Digital Currencies : will regulators repeat the mistakes of the past?

Digital Currencies : will regulators repeat the mistakes of the past?
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[T]echnological innovation represented by the rise of Bitcoin and the other alt-coins highlight the need for a renewed policy debate surrounding the nature of financial innovation and citizens ability to participate in such innovation under a more flexible regulatory process than has been the case historically and thus far in the 21st century.

Introduction

The rise of Bitcoin, crypto-currencies as a store of value and distributed ledger technology such as blockchain are extremely exciting technological innovations.

However, history has proven that during any period of innovation there are winners and losers, risks and rewards. This article will seek to explore historical responses to technological innovation and provide current market participants from consumers to policy makers with points for consideration.

The wide spread adoption of crypto-currencies and the blockchain technology that underpins them, I argue here, stems from both the lack of innovation in the financial sector, a popular desire for control and avoiding a future financial crisis such as the “Great Recession” of 2008.

It is my belief that the technological innovation represented by the rise of Bitcoin and the other alt-coins highlight the need for a renewed policy debate surrounding the nature of financial innovation and citizens ability to participate in such innovation under a more flexible regulatory process than has been the case historically and thus far in the 21st century.

This article will argue that policy makers and regulators around the world should acknowledge and encourage the financial innovation we are seeing today by discussing the (i) organic demand for digital currencies (ii) need for a 21st century regulatory framework (iii) core questions for policy makers to consider (iv) historical examples of financial innovation (v) pace of innovation (vi) creation of faith in a store of value (vii) conclusion.

Organic Demand for digital currencies

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The focus should be on fostering innovation, increasing access to capital and participation in the financial system and not merely control of populations or mitigation of perceived risks at the societal cost of innovation itself.

The growth in market capitalization and the explosion of the crypto currency asset class as discussed previously is often viewed from the regulatory lens of money laundering or terrorism or at the most extreme — control of the monetary system and money supply. Readers need to look no further than the daily deluge of regulatory pronouncements emanating from governments, agencies, investors and large bank CEOs.

Time will tell as to the true intention of each of these categories of pronouncements from various state and non-state actors and whether or not they are genuinely for a broader public good or merely self-interest. While the concern for the criminal element or even the broader monetary system is valid and important, such myopic view points are short cited in their focus.

The focus should be on fostering innovation, increasing access to capital and participation in the financial system and not merely control of populations or mitigation of perceived risks at the societal cost of innovation itself. History has shown that that attempts to curtail and stifle innovation are rarely successful in the medium to long term as market participants will innovate around legal and regulatory barriers in ways that are both unanticipated and potentially more vexing to regulators and policy makers than the initial perceived threat.

To wit, monetary policy, money laundering, terrorism financing and the need to combat such nefarious actors are a real and serious concern. However, we should not conflate the need to prevent such deplorable acts with the needs of the 99.9% of the citizenry speaking for their desire to participate in the 21st century financial economy in a manner that is more inclusive than the current global regulatory regime allows.

Need for a 21st century regulatory framework

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Policy makers and regulators are again called upon to do something they have never been successful at, sans accepting changes at the margin, which is managing the shift in the status quo.

The contemporary financial regulatory regime has its roots in 19th and 20th century institutions, yet we are operating in the 21st century. In this century, a new paradigm, calls for a new regulatory frame of reference. The argument here is not that “this time is different”. The argument is that “we” are different — society itself is evolving and influenced by the shift towards a digital economy that was set in motion over 20 years ago. The innovation represented by crypto-currency is merely the latest manifestation of this change — but it will not be the last. Just as the movement from analogue to digital required a new frame of reference and not merely a grafting of the old onto the new.

In this instance, policy makers and regulators are again called upon to do something they have never been successful at, sans accepting changes at the margin, which is managing the shift in the status quo. To further complicate matters the global and distributed nature of the internet means that the status quo is being tested in every corner of the planet at the same time — a development rife with danger and opportunity.

The very idea of digital currency and the underlying blockchain technology created to facilitate it are egalitarian platforms created as a response to the status quo or more apropos, market inefficiency. A market inefficiency is defined as:

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A situation in which a financial market does not operate as well as it should, for example where customers do not have enough information about products, prices are not related to supply and demand, etc.

The core questions for policy makers to consider

The core questions for policy makers to grapple with are as follows:

(1) Where there is a recognition that the market is inefficient as it relates to financial innovation and inclusion, then who are the current beneficiaries of such inefficiencies?

(2) Whom should the new beneficiaries be for a more inclusive financial system?

The unique development in this specific case is that the traditional financial system represents the market that is inefficient and therefore faces disruption. However, the principal at play has not changed and has been playing out for centuries. For recent examples, see Amazon’s initial disruption of the market for books, Napster for digital music, Windows and Mac OS as an innovation of Unix, and Android and iOS as an innovation derived from prior advancement in the movement from desktop to mobile.

The chart above shows the current data available regarding the use of token sales as a financing mechanism. This ground breaking innovation represents the financial services equivalent of direct to the consumer distribution business model that Amazon embarked upon in 1994. In short, a revolutionary sea change in the way buyer and sellers interact. Whether or not governments attempt to crush the current iteration, such efforts at control will ultimately be unsuccessful in the same way the demise of Napster did not stop the broader trend of digital music that we all enjoy today.

Historical Examples of Financial Innovation

In 1792, the United States Congress through the Coinage Act created the bimetallic dollar inspired by the Spanish dollar and convertible into silver or gold. In 18th century Britain, arguably, the most innovative and dynamic financial market at the time was energized by the financial innovation of The House Rothschild and led to a new era in the internationalization of debt financing.

In 1944, the Bretton Woods conference established the international fixed exchange rate system based on gold. In 1971, the rise of a purely fiat monetary system was memorialized via the Smithsonian Agreement. In 1998, Wei Dai published the first paper on distributed electronic cash, b money followed by Nick Szabo’s writing on bit gold. In 2009, Bitcoin arrives. In April 2017, Japan recognized crypto currencies as legal tender. In August 2017, the first Bitcoin denominated bond issuance was announced also in Japan. In September 2017, we have started to see the divergent regulatory approaches to digital currencies along largely historical political lines of analysis.

The pace of innovation

As this article is being written, the pace of change marches on and there have been countless new developments with some governments takes more restrictive approaches than others. As the World Bank has addressed in its report Beyond Fintech from August 2017, incumbent financial intermediaries will face pressure from all sides of the value chain for delivery of financial services.

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The risk I seek to prompt discussion of here is that in facing the current and future pressure on existing institutions regulators should not simply gift incumbents market dominance by grafted new policy on top of old law and regulatory structures.

The challenge for regulators and policy makers is to resist the urge to restrict, kill and fully control the digital financial age that is upon us. In fact, I posit that the innovation we are seeing is much like a virus in the medical sense, once released in the wild it can never be truly contained nor eliminated.

Importantly, people across the globe are seeking the innovation — on their own terms and not on pre-determined and curated terms as has been the historical case with regards to access to the financial system.

Internationalization of the bond market

Niall Ferguson, in his seminal work on the House Rothschild, details among many other things the importance of the Rothschild family in the development of the international bond market in the 19th century when he quotes a German writer in 1830 stating:

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“[E]ach possessor of state paper [can]…collect interest at his convenience at several different places without any effort. The House Rothschild in Frankfurt pays the interest on the Austrian metalliques, the Napoleon rentes and interest of the Anglo-Neapolitan obligations in either London, Naples or Paris, whichever it suits”

The quote above has immense significance in the history of modern finance because prior to the financial innovation of The House Rothschild, an investor in the equivalent of government bonds during the 19th century had to physically be in the relevant country to collect interest on such payments and had to purchase such bonds in the relevant local currency.

However, the multi-country location of the Rothschild bank enabled investors to purchase another nation’s debt in their home currency and receive the foreign currency equivalent in interest payments at any of the Rothschild bank locations. During this time the ability for a nation state to raise capital fund budgets significantly expanded the ease and ability of nations to raise capital globally and contributed significantly to global growth. While this article will not go into detail, I encourage interested persons to read Niall Ferguson’s seminal three volumes on this history for the invaluable insight. My purpose in using this illustration is to provide a historical example for what the current wave of innovation represents.

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In short, digital currencies have the potential to shift the very nature of the relationship between capital formation and raising out of the hands of banks and governments and into the hands of the people. Alternatively, there is the potential for a new relationship between citizens and their financial system with both increased liquidity and inclusion in all aspects of financial markets and economic activity.

My reasoning for the historical example above is to lay the historical context for where we collectively find ourselves today. In the digital world, there is no longer the need for investment banks to physically carry local currency and scuttle pieces of paper representing shares across boarders or visit with kings to negotiate the terms of repayment periods for bonds.

In fact, in the digital age, the traditional banking model has been exposed as being outdated and serving only established interests. Further the traditional role of the nation State to issue, control and debase currency has been thrown into question and it is therefore inevitable to face resistance to such a shift in the world.

In this digital age, currency can be created and issued based upon principles of mathematics and cryptography without the need of a State apparatus or regulator to shepherd the process. This is truly a revolutionary development — such developments throughout history are usually snuffed out as dangerous given their real or perceived disruptive capacity. Yet, here we are.

Crypto currencies are “real” notwithstanding what bank CEOs or other naysayers have said about their worth as a store of value. In fact, I would urge readers to watch was the naysayers do and not what they say. As developments are very fluid in this area even out spoken critics of digital currencies have admitted being receptive to changing their minds. For example, Howard Marks of Oak Tree Capital.

The creation of faith in a store of value

At a philosophical level, value derives from wherever “we” as a society place such values and history has shown that the “thing” that sits atop the pedestal of value always changes over time. According to the IMF, money is anything that can serve as a:

Conclusion

A shift from analogue to digital

The growth and adoption of digital currencies and their facilitating blockchain technologies are manifestations of the shift in the faith of exchanging value from the analogue to the digital world.

Under this premise, the creation and adoption of a digital currency or currencies can be understood as an extension of the evolution of society. In the digital age, the method of creation and distribution has miraculously been created by the people for distribution among the global community. From a historical statist paradigm, financial innovation of this sort could be viewed as dangerous.

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Specifically because of the inherent regulatory pre-disposition towards the status quo, I believe we are facing a great risk and that is the risk that the innovation which could prove to be the digital equivalent of the printing press or the industrial revolution is snuffed out or curtailed before it has the chance to mature.

I am sure there are many that would seek to regulate and control this development under the guise of anti-money laundering or terrorism which is legitimate as discussed at the beginning of the article. However, I believe that such arguments are short cited.

I would like to encourage policy makers globally to fight the urge to stifle innovation at a time when the rate of change and innovation is increasing. Indeed, the internet as made commercially popular by AOL, Prodigy and CompuServe in the United States did not come about until 1994 making the modern internet 23 years old. Imagine a world where Alfred Einstein or Alexander Fleming only lived to 23 years old — a scary proposition.