GeoLegal Weekly #37- The Federal Reserve of Crypto?
I contemplate crypto in light of one of the most watched Fed announcements in recent memory. Also - catch me in New York and London in October.
Last week the US Federal Reserve Bank cut interest rates one-half a percent, or what financebros call 50 basis points — written “bps” and pronounced “bips” because it sounds cooler. Fed cuts during election season generally boost customer sentiment, thus favoring the incumbent party - so it was no surprise that Donald Trump called the cuts political (after previously saying he’d want direct control over the Fed) or that President Joe Biden had “predicted” a rate cut earlier this year (which is tantamount to pressure).
The Fed announcement was as hotly anticipated as the Super Bowl (or at least the Oscar for Best Motion Picture), which got me thinking about whether the Fed will truly weather the storm of institutional destruction that is eroding international organizations and government institutions alike. The biggest threat is not actually political pressure, as the markets will vomit on any attempt by politicians to restrict Fed independence. Rather, the biggest threat is that technology delivers an alternative to money as we know it.
In Crypto Some Trust
As of this writing, the market capitalization of the world’s crypto assets exceeds $2 trillion. That’s about 2% of world GDP, which sounds impressive, but it’s less than a third of the Federal Reserve’s current balance sheet holdings of $7 trillion. We are a long way from a crypto based monetary system, even if the instrument is widely held both in its own right and through second-order derivative instruments like ETFs. But the sheer existence of a burgeoning alternative raises interesting geolegal issues.
The most well-known of these cryptocurrencies, Bitcoin, is a “private” money designed to do two things—to serve as a lasting store of value because its full supply was constrained by design, and to be transferrable among users along pathways that guaranteed anonymity. Both of those can undermine governments as sovereigns have traditionally retained the right to print money and serve as guardians of its value - along with the right to manage the economy and who is transacting within it.
The feature of anonymity that has set off lots of alarm bells, and not just for Bitcoin, but for all digital currencies that have the feature of enabling anonymous transactions. A money whose pathways are opaque to official surveillance is of course seen as a natural vehicle for ill-gotten-gains to move through the system. And there are lots of stories of just such a thing. Even if illicit transactions are a relatively small fraction of all crypto-transactions, they are sizable enough to make authorities fret. One report estimates that while only 0.34% of all crypto transactions were received by “illicit addresses” that still added up to 24 billion dollars in 2023. And there is probably nothing that can raise the hackles of governments anywhere in the world than a headline featuring the words “North Korean Crypto Hackers.”
Of course, this type of government insight into transactions as well as fears of inflation from printing money goes down well with groups that already mistrust government. In the US, parts of the modern Republican Party are sympathetic, though it should be noted that crypto is a bipartisan ecosystem. The disgraced Sam Bankman-Fried –once feted as the J.P. Morgan of crypto – was a major donor, primarily (but not exclusively) to the Democrats. In any event, there is a part of the Bitcoin ecosystem that has for reasons of ideology and interest, embraced vociferously anti-establishment strongmen that it sees as being supportive of its anti-inflationary creed–Nayib Bukele in El Salvador; Javier Milei in Argentina; and Donald Trump in the US. But ironically, while Trump has stated his love of crypto and will accept donations in it, and Bitcoin’s most famous twins have made clear their support for Trump, it’s not clear that he actually “gets” what (purportedly) animates crypto enthusiasts. In a recent exchange captured on film he responded to one by saying that he thought the future of crypto “looked very bright” and then added, “Maybe we’ll pay off the $35 trillion US debt in Crypto. I’ll write on a little piece of paper ‘$35T crypto we have no debt.” But revulsion at this creation of “fiat” at the stroke of a pen is precisely what motivates Bitcoin enthusiasts. The episode might also suggest some of the cognitive dissonance between anti-establishment politics and anti-establishment finance, whatever they might share otherwise.
And that cognitive dissonance can run both ways. One problem with creating a monetary or financial ecosystem entirely free of the state is that financial systems tend to run lots of risks–they are practically designed to do so. And only the state is big enough to backstop those risks. Taking deposits that can be withdrawn at whim, lending money to someone with a good idea, getting it back a few years later with interest, passing on a portion of the interest to depositors and keeping the rest is a pretty basic description of the job. But it’s an enterprise that can go wrong because of incompetence, malice, just plain bad luck, or some combination of the above. And when things go wrong, they can go wrong spectacularly because people who hear about their neighbor’s bank failing might want to pull money from their own. The same is true of crypto currencies.
My co-author Karthik Sankaran has written here that while Bitcoin’s purported ability to resist its debasement by captured central banks might make it a highly desirable asset (like diamonds), it might also make it less useful as a “money.” An asset designed to appreciate against everything else is to be hoarded, rather than borrowed or lent. This is because an asset that rises in value against everything is one that is really hard to pay off if you borrowed some —bad news for both the borrower and the lender. And a money is something that has historically moved rather than just sat still.
A larger number of transactions have migrated to a newer vehicle, the so-called stablecoin. One thing bitcoin and other crypto assets have become known for is eye-watering volatility, trading constantly, keeping the hours of a Denny’s. Such volatility might not be for all, so a somewhat newer innovation is the Stablecoin—a crypto asset that functions like a money-market fund guaranteeing redemption at par value to the dollar. But stable coins still retain the feature of opaque transactions, something that has set off lots of alarm bells. The first is that the cross-border availability of stablecoins could enable electronic capital flight. This might be something the US government wishes happens to its adversaries, but the US has lots of allies in developing countries that would be just as susceptible to financial and political instability were such a thing to happen. And capital flight is not just a concern for the source of such flows, but also for the sink because large inflows of capital can lead to currency appreciation, asset market bubbles and other undesirable things.
There are also specific regulatory and legal issues surrounding Stablecoins. In essence, they are laying a claim to replicate the features of money-markets but doing so outside the penumbra of financial regulation. But the analogy does (or at least should) raise questions among holders –and governments. What assets are they investing in order to guarantee par redemption? Are they investing solely in short-term US government debt instruments or are they taking credit risk or duration risk? Could they be subject to runs–whether due to concerns about asset quality OR due to concerns about official breaches of customer confidentiality? Could they create systemic risk through a firesale of assets if subject to a run? If so, would they have access to Fed liquidity facilities in extremis? Do they deserve it if they are located offshore and/or fail to follow basic KYC and AML regulations? Recent news stories about the largest of the stablecoins–Tether– have raised just such questions about transactions opacity and the potential impact on financial stability.
GeoLegal Implications
We can bring together a handful of the challenges governments face from crypto so far: First, a rise in bad stuff they can’t track despite all the investment in KYC and other bank compliance infrastructure built over the last decade and a half. Second, a rise in tax avoidance that is hard for governments to see - or, alternatively, makes weekend crypto gamblers tax criminals. Third, there’s no centralized authority that has any oversight of these currencies, which means that these become transactions where governments can’t offer consumer protection or really regulate much at all. Fourth, governments can’t really stop crypto within their borders because the decentralized nature of it enables it to be accessed regardless of a buyer’s home rules.
And, finally, by steering transactions away from banks, control over the money supply is weakened and financial instability increases - which also makes having a monetary policy challenging. Now, one solution to that is central banks getting into the crypto game, which is worth a moment to examine, as some are considering launching a Central Bank Digital Currency (CBDC). Of course, Central Banks already have a digital currency—trillions of dollars move around the world every day because people working in banks, brokerages, exporters, importers, speculators push buttons on a keyboard. But the CBDC is special—it would be a direct liability of the central bank, rather than one backstopped by the central bank or another arm of government (like a checking or savings deposit under the FDIC limit). This would make it akin to a physical currency note or commercial bank reserves held in an account at the Fed or another central bank.
There are fears in some corners that a CBDC would erode the privacy associated with cash transactions, and worries that a CBDC would make it possible for a central bank to impose negative interest rates (admittedly something its proponents have touted as a virtue). There are also concerns that a CBDC would enable much easier bank runs as people flee the private banking system to choose to deposit their money at the central bank in a feared crisis (thus creating or exacerbating one). This in turn has led to debates over whether any CBDC should be “wholesale” (i.e., limiting access to the banking system) or “retail” with most (but not all) proponents looking for the wholesale option.
That said, all this does feel a bit like a solution looking for a problem that is not necessarily evident. And while the problem might not be evident in economic or financial terms, it is evident in geopolitical ones. And here one (extremely overwrought) worry is that if China gets there first, it would strengthen its claims to displace the dollar—a concern I think is misplaced given that the yuan is simply not freely convertible in the way the dollar, euro, yen, sterling etc. are. But a more limited worry (and one that seems at least realistic) is that a Chinese CBDC moving along Chinese digital pathways could lead to transactions that are transparent to Chinese authorities but opaque to American ones, denuding the US of the powers of surveillance, suasion and punishment that come from the centrality of the dollar in the global financial system.
Net Assessment
Most arguments about crypto are all or nothing because it is an enthusiast vs. purist debate. While it’s clear to me that decentralized finance will be a feature of the future, it’s not clear to me the extent to which it will start to truly eat away at institutions. As my readers know, I’m of the view that many traditional government and legal institutions are under significant pressure and crypto is yet another force to track. But governments have a lot of moves to play before they are overwhelmed by it.
Many years ago, one of the early crypto pioneers told me that for the average person it’s too risky to bet on a full crypto future and that, instead, I should assess whether I believe crypto will play some role in the next few decades and, if I did, to invest $10,000 in it because if it plays any role at all, that investment will multiply many times over. I wish I had listened.
GeoLegal Summits
I’m hosting all-day GeoLegal Summits in New York and London in October with unbelievable speakers from top corporations like Zoom and McDonalds, top law firms like A&O Shearman and Pillsbury and a host of risk analysis companies. If you’d like to attend or sponsor, use the links above or let me know. If you just want to grab some decaf while I’m in town, give me a shout.
-SW & KS