UK and US Take Differing Stances in Assessing the Financial Stability Risks of Cryptocurrencies

Recent statements by representatives of the Bank of England, the President’s Working Group on Financial Markets, and the Financial Stability Board (FSB) suggest that consensus on the potential of cryptocurrencies to put the stability of financial systems at risk is diverging, at least in emphasis.

In the US, the President’s Working Group on Financial Markets, together with the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency, released a report in which it claims an urgent need to regulate stablecoins and the entities that issue them. The potential risks raised by the group include payment system disruption, concentration of economic power, and destabilising runs. This is the next in a series of attempts by the US to regulate systemically important parts of the digital asset industry, and this approach particularly highlights a focus on regulating the environment in which digital assets function, rather than regulating the assets themselves.

In contrast, in a speech at SIBOS, Bank of England deputy governor for financial stability Sir Jon Cunliffe stressed that, while the risks that cryptoassets pose to the financial system are now ‘relatively limited’, that assessment may change rapidly. This marks a shift in attention from addressing stablecoins as a first priority towards a broad-brush approach to the digital asset class as a whole. Cunliffe’s key point was that the USD 2.3 trillion market value of cryptocurrencies today may comprise a relatively small part of the total USD 250 trillion global financial system, but it could more than suffice to cause issues given the lesson of the USD 1.2 trillion sub-prime mortgage sector in 2008. Crypto technologies could offer ‘radical improvements in financial services’ but are already a concern. Cunliffe underlined the fact that policymakers around the world have only just begun to develop a framework appropriate for digital assets but they should pursue it ‘as a matter of urgency’.

Cunliffe’s comments were echoed by Bank of England Deputy Governor Sam Woods, Chief Executive Officer of the Prudential Regulation Authority, who stated a willingness to ‘front-run’ regulation – i.e. to lead global regulatory efforts rather than wait for a consensus to emerge – in order to prevent UK banks from accumulating over-large exposure to cryptoassets without supporting capital. Referring to recent Basel Committee proposals to apply a risk weighting of 1,250% in setting the capital backing for cryptocurrency holdings, translating into requiring capital at least equal in value to them and disregarding banks’ ability to hedge exposures. Woods said that UK rules may not exactly match the Basel Committee approach, but that they would be ‘very conservative’.

The announcement is another example of a change in attitude by an important public entity, as only 5 months ago BoE governor Andrew Bailey stated, ‘If consumers invest in these types of product [cryptocurrencies], they should be prepared to lose all their money.’

In marked contrast, the Financial Stability Board’s Patrick Armstrong presented a view at September’s Global Digital Finance Summit that cryptoassets – while on the radar and growing in value – are still too small to cause concern for global financial stability. His view is predicated on the asset class remaining relatively insignificant in proportion to total financial assets, real assets, and household wealth. The FSB acknowledges the risk that investor confidence in cryptoassets could be damaged through volatility, fraud, theft, or operational failures, but believes this is unlikely to affect overall stability. Use cases for cryptocurrencies remain niche, although monitoring is warranted due to a lack of the systemic safeguards built into fiat currencies and other assets.

Snapshot of Global Progress Towards Acceptance of Cryptocurrencies

Vlad Totia

Last week El Salvador officially adopted bitcoin as legal tender, thus becoming the first country in history to start using a purely digital and decentralised form of currency. Salvadorans can now pay taxes, take loans, and use bitcoin for the exact same purposes as they use the US Dollar, the country’s only other official currency.

The adoption of bitcoin as a national currency is a monumental milestone for digital assets. For now, the experiment raises more questions than answers, with concerns such as initial protests against the measure and the disrupted launch of the government-issued wallets. However, this is not the only significant change to happen in the regulatory landscape regarding cryptocurrencies. These past few months have been filled to the brim with regulatory changes in every corner of the world.

Another sizeable leap forward for digital assets has been the US Senate’s vote on the Infrastructure Bill and its definition of the ways in which cryptocurrencies can be taxed and reported. It shows that the US Government is moving on from a previously sceptical and even adversarial attitude. There is now a legislative package to shape a more predictable and regulated environment in which these assets and services can grow. Moreover, it has recognised cryptocurrencies as an asset class that should eventually have the same legitimacy as fiat currency.

While some countries are optimistic and friendly towards cryptocurrency acceptance, others have outright banned its use. It is likely that we will continue to see differing attitudes and approaches to the regulation of digital assets more broadly. However, while all eyes are on El Salvador and its leap into cryptocurrency adoption, it is worth taking a step back to look at the larger picture with regard to crypto regulation worldwide.

The opposers

Although governments are becoming more comfortable with digital assets, there remain some areas of the world that continue to treat them with varying degrees of scepticism. China cracked down on crypto-exchanges and miners in the country in July, contributing to the 20% drop that bitcoin experienced – part of a trend down to a level less than half its April peak value. This move was the latest and most significant in a series of periodic shake-ups of the sector, with the declared purpose of guarding against financial risk. Where exactly cryptocurrency regulation is heading in China remains to be seen, but the shorter-term impact is that the country’s dominance over the Bitcoin network and other blockchains by means of controlling mining or ‘hashing’ power is dropping rapidly. The miner exodus and an increase in mining in other regions of the world have caused the Chinese share of Bitcoin mining to drop 55% since the beginning of the year. These events have led to a more even share of blockchain responsibility and have potentially thereby strengthened network governance.

Turkey is another example of a country that does not look kindly on widespread use of cryptocurrencies as it has banned paying for goods and services with them. The central bank cited concerns such as anonymity, protecting existing payment systems (a further step beyond its long-standing ban on PayPal), illegal activity, and the potential for retail investors to lose money. The ban does not extend to the ownership or purchase of cryptocurrencies via a personal bank account, potentially leaving the door open for regulated investment use cases in the future. This has interesting implications for a population that has already demonstrated its keenness to hedge against high inflation and the devaluation of the Turkish lira.

Similarly to Turkey and China, India is another country that has considered banning digital assets in one form or another. The latest digital currency bill proposal is under review. The legislative package mostly targets how exchanges operate and what the regulatory landscape they fall under should look like. This potentially presages a ban on the ownership of private cryptocurrencies while paving the way for an official Indian central bank digital currency (CBDC).

While these countries may not be seriously considering an outright ban of blockchain technology or cryptocurrencies, these regions are likely to see significant regulatory restrictions on digital assets for a long time.

The cautious

Despite pushback from some countries, most are not opposed to blockchain adoption, and maintain a cautiously positive outlook on the emerging digital asset ecosystem. The European Union is actively interested in blockchain technology and has set up and funded a variety of initiatives to encourage its advancement while working on its proposed Markets in Crypto-assets Regulation, or MiCA. Arguably the most encouraging development is its own push for a CBDC, also referred to as the digital euro. The initiative was initially announced with a planned rollout in 2025, but the European Central Bank has expedited the timeline and launched a two-year investigation phase in July. It is encouraging that even a massively bureaucratic organisation such as the European Union senses the urgency in moving forward with digital money.

Despite the positives, the aforementioned US Infrastructure Bill passed by the Senate last month caused the cryptocurrency community concern. The bill’s most controversial elements see legislators taking a tough stance by potentially classifying most entities that are involved with cryptocurrency-related transactions – even tangentially – as ‘brokers’ that must be tightly regulated. While its intentions have not yet been clarified, the United States has clearly begun to catch up when it comes to defining its stance towards digital assets. This is a key precursor to the clear regulatory environment demanded by investors. As a whole, regions such as the United States and the European Union are approaching digital assets at a more methodical pace but are certainly not opposed to them.

The optimists

While only official legal tender in one country thus far, cryptocurrencies like bitcoin are slowly starting to be legalised and accepted as a payment method in various parts of the world. One of the most recent countries to authorise a slew of cryptocurrencies for merchant payments is Cuba. The resolution, which came into force on 15 September, regulates "the use of certain virtual assets in commercial transactions" in "operations related to financial, exchange and collection or payment activities" in or from Cuban territory. Digital assets, and more specifically cryptocurrencies, are already quite popular in the Caribbean Island, with an estimated 10,000 Cubans using them to transfer money.

Germany is another example of a country moving forward positively in the regulatory space. Earlier this year, it passed legislation allowing investment funds to allocate up to 20% of their value to cryptocurrencies under a provision called ‘spezialfonds’ or special funds. On a similar note, France has also ramped up its regulatory programme, proposing EU-wide regulations for cryptocurrencies. The proposal’s language is positive as it recognises the potential benefits in terms of market efficiency and economies of scale enabled by digital assets. Countries such as Germany and Cuba are examples of an understanding of the benefits that blockchain technology can bring to help meet demand and solve inefficiencies specific to their own socio-economic landscapes.

The pioneers

There still remain few countries in the world that have taken the initiative when it comes to regulating such a new technology. Switzerland has a reputation as a pioneer in banking and financial services, and it has no intention of missing the digital asset boat. Just last month, payments via cryptocurrencies started to be offered within the country through a partnership between Worldline and Bitcoin Suisse, and several cantons accept payment of local taxes in cryptocurrency. Switzerland has also consistently allowed the many financial institutions that it harbours to experiment with digital assets through permissive legislation. This has cemented the country’s status as a hub for a variety of crypto-asset companies.

As of 7 September 2021, El Salvador became the first country to accept bitcoin as legal tender, putting it on par with the United States Dollar, the official fiat currency of the state. While there are many questions to be answered regarding how or if the central bank will be able to exert any form of monetary policy on a currency which it cannot control, El Salvador has started one of the most interesting economic experiments of the century. How international financial institutions, banks and corporations will support bitcoin use within the country is yet to be seen. Several other Latin American countries and Ukraine are observing closely as they consider their own plans to follow El Salvador’s lead.

Countries like Switzerland or El Salvador have taken the first bold steps in approaching a wide range of questions from regulation to the taxation of digital assets. They have secured their places in the history books by creating templates for other countries to follow when it comes to architecting the digital asset ecosystem. The potential to attract innovation and growth this early on in a strategically competitive new field is significant.

Total Cryptocurrency Market Capitalisation Hits USD 2 Trillion Again

For the first time since May, the total market capitalisation of cryptocurrencies has rebounded above USD 2 trillion, according to some exchanges and data trackers like CoinGecko. This is reflective of the strong interest and the plethora of regulatory and technological progress that the ecosystem has seen for this past year. This ranges from the likes of J.P. Morgan allowing wealth clients access to crypto funds on demand, to Mastercard overhauling its crypto card programme, to Allianz implementing blockchain in order to streamline international motor insurance claims.

With this latest rise in value, total cryptocurrency market capitalisation now once again exceeds the market capitalisation of corporate titan Amazon – but it has reached this position in a third of the time it took for Amazon to grow from a bookseller to today’s technology giant. Blockchain is making strides towards becoming a mature industry and its use cases are starting to have an impact on the way traditional industries operate.

With the current rebound in market value, the health of the digital asset ecosystem as a whole also shows strong signs of improvement. Bitcoin dominance of the overall asset class fell from around 71% in January to a current level of 43.4%. This diversification of asset allocations within the cryptocurrency space shows that other projects are receiving funding, from both retail and institutional sources.

While total market capitalisation and price changes are relevant to traders and attract much attention, in the long term it is the success of specific projects that pushes blockchain technology forward. Around this time last year, Amazon’s valuation was roughly 15 times that of cryptocurrencies, however advancements such as the latest Ethereum hard fork or Cardano’s work on smart contracts continued apace. Ultimately, value will be driven by real transaction volumes and utility in preference to a speculative belief in future potential.

This rapid growth in value is both a sign of the exponential growth of technology and a guide to the future trajectory and value of crypto assets in general, as they move from today’s still relatively small and largely cryptocurrency-driven market to a future in which they underpin all financial instruments and services.

Bitcoin Adoption in El Salvador Raises Policy Questions for Cryptocurrencies

El Salvador has been everywhere in the news recently as the first country to adopt bitcoin as legal tender. This puts the cryptocurrency on par with the US dollar, which has held this status since the country abandoned its own currency, the colon, in 2001. The move marks the first time in history that a country has adopted a fully digital and decentralised currency for official national use. Salvadorans can now transact, take loans and pay tax with bitcoin, if they so choose. Slowly but surely, adoption of digital assets has moved on from something solely for retail users, or used in niche circumstances such as paying wages to sporting stars, towards the mainstream of public sector acceptance.

While the launch of the programme did not run perfectly smoothly, with the government’s official Chivo wallet experiencing a temporary blackout due to usage exceeding system capacity, the infrastructure is now in place for one of the most interesting economic experiments in recent history. With this adoption come many questions, particularly surrounding how central banks and other national and international financial institutions will deal with settling payments with the small Central American nation. Will the Central Reserve Bank (CRB) of El Salvador take bitcoin and exchange it for USD? Will it eventually issue its own central bank digital currency (CBDC)? Given the volatility of cryptocurrencies today, will the CRB take steps to hedge against massive price movements?

One solution that could offer more long-term stability to the national economy would be for the CRB to create a stablecoin – a token pegged to and backed by a reliable underlying asset – against its own reserve of bitcoin, and issue that same stablecoin for use as a form of payment. This solution would be similar to a CBDC, essentially a tokenised version of the national currency, but would give the government the possibility of amending the peg should circumstances such as major price swings require it to take action to protect its economy, giving it some degree of monetary control.

With many other potential challenges ahead for this first-of-its-kind experiment, it is clear that policymakers all over the world will pay close attention to how the Latin country goes about tackling them. El Salvador may be the first country to take this leap but, given the noises from several other nations, it may very well not be the last.

What Today’s ‘London’ Hard Fork Changes for the Ethereum Network

Ethereum is the second most used blockchain network in the world, second only to Bitcoin. Today marked a significant milestone in its development. The ‘London’ hard fork, as Thursday’s major upgrade is called, is part of a more extensive set of enhancements leading to Ethereum 2.0 that will effectively see the network undergo massive changes like changing from a Proof of Work model to Proof of Stake.

Arguably the most important aspect of the London hard fork is one of the five Ethereum Improvement Proposals (EIPs) that went live: EIP-1559. This protocol introduces transaction fee ‘burning’ to the Ethereum network. Before the update, each Ethereum transaction was accompanied by an additional sum in the form of a bid for miners to process it. This bid – known as the ‘gas’ fee – was made in small sub-units of the Ethereum network’s native cryptocurrency, ether, called gwei (1 gwei = 0.000000001 ether). The sender had to set a fee based on willingness to pay for space in the block of finalised transactions. Naturally, when the network is very busy, gas prices increase substantially due to competition for the miners’ processing services.

EIP-1559 changes this model completely by introducing a base fee (BASEFEE). This simply represents the minimum fee needed to be paid so that a transaction can be included in a block. The fee fluctuates depending on market congestion. The capacity of the network has been doubled, from a maximum of 12.5 million gas limit per block up to 25 million. There still remains the possibility to ’tip’ the miners to make a transaction more urgent, but this is optional. The base fee is destroyed or ‘burnt’ upon completion of the transaction.

The London hard fork changes a lot for Ethereum and for blockchain in general. Beyond the involved technical details of how the network is becoming more efficient and scalable, the world’s second most popular blockchain has undergone a massive upgrade to its core system without so much as a hiccup. Within the first 24 hours, 4,700 ETH was burned (c. USD 13 million). The vast majority of dApps (Decentralised Applications), most of the DeFi ecosystem, and many other payment systems and platforms are built on Ethereum. The fact that the network upgrade went by seamlessly is very encouraging for digital assets, as it proves yet again that the technology behind the hype is strong, tenable and increasingly mature.