a mean of payment.’

Moreso, although China’s CBDC is cited as a case study for many central banks, the reality is complicated, and it faces economic and political challenges. CSIS found that although there are over 261 million e-CNY wallets since April 2022, most of these are inactive and empty, and the average balance is less than $0.50. According to the Economist Intelligence Unit, some barriers preventing people from investing fully into CBDCs are a lack of education and technical literacy.

What Will Happen to Commercial Banks?

CBDCs have strong potential to become competitors with commercial banks. It would mean that an ordinary person can hold savings at a central bank rather than a commercial one, which is less risky. However, given the disruptive nature of CBDCs, central banks are proceeding with caution despite no implication of a decline in commercial banks.

The likelihood of a complete wipeout of commercial banks is extremely low, and most experts see them acting as the ‘middlemen’ if CBDCs take off. Marion says,

‘What commercial banks and central banks are doing currently [is], say the consumers have the bank account directly at the commercial bank and the commercial bank is liaising with the central bank. This is what we have currently. What they are planning to do in the case of a CBDC is the consumers will hold the bank account at the central banks, but the relationship will be mediated by commercial banks.’

According to a BIS working paper, too swift a shift to CBDCs could throw existing financial institutions off balance, but it concluded that a slow transition could make the system more manageable. The bottom line is that CBDCs far from implementation, but their eventual emergence seems almost certain. G7 countries are actively exploring the idea, but hesitantly, wanting to avoid destabilising the current financial and banking system.

Bottom Line

Although crypto is creating a space to make banking and finance more accessible, the chance of it overtaking traditional forms of banking is slim. We need only look at the recent stablecoin crash to understand the major hurdles facing the technology.

However, central banks have noted the advantages of digital currency and are exploring the possibility of implementing CBDCs. Again, CBDCs are unlikely to completely disrupt the traditional banking system in G7 countries, yet a future banking system with a centralised digital currency does not seem so farfetched.

Sarah Blaseby is the Editorial Assistant at Macro Hive. She studied English and History at the University of Leeds and has two years of work experience in the publishing/creative industry. 

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)