Money - Dead Reckoning Part Two

The US appears hostile to crypto, but blockchains hold the future of money. What's behind the mask? It's time to take The Sniff Test.

The Threat to Dollar Dominance

The battle for the future of money is underway and with it the struggle to be the dominant power for the rest of this century. The US leads, but its fractured political system does not appear ready to respond to rapid technological change. While we are liable to overestimate how much things such as AI and blockchain will progress over the next year, we generally underestimate how different things will be a decade from now.

Dollar dominance puts the US at the centre of the world’s financial system. Countries accumulate dollars through international trade and America is the natural place to invest them, which reinforces its financial leadership. This allows the US to watch the movement of money and interrupt it at will, as well as giving it control of the technology behind financial flows.

This causes resentment and resistance. Russia’s US assets have been rendered worthless unless it recycles them through a neutral state, much as its oil flows through India and other opportunistic nations in circumvention of sanctions. Out of necessity, alternative routes are being created using different currencies, with the main beneficiary being the Chinese yuan.

China itself watches on, conscious of a coming conflict with the US. It lacks the financial or military might for that today, but it plays the long game. Worming away at the dollar’s dominance is a key part of that strategy.

The Global Competition for Money

London remains at the heart of global finance long after the dollar replaced sterling as the global currency. The UK is the largest hub for trading foreign exchange and interest rate derivatives, and is a destination of choice for offshore dollars looking to avoid the scrutiny of US authorities. The UK is heavily invested in dollar dominance, but retains its ability to move with the times.  

The latest prize up for grabs is to be where crypto currencies move in and out of the conventional financial system and, by extension, the leading player in blockchain technology. Less than 10% of bitcoin trading is US-based, which throws the competition wide open. Singapore and Hong Kong are circling and earlier this year the EU passed significant legislation. This lays out a regulatory regime for digital assets that removes the risk of future prosecution, which still hangs over those doing business with Americans.

Recognising this, US enthusiasm for attacking crypto is fading. Having hobbled the first wave of industry pioneers, the SEC is set to bless mass market ownership of digital assets, provided they are managed by leading US financial firms. Blackrock, the world’s largest investor, has filed for a stock market fund that holds bitcoin, and only once in 550 attempts has the firm been turned down for this type of vehicle.

The contest is about how best to legitimise crypto by bringing it into the mainstream. By making it one of many different assets available for public investment, the authorities gain control and marginalise the shadier elements in the space. The purists will note that because you don’t own digital assets, but rather a fund that invests in them, then you remain reliant on the state. That’s the point and probably the only way that crypto goes mainstream.

The Future of Money

A blockchain is a global platform for the simultaneous exchange of goods. When you buy something there are two parts to the transaction. The first is the exchange of money and the second the transfer of whatever you bought. Blockchains are a faster and cheaper way of doing the money part. They can also be used for certain goods.

Digital art received a spike of interest as a result of the money sloshing around during the pandemic. This medium allows both the transfer of money and of the goods on blockchain, and consider it as a test run for how digital assets may trade. The fact that monkey pictures aren’t worth what they once were is irrelevant for the value of the non-fungible token technology underpinning them.

Anything where ownership is removed from the underlying asset, for example shares in a company or the deeds to your house, may be represented, traded and transferred on chain. The company and the house don’t move.

When ownership of your house is represented by code on a blockchain, then other things may be written into that code. The deeds can transfer to you automatically when you repay your mortgage, or transfer to a buyer once they pay. Code is a series of ‘if’ and ‘then’ statements, which is how most investing is done and most contracts work.

Of course, many contracts are convoluted with ‘if’ and ‘then’ followed by ‘but if’ something else ‘then’ something different. The challenge automating more complicated contracts is having an oracle, which is an authority trusted by both parties to determine when an event has happened.

Consider insurance for crop failure. The farmer and the insurer may agree that when a reputable global weather agency says temperatures were above a certain level, or rainfall less than a particular amount, the insurer pays the farmer. Alternatively, a third party could confirm that the crop yield fell below the level required to trigger the insurance. Both requirements could be coded into the contract, along with the proof, and when met money would transfer automatically.

Existing law is ambiguous and lawyers make their money interpreting it, playing the role of the oracle in the above example. On blockchain the code is law. Any blockchain that remains under the control of the state and therefore national laws, will continue to be vulnerable to rewriting of the code. Those who want definite decisions and instant transactions, therefore, will favour decentralised blockchains beyond the control of a sovereign nation.

This does not mean that governments lose the ability to see who is doing what. It is a myth that Bitcoin is anonymous and the best way for criminals to operate. Every transaction that ever happened is recorded on chain and accessible to anyone. When anonymous accounts move money back into dollars they can be identified. Laundered cash is untraceable and I bet the FBI loves crypto.

What the authorities do lose control of when blockchains are neutral is the ability to sanction parties to a trade and stop it happening. This is appealing to crypto bros with an inherent distrust of the state and particularly attractive to rivals of the US.

The Future of Central Banks

The all important question remains what is the money that will be used to settle these coded contracts that are the future of trade and transactions.

The current race leader is stablecoins. These are digital tokens that represent a currency, typically the dollar and may be used on multiple blockchains, removing the need to own the individual tokens of each chain. The stablecoin operator uses dollars deposited with it to buy assets that support the value of their coin. This should be attractive to the US, because it creates huge demand for high quality and liquid dollar assets, which is what the US government issues.

The US is in the process of litigating most stablecoins out of existence. While this is interpreted as an anti-crypto measure, it is more likely to be a way to consolidate the industry to a preferred supplier that acquiesces to US law. Perhaps in the next decade a stablecoin operator will surprise everyone by being granted a banking licence. That threat will keep JP Morgan in line.

Provided the operator agrees to check the identity of its clients and make it available to the authorities, it should be full steam ahead. Remember, the US is happy for Joe Public to punt around in the value of bitcoin, provided it does so through a US financial company.

Central Bank Digital Currencies are an alternative to stablecoins on chain. These would negate the need to manage the value of a stablecoin against the dollar and cut out the middle man. But it’s not that simple.

In order to gain the benefits of digital money, it needs to be programmable so that contracts can be written in it. For state-controlled blockchains, this may mean too much access to the underlying code, including by nefarious actors in hostile countries. North Korea is believed to be funding its nuclear programme through hacking weaker cryptocurrencies, which ironically is speeding up the transition to a single, government-approved operator.

Equally, the point of blockchains is that they are fast with near infinite capacity. Both Bitcoin and Ethereum fall short, which is why a series of competing chains appeared in recent years. The shortcomings are mostly due to the security measures that protect Bitcoin and Ethereum and are the source of their acceptance and longevity. Security is also the cause of Bitcoin’s massive energy consumption.

Newer technologies, known as layer 2s, have been developed to boost the capacity and speed of both networks. These batch up transactions and periodically put them back on the parent chain. They are lightning fast with minimal energy use. Ethereum has the advantage because it is designed as the world’s computer, while bitcoins have the primary purpose of holding their value over the long term.

The US must make the digital dollar the preferred means of backing stablecoins to maintain the primacy of its currency. If it doesn’t, others will step in.

The Role of the Eurodollar

One of the innovations that kept London at the heart of global finance was the development of the Eurodollar market. This refers to the vast quantity of dollars that circulate outside of the US and are the source of 90% of international loans. Originally they were held mostly in Europe, hence the name, but nowadays dollars are earned by all exporting nations, with China, Japan and South Korea notable among them.

Banks all over the world tap into these dollars and can operate in the currency beyond the reach of the US. All that is needed is a London registered bank to legitimise the reintroduction of this money into the US sphere of influence. There are over 250 foreign banks in the UK and they control over a third of the financial assets here.

Eurodollars are an alternative means of backing stablecoins if the US is too late to the party. From here it is a short step to a digital yuan, which already exists, or euro being the mainstay of stablecoins. Testimony before Congress has indicated that the US has around four years to act. This is the prize that countries seek as they open up to crypto currency trading in their existing financial centres.

Tom Cruise, The Joker and The Sniff Test

Part of the reason for writing The Sniff Test is a fascination with the idea that when you know something then you are probably being fooled. This idea is attributed to Al Capone, but I prefer The Joker’s look.

Remember, knowledge is the best existing explanation for the evidence. The transition to a digital currency is onerous in the West, where the sunk cost in the existing financial architecture is huge and many smaller banks may not be able to afford to switch. Yet if replacing this architecture is the price to retain monetary sovereignty, it is worth paying.

It is barely conceivable that whatever its instincts about crypto, the US will surrender sovereignty by virtue of failing to act. The stakes are simply too high. It is more likely that it is masking its true intentions behind a veneer of hostility to crypto, with compliant fools in media and politics providing the masquerade.

The US has an increasingly concentrated banking system, although nothing like the UK. The 4 banks that went bust earlier this year represent a similar share of the economy as the over 10,000 that closed during the Great Depression. The US response to the latest rescues was to allow JP Morgan to go above the longstanding 10% limit on deposit market share. A much more concentrated banking system might be necessary to herald the age of digital money.

We will have to wait for June of next year to find out how Tom Cruise resolves the control of the all powerful AI. It may take slightly longer to discover the future of money. One thing we do know is that while Hollywood has the option of having Cruise destroy The Entity, no one is destroying money or its digital equivalents.