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Crypto’s Icarus movement

Bitcoin, the poster-child for cryptocurrencies, has shed more than two thirds of its value since the price for each ‘coin’ spiked to nearly $US20,000 last December. On Google Trends, a measure of global interest in a particular term, searches for ‘cryptocurrencies’ have followed a similar flight path to bitcoin and Icarus.

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Now the global bank regulatory body, the Bank for International Settlements, has delivered a withering assessment. In its just-released annual report the BIS gave a categorical ‘no’ to the question of whether cryptocurrencies could deliver on their promise of being a new form of money.

"[Crypto is] combination of a bubble, a Ponzi scheme and an environmental disaster.” - BIS

They are, in the bank’s view, “a combination of a bubble, a Ponzi scheme and an environmental disaster”. It’s an official assessment which, while completely rational, will no doubt inspire another bout of conspiracy theories - which helped fuel speculation in such currencies in the first place.

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Pic: Google search trends from 2016-18 for the term "cryptocurrency"

It’s not unusual for speculative bubbles to follow such a trajectory – and many point to bubbles in tulip bulbs, the South Sea and late 90s dotcom companies.

While fortunes are made and lost on speculation, often the underlying commodity does persist. Tulip bulbs are still popular with gardeners today, the South Seas are now an economic region and the world has been transformed by the mammalian rivals of the first dotcom era’s dinosaurs.

Will the same be true of cryptocurrencies? They promised a rival system to central-bank controlled and financial system mediated fiat currencies, one with vastly lower transaction costs and anonymity.

Meanwhile, the underlying blockchain or distributed ledger platforms can be used far more widely than a currency.

But there has been a growing resistance to such currencies which has surely contributed to speculators cashing out.

Critical

Most prosaically - as with any new technology and particularly one disrupting the financial system - as cryptocurrencies have grown and become more valuable, more critical attention has been focussed upon them.

The same happened with the internal fees on credit cards – it was only when the value of transactions became substantial regulators showed an interest. However credit cards maintain a significant role in the payment system albeit under greater regulation.

The BIS itemised the shortcomings of cryptocurrencies.

“These relate to their limited ability to satisfy the signature property of money as a coordination device and their questionable promise of trust,” it said. “Cryptocurrencies cannot scale with transaction demand, are prone to congestion, and fluctuate greatly in value.”

“And trust in them can evaporate at any time, owing to the fragility of the decentralised consensus mechanisms used to record and validate transactions. Not only does this call into question the finality of individual payments, it also means a cryptocurrency can simply stop functioning, resulting in a complete loss of value.”

In short, despite their sophistication, cyrptocurrencies are “a poor substitute for the solid institutional backing of money through independent and accountable central banks”.

Along with a growing number of others the BIS was careful to distinguish the false promise of a new currency kind with the underlying technology of distributed ledgers. It accepts there is potential for these platforms in simplifying settlement of financial transactions, for example.

However, the most damaging observation the BIS made was a superb piece of passive aggression.

“The emergence of cryptocurrencies calls for policy responses,” it said. “A globally coordinated approach is necessary to prevent abuses and strictly limit interconnections with regulated financial institutions.”

“In addition, delicate issues arise regarding the possible issuance of digital currencies by central banks themselves.”

In brief, like it or not, cryptocurrencies will be regulated, heavily.

Role

In a speech delivered at the BIS Annual Meeting, the bank’s economic adviser and head of research Hyun Song Shin delivered an assessment specifically on the economics of cryptocurrencies, looking at whether they could actually replace conventional money or even perform the role of money.

“Our assessment is that cryptocurrencies fall a long way short of being able to oust the conventional monetary system, even taking account of possible technical advances,” he said.

Shin emphasised two key failings: lack of scalability; and lack of finality of payment. He argued current systems lack the capacity to support growth and prevent congestion. Moreover, a payment being recorded in the ledger does not guarantee it is final and irrevocable.

“For cryptocurrencies, what counts as the truth is a matter of agreement among the bookkeepers,” he explained. “If a pack of them collude and rewrite history, the payment could be erased.”

“Payment histories interwoven through the system will then be subject to unravelling, giving rise to a new twist in the systemic risk of payments, where voided payments cascade through the system.”

Shin specifically avoided the scope for illicit activities but this is another fatal flaw in the case for cryptocurrencies.

Whether combating simple fraud or thwarting funding for terrorism, there is greater and greater attention being given to two governance concerns in global finance: anti-money laundering measures and customer knowledge – known as ‘know your customer’ requirements.

In making anonymity a central attraction, cryptocurrencies essentially market themselves as the system of choice for illicit activities which such governance measures are designed to cut off. Institutions simply cannot support the anonymous transfer of funds while at the same time satisfying regulation they know their customer.

This emerges even at a relatively trivial level. Both tax and labour invigilators have increased their focus on ‘cash only’ businesses which refuse electronic payments - not because this is in itself illegal but because such businesses are over-represented in both tax avoidance and underpayment of staff.

Ironically, one of our local eateries, with a suspiciously high turnover of usually young, poorly trained staff, has always been cash only. Now it has a big sign out the front saying ‘we take bitcoin’. It’s hard to say what’s riskier, the food safety standards of their takeaway or the potential currency plunge you’re exposed to in buying the bitcoin needed to pay for the takeaway.

Like tulips, the South Seas and the first dotcom bubble, a sustainable asset class may well emerge from the current cryptocurrency mania. It has certainly delivered technology disruption which has paved the way for smart contracts and other advances which can benefit from distributed ledgers.

But as far as control of currencies being ripped from the grasp of central banks and financial regulators, it is hard to go past the BIS view that cryptocurrency mania is a combination of a bubble, a Ponzi scheme and an environmental disaster.

Andrew Cornell is managing editor at bluenotes

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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