central banks

CRYPTOCURRENCY & BLOCKCHAIN: Regulators regulate, whilst institutions vacate

“Change is the law of life, And those who look only to the past or present are certain to miss the future”

 – John F. Kennedy

Wise words from the former U.S. president whose ambitions for change were, quite literally, sky-high – the pursuit of his administration to place the first man on the moon. Such ambitions for change are what push today’s entrepreneurs to rethink products, services, systems, and value delivery to end consumers, some notable examples are: Elon Musk’s private space company SpaceX and commercial e-vehicle company Tesla, Nikolay Storonsky’s challenger bank Revolut, and Satoshi Nakamoto’s decentralized digital currency Bitcoin. Yet some would argue that such examples, especially within FinTech, are nothing more than examples of regulatory arbitrage than providers of real value (from their underlying technologies, business models and ability to automate and scale.).

 According to Investopedia regulatory arbitrage is the idea that firms capitalize on loopholes in regulatory systems in order to circumvent unfavorable regulation (either because the regulation is not up-to-date, too slow to react, or restrictive to new entrants). Just last week we attended the OMFIF lecture by Denis Beau, First Deputy Governor of the Banque de France on ‘The role of crypto-assets in payment systems’, in which it was made clear that regulators do not have a clear cut solution to proactively address the speed at which crypto-asset entities like Libra, Binance, and Telegram move in order to ensure that they are compliant within the regulatory requirements of their operational jurisdictions.

 Now let’s talk Libra – the global digital currency and financial decentralized infrastructure that sought to empower primarily the billions of the unbanked and sparked a global debate over the role of cryptocurrencies in payments and financial services. Specifically, both private and public institutions alike have raised major concerns around the notion of a single global currency, Libra, running over new payments rails, and into a Facebook wallet called Calibra. All of which is managed by the Libra Association – a consortium of 29 private companies, including Visa, Coinbase, Spotify, Vodafone, and Andreessen Horowitz to name a few. Additionally, Libra was conceived by a global organization Facebook Inc. founded, in part, on breaking the rules, running up against the sub-global entities that created those rules, to operate a network and a currency that could unseat the power of central banks and governments to make fiscal and monetary policy.

 In early October, the Wall Street Journal reported financial partners such as Stripe, Mastercard, Visa, and PayPal were “reconsidering their involvement following a backlash from U.S. and European government officials.” Among those concerns was that Libra, backed by big private institutions, could create — as French finance minister Bruno Le Maire put it in September — “a possible privatization of money.” “The monetary sovereignty of countries is at stake,” Le Maire said – and there is a good chance he is right. But Libra threatens more than that, and both Le Maire and Beau probably know it. As regulators and governments have recently recognized that the actual idea of the countries themselves is at stake.

Needless to say that what was a tough sell at launch, has become nearly impossible four months later, and here’s why:

(1) Central banks need to accept the idea of an entirely new global financial network using an entirely new digital currency that is in part removed from their own fiat currencies (apart from those in the basket Libra is pegged to) and that could, at scale, compromise their ability to control their fiscal and monetary policies.

(2) Regulators need to be assured that Libra and Calibra – the network construct, the code, the initial digital wallet, the currency – integrates security features to prevent the likelihood of illegal activity i.e., money laundering, and ensures that, in the long run, no single representative of the 29 member consortia holds a disproportionate share of influence over the rest.

(3) Card networks and banks need to ensure that Libra and Calibra will complement their future growth and development strategy, rather than be a Trojan horse.

(4) Digital wallet providers require a similar surety that Calibra will accommodate their products and services beyond the initial P2P use cases that many of them already enable today.

(5) Attention Platforms need to be assured that Libra will help direct and enclose users into the platform via encouraged engagement and attractiveness of use (much like beautifully designed and integrated Apple software, quirky Snapchat filters, or Amazon's user-centric business model).

 Apart from this, each Calibra member has to be convinced that it’s collectively worth putting $1 billion into the Libra Association’s bank account to get it off the ground. Needless to say that over the course of the past month, seven of the Libra Association’s founding members -- mostly financial firms -- dropped out, namely: Stripe, Booking Holdings, PayPal, Mastercard, Mercado Pago, Visa, and Ebay. More importantly, Mastercard, Visa, PayPal, and Stripe represented a significant chunk of the strategic value and commercial leverage of the planned association, specifically, a huge number of payment processors and merchant touchpoints that the new cryptocurrency would need, were it to dramatically scale to the size Facebook wanted at launch.

This week, Facebook CEO Mark Zuckerberg discussed Libra before the U.S. House Financial Services Committee. Zuckerberg insisted that if America does not lead on digital payments via initiatives like Libra, foreign companies and countries will move in, perhaps without the same level of regulatory oversight. Specifically, he says, "China is moving quickly to launch similar ideas in the coming months," an allusion to the People's Bank of China's planned digital currency.

From what has been mentioned, it is clear that Libra has too many moving parts and nothing as a cornerstone to give leverage over regulators to be granted a green light, at least in the near term. Libra relied on the narrative that the financial system is broken and that the cross-border movement of money is too expensive and clunky. The only solution being a complete overhaul, the creation of a new network from scratch that would reinvent the process. Yet, the global financial system isn’t broken. The unbanked can still transfer money in minutes, via mobile money accounts (MPesa) or in cash. Entrepreneurs in emerging markets are using existing payment rails to ignite digital wallet schemes -- similar to the structure used by Alipay and WeChat Pay. 


INCUMBENT BANKS: If half the world's incumbent banks do not embrace digitalization, the next financial recession could wipe them out

We agree that this seems like a clickbait title, but there's a reason behind it thanks to the new Global Banking Annual Review 2019 report by McKinsey. Essentially the report centers around the notion that half of the world's banks are not viable due to their cost of equity being higher than their return on equity. This means that should a recession hit, the vulnerable banks will likely collapse. On a side note, to read on where we stand with regards to the digitalization of traditional banking, please refer to a previous entry here.

McKinsey notes that "Every bank is uniquely bound by both the strength of its franchise and the constraints of its markets or business model … their business models are flawed, and the sense of urgency is acute. To survive a downturn, merging with similar banks or selling to a stronger buyer with a complementary footprint may be the only options if reinvention is not feasible".

Regulators haven't helped either as newly passed regulations have aimed to increase transparency and boost competition by lowering barriers to entry, such as PSD2. These new regulations have been instrumental to consumers driving incumbents to provide more timeous, personalized, and cost-effective services across all their digital banking solutions. Whilst initially this seemed to only affect retail banking and asset management, there seems to be an expectation for similar service quality in corporate banking, capital markets, and investment banking. 

This is not the only report to raise an alarm regarding the vulnerable state incumbent banks currently find themselves in. Accenture's 5 Big Bets in Retail Payments in North America notes that "by 2025, nearly 15 percent of retail payments revenue will be at risk from card displacement by real-time payments, competition from non-banks and digital disruptors, and pricing compression" resulting in a future reality where banks exist as mere funding sources and not primary, customer-facing retail payment leaders. That 15 percent equates to a cool $82 billion directed to FinTech firms from incumbents over the next 3 years. Moreover, Accenture list five bets that show promise to help drive transformational change in the future of retail payments: (1) Reinvent revenue through new value generation, (2) Jettison legacy tech using agile technology as a foundation, (3) Run with the unicorns by embracing collaboration with FinTechs, (4) Spin data into gold via leveraging deep data analytics as the key, and (5) Treasure trust via safeguarding the consumer's best interests. 

The assault on incumbents has not purely stemmed from consumers and regulators but central banks as well. The European Central Bank (ECB) recently kept its key interest rate at a record low of -0.5 percent, whilst The Fed cut interest rates for the third time this year. With such interest rates, banks have had to pass the negative rate burden onto their customers, such is the case with Berliner VolksbankUniCredit, and Spar Nord. That being said, it seems neobanks are taking a revolutionary stance by giving consumers a way out of this mess. Whether it's Venmo moving closer to the likes of Varo, Chime, Cleo, Stash, and N26 by announcing their first-ever credit card as part of a partnership with US-based consumer financial services company Synchrony, or zero-fee stock trading app Robinhood launching Cash Management -- a feature that earns users 2.05% APY interest on uninvested money in their account regardless of the balance. Competing directly with Betterment's 1.79% APY, and Wealthfront's Cash product with 2.07% APY interest (20 times higher than that offered by an incumbent bank). It's only a matter of time before we start to see some fireworks, let's just hope they'll be celebrations of new partnerships, rather than commiserations of missed opportunities.


CRYPTO: Can Stablecoins jumpstart the digital economy?


We are bummed with the SEC's rejection of pretty much every effort to launch a Bitcoin ETF, which is at the top of the wish-list for normalizing crypto currencies and assets. The investment management value chain is now caught in a weird race: (1) either crypto custody will become regulated and build tendrils to plug into existing infrastructure, or (2) a regulated wrapper, like an ETF, must contain underlying crypto assets, and then travel along into asset allocations of regular investors. Neither is going to change the mood of the market tomorrow. So instead of focusing on financial progress, could the crypto economy show some economic progress? 

A recurring thesis for spurring on that economic activity, supported by continued investment from crypto funds and ICOs, is the emergence of stablecoins. The argument goes that if you have a virtual currency that stays pegged to the US dollar, for example, then the currency can be used to buy and sell goods without the fear of volatility (or capital gains on buying a sandwich). It can also work as a unit of account in which other assets are traded. And if we can figure out how to dampen volatility in the markets, perhaps that will also be seen as a positive by the SEC. A lot of ink has been spilled on how different projects are different -- but at the core, this is an automated macro banking algorithm that must maintain price parity, backed by assets, leverage, or fraud. One that can be manipulated or broken (e.g. below, Nubits).

We see stablecoins as incrementally helpful, but not sufficient. You still need a fiat/crypto equilibrium mechanism, and if a stablecoin becomes large enough to maintain a digital economy, it comes into direct competition with the United States government, its monetary policy, and its police force. It is highly unlikely that the US will let a decentralized or private actor print the equivalent of dollars. Who knows, maybe a central bank issued coin is still a reality -- take for example,Thailand, which is working with R3 on interbank transfers. While this isn't what most Bitcoin enthusiasts would want, the USD is the best peg to USD. Let's just get people to hold it in a Bitcoin wallet -- which is why rounding your change into crypto using Revolut, or getting a blockchain-native phone once it's out, could be so meaningful.


Source: Medium (Nathan Sexer on Stablecoins), WSJ  (SEC rejection), CoinDesk (Thailand bank coin)

REGULATION: Convergent Evolution of Financial Standards

Source: IMF

Source: IMF

Convergent evolution in nature is a fascinating phenomenon. Organisms that have entirely different histories can develop similar solutions to a recurring problem in the environment. For example, take the flight skills of birds and bats, or the eyes of mammals and cephalopods. Natural selection has a way of chiseling away at wetware until we get a serviceable answer. In a similar vein, we expect to see similar governance outcomes in the traditional financial services industry and the crypto economy. And we don’t mean the vanilla stuff, like the regulator presence, or industry boards that create standards. Instead, we are pointing to two different phenomena that should have the same effect: (1) the Dodd Frank legislation requiring capital standards from banks (and especially the FSB rules for Globally Significant Banks), and (2) the steady move in several public blockchains towards Proof of Stake.

Let’s back up. In traditional finance, sentiment and impression of financial stability is key to the functioning of the system. The simple reason is that banks are massively levered, especially when involved in capital markets activities, like trading and investment banking. And even in the case of the depository bank, the bank lends out the deposits it collects from clients. A run on the bank occurs when all the clients try to pull funds out at the same time, learning that the funds aren’t there, and causing further panic. Thus things like government insurance (FDIC). And in complicated cases like 2008, the run was on the banks by the banks themselves. When Wall Street thought Lehman couldn’t pay its overnight commercial paper because it was insolvent, credit dried up. And so did Lehman.

Which brings us to capital requirements. In brief, this is a regulation that forces financial institutions to hold a certain amount of assets on its books, rather than circulating out there in the markets earning a return. Instead of being 30x levered, you may only do 15x or 20x, depending on how important you are and what assets you hold. Having cash on the books is better than a bunch of junk bonds, and so on. When a confidence crisis happens, the institution – so goes the theory – will have enough buffer to absorb a shock, and no government insurance is needed. In the abstract, that means that today’s banks all hold assets in order to participate in the financial system as players (and take their economic rents). But remember the refrain – banks supposedly manufacture trust, trust in the economic system, in the presence of cash, in payments, in commerce. This capital is the government’s (and if we believe in effective representative democracy, it is our) way of putting institutional “skin in the game”, which scales with importance to the industry.

If you know your crypto consensus mechanisms, you may know where we are going. Today’s Bitcoin and Ethereum chains are secured by a computationally expensive method called “Proof of Work”, where the “Work” is the burning of electricity to power processors good at solving arbitrary math. Various groups are unhappy with this power consumption, and the centralization of mining power it has caused whispered complaints. Different consensus algorithms exist, as do controversies about them. But generally speaking, approaches like Proof of Stake, or EOS’ Delegated Proof of Stake, will work of crypto resources instead of physical ones. Your “stake” is the capital you hold, that may be committed to participating in the system and manufacturing trust, through voting or forging or something else depending on the project. Built into the economics of committing such capital to validate blocks is a probabilistic rewards, which looks a lot like interest on average.

Source: Cointelegraph

Source: Cointelegraph

What this means is that crypto and banking have converged on the same solution. Some central authority declares the guidelines of the system, and how much capital is required to be committed to keep it humming along. Then, parties that manufacture trust put this capital aside as table stakes to be in the rent-taking business. And, by the nature of the beast, scale efficiencies of running such operations lead to consolidation and some form of global oligopoly A large bank today may find such a system to be pretty familiar and comfortable – and they certainly have the capital to deploy. Goodbye crypto utopia!

CRYPTO: Economic Rent-seeking is Universal

Source: American Institute for Economic Research

Source: American Institute for Economic Research

The post-AI and post-crypto world will reconfigure many of our basic economic assumptions and requires a bit of philosophizing. So forgive our attempt, but we need to talk about economic rent-seeking and wealth creation. The Peter Thiel definition of building a successful company is to discover a piece of information around which a monopoly can be built. Building a monopoly is the primary reason that supports the venture capital industry model of rushing to massive unprofitable scale fist, and then creating moats and extracting value (i.e., economic rents from the monopoly/oligopoly position). See Amazon, which has leveraged not-caring about profitability into an unshakeable bedrock of retail. And once you have rent-seeking monopolies in place, they grow tendrils into media, politics, and customers -- and are very hard to remove. This snowballs and leads to extreme inequality, which is exacerbated by the power laws of software and the attention economy.

In the crypto world, there is a techno-utopia story that posits that a decentralized open technology ecosystem will be the antidote to centralized institutions that are controlled by questionable interests.  A key argument by bitcoin maximalists is that central banks print fiat money at will (often at the behest of bailing out Wall Street), which represents debt that erodes regular people's hard-earned savings through inflation. The argument goes that Bitcoin, on the other hand, has a fixed supply of currency and therefore cannot be manipulated to enrich some particular hegemonic party. This view is unsurprisingly contentious and only tells some of the story. We may be upset with instances when governments, which are to some extent accountable to citizens, use sovereign power to lower our purchasing power. But does that mean anyone and everyone else should be able to do the same?

Crypto currency and tokens issued by projects, through ICOs or reverse ICOs or airdrops or forks, are all a version of money printing. Mature capital markets do this all the time, through the issuance of debt and equity that time-shift financial resources to enable productive use. We allow and regulate such activity to encourage economic growth -- but may rightly be concerned that oligopolies have captured the process and are taking economic rents by being closest to the river of money. But does that imply that any individual at any time should be able to issue personal currency in billions of flavors? And that those most enriched by this process are those with the highest control of the attention economy -- i.e., the armies of bots pushing the latest altcoin, the ICOs with the best bounty programs, the biggest celebrities, the largest pump and dump Telegram groups? Disagreeing with central bank policy execution does not imply a right to be a Bernie Madoff.

While the stated motivation for much of the crypto movement has been to solve economic rent seeking by traditional finance and governments, we are now at a place in the industry where crypto is full of rent-seekers. Crypto investors have focused on owning the protocols of the new world. That means owning the highways on which information travels and taking a toll (through capital appreciation) any time someone uses the highway. Is that a productive outcome for global wealth distribution? Look at the blockchain name game and the reverse ICO phenomenon. Telegram is aiming to raise $2 billion for which it will give out no equity, with 52% of the tokens will accrue to the company owned by the founders. Looks like a self-minting of billionaires - a massive economic rent on controlling a popular messaging platform that dilutes the ecosystem. And that's not to mention the self-enrichment from premining in forks like Bitcoin Gold

But the traditional system is catching on! See Japan's largest bank, Mitsubishi UFJ Financial Group, which plans to launch its own coin in 2018. If it is okay for tech firms to extract this type of value, then those who are most familiar with the money printing process will do it too. As another data point, Bank of America has more blockchain patents than IBM, trying to create intellectual property control over a resource that is meant to be open source and free. We need only look at the sideways journey of the web -- with the loss of net neutrality and the walled gardens of Facebook and its newsfeed algorithm -- to understand the danger of unabridged rent-seeking behavior on public goods.

So after all that, what is the answer? We don't have many. But we know at least to (1) highlight that rent-seeking is a universal human trait that exists in all types of communities, and (2) avoid cultish beliefs that are allergic to evidence. Penny for your thoughts?

FINTECH: Behold Production Blockchain!


With public crypto funding at $700 million in November alone, it is easy to forget that anything else matters. But let's check in on the progress of sovereigns and incumbents in capturing and controlling blockchain technology. Take for example, the Australian Stock Exchange working with Digital Asset Holdings ($115 million in venture raised) on replacing the entire trading chassis with a proprietary "Distributed Ledger Technology", i.e., a private blockchain with the attributes of confidentiality and scalability.  ASX is moving forward with DLT as a production system, which is a big deal. For context, the sum of market capitalizations on ASX is $1.5 trillion, or 3 to 5 times larger than all of crypto. Which of course raises the question of how private and public chains will interact. For that, see AionPolkadotBlocknetWanchain, and various others.


Another development is the growing progress towards sovereign digital currency. Certainly the US Federal Reserve is flirting with the idea, especially after Russia has indicated strong interest in building the crypto ruble. Also surprising is the news that Venezuela, famous for putting people in jail for Bitcoin mining, is going to launch its own cryptocurrency. The planned offering sounds like an ICO of the country's national resources. If you can't beat them, join them.

The silliest data point we've seen is this. Bulgaria, a country with a $60 billion GDP and $16 billion of national debt realized it owns on $3 billion of Bitcoin, which was seized in a law enforcement action earlier in the year. 5% accidental GDP growth (or 20% national debt repayment) is nothing to sneeze at. Will Bulgaria go long BTC or hedge out some of that risk using CME futures? Or, manipulate public opinion with some soverign propaganda bots to impact the price?

Source: Australian Stock ExchangeDigital Asset Holdings