Crypto and the ghost of banking past — Bitvo
Banking is a great business. Sometimes, it can be a brutal one.
In order to make banking work, there must be some safety valves. These valves are various entities, financial products, and legal frameworks that create a series of options in a dynamic system.
The system has key consumer benefits: storage or custody of funds, payment options, financial advice, and access to capital. But all of this is based on something ephemeral.
Confidence.
The entire money creation, storage, and transmission system is based on the intrinsic value of confidence.
We saw this in 2023 with the fall of Silicon Valley Bank and a couple of others.
The efficacy of specific crypto projects relies on the same ephemeral idea of confidence. The difference is that in the traditional system, there is regulation and a series of authorities to step in and guide the system in times of stress.
One of these is the central bank.
The origin and purpose of central banks is a hotly debated topic. However, a more interesting question might be, if we look at the evolution of banking, does crypto need its own version of a central bank?
Heresy, I know, but let’s explore this a bit and see what comes up.
When banking is brutal
If you watched the drama earlier this year, you could see the brutal side of traditional banking.
Banks are heavily regulated and have certain responsibilities. One is to have enough liquid cash to meet requests on demand. The balance is invested in instruments that help them earn a spread between what depositors receive and what the government or mortgage bond, for instance, will pay them.
They also lend money by creating credit, otherwise known as money creation, where they earn a return. These are essentially performance contracts.
Despite a relatively simple business model, there is key risk management required to make this system work. As we saw in 2023, what worked for years can suddenly go sideways with a simple change in rates and an adjustment in confidence.
The corresponding liquidity event saw demands for cash exceed available cash. That meant selling assets. But those assets were long-dated debt products at lower rates. Therefore, the price of those bonds had fallen precipitously.
Selling these bonds during such an event is either done at a severe discount or, in some cases, certain bonds may not have a bid to hit. Either way, these events shape a flywheel like deterioration in confidence.
And what results is a banking crisis.
This was the reason the Federal Reserve Bank was founded.
The Federal Reserve
The Federal Reserve is not the first central bank in the US. It is actually the third attempt.
The first central bank was from 1791–1811. Its charter was not renewed in 1811 over in part concerns over foreign ownership and the potential for transfer of all important gold reserves overseas.
The second bank started in 1816 and was closed in 1836, leading to the free banking era until 1863. During this period, banking was under the supervision of the individual states. The period was littered with numerous banking problems and failures. This was all brought back under Federal authority with the National Banking Acts of 1863–64. The Acts had numerous flaws and failed for a variety of reasons to address liquidity problems related to demand deposits circulating currency relative to treasuries and so on.
One of the big challenges of the periods between central banks is that monetary policy returned to the states. Each state had its own banks, and some banks created their own paper notes. So, without a single currency, there are all kinds of problems you can run into, including valuation differentials and sometimes non-acceptance.
There were similar situations in Canada prior to the Bank of Canada in 1935.
State banks found themselves running into confidence problems on a somewhat regular basis. And they had nowhere to gather the liquidity required to meet demands, leading eventually to failure.
On occasion, these panics manifest in stock market panics, causing disruption.
Now, the story in the US was that after the panic of 1906–07, J.P. Morgan provided a loan to address the problem. Of course, the problem then became, does it make sense for one man to have that degree of power over a nation?
This led to the current Federal Reserve Bank of 1913. The Federal Reserve Act included several private regional banks that would manage rates and money supply in their respective regions. Eventually, the Federal Reserve system moved from a regional-focused rate to a single national rate.
Initially, the Fed was authorized to buy corporate bonds to help stabilize the market. But in WW1, they were instructed to buy government paper to control rates. This is because war is historically inflationary. This mandate to buy government bonds was never reversed.
As of September 2023, the Fed has around $8 trillion in various securities on its balance sheet. The bulk of which are US government and mortgage securities.
The US dollar as the world reserve currency
1931 was a year of sovereign defaults worldwide, but not in the US. According to economist and former hedge fund manager Martin Armstrong, the result of sovereign defaults across the world was a flood of gold and capital into the United States instead.
By 1933, around 9000 US banks (outside of the Federal Reserve System) had failed, resulting in a banking holiday. What followed were three key executive orders by Roosevelt. The executive orders made holding and transferring gold by US citizens essentially illegal.
As a result of Executive Orders 6073, 6102, and 6260, there are claims that Roosevelt effectively declared US bankruptcy in 1933. It would be more accurate to say that the US defaulted on its gold-backed bonds by replacing gold convertibility with paper currency.
1933 was also significant because it was the start of Roosevelt’s New Deal policies, which included the Securities and Exchange Act, the Banking Act, the FDIC, and later in 1935, the creation of Social Security.
By the end of the war, capital, gold, and labor flooded to the US. So, in 1944, the Bretton Woods Agreement established the US dollar as the world reserve currency. This agreement established the relationship between the various Western nations in terms of money convertibility and the role of gold.
The US formally left the gold system in 1970, ending the 1944 Bretton Woods agreement. It was here that the US defaulted on its debt. Following this was the start of the floating fiat currency era, which began in 1971.
The Fed has remained an integral part of the international monetary system since.
Today, we see parts of a sophisticated international monetary system that is driven by a wide range of inputs, including geopolitics, fiscal policy, borrowing in US dollars, and numerous other inputs.
Modern crypto arrived on the scene just as the last financial crisis was coming to a close.
Crypto infrastructure
When Bitcoin dropped in 2009, the Federal Reserve was wrestling a giant elephant of a financial debacle. They used quantitative easing liberally, buying various securities at par. They lowered interest rates and changed how reserves are calculated on the balance sheets of banks. This is the HTM (Hold to Maturity) assets that everyone was suddenly looking at earlier in 2023.
Crypto, at the time, was introducing the equivalent of an economic seed. The seed was a ledger, complete with a fully automated payment system and an exchangeable asset.
From there, the crypto system has defined itself around a series of benefits that are in contrast to modern banking.
One of the key benefits of crypto revolves around the concept of decentralization. The idea, you will recall, is that not having any one point of failure reduces risk and losses.
This benefit is provided by the distributed ledger. The ledger or blockchain creates numerous exact copies of the ledger, providing accurate, immutable records of ownership, provenance, and security spread across the globe. There was also self-custody.
And the tokens that reward the miners for securing the network, maintaining the ledger, clearing transactions, and forming a block become a source of currency creation. The value of the reward in the form of a token is a reflection of work successfully completed.
The peer-to-peer nature further decentralizes exchange by giving two or more individuals the ability to transact in a private, semi-anonymous manner. It’s like cash but through digital means.
If we look specifically at Bitcoin, we see a ledger copied across multiple nodes and maintained by miners and a network. All of these elements represent infrastructure.
The infrastructure facilitates trade and exchange of value, information, and a form of free financial expression.
And the tokens, which in the case of Bitcoin are fixed in total issuance, eliminate taxation through inflation.
Payment Infrastructure Supremacy
Fast forward fourteen years later, and Bitcoin started a race to build payment infrastructure. In crypto, a million plus projects have created new concepts, some have failed, and new experiments abound.
Alongside this, numerous announcements across fintech and government are being made, telegraphing the key importance of the infrastructure.
When Circle launched USDC, there is little doubt that Allaire envisioned the potential for the project to be adopted as a CBDC or substitute. This might explain why PayPal has recently announced its own stablecoin. And it is likely we will see others vying for a piece of this potentially lucrative and powerful position.
VISA and Mastercard have also been active. They are innovating rapidly, including settlement in various cryptocurrencies and numerous investments in cutting-edge technology.
In September, SWIFT, the international payment consortium, announced multi-chain settlement across various blockchains with the help of Chain Link (LINK), which is significant for a couple of reasons. One is because SWIFT is the big dog in space. But also because it was the weaponization of SWIFT by cutting off the Russians in 2022 that appeared to further accelerate international payment infrastructure development.
China is working on its own CIPS system while attempting to create a new dollar alternative through the other BRICS nations.
There are also numerous fintech operations developing payment infrastructure, including Stripe and Fiserv.
And crypto is very much a part of the picture. Bitcoin is payment infrastructure. Ethereum, with its DeFi layer, is a form of payment and settlement infrastructure. Every legitimate crypto exchange and trading platform is also part of this infrastructure.
And this is the race that the CBDCs are competing in.
But crypto has grown a lot since 2009. And it could be argued that crypto might have a Federal Reserve problem.
The Crypto Federal Reserve problem
Now, when we talk about a Federal Reserve problem, we’re not talking about the Federal Reserve founded in 1913. In this case, we’re going to look at crypto as a system, not unlike banking between central banks in the United States.
You will recall that in those periods, it was a bit of a wild west. Different state banks had their own currencies. There were numerous runs on banks. When liquidity dried up, there was no lender of last resort, and many went belly up.
Since the founding of Bitcoin, there have been thousands of projects created. And many thousands have failed.
Lots of these projects are unique blockchains with their own tokens or currencies. Many of these are chain-specific and difficult or impossible to use outside of its chain-specific infrastructure.
Bridges like LayerZero and wrapping tokens like WBTC are helping to address some of this. But these are typically confined to the top chains and their tokens.
In 2022, we had the equivalent of a banking crisis in crypto.
That crisis involved lots and lots of leverage, including the layering of leverage by “hedge funds.” Terra, which attempted to create the crypto version of the Federal Reserve, vaporized itself, choking on its own hubris. Others used funds in ways that failed to take into account some basic financial rules and some moral ones, like with Celsius.
And when you go back and look at 2022, what you see is shockingly similar to the banking problems that go all the way back to the 1800s. No, crypto isn’t banking, but it is amazing that the parallels to past financial paradigms are pretty similar in a lot of ways.
Now, like the states running their own banking and money creation, crypto is now at something like 1.8 million projects, give or take. In contrast, these are international in nature, thanks to our modern networks. These projects cover a wide range of areas, and many of them are part of a vast exploration of value discovery and creation. This is good.
But one question will be, will there be a single standard?
The Bitcoin maxi’s believe there already is.
But what they haven’t considered is what Armstrong said in a recent interview about returning to a hard money system. That is a system backed by a fixed asset in order to control money creation and the ravages of inflation.
Armstrong said if you go back to hard money, you have to change the whole system. Why? Because politicians won’t be able to make the kind of promises they do today in a fixed monetary system.
However, in the meantime, a question might be, are we seeing any examples of a system where Federal Reserve-like qualities are being explored?
Does Ethereum have its own reserve-like system?
What’s exciting about crypto is the development of numerous ideas based on an innovative process. This means that things can be tried, go sideways, and either be improved or abandoned. Throughout the last decade, we’ve had the opportunity to see an accelerated version of new ideas around money, payment infrastructure, and security.
We’ve also seen a wide range of discussions about money, monetary systems, and potential solutions. Seeing some of these get tested in real-time, and the opportunity to participate in them through trading and holding some tokens in given projects is a powerful way to participate in rapid discovery of efficacy.
Reflecting on the current market environment, Ethereum, for example, shows us the beginnings of a system with a flexible token system. Tokens can be created and be burned. They aren’t static. The participants can stake for the proof-of-stake consensus. The project is open source and has a large community of developers working on Ethereum and on the DeFi layer on top of it.
You could argue that DeFi is a bit like the free banking era in the US during the 1836–1863 period. Lots of things are being tried. Some are failing. Money is being lost and gained. But if the whole system was one-sided, as in, the consumer could only lose. There is no way it would survive.
However, in traditional markets, it is well known that people lose lots of money in the market and keep coming back for more.
In other words, in Ethereum, customers and users can contribute in a variety of ways to the development of the system. It is this participation that makes the system more antifragile. This is why, in a sense, crypto is more risky than plain vanilla banking, but it also means that over time, the relationship also has more symmetry, depending on the scope of participation.
This doesn’t just apply to Ethereum, but to several other chains as well.
And as we have discussed previously, we might be coming into an era where one currency or token is not necessary. We may benefit from several with a variety of unique characteristics.
Some could be deflationary, others inflationary and others neutral all depending on the use case.
But what is clear is that it isn’t just a money question. It is the transmission, custody, and transmission of money that matters. And crypto has joined a vast competition that centers around payment infrastructure, but with benefits.
What is crypto’s answer to its free banking era?
When Musk took over Twitter, there was much fanfare about his contribution to freedom of speech. We opined that it might lead to accelerating crypto adoption.
Instead, the platform has taken a different path.
Twitter was rebranded to X and is being converted into an everything app. Or, put another way, Twitter is being converted into a service with integrated payment infrastructure. We saw FaceBook try this with Libra and then Diem before selling the project to Silvergate. And it is likely that we will see other platforms develop this financial infrastructure. Apple, Google, and Amazon are already in the game.
But it is crypto that is moving the ball along in novel ways.
At first, we saw the space borrow extensively from traditional finance. You see this in the design of your trading screen, the function of futures and options, perpetuals, stablecoins, and other financial products. Then came some departures, like smart contracts and the development of DAOs, DEXs, and AMMs. Then, different kinds of tokens arrived, which are in the process of evolution into unknown and unknowable abstractions that may become new financial products.
But crypto has also demonstrated that as a, let’s call it a sector, it has many of the same problems as the banking system it borrows from.
The lending model, when it uses credit creation rather than lending specific reserves, concentrates risk. The 3AC story of using leverage across numerous crypto services layered risk leading to implosion. Celsius using customer funds as their own to generate unrealistic returns led to a chain of very bad decisions.
And while some of these led to a three trillion market cap, it took away two-thirds of that in a hurry.
Leverage and concentration create the antithesis of the decentralized talking point.
Banking is a great business. But sometimes it’s brutal.
But does the space need a stabilizing force? If you want the benefits of modern banking at your disposal through crypto, a solution might be required.
However, whether that’s the right path or what the solution might be should be open for debate.
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Bitvo is a crypto trading platform regulated with FINTRAC as a Money Services Business and as a restricted dealer with the Canadian Securities Administrators.
Originally published at https://bitvo.com on September 18, 2023.
