Bitcoin has been around for more than 10 years, but the gatekeepers of our fiat money have yet to make a convincing case for how cryptocurrencies and fiat money will co-exist in our financial system.
Why we need to do more to maintain trust in our currencies
By Paul Koster, CEO European Investors
Can you believe it? One Bitcoin can now buy you two Fiat 500’s (provided the dealer accepts Bitcoin) and still leave you with change (in regular euros?) for a nice Italian espresso. Bitcoin broke the $30,000 barrier on the last day of 2020, jumping more than 20% in that last week of December. There seems no end to the upside of this ‘young’ currency.
Currency plays a central role in our economy. In the book “Money”, Jacob Goldstein explains how societies moved from monies with intrinsic value like coins made from precious metal to paper currencies. Goldstein describes how in the 1200s Kublai Khan broke with precedent by severing the link with precious metals so that money became “almost a pure abstraction, backed by nothing”. Goldstein highlights the social side of currency–belief and behavior–and that money changes when society does.
The key to any currency is trust and the belief in the value (purchasing power) it represents. Once expectations are violated, confidence drains and people begin to fear holding money. From WWII to 1971, the U.S. participated in the Bretton Woods system, which fixed exchange rates among the major currencies. With the U.S. abandonment of the gold standard in 1971 (part of series of measures by President Nixon to halt inflation), all world currencies became fiat money, which lacks intrinsic value. This put pressure on governments to manage the stability of their exchange rates to protect their economies against volatility. Hyman Minsky so pointedly argued ‘anyone can create money, but the problem lies in getting it accepted’. This problem was compounded by the collapse of the Bretton Woods system.
Bitcoin was developed as a response to the ongoing printing of money by governments, also known as Quantitative Easing. Central Banks focus on tampering the volatility of the markets at the cost of ballooning balance sheets and centralized support for specific asset classes. Central Banks, the gatekeepers or the overseers of the financial system, have erred before on this front. It is worth considering the words of Friedrich von Hayek, a staunch free-market defender and principal proponent of libertarianism who sought limited government intervention. He once said, following the unilateral U.S. abandonment of the gold standard in 1971, ‘I am convinced we shall never have ‘good money’ again so long as we leave it in the hands of government. Government has always destroyed the monetary systems’.
Proponents of Bitcoin argue it is a good substitute for the currencies currently in use. They fear the growing debt mountains worldwide in relation to the future value and stability of money. The purchasing power of fiat money depends on the issuer’s economic strength and how its money supply is managed. As Ludwig von Mises, an important Austrian School economist explained, ‘Money is not neutral with regard to the real side of the economy, rather it intervenes in the real affairs of the economy and affects output, employment, interest rates, allocation of resources and so on.’
The following historic event might explain some of today’s legitimate concerns of government intervention and the growing debt mountain: in 1933, President Franklin Roosevelt, depreciated the dollar in relation to gold in a bid to pull the United States out of the Great Depression, effectively annulling all its debt obligations. By some it was seen as “the most serious question of national dishonor” especially since the Administration had issued, a few weeks earlier, half a billion dollars of notes that included the clause and promised payment in gold coin. But against the backdrop of the growing economic crisis, it was felt that it was right “to cease to pay tribute to the gold standard at the expense of the citizens.”
Distributed ledger technology — the technology that underpins Bitcoin — offers a store of value without requiring a government or trusted intermediary to protect the value of users’ holdings. Furthermore, bitcoin and other cryptographic assets have opened the way to innovations in our (outdated) payments system. Bitcoin facilitates peer-to-peer transactions throughout the world, at lower transaction cost and faster speeds than most traditional forms of cross-border payments. In contrast to services like PayPal or TransferWise where a digital IOU is sent instead of actual money, in crypto, the recipient possesses the actual value without relying on third parties. If you wanted, you could pay your employees in bitcoin without relying on a bank or any other intermediaries (although this raises questions on how to deal with this tax-wise and accounting-wise, which we will deal with later).
Given their growing popularity, cryptocurrencies and crypto networks could bring about permanent changes not just to how payments work, but to how society functions as a whole. However, the future of this technological innovation depends to a large extent on how the disruptors, lawmakers, businesses and institutions cooperate to establish and incorporate the new technologies into the broader financial system. A prerequisite for success is that lawmakers and government agencies, like tax authorities and prudential and market regulators provide clear guidance and set boundaries for these disruptive newcomers, including providing legal definitions of cryptographic assets in law and regulations.
Areas that should be considered for updated requirements are consumer protection, ICT/cybersecurity risks, accounting treatment of crypto and auditing requirements, market integrity, financial stability, monetary policy transmission as well as requirements to protect monetary sovereignty. Four areas stand out to me, given my background as a financial regulator and accountant:
- Tax: Companies that are acting as intermediary or using cryptocurrencies actively in their business transactions should realize that tax reporting requirements vary per country and that some authorities consider it as a currency and others as an intangible asset. The IRS has stepped up its scrutiny of tax filings and proper disclosure of profits made with cc’s and cryptos held. Full disclosure of crypto transactions is a legal obligation in the US starting this year.
- Accounting: There is no legal definition of cryptocurrency and no formal guidance from IASB on the accounting treatment and the wild swings in bitcoin prices make valuation of these currencies difficult. It is a fractured marketplace with many independent exchanges managing its own data feed and thus difficulties of getting reliable historic data. As long as the markets remain opaque companies should follow a consistent route in valuing the Bitcoin currency to avoid appearing to seek the most favorable one to hide poor performance. New products are on the way that might help to better value cryptocurrencies. The accounting treatment is still more of an art than a science and will require further investigation, according to a very useful report from PWC on this topic.
- Anti-money laundering: The gateway between fiat money and cryptocurrencies is one crucial area that demands special attention. Central Banks are starting to demand registration of these gateways as “obliged entities” or “virtual asset service providers” to address the growing risk of money laundering via cryptocurrency transactions.
- Board oversight: The evolving tax, accounting and AML landscape for crypto illustrates that the buying/selling and other transactions in cryptocurrencies will bring new challenges to Corporate Boards in their oversight role. Boards should ensure they have the required technical expertise to adequately assess the risks stemming from cryptocurrency. It requires alertness and awareness and knowledge of developments with regard to new laws, rules and regulations, requirements and risks with respect to new currencies.
As with many nascent technologies, hype and euphoria have accompanied Bitcoin. As we now experience with the latest explosion in the Bitcoin market price (which may have crashed by the time you read this), the hype reinforces the upward momentum and attracts new investors. Many investors are often without full awareness of the nature and risks of cryptocurrency investments.
Prudential regulators have to look beyond the hype to protect their monetary sovereignty and develop a concrete response to the increased traction of cryptos and find ways to maintain, above all, trust in their fiat currencies. Undoubtedly, a lot is happening behind the scenes, but the crypto momentum warrants a transparent, robust and urgent response from regulators not fighting innovation, but seeking to enable a transition to the new environment. A delayed response could potentially further erode the standing of fiat currencies with dire consequences for the real economy.
Bibliography:
- American Default by S. Edwards;
- Money by J. Goldstein;
- Essays in Persuasion by JM Keynes;
- The Age of Cryptocurrency by Paul Vigna;
- The Road to Serfdom by FA Hayek;
- Why Minsky Matters by L. R. Wray;
- White paper on Cryptographic Assets and Related Transactions by PWC