Crypto finance and the Global financial system

Updated: Aug 13, 2020

Cryptocurrencies and the global financial system : the status

It is not by coincidence that crypto-assets made the agenda of G20 summit which held in Osaka, Japan on 28–29 June 2019. In their declaration, the G20 group of nations’ leaders acknowledge the benefits that technological innovations can deliver to the financial system and the broader economy. They reiterate that crypto-assets do not pose a threat to global financial stability at this point. However, they recommend close monitoring of cryptocurrency developments and vigilance to the underlying risks.

The crypto market has evolved dramatically in the past few years. According to (PWC strategy&, 2019), the global crypto market reached a market capitalization of USD 270 billion by the end of May 2019.

One of the critical challenges that the global crypto market has been facing is the absence of a regulatory framework. The lack of regulators and legislators hand exposed the cryptocurrency market to financial crimes activities such as money laundering and funding of terrorism. Financial standards-setting bodies and financial regulators are responding to the need for a regulatory framework of the Crypto Finance ecosystem. In June 2019 only, two significant and global regulatory developments were concluded. Financial Action Task Force (FATF) introduced a revised comprehensive Know Your Customer/Anti Money Laundering (KYC/AML) standards for crypto service companies. Financial Stability Board (FSB) published the report on financial stability, regulatory and governance implications. What makes it more essential is that the G20 group of nations welcomed both FATF regulation and FSB report.

The recent active involvement of global financial standards-setting bodies and regulators on the global cryptocurrency market and including the decentralized financial technologies topic on the agenda of the 2019 G20 group of nations summit sends a clear message of the position that cryptocurrencies have on the global agenda.

In addition to the G20 declaration, media have reported that many central banks such as Bahamas, Sweden and Switzerland are exploring the possibilities of adopting cryptocurrencies in their monetary systems. Bank of England is exploring possible uses for Blockchain technology to upgrade the Clearing House Automated Payment System (CHAPS) platform.

Another recent and significant development in crypto finance is Facebook’s libra stable coin. According to libra’s white paper, the cryptocurrency could provide a possibility to sending money at low cost or free to an estimated population of 1.7 billion mainly in developing countries who do not have access to financial services. Facebook has an estimate of 2 billion users, the adoption of the libra cryptocurrency by 2 billion population could affect the global financial system. Dozens on corporations including well known financial service providers such as Mastercard and PayPal, joined Facebook’s project under Calibra umbrella, a non-profit organisation.

Facebook’s announcement of a plan for a new digital currency “Libra” has brought attention to financial sector stakeholders from regulators to financial services providers and consumers. Financial standards setters and regulator are already started watching the Facebook’s project closely, and some of them such as Thomas Moser, alternate member of the governing board at the Swiss National Bank have already shown their support according to Reuters.

France has set up a G7 working group in conjunction with the IMF and central banks to ensure proper consideration of any stability risk in case of mass adoption of the cryptocurrency. The US House Financial Services Committee and the Senate Banking Committee will host a hearing on Facebook’s cryptocurrency in July.

Tokenisation is another financial innovation built on blockchain technology, which is revolutionizing the financial market. Security tokens are mainly created through Initial Coin Offerings (ICOs) or Security Token Offerings (STOs). The token offering has developed significantly over the last three years and gained popularity due to the benefits they offer compared to traditional fundraising methods.

The global Foreign Exchange (FX) markets and Cryptocurrencies

The global foreign exchange (FX) market is the stimulant of international trade, the global financial system and global economy. According to the 2016 triennial central bank survey conducted by Bank for International Settlements, the average FX market trading was USD 5.1 trillion per day in April 2016. However, despite its role in the global financial system, the complexity of the current global FX market makes cross-border payment slower and costly.

A single payment transaction may involve several parties with a centralised and complex correspondent banking networks that face challenges of transaction costs, FX losses and time-consuming due customer due diligence process and other manual processes. Inefficiencies also arise from operations across different currencies, message formats, time zones and laws which makes the current FX market operations ineffective

Cryptocurrencies are the engine of the distributed financial system. The aim of the distributed financial system is to eliminate or reduce intermediaries or centralised processes that have been the centre of the provision of financial services over the past.

Cryptocurrencies built on blockchain technology and traded on peer -to — peer (P2P) networks could allow users to interact directly and decentralise their decision making without centralised intermediaries such as banks. Elimination or reduction of intermediaries could play as a catalyst to the decentralisation of financial activities as they significantly reduce financial transaction costs, complexity, transactions processing time and cut the barriers to entry. As the cryptocurrency market matures, they will be integrated with other emerging technologies such as the Internet of Things (IoT) and Artificial Intelligence (AI) to boost the entire ecosystem.

With reference to how the internet has freed communication, there is a huge call for cryptocurrencies to free finance where people can easily share wealth across the globe which could, in the end, have a significant social impact to the humanity. According to the 2017 World Bank report on Migration and Remittances which focussed on return migration, African diaspora populations sent USD 37 billion back home to relatives and friends in 2017. The average cost of sending these remittances can go up to 10% and it can take up to a week or more for the money to each the beneficiary. Realities shown by the already available use cases give evidence of how cross-border payments are money transfers can be completed the same way we do exchange text messages which were not the case in a few years back. The adoption of an internationally recognised cryptocurrency could remove the need for foreign exchange both in money transfer and international trade leading to the transparent and efficient movement of funds.

The maturity of crypto market infrastructure

Tokens have evolved as the foundation of the crypto market. The role of Initial Coin Offerings (ICOs) in raising funds to finance start-ups and other projects is unimaginable. Due to the borderless and lack of legal protection ICOs and the crypto finance market have in recent years become a target by cybercriminals. The recently reported cases of stolen cryptos through hacks have shown that the cryptocurrency ecosystem has some weak points and need to be adequately secured. A financial institution which engages in offering crypto services could consider implementing proper security measures to secure the whole crypto market ecosystem.

The recent and ongoing developments in crypto finance regulations such as KYC and AML by FATF gave rise to new forms of crypto funding instruments; Security Token Offering (STOs) and more recently the Initial Exchange offerings (IEOs). These new crypto funding instruments have legal stand compared to ICOs and therefore, they need to meet a set of regulatory requirements before they can be issued which protect them from some of the challenges that ICOs have undergone through. While the recent development in crypto finance legal framework has gradually reduced uncertainties, which were caused by the long passivity of regulators, there is still a need for lawmakers and standard setters to create an environment which is free from legal uncertainties within the crypto finance sector.

A stable crypto finance sector requires not only technological security but also financial security. One of the main reason why crypto assets are considered by regulators as high-risk investments is that their custody is not trustworthy. The crypto finance ecosystem still needs to work together to find appropriate solutions for the custody of crypto assets. Some of the solutions could require issuers of crypto finance instruments to have a minimum capital requirement in the form of fiat currencies deposited in respective central banks of other investment banks.

Another important point to consider when it comes to crypto market infrastructure is internet accessibility. According to the report by the World Economic Forum (WEF) as of June 2018, the world counted 3.8 billion internet users, more than 50%. However, the report highlights the inequalities in internet penetrations across different regions. For example, in northern Europe and Northern America, internet penetration is at 95% compared to 12% in the central Africa region. The low internet penetration in some parts of the globe is still a point not to ignore. Some of the short-term solutions may include the establishment of Public Point of Service (PPOS) with internet access and easily accessible by the population who do not have internet infrastructure.

Crypto Finance involvement in the near future

Over the past years, the crypto finance market has been fluctuating mainly due to the lack of regulatory clarity and unstable market of crypto finance. The movement from USD 110 billion market capitalisation in February to USD 270 billion market capitalisation as at the end of May 2019, as reported by PWC, is the clear example of the movement. The recent development in crypto finance legal frameworks such as FATF for KYC and AML and G20 group of nations’ declarations with regards to crypto finance has shaded more lights on the crypto finance ecosystem and will result in improved confidence within crypto finance stakeholders mainly investors and users.

The current noticeable public institutions exploration of cryptocurrencies projects such as central banks will enhance the regulatory framework. The continued developments in blockchain projects and cryptocurrency such as Facebook’s stable coin libra project will boost the crypto finance infrastructure and mass adoption and overall continued exponential growth. However, the evolvement of crypto finance is not with no challenges. As a public an interesting sector, they will have to comply with tight laws and regulations which at a certain point might suffocate the desired innovations in the sector. While crypto finance is considered as border-less, it may face challenges of differences in laws and regulations across different jurisdictions. As the market matures, there will be a need for coordination with regulators across borders in setting up independent standards-creation bodies which can facilitate the alignment between different jurisdictions.

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