In this insightful piece written by Zerocap treasurer William Fong and trader Joe Wilson, we discuss the potential cryptocurrencies have of providing a level playing field to world capital markets through the variables of CBDCs and stablecoins.
Since the global money market system left the gold standard in 1931, the US dollar (USD) has been the dominant currency of choice for capital raising. In short, the USD-based capital market allows the US and its major allies (G7s) to reward borrowers that perform to their expectations and penalise those who don’t. Emerging market economies can access the global bond arena through a number of capital markets dominated in USD, JPY, GBP, or EUR. However, entry points are predominantly in US dollars. As we’ve witnessed during the previous liquidity crunches of the Asian Financial Crisis, the Tech bubble pop, the European Financial Crisis, the GFC, and the asset sell-off at the beginning of the COVID19 pandemic, USD funding costs almost always go higher. USD repayments against domestic EM currencies always get more expensive as the USD index appreciates. This is a vulnerability that emerging market economies have faced for decades.
Since borrowing and lending in international capital markets are primarily denominated in USD, borrowing and lending carry no currency risk from the US government’s point of view. Over the decades, this inherent bias that favours the US economy has been taken for granted. EM borrowers have little to no alternative but to be subject to an uneven playing field. However, two recent developments or events have brought the USD system into question. Now an opportunity, not seen since the end of the Bretton Woods agreement in the 70s, is apparent. This article will introduce these events and initiate the discussion.
Freezing of Russian central bank FX reserves
The majority of exporting countries in the emerging market economies sell their goods and services internationally and often receive USD in return. As part of the OPEC + group that supplies most of the world’s operating oil requirements, Russia receives USD and other major currencies for the oil exports they sell to the world. Over the years, the Russian central bank has monetised some of that export-led income and placed it into USD, GBP, and EUR-based investments, including the US treasury bond market. Custodians of these assets are quite often aligned with their own respective central banks, such as the Federal Reserve of the US. However, for the first time since leaving the GOLD standard, the FED and other G7 central banks have frozen all Russian owned USD, GBP, and EUR-based FX reserve assets that are in custody under their jurisdiction. This is in retaliation for Russia’s invasion of Ukraine.
There is no justification for the loss of human life and the economic suffering Ukraine has experienced as a result of this war. However, in a free market, the FX reserve holdings of a country should belong to that country. There are nuances to this argument – Russia is clearly Communist, so should this preclude them from participating in a truly free-market economy when they act nefariously? There was a gentleman’s agreement of trust for Russia to purchase US treasury bonds with the proceeds from years of oil revenue -many are arguing that geopolitical disagreement should not overwrite this contract.
The action to freeze Russia’s central bank reserve raises an important question. A question that has been on many exporting countries’ minds for some time. How can countries be reassured that their savings are not vulnerable to the same treatment if at any time in the future they fall out of geopolitical agreement with the US? In addition, it raises the question of US power dynamics and the control of other sovereign economies.
The rise of CBDC and stablecoins.
Recently, we’ve explored the history of cryptocurrencies and the differentiation between various digital assets as a medium of exchange and assets for investment. There are two significant and recent innovations which present an alternative to the USD system. Firstly, a recent survey conducted by the Bank for International Settlement (2020), suggests that up to 80% of the 66 central banks polled around the world are investigating the introduction of a Central Bank Digital Currency (CBDC). Secondly, the popularity of stablecoins as both a partnership with the USD and an alternative to the USD system is now a frequent topic among economists, regulators, and industry participants.
Here are a few Zerocap articles related to CBDCs and stablecoins:
- Stablecoins: A Zerocap Summary
- CBDCs – Central Bank Digital Currencies
- Central Bank Digital Currencies – Advantages, impact and privacy concerns
What are CBDCs?
CBDCs are digital tokens and an electronic representation of a country’s official currency. Unlike cryptocurrencies that are typically run by private entities, a CBDC is poised to be a cash equivalent issued and regulated by a nation’s monetary authority such as the RBA. CBDCs can speed up and reduce the cost of transactions and simplify the implementation of monetary and fiscal policy. Historically, economically vulnerable households have had disproportionate access to digital payments systems. Thus, the issuance of a CBDC could eradicate financial barriers by reducing transaction costs, promoting access to credit, enabling instant payment of wages, tax refunds, and other federal payments. Last year, China’s proposed virtual currency rolled out across several provinces. As of the end of October 2021, China’s CBDC has been used to conduct $9.7B (USD) of transactions across 140 million individual wallets.
However, CBDCs, like all government inventions, can generate issues of control. When China first introduced the e-Yuan to the public, they deposited RMB 1,000 into every one of the citizens who had set up an e-Yuan wallet. However, there were many restrictions on how and when you could use those funds. There is also the fear that if the government could instantly deposit into your wallet, authorities could also immediately withdraw from your wallet or even freeze a wallet’s entire savings if one was to fall out or disagree with government initiatives. An IMF paper on proposed CBDCs floated the concept of expiring digital money, thereby forcing economic activity. There are free market implications to the design of CBDCs that are yet to be fully determined.
Why issue CBDCs?
The way people interact with cash has changed. The rise of electronic transfers, smartphones, and credit cards has reduced the need for physical cash. This, coupled with the rise of cryptocurrencies and their relationship to decentralisation, has prompted central banks to consider the implementation of CBDCs as a defensive measure to maintain control over the supply and value of their domestic currency. Benefits associated with cryptocurrencies such as near-instantaneous transactions, impressive transaction volume capacity, and improved access are additional incentives to implement a CBDC.
Can CBDC create the new USD system?
On the positive side, CBDC takes advantage of digitisation and tokenisation, making transactions and money multiplication more efficient. It would be easy for governments to implement fiscal stimulus quickly and efficiently – near instantaneously crediting citizens that are in need of support and who are likely to spend, resulting in economic growth. In times of inflationary pressure, a tightening could go through with a tax hike that instantly deducts your projected payables. Central banks could also stimulate economies by reducing monetary interest rates on all interest owning liabilities, in the entire banking system instantaneously.
A downside of CBDCs in their attempt to replace the USD system, is scalability. The issue exists today where emerging market currencies do not attract enough investor interest from the international capital market. That means an Indian or Danish bond, issued in their own domestic CBDC, would likely not generate the kind of global portfolio interest and hence demand required to match their funding needs.
How about Stablecoins?
An issue faced with stablecoin creation is the lack of a recognizable credit profile from the issuer of the stablecoin. Tether is the world’s largest stablecoin by market cap (USD 82 billion at the time of writing). However, its employability in traditional capital markets has been below optimal. This is due to a lack of transparency and inadequate auditing by international financial institutions. There are suspicions that the issuers of USDT are not backing each USDT with the same exact amount of risk-free assets. There is merit to this skepticism for two reasons – issuers can make money by investing the issuance into yield-paying assets, and the higher the yield return, the better the profitability, and because banking rails for unregulated stablecoins are very tough to secure and maintain. Since private issuers are in the business of making a profit (unlike a central bank), it makes sense to invest the proceeds from the issuance of USDT into higher yielding assets instead of risk-free money market products. But it also means there is always the risk of a liquidity crunch during the period of a bank run, where everyone demands to sell back the Tether for the USD.
The introduction of the institutionalised stablecoin
Zerocap has recently partnered with ANZ bank to facilitate the first bank-backed stablecoin transfer. A$DC is backed 1:1 by AUD money supply, and holds the credibility of a true bank. This is a world first, and further validation of institutional infrastructure in the crypto space.
Despite rising concerns in the USD system and its implications for emerging markets reserve management, an alternative platform for the fiat-based money system is currently not available. Through the form of stablecoins or CBDCs, cryptocurrencies could potentially provide a viable alternative in the distant future. The idea of the tokenization of global capital markets has incentives to attract investors from all walks of life rather than only being confined to international institutions. Bank-based stablecoins not only provide credibility through their tokenisation mechanics, but can also coexist with CBDCs without interrupting the money supply of an economy. Or perhaps we re-enter the GOLD standard via PAXG’s tokenisation strategy to allow precious metal stored of value without the storage and transportation cost. A bulletproof choice out of the USD system, which provides global access to the international capital markets, remains a work in progress. There is a light at the end of the tunnel for a level playing field. When it comes to rebalancing towards emerging market economies on raising global capital, cryptocurrency development appears to be the best hope. Watch this space for further developments.
Founded and bootstrapped in 2017 by three individuals with a mix of tech, finance and entrepreneurial backgrounds, Zerocap is a market-leading digital asset investment bank, providing unique investment products and technology to forward-thinking investors and institutions globally. We have a growing team of 50 staff, focused on providing the smartest advice and technology for wholesale investors and institutions.
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