On Digital Assets and Banking

I’ve met with multiple regulators to discuss their stance on digital assets and it’s not what you’d expect. Despite the media-fuelled dichotomy, that regulators and digital assets are pitted against each other in a fight to the death, when asked directly, they remain “cautiously optimistic”.

They are aware of the important role technology plays in progression, but they’re also responsible for many things of which the average person is simply not aware.

So, the trillion-dollar question is: do digital assets have a place in society and, if so, where?

Banking and Regulation

Regulation is not exactly popular in the crypto community. Maximalists are quick to sharpen pitchforks, but are not so quick to examine why these rules and rule makers exist in the first place. I know, I was one of them. How many know the ’08 bailouts were loans? Or that they actually generated profit for the United States Treasury?

Here’s a novel question: without the banking system that everyone seems to hate, how do we pay for anything?

This is usually where someone shouts “lighting network” or “Bitcoin Cash” — God forbid — from the back of the room. Sure, cryptocurrency is a mechanism for payment, but the banking system is a mechanism for economies.

Banking sits at the centre, providing capital to businesses and interest to depositors. And while it may be bloated and inefficient — and struggling to stay relevant — eliminating it is short-sighted; evolving it is not.

Tokenisation

This fight for relevance has seen banks move into telecoms, insurance and even consumer electronics. But if you remove the carefully fitted marketing veil, you see it for what it really is: desperation.

Tokenising assets could be a much-needed lifeline for banks who can then focus on custody once more. It has many benefits, but the one that really stands out is efficiency of transfer. Think about how much work, and costs, go into the transfer of ownership of a house. Instead of listing your home with an estate agent, you could simply sell it on an exchange; and instead of hiring expensive lawyers for transfer, you could simply send a token to another wallet.

Then there is identity. Think about the many forms we fill out on a weekly basis. Every time we sign up to a website or service, participate in a rewards programme, or buy a mobile contract. Besides the schlep for us as consumers, there is risk for institutions, and risk means cost. Institutions need to verify our identity each and every time. A Blockchain based digital identity, on the other hand, could ensure consumers only have to update information once.

Not only would consumers only have one place to update information, but they would also own their data. Like really own it. In fact, you could take control of how it’s monetised, even use it to pay for things…which isn’t something new by the way.

A tokenised economy gets exciting when you consider how it affects liquidity and the banking system. Banks have one main goal: they turn short-term liabilities into long-term assets. But, when confidence in banks declines, and people want to withdraw their money, they can find it locked up in illiquid assets.

While liquidity has a large role to play in these kinds of financial crises, the real underlying cause is solvency. Tokenising assets can lower barriers to liquidity and ensure that banks can liquidate assets faster, which could go a long way towards stabilising depositor confidence and avoiding bank runs.

In addition, the transparency that can be woven into Blockchains could help with solvency. In the 2007/08 banking crisis, many of the instruments that were at the heart of the collapse we derivatives of derivatives. Risk was estimated and packaged together. Those packages were then graded and packaged, and so on. Eventually, few had a solid understanding of what made up those instruments, including the banks that traded them. Those that did know, well, you’ve seen the Big Short.

Cryptocurrencies and the economy

One of the concerns that central banks have is how moving funds into cryptocurrency affects the economy itself. Part of the banking system’s role is to provide credit to businesses, which uses depositors money to help drive the economy. But there needs to be a balance. If too many people are saving and not consuming, there is a surplus of capital and a drop in demand for produce. Conversely, if too many people are consuming and not saving, there is not enough capital available for businesses, resulting in a drop in production.

This is part of the reason why inflation is believed to be a good thing for economies, provided its managed well. If the cost of goods is rising and the value of a currency is declining, it makes sense to buy now rather than later or to invest where value can grow. Essentially, inflation is used to balance consumption and investment, which then drives the economy.

But what if that capital is put into cryptocurrency and isn’t available to the economy?

One potential solution could be the infamous Initial Coin Offering (ICO). A big reason why ICOs are so popular is because they reduce the barrier to investing. Incidentally, this is also the reason for its bad press. Many — and I mean many — scammers have taken advantage of the lack of regulation, leveraged the hype and defrauded unwitting investors. In the ‘real world’ there are barriers preventing the everyday person from investing. But with crypto, the only barrier is complexity.

But what if banks took over the vetting process in ICOs? That is, carry out due diligence, help raise funds, provide tools, secure raised funds, and even enforce lock down periods. Consumers would then be free to invest as they see fit, worrying only about the project’s efficacy, not its existence.

Banks could put together portfolios of vetted businesses to be used to generate returns on deposits for consumers with appetites for higher risk; a first step towards folding digital assets into the broader economy.

Banks could then put together portfolios of vetted businesses to be used to generate returns on deposits for consumers with appetites for higher risk; a first step towards folding digital assets into the broader economy. They would, however, have to be adequately diversified to ensure that risk is managed — but even then, the risk of all new ventures is extremely high, right?

Well, in his book Capitalism without Capital, Jonathan Haskel and Stian Westlake argue that while the top performing mutual funds vary year on year, often with the top 20% being amongst the worst 20% according to a UK study (Vanguard 2015), the top venture capital funds tend to perform well year after year.

They argue that this is because of the ‘spill over’ effect of specialisation. These funds typically perform well on a consistent level because the businesses they invest in are mutually beneficial. That is, they invest in businesses that make products or services that their other businesses can use to improve their odds of success.

Gross Domestic Product

Lastly, tokenised assets could help governments. Until recently, if you had a business, it’s likely you had real assets to back it up. Factories had machines, farms had land, even banks had gold. But now companies have more intangible assets, like intellectual property, brands, reputation, networks, relationships and software.

The proliferation of intangible assets is a big deal, especially when you consider GDP, a vital factor in the health of economies. Typically, GDP is calculated by adding what everyone earned, or what everyone spent. But, as you can imagine, it’s far more complicated than that.

With intangibles, the affair becomes more complicated still. How do you measure the value of design? Or brand development? Or software? The tokenisation of assets could assist. Not only would it make it easier to measure for GDP but, in some cases, it could facilitate markets of intangible assets and serve as real collateral for debt.

If you take a step back, a bigger picture starts to emerge. Digital assets are the inevitable next step in a campaign to evolve society. But that’s not to say, despite the evident potential, that their promises are free from exaggeration. Like all new paradigms, there will be a period where reality must ground the fantasy.

So, when one considers the potential of digital assets, and the dire need for new paradigms in the economy as a whole, one sees that the financial industry is not so much the target of the coup, but rather the landscape in which it’s taking place.

Although there is still much to figure out in this digital revolution, and much to be debated, there’s something to be said for cautious optimism. For me, the sweeping statements that cryptocurrency will replace the financial system are analogous to the rhetoric of the early 2000’s, when so many were adamant that the internet would completely replace televisions; instead, we got Netflix.