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Crypto and blockchain: the foundation of a new financial system

By Mikhail Karkhalev

January 3, 2020 marks 11 years since the official launch of the world’s first cryptocurrency. In the first decade since its launch, Bitcoin has come a long way from an obscure and unknown virtual currency to a ‘digital gold’ status.

Today, Bitcoin and its various derivatives are traded both on cryptocurrency exchanges and on major institutional platforms. For instance, the Chicago Mercantile Exchange (CME), the world's major diverse derivatives marketplace, offers Bitcoin futures trading product along with oil, gold, wheat and other futures. SIX, a leading Swiss stock exchange, also launched Bitcoin and Ether exchange traded products (ETPs). And ICSE, the company which is operating NYSE, launched a platform for trading Bitcoin futures called Bakkt.

From 2015 to 2019, we saw a lot of useful cryptocurrencies and blockchain projects emerging. According to Coinmarketcap, by the end of 2019 there were 2389 cryptocurrencies and tokens across the world based on the Ethereum, EOS, and NEO blockchains. We also have witnessed dozens of hard forks, such as Litecoin, Bitcoin Cash, Monero. Moreover, there is a whole family of Bitcoins, from the main one to the mysterious Bitcoin X with market capitalisation of just $451. However, more than 90 per cent of those cryptos are nothing but scam projects that have been out of service for a long time and were created just to raise money for initial coin offerings, or ICOs, without any plan for further development.

Dubai and Venezuela issued their own digital currencies, emCash and Petro. China is already working on creating its own yuan-pegged central bank digital currency, or CBDC, in 2020. Other countries are considering the possibility of launching their own CBDCs. Here’s the list of governments that have announced such plans: the United Kingdom, Switzerland, Sweden, Norway, Denmark, Spain, the Netherlands, Germany, Lithuania, Israel, Iran, South Korea, Japan, Thailand, Singapore, India, Canada, South Africa, Australia, New Zealand, Uruguay, Marshall Islands and the Bahamas.

Crypto regulations have been introduced in almost all jurisdictions across the world. Digital currencies are partly regulated in the EU, the US and Japan. Full regulation was introduced in Switzerland, Belarus, and Estonia. Russia and Ukraine are in the process of developing such legislation, while India, Ecuador, and Brazil have completely banned crypto.

To sum up, the crypto industry has become a phenomenon that is hard to ignore. Let’s now turn to the main questions that are related to this new area of finance:

1) What is cryptocurrency?

2) What are the prospects for cryptocurrencies?

As cryptocurrencies are not directly involved in the monetary policy of states and do not play an important role in the traditional financial systems, it is difficult to find an exact definition of the term. It would be logical to define cryptocurrencies as an alternative asset, at least for now.

To answer the second question, we have to move on to the main part of this story. If the financial world formally recognises cryptocurrencies as an asset, then the economists should consider the benefits and feasibility of creating a state-controlled digital currency. Moreover, such recognition opens doors for the evolution of the global financial system. Why is that?

Formally, cryptocurrencies can be divided into three types:

  • Cryptocurrencies designed for settlements and preservation of value: BTC, ETH, XRP, LTC, BCH.
  • Cryptocurrencies designed as platforms for business and project development: Ethereum, Ripple, EOS, Stellar, Tron, Cardano, NEO, IOTA.
  • Internal tokens of particular projects: Binance Coin, XZT (Tezos), Huobi Token.

Top-50 cryptocurrencies have enough market capitalisation and customer demand to survive, transform or merge with other projects. But over half of them may not survive until 2030. More than 2,000 projects outside the top-50 could be even more unfortunate. 99.9 per cent of them will disappear just because the two thirds of them are no longer functioning and have absolutely no practical use. This is the result of the first attempt to create a huge crypto market from scratch, which was unsuccessful as the key audience of crypto was extremely small. According to a report published by the Cambridge Centre for Alternative Finance, there are no more than 50 million active crypto users around the world, roughly 0.65 per cent of the world's population.

During the next decade, a new digital economic system is likely to emerge. Its main features are:

1. Cryptocurrencies will be used as a payment instrument, a safe haven asset, or as a store of value. Their practical application will be adjustable. State-controlled CBDCs will be established by different governments.

2. Whole business units will use blockchain, such as Ethereum or EOS, as a basis. Some state-owned companies and projects will be based on CBDCs.

3. New projects and businesses that use their own blockchain ecosystem will be created. The new move will not be like an ICO market, but rather like a regulated area, such as IPO, probably based on state-owned CBDCs.

Roughly speaking, we will witness how the global financial system is transformed into a new digital one, divided into a public sector and a private one.

How likely is this to happen? It is difficult to predict the exact path of transformation of the international financial system. However, such evolution has already happened before, and the coming version of a new monetary system will in fact be the sixth one in our history.

How global monetary system evolved

As technology advanced and the world's population grew, the need for money supply was growing too. Many new ways to monitor financial relationships between ordinary people, business and states emerged. At certain points in history, approximately every 40 years, the monetary system required drastic changes or updates.

Basically, there are times in history when the existing system is creating shortages, or the states fail to comply with the agreements made with citizens. Normally this happens during a jump in human development, when the amount of trade deals between the countries surges, or during a crisis such as a war, which is very expensive.

Gold standard

In 1821, when the post-Napoleonic Europe required restoration and development, the Bank of England established the basis of the gold standard, which had been used for over 40 years. Gold coins became the main currency that replaced the bimetallic and paper standards. Therefore the states were not able to print paper money and stamp coins from other metals in unlimited numbers. Gold circulated freely until it became more scarce.

In 1867, at the height of the industrial revolution, the Paris monetary system was founded. Major countries, except China, agreed to use both gold coins and gold-pegged national currencies for international settlements. Moreover, the gold parity for each currency was established. All fiat money could be freely converted into gold. To use gold exclusively was not convenient anymore, since the development of industry and international trade needed a more flexible tool, but at the same time required tight control. Gold-secured currencies were just perfect for that age. The British pound was considered as the world’s major currency. Moreover, gold itself was also in free circulation.

Gold exchange standard

As the First World War ended, it became obvious that the current financing system had collapsed into chaos and the Paris monetary system should end. States simply printed the necessary amounts of unsecured money to support the army and to restore the country after the war. Meanwhile, there was either no gold in the reserves at all, or it was mined in such small quantities that it was not able to provide the state’s needs for financing.

In 1922, the Genoese monetary system was established during the Genoa conference. For international transactions, the countries began to use gold bullion and gold-backed currencies such as the British pound, the US dollar and the French franc. These fiat currencies were used at a global level with a fixed exchange rate that relied on gold parity, while the rest of the currencies had a free floating exchange rate.

The problems of the Genoese monetary system began evident as states’ needs increased. Some national currencies were devalued, which ultimately led to their complete depreciation and default. World War II had put an end to the existing monetary system as countries declined to comply with previous international agreements.

In 1944, at the end of World War II, the Bretton Woods monetary system was formed. It marked the beginning of the US dollar hegemony in the global financial system. The price of gold was fixed at $35 per Troy ounce, and the rate of all other currencies was fixed towards the US dollar and the British pound. However, as the British pound gradually weakened, the leading role in international settlements went on to the dollar.

Floating exchange rate

In 1976, the Bretton Woods system was replaced by the Jamaican system, which is still used today. The dollar was no longer considered a main international currency, since its issuance could no longer be backed by actual gold reserves. Exchange rates were sent to float freely and the price of fiat currencies was determined by market demand and supply. Gold finally lost its world reserve status and became an ordinary commodity, such as oil or wheat. Polycentricity and decentralisation formed the basis of a new global financial system.

The whole world believed that the Jamaican system would become more flexible than the Bretton Woods one, as it was expected to help various states to independently manage their monetary policies and to cope with economic instability much easier. However, the American dollar, which was supposed to lose the status of the world’s major fiat currency, still remained the leader. American economy was far more powerful than others, with its military and scientific potential forcing foreign investors’ capital to flow into the US. It turned out that investors prefer a strong and stable currency for international payments and are more likely to invest in a strong economy rather than developing countries that experience a liquidity shortage. In addition, the headquarters of major intergovernmental organisations, such as the United Nations, World Bank, and IMF, are based in the US and tend to act for that country rather than any other state.

Today the world’s major financial hub is located in the US, while the development of other states is heavily dependent on it. Any financial crisis begins within the US and any economic turmoil in the country could act as a kick-off for a financial tidal wave across the world. This was clearly demonstrated during the crises of 2000 and 2008. The US has a tremendous influence on the banking sector, as well as on the global financial system, and is able to freeze the accounts of entire states, impose sanctions and translate its point of view to the rest of the world. This is drastically different from what the Jamaican currency system should hypothetically be.

In 2008, the G20 summit was held to deal with the evolving crisis. The states also decided the fate of the Jamaican currency system and its possible reformation, while trying to solve other issues related to the global financial system. The dollar hegemony was discussed repeatedly, and the controversy continues until now. Just a year after the G20 summit Bitcoin was created.

Bitcoin: the decentralised era

On January 3, 2009, Bitcoin’s first block, also known as genesis block, was generated and the first 50 Bitcoins were mined. The person behind the world’s major cryptocurrency is still unknown. We only know that its father, or maybe a group of people that created “digital gold”, acted under the name of Satoshi Nakomoto. The emergence of Bitcoin has led to the development of a new digital financial system. It is highly likely that blockchain and cryptocurrencies will form its basis. As we already mentioned, many leading states are currently working on their own digital currencies.

If we seek to imagine the future of the new financial system, it is quite possible that each state will work on developing its own centralised system, which will be independent from the global one or from a single centre. It is not clear how the countries will interact, though.

The essence of this estimated model is similar to existing blockchain projects, such as Ethereum, but the particular central bank of each state would in this case act like Ethereum itself. Blockchain-based projects developed in China, or its CBDC that is currently underway, are state-owned.

The People’s Bank of China (PBoC), in its turn, can be integrated into a global decentralised financial system, where all the global central banks would have equal rights. In this system, there will be no possibility of imposing decisions, such as forced sanctions, on other countries. However, as of now, it is quite difficult to predict how this new system will be regulated. The described model is nothing but the product of the author's imagination. However, the state CBDC in China is already on its way, scheduled for launch in 2020. If it happens, the country will have to integrate its digital yuan into the global payments system. If other countries follow the path, the world will need a single decentralised system that will unite all state CBDCs into one network but at the same time provide equal rights for all states within it.

To make this a reality, at least two global events must happen. And furthermore, they have already occurred, forcing us to create a new financial system:

1. A new technological breakthrough, which implies the development of new technologies in IT industry, medicine, energy, bionics. The emergence of AI and other modern technologies, such as powerful computers with quantum processors, will give rise to the further development of humanity. Quantum computers are being successfully tested by Google, IBM, Microsoft and other corporations. We only have a few years left for them to become mainstream. This could be compared to a similar IT breakthrough when Steve Jobs presented to the world his Apple II personal computers. Just 20 years before that, IBM invented the world's first hard drive with a memory capacity of 5MB.

A technological breakthrough plays a main role in the development of a financial system, as it begins a new chapter in the development of humanity.

2. The crisis. Even the most ingenious economists are not able to solve current problems in the global financial system in one fell swoop. However, each new crisis, whether financial or military, solves the majority of the problems. After a powerful crisis, the financial system changes completely.

How soon will the crisis come and what will it look like? The third part of the article will be dedicated to this matter.

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