By Paul H. Kupiec

What follows are my opening remarks from an AEI event I hosted last week. You can view the event page and hear from my three panelists here.

Digital currencies and fintech. These two terms are used to describe an enormous range of financial activities, some of which have created challenging issues for policymakers.

Bitcoin, the original and perhaps most famous cryptocurrency, has fallen from its recent high of $67,000 in late November, to about $36,400 as of this morning. Its total market cap is about $687 billion. ETH, the cryptocurrency that trades on the Ethereum blockchain, fell from a high of $4,816 in mid-November to $2,384 today. Its market cap is about $283 billion. Together, even after recent losses, the combined value of these two cryptocurrencies is almost half that of the $2.2 trillion of outstanding Federal Reserve notes.

Libra, subsequently renamed Diem, once the promising poster child for the global stablecoin ecosystem, was abandoned this week by Facebook (a.k.a. Meta Platforms). Diem’s technology and remaining assets were sold to a small California crypto-focused bank for $200 million.

Is there a common causal factor for the recent carnage in
the cryptocurrency world? My hunch is that losses can be traced, at least in
part, to rising inflation and the realization that interest rates must rise
soon, maybe substantially. I’ll come back to that thought later.

Recently the president’s working group, a collection of FSOC
member regulatory agencies, labeled private stablecoins “a clear and present
danger” for the financial system. The working group recommended that private
stablecoins be treated like bank deposits and that stablecoin issuers be
required to comply with all banking rules and regulations.

Seizing an opportunity to become known as the US home for cryptocurrencies, in addition to being home to Yellowstone and the Cheney’s, Wyoming took the entrepreneurial step of passing HB-74, legislation that creates crypto-friendly special purpose depository institutions. These institutions are regulated by the Wyoming Banking Commission, not federal banking regulators.

Wyoming’s special purpose depository institutions are
required to have capital equal to $5 million plus three years of operating
expenses, maintain 100 percent reserves against deposits, and obtain private
insurance against theft, cybercrime, and other wrongful acts. These
institutions are specifically authorized to hold digital assets for customers
and must follow the custodian rules promulgated under the Investment Advisors
Act of 1940. Wyoming law also authorized the creation of “security tokens,” or
digital assets that represent certificated shares of stock that can be
transferred to anyone using blockchain technology.

Two crypto banks have since been chartered under Wyoming
law: Kraken and Avanti. Both banks have asked for access to the traditional
bank payments system by applying for master accounts with the Federal Reserve
Bank of Kansas City. Decisions are pending. Neither bank has acquired FDIC
deposit insurance, and neither bank appears to have a pending deposit-insurance
application.

In November, the SEC halted the registration of two digital
tokens, Ducat and Locke. These digital tokens were created by American
CryptoFed DAO LLC — which advertises itself as Wyoming’s first decentralized autonomous
corporation.

Both tokens attempted to register as securities using the
March 2021 SEC “Token Safe Harbor Proposal 2.0,” a proposal that recommended exempting
crypto tokens from many of the SEC registration requirements that apply to
traditional securities. As it turns out, the SEC proposal was only just that,
and under new SEC leadership, the agency halted the digital token registrations
because the applications did not meet regulatory standards.

The two tokens were DAOs — decentralized autonomous organizations
— which are comprised of computer code that can be executed on a
blockchain-type distributed ledger system. DAOs are a collection of computer commands
that are designed to execute a set of so-called “smart contracts” when specific
conditions are satisfied using the blockchain — with conditions that can be verified
using the blockchain.

DAOs do not have income statements or balance sheets, tangible
equity capital, auditors, managers, a board of directors, a physical address,
or even a postal mailing address. The business conducted by the DAOs occurs
entirely using the blockchain-distributed ledger and there is no one central, legal
person responsible for its activities. A DAO is not a corporation in the
traditional sense, and so it is difficult if not impossible for a DAO to
satisfy the current SEC requirements to register as a security. Or so it would
seem.

Are DAOs a fundamentally important innovation in the way
society organizes and manages economic activities? If true, then there is a
pressing need for modifications to corporate laws and regulatory rules so that
DAOs can legally organize and operate. If the economic case for DAOs is less
compelling, there is no need to rush reforms.

Aside from discussing the legal and regulatory speedbumps
encountered by DAOs, I want to take a short detour into some social/philosophical
issues they raise.

One example is the politics of DAOs. I was surprised to learn
that DAOs are political, and they seem to lean left. Most of what I know about
DAOs comes from reading the so-called “white papers” that DAO creators produce to
market their DAO tokens. There is a noticeable socialist slant in the DAO white
papers I have read.

A typical script will explain that the DAO creates a
“community” where every token is treated equally. The DAO eliminates corporate managers,
accountants, lawyers, bankers, and bosses of any kind. A DAO has no corporate hierarchy
— only equally empowered tokens. DAOs use dispassionate computer code to
accomplish complex transactions using DAO-preferred private stablecoins and
tokens. Stablecoin transactions can be completed quickly and anonymously by
anyone in the DAO community without bias. The only fundamental inputs required
to join the “DAO community” and get started initiating unbiased transactions are
US dollars and access to the internet.

Who knew that we needed private stablecoins to avoid the
“bias” of transacting using Federal Reserve notes?

If DAOs are a new and important method for organizing economic activity, then lawyers, accountants, bankers, and MBAs could share their fate with McDonalds french fry cooks and humans in call centers — they will soon be replaced by robots. In the case of the corporate elite, their services will be replaced by “DAO bots” that are just so many lines of computer code that eliminates the need to pay the high salaries, health care, and pension benefits of the managerial class. DAOs will work for stablecoins 24/7.

While DAOs may catalyze economic “equity,” what happens in
the new DAO-centric world when a crackerjack coder finds a weak link in the DAO
code or Dr. Evil perfects his quantum computer? Will DAOs morph into HAL of
2001 fame, lock Dave out of the system, and empty all of the DAO’s stablecoin
wallets? No doubt cryptologists and cybersecurity experts are working on
safeguards.

But enough of the DAO tangent and back to crypto tokens and
SEC regulations.

Many cryptocurrencies and stablecoins avoid SEC regulations by not paying interest or dividends. You can earn income by mining Bitcoin, but Bitcoins themselves pay no interest or dividends. Libre/Diem was structured so that the interest earnings on Libre/Diem reserve assets went to the association members, not to the coin holders.

In my opinion, many existing stablecoins have had a willing
audience in part because short-term interest rates have been close to zero, even
negative in some currencies. Coin holders were not sacrificing much if any
return by exchanging national currency for private stablecoins. But with
short-term interest rates on the rise, investors are likely to become much more
concerned with earning interest on their stablecoins. Once they pay interest,
stablecoins are securities in the eyes of the SEC, and subject to the rules and
regulations that apply.

Much in the crypto news these days is about central bank
digital currency. The Facebook Libra initiative grabbed the attention of regulators
across the globe. With Facebook’s massive user base, many regulators worried
that Libra could displace some national currencies as the preferred means of
exchange. Legitimate concerns also focused on enforcement of know-your-customer
anti-money laundering regulations. And there were potential financial stability
issues should Libra become widely adopted. Ultimately the regulatory hurdles of
launching multi-currency Libra, and even the scaled-back plan for the
dollar-linked Diem coin, proved to be intractable, and Facebook pulled the plug.
Regulations, it seems, drained the profit from the proposition.

Central banks responded to Libra and the growth and
proliferation of other private stablecoins by proposing that central bank
digital currency be made available to the public. In the past, the public could
hold central bank money only in the form of physical currency (e.g., Federal
Reserve notes or Euro notes). Central bank digital currency could only be held
by banks and specialized financial institutions. Control over a financial
system’s holding of central bank digital currency is a crucial aspect of monetary
policy, so the idea of issuing central bank digital currency to the public is
no small matter.

The push for central banks to issue distributed ledger-enabled
digital currency raises the question of why commercial banks haven’t made bank deposits
tradeable using the internet and blockchain. Are there legal or regulatory
roadblocks to doing so? And if banks were to do so, would it obviate the need
for central bank public digital currency?

It turns out that at least one bank has developed a system
to transfer banks deposits using the internet and blockchain technology. I know
few details, but JPMorgan offers something called JPM Coin that can be linked
to traditional deposit accounts. According to JPMorgan, they have built a
technology that allows 24/7 instantaneous business-to-business transactions
using JPM Coin and blockchain technology.

At this juncture, the future of money is unclear. Will the
costs and benefits of traditional bank deposits and the interbank payments
system remain competitive or will it be replaced by digital currencies that are
tradable over the internet and are processed using some sort of distributed
ledger technology? Will the digital currency that trades include private
stablecoins, bank digital blockchain-enabled deposits, and central bank digital
currency, or will one technology dominate?

And there are other aspects of fintech I have not yet mentioned:
For example, there are fintechs whose entire business model seems to be based
on arbitraging our complex system of banking and securities market regulations.
How pervasive is this issue?

To learn more about the future of digital currencies, check out the event page.

The post Will digital currencies and fintech shape the financial system of tomorrow? appeared first on American Enterprise Institute – AEI.