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Why cryptocurrencies are years away from replacing Fiat currencies

Cryptocurrencies like Bitcoin and the underlying Blockchain technology was invented/created over eight years ago as an alternative means of payment through the mining of digital currency (Bitcoin) by solving cryptic equations.

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Why cryptocurrencies are years away from replacing Fiat currencies

The rhetoric was that it eliminated the need for a third-party intermediary, hence giving the power of choice back to the people in a peer-to-peer system which no longer had to rely on trusting a third-party custodian or central authority – writes Musheer Ahmed in an article which first appears in LTP.

Initially, cryptocurrencies were consigned to a small community of techies who wanted to be part of the decentralized world. However, following the spectacular collapse of Mt. Gox in 2014, a major Bitcoin exchange that handled nearly 70% of Bitcoin volumes, along with the use of Bitcoin in nefarious activities, Bitcoin came into focus in the mainstream.

A lot of people in the financial services industry stayed away from the cryptocurrencies owing to the notoriety it had gained, but the underlying structure, i.e., Blockchain, started to attract interest from technology players and those looking to innovate in financial services.

With increasing PoCs and actual use cases of Blockchain in the last two years, more cryptocurrencies started to be created, through the process of Initial Coin Offerings (ICOs). In the last month or so, major financial news headlines have centered around cryptocurrencies and its fundraising processes of ICOs and token sales. These fundraising activities have topped over $2 billion in 2017.

As of the last count on September 16, 2017, there were 1109 cryptocurrencies with a total market cap of $127.5 billion. Another factor for the uptick in interest in cryptocurrencies was the development of Ethereum, which brought with it the ability to execute smart contracts and transfer software via the Blockchain. A large number of the recently launched ICOs are based on an Ethereum platform.

With a boom in capital being raised through ICOs and ITOs, it was inevitable that most regulators around the world, including the SEC, PBoC, SFC and MAS waded in on the possibility of coins being securities to outright banning them. There are guidelines issued on how one needs to treat ICOs and token sales, cautioning investors to be very careful in investing in these highly volatile, and in some cases, bogus currencies.

Besides regulators stepping in to protect average investors, one factor that has gotten a bit lost in all the hype is about how central banks and governments are dealing with the impact of cryptocurrencies on their monetary systems. Secondly, many cryptocurrency enthusiasts and investors believe that the cryptocurrencies will overtake the world of transactions replacing fiat currencies and achieve financial empowerment.

This rhetoric is a folly and, in many ways, showcases a lack of understanding of the global monetary system and its dynamics. Additionally, it fails to take into account the initiatives that central banks around the world are taking to completely digitize their fiat currencies.

In 1944, the Bretton Woods agreement adopted a monetary policy that tied a currency’s exchange rate to gold, following which paper currency was created to replace the need to carry bullion and make it easier to transact. However, with the abandonment of the Gold Standard, governments around the world moved to printing their own currencies backed by the trust in their central banks that have relative value against each other, thereby creating fiat-currency economies. The value changes due to a host of factors, including relative interest rates, terms of trade and inflation.

The money is printed and volumes in circulation are regulated by central banks. Through many measures from M1 to M3 and beyond, the central banks gauge the money supply and accordingly print more money if the supply is tight or absorb from the system if they feel there are inflationary pressures due to easy availability. In normal economic conditions, this is largely driven by interest rate hikes/cuts which impact the supply: If the interest rates are higher, less money flows in the system and vice versa.

Now having had a look at the fundamentals, let us now take a look at why cryptocurrencies are many years away from making a significant mark on the way most of the world uses money.

Adoption & acceptance

While over 85% of the world’s transactions are conducted in cash, cryptocurrencies are digital currencies. The total market cap of all cryptocurrencies in use is only $127.5 billion – a drop in the ocean when compared to the $81 trillion of all currencies in circulation worldwide. One might argue that cryptocurrencies are currently in their infancy and over time they will be able to gain ground.

There are two flaws in this argument. There are over 1110 cryptocurrencies in circulation vs. only 180 fiat currencies recognized by the UN. There are way too many cryptocurrencies in circulation and these will only increase in the future, making it harder for ease of use, exchange and enough exchange vehicles. All token sellers believe that their coin will be widely used and accepted to buy any service and product but in reality, only a few of them will succeed.

Secondly, the world is dominated by two major currencies, the US dollar with 43% and the euro with 30% of transactions. The yuan, which represents the world’s second-largest economy and in use by over 20% of the world’s population, has only 1.6% of market share – further showcasing that cryptocurrencies are very unlikely to reach a significant scale of market cap in the coming decades as they are not likely to be widely used for all types of transactions.

Need for central authority during crisis

When there are financial crisis or problems with major financial institutions, the central banks might support their financial eco-systems through various measures to bring stability to their currencies and exude confidence. These can vary from the standard ways of cutting interest rates and/or printing more money, to measures of quantitative easing.

A cryptocurrency is as much an investment as it is a utility to perform transactions. A vast majority of the world’s population deals in only one currency – their local currency, and the intention of using this currency is purely as a payment utility and not as an investment instrument. If one were to use a cryptocurrency, there is no central authority to execute stability measures and bring things into control when there is a crash. There is no centrally covered insurance on the accounts/wallets. The users will see their wealth erode quickly and will have no backstop or insurance to save their monetary assets.

Need for effective governance and controls for governments and monetary authority

Most, if not all, governments want to be in control of how money is exchanging hands in their countries – from the need to control things blowing up and crisis being created, to being able to control the outflow of funds during tough economic times like in the case of China in 2015 and 2016.

The central banks want to be able to follow and keep control of their M1, M2 and M3 so that they have a pulse of the economy. They are unlikely to let a decentralized system run amok and would not let the new currencies to take over. A lot of currencies in the world are not even fully convertible against more than one currency, which is usually the US dollar. This again comes with the need to keep a tight ship and control over their money supply.

Secondly, in the new world, economies are largely linked and central bankers are closely co-operating to ensure that the impact of one large central bank’s action on other countries is limited, or provides scope for the other central banker to adjust their monetary policy. However, in the cryptoworld, there is no central authority and can’t have a coordinated action. Even in the case of the Bitcoin Blockchain upgrade, there were differences in opinions leading to the formation of an additional currency, Bitcoin Cash, highlighting the instability and lack of coordination among players.

Anti-money laundering & KYC

With cryptocurrencies, it is harder (not impossible) to track the flow of funds and to know who is holding how much of these currencies. In the current world dynamics, high-street banks are spending a lot of money and will continue to do so on their KYC and AML processes due to regulatory demands and risk of massive fines. With cryptocurrencies, these costs are even higher, and worse still, the movement of funds cannot be realistically controlled or monitored making the authorities even more likely not let them proliferate. Additionally, the key point for KYC/AML is to ensure money is not used by terrorists and criminals and being able to track the users.

Stability in value

It is rare for a recognized currency to have high volatility of over 5% in its value and for a currency to lose more than 10% in a day. Most moves tend to be in the 1-2% range, unless there is a massive crisis that erupts, such as a fall in government or if the central bank prints a massive amount of new currency, like in Zimbabwe causing hyper-inflation. Cryptocurrencies are highly volatile and with a significant change in value, people cannot perform reliable transactions in them owing to the significant market and liquidity risks. A similar pattern is can be seen in the usage of fiat currencies that are highly volatile, such as the Argentinean pesos.

Digitization of fiat currencies

Lastly, some of the world’s biggest central banks have been running PoCs on adopting digital currencies of their own. From the PBoC to the MAS and E-Estonia, many are looking to have their currencies go digital. In Sweden, they have already declared cash dead and India recently had a massive demonetization drive, part of which was driven by the need to make cash transactions digital.

Through a digital currency, central banks can trace funds more easily, hence be able to tax them. Secondly, they will be able to impart interest rates more effectively, especially negative interest rates which can be dampened if people hoard their physical cash. It also reduces the costs of printing and maintaining paper currencies, which according to some estimates costs up to 1.5% of GDP. Additionally, the cost of handling physical cash reduces for banks consequently reducing the need to operate physical bank locations.

This is not to say that cryptocurrencies will die down or will cease to exist in use in a few years. The major currencies, led by Bitcoin and Ether, will be very much in use and their market capitalization is likely to increase. They will have their place in the world of transactions especially in peer-to-peer (P2P); however, one needs to be realistic in their expectation of growth of these currencies and their wide use which will be on a small scale and not as widespread as suggested by some of the hype and hoopla in the recent weeks.

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