Removing trust from the equation

I have many times heard that the reason why the global banking systems work is because banks trust each other. Nothing could be further from the truth. The fact is that banks mistrust each other and only engage in international money transfers and cross-border (even domestic transfers) because they must, otherwise, the financial systems wouldn’t work. Crashed: How a decade of Financial Crises changed the world  by  Adam Tooze

When a Danish bank transfers money to a bank in the US, the system works in the same way it has done for a long time. The funds will be transferred to the US bank against a promise to repay on demand. The money is transferred to the bank directly if the US bank is a correspondent bank to the Danish bank against credit limits set in advance against the US bank.

The bank in Denmark will only transfer money to its correspondent bank, which in turn will transfer the funds domestically to the receiving bank. If banks trusted each other, why not just send the money directly to the bank of the receiver? The fact is that mistrust prevails over trust. (Crashed: How a decade of Financial Crises changed the world — Adam Tooze)

The less developed a country is, the less risk a bank is willing to take against a country overall and the less bank risk the correspondent bank will take and the higher the fees and settlement time.

But what if the risk is not part of the equation anymore, what happens then?

Well, this then boils down to a question of whether one trust banks more than technology and whether the consequences of taking the ability for banks to leverage deposits out of the equation is a good thing or a bad thing.

With blockchain technology, we can store assets like money or commodities and transfer those safely from one place in the world to another almost instantly — and that changes everything! Trust is no longer a part of the equation, simply because you can’t transfer more than you have in your digital wallet.

If credit becomes part of the equation, things change dramatically; a system must be able to handle a situation where a loan is not repaid. Credit, however, could be added as functionality in the form of a DApp (decentralized application) to a digital blockchain-based system.

Solvency

Proving solvency is not a matter to be taken lightly.

In the stablecoin world, solvency is a different matter than in the commercial banking world. Here, solvency is a question of ensuring that assets and liabilities always match 1 to 1 or assets exceeds the amount of liabilities outstanding, or that assets exist in an interdependent ecosystem to cover deficiencies in this equation.

In the banking world, solvency and compliances are monitored continuously by central financial authorities. This is not the case in the unregulated and unsupervised crypto world. Therefore, the minimum requirement as far as solvency checks are concerned are:

• That an independent and trusted party checks solvencies

• That the 3rd party verifier reports its findings upon demand and in a transparent manner independently of the crypto issuer/manager to relevant crypto communities/forums and the general public

• That the 3rd party verifies when they want to and at random

• That information can be provided to the 3rd party verifier without the data passing through the crypto issuer/manager first.

Ideally, a system should, if possible, be set-up so that an autonomous system (DAO) independent of all external human interference can verify solvencies.

Programmable Money

Once money is issued in the form of a digital value, the money becomes a digital stake on a certain amount of digitally issued cash, which in this case should always be backed up 1 to 1 with underlying real money (fiat). Money is not necessarily moved around as such, but merely as a digital representation of the equivalent amount transferred in the form of a digital IOU.

When money is digital in this form, it becomes programmable, meaning that its possible to create digital financial and insurance products, for example, which represent a guaranteed assurance of completion of an asset, a contract or money transaction.

In such a case, arrangements can be established that guarantee payment against a particular service or goods being delivered. For example, a purchase of digital stocks or bonds with regulations already programmed into the asset. It happens instantly and without dispute. No banks or other types of intermediaries are required. There is no uncertainty about payments or contracts being honored.

There will pretty much be no issues about payments for international trade, and a vast number of financial contracts and insurance products can be built on programmable money with reactive ease, ranging from micro-donations for foreign development aid and trade finance products, to fully automated payments of compensations for delayed flights.

The new order

It is theoretically possible that sometime in the future Bitcoin will be the reserve currency we will measure everything up against, replacing USD as the global reserve currency. I.E., a situation where Bitcoin is accepted as the only an accurate representation of global economic value and accepted as the value represented of real value in thousands of supply chain from primary producers to final consumer.

In such a situation, a stablecoin could be a derivative or composite product which reduces the relative volatility against Bitcoin, but we are currently quite far away from such a situation.

For this to happen, Bitcoin would have to be accepted as a means of payment for starters throughout the economies of the world, but it might come as a surprise that the total amount of USD in circulation outside the banking system is USD 1.67 trillion at the time of writing while the market cap of BTC is USD 112 bn or 6.9 % of the total amount of USD in circulation.

This is surprising because it means that if BTC over time increases 14 times in value measured against USD (stranger things have happened in the past), the BTC in circulation will be identical to the amount of USD issued by the federal reserve circulating outside the banking system. Hardly enough to replace cash in a global economic cash content but still.

This money in circulation is of course not the same as the actual money in usage in an economy, as measured by M3 (M4), which is a measure of the amount of money in use after expansion through leveraged lending, primarily from the banking systems.

However, there is, in theory, nothing that prevents the same kind of credit expansion to take place with BTC over time, if BTC was globally accepted as a reserve currency or a representation of true economic value.

In presentations, I often use an analogy, comparing the market cap of Google, Apple, and Facebook against the market cap of the entire crypto-space and BTC to underline how little this represents in an overall economic context.

Such a comparison is, if not wrong, at least unfortunate if we stop thinking of BTC as an investment, but instead as currency which value will increase or decrease depending on the demand for usage in money supply terms or right economic terms on an unleveraged or leveraged basis.

It should be noted that extending credit and credit expansion through a monetary system is heavily regulated activities. Just how credit extension and expansion would happen in a decentralized system with no central authority is difficult to see, unless of course the decentralized system would be able to make decisions based on majority vote and protocols derived from precisely that — the power of decentralization with no central point of control, which essentially was the fundamental principle of cryptocurrencies from the beginning.

But that’s all a story for another day. Meanwhile, the best proxy to central bank issued digital cash, which functions in practice across borders, is the stablecoin which best represents the actual risk of underlying government risk.

Article by Morten Nielsen, Co-Founder and CFO of ARYZE

Disclaimer

The views and opinions expressed in this article are those of the authors and do not necessarily reflect the official policy or position of ARYZE.

Morten has many years of experience in finance, fundraising, and the cryptocurrency space. Previously at JP Morgan for five years, where he was mostly working with hedge fund fixed income and derivative marketing. He has also held a position as global head of hedge fund derivative marketing at UBS. He is now CFO and co-founder at ARYZE and is responsible for financial risk assessment and management, as well as management of a range of business and revenue activities.

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