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The views and opinions expressed in this article are those of the authors. CdR Capital Ltd is authorised and regulated by the Financial Conduct Authority. This article is for professional clients and eligible counterparties as defined by the FCA only.

The Subversion of Money?

“Banking is necessarybanks are not” Bill Gates (1994)

What price will Bitcoin be by the time you read this? $50,000? $5? Its value today, 12 December 2017, is around $17,000, which represents an increase of 1,600% since 1 January 2017 and around 5,666,666% since 1 January 2011.

That in turn means that the total market capitalisation of all Bitcoins mined so far (perhaps 16.5 million of an ultimate 21 million) is close to $280 billion. This is just short of the market capitalisation of Wells Fargo on the S&P500. If Bitcoin were a corporation, it would be among the largest dozen or so in the US. At least for now.

The furious pace of Bitcoin’s rise has sucked in other cryptocurrencies: the next largest by market capitalisation, Ethereum, is up more than fifty-fold in the year to date.

This week also saw the launch of Bitcoin futures trading on the CBOE¹, with large gaps opening up between the derivative price and the underlying market. There have even been stories recently about an unregulated mutual fund launch².

The questions that this extraordinary boom begs are obvious: why cryptocurrencies? And why now? To take the second of them first, there are doubtless multiple answers.

Speculative financial frenzies feed on themselves. Bitcoin’s trajectory this year has traced a classic financial bubble, driven higher by the wave of money chasing a limited supply of assets that exhibit powerful upward momentum.

This is especially true of China, which has accounted for a huge proportion of recent Bitcoin trading volumes, and has a well-earned reputation for retail-driven bubbles and busts, although more usually in its mainland equity markets.

When stories appear with headlines such as ‘Three reasons why Bitcoin could go to $100,000’, you know you’re not in Kansas anymore. Yet some Wall Street leaders, such as Jamie Dimon of JP Morgan and BlackRock’s Larry Fink, view Bitcoin and its ilk as the tools of choice for today’s black market operators. Fink suggests the price of Bitcoin “shows you how much demand for money laundering there is in the world today – that’s all it is”.

For any of the millions who have marvelled at the industrial scale of money laundering operations revealed in Netflix series such as Narcos and Ozark, Fink’s comment that cryptocurrencies are the ‘index of money laundering’ will doubtless ring true. Drugs are a cash business and for these operators processing the cash is a major enterprise in itself.

Spreading adoption of cryptocurrencies – encrypted digital assets that are not subject to state control – among international criminal organisations and rogue states may well be contributing at the margin to their price surge. It seems unlikely, however, that demand for money laundering has expanded 10-fold during 2017.

Could another factor be that Bitcoin offers an alternative escape route for capital trying leave China³? And furthermore, have these flows gathered urgency as President Xi tightens his hold over the country’s political and financial system, clearly foreshadowing the character of his second presidential term now just beginning?

In early September, ahead of the five-yearly Communist Party congress, it emerged that the People’s Bank of China was leading moves to close down China’s Bitcoin exchanges4.

Whether China’s move was an attempt to cool runaway speculation or to send a signal to those trying to take capital offshore, one conclusion was clear: governments are becoming steadily less comfortable with the existence of private, digital assets that have some, if not all, of the characteristics of state-backed money.

At the same time, financial regulators are growing increasingly unhappy with the digital quasi-securities sold to the public in so-called Initial Coin Offerings that, so far, have manged to circumvent mainstream securities regulation and basic investor protections.

And although the parallel is less clear-cut, how different is official anxiety over cryptocurrencies from the unease that governments and media owners now feel at the social currency created by Facebook? Both weaken the control that they have long enjoyed over the domestic political agenda.

All of this points to the issue that lies at the heart of the Bitcoin phenomenon: control. Cryptocurrencies may not function satisfactorily as money – a medium of exchange, store of value and unit of account – not least because their day-to-day value is far too volatile.

But they are a close enough approximation to have their uses. Many non-monetary items such as art or high-value collectibles provide serviceable stores of value that pass under the radar for tax purposes and are not tracked by central authorities.

As such, they can be readily taken offshore to enable tax evasion and capital flight. Stolen works of art are periodically recovered from underworld figures, who are reported to use them as collateral for drugs and black-market deals.

Bitcoin and other private digital currencies have many of the same properties: they are portable; can be readily valued; and are in finite supply. On that basis, a Bitcoin is not that dissimilar to a Penny Black, a Patek Philippe, or a Hirst spot painting. Like them, it can be used to transfer value privately from one person to another and one place to another.

Like a collectible, its price is set purely by supply and demand, and can therefore be extremely volatile. Also like a collectible, cryptocurrencies must be stored safely and can be stolen. In time, advances in computing may even reveal that – again like collectibles – cryptocurrencies can also be forged and even destroyed.

However, the major problem for black market users of Bitcoin and newer equivalents today is that the price has become far too volatile for it to be a satisfactory vehicle for illicit transactions. That said, its utility for that purpose will survive the bubble conditions in which it currently trades.

This is why – in the absence of successful government attempts to stamp Bitcoin out it is unlikely to go to zero. That does not tend to happen with collectibles.

Consider the parallel with Beautiful Inside My Head Forever, the two-day sale of works by Damien Hirst direct to the public on September 15-16, 2008, just as Lehman Brothers collapsed and weeks before the publication of Satoshi Nakamoto’s paper setting out the blockchain technology that underpins Bitcoin.

The sale, which Hirst intended would bypass the traditional gatekeepers in the major galleries and so democratise access to the art market, realised around £111 million and helped to drive his prices to new highs.

Inevitably, prices subsequently fell sharply, but never came close to zero. Hirst’s works still have value, just not the value placed upon them during a frenzy of speculation. The same is very likely to apply to Bitcoin.

The world of high-value, portable collectables offers the most useful parallel in trying to understand the niche that private cryptocurrencies occupy: a new source of supply for a special type of collectible. Namely, one that lacks aesthetic quality but enjoys turbocharged utility – ‘near-cash collectibles’, if you like.

And, because of this quality, the story of private cryptocurrencies will centre on the battle to own and control the cash-like utility that they embody. This value is coupled with near or total anonymity.

It is already clear that governments will not ultimately allow private cryptocurrency networks to flourish because the future of their nations’ financial and social systems depends on their retaining a reasonable degree of control over the ‘utility of cash’.

If that is lost, far too much untaxed value will disappear via private currencies into the black economy, helping to fuel the sex, drugs, arms and terror industries along the way.

Governments in developed economies are already struggling to fund their welfare systems and close budget deficits: they cannot risk any serious additional erosion of the tax base from new sources, such as private cryptocurrencies.

This was clearly the risk on Axel Weber’s mind when the chairman of UBS and former President of the Bundesbank spoke to the Financial Times recently 5. Weber “worries that his former public-sector colleagues may be left behind” by the spread of private, encrypted digital currencies, the newspaper reported.

“While the official sector very often looks at the risks of these new means of payment, the private sector tends to look at the opportunities they offer,” he noted, suggesting that the risk of anonymous crypto-financing of terror or money laundering meant that there was “a relatively high probability that regulators will regulate it at some point.”

This unfolding battle to control ‘the utility of cash’ in the digital world also explains why governments and central banks are now starting to experiment with state-backed digital currencies. In September, the Emirate of Dubai signed a deal to create its own digital currency, emCash.

Meanwhile, the 2017 Global Blockchain Benchmarking Study, carried out by researchers at Cambridge University’s Judge Business School, questioned 25 central banks on their engagement with blockchain and found the largest proportion, 82%, were researching it with a view to establishing a central-bank issued digital currency.

These experiments could ultimately allow state authorities to control the infrastructure behind digital currencies – subject to constant caveats about risks from hacking and/or quantum computing – and they could also have dramatic effects on commercial banking, potentially removing their role in credit creation.

Could central bank digital currencies spell the end of monetary policy as we know it? If state institutions can successfully introduce official digital currencies with stable values – enabling them to fulfill the traditional roles of money – they will be able to create a digital record of every transaction everywhere, making all of them visible to tax authorities.

“Weber envisages digital currencies not having the anonymity of cash,” the FT reported, “indeed features in the currency could identify users, so minors could be prevented from buying alcohol, for instance.”

It’s a fair bet that thirsty minors won’t be the only ones to chafe at such restrictions. Black market businesses will always need the cash-like utility that private cryptocurrencies can bring. This gives us a clue where the nexus of innovation will continue to lie: in efforts to create anonymous, cash-like digital assets to facilitate black-market transactions and to help launder illicit gains.

The current fever over Bitcoin and its fellow cryptocurrencies foreshadows the incipient tug-of-war between governments, rogue-state and non-state actors over the utility of cash, which brings so much power to those who control it. Expect accelerating innovation on both sides, but bet on the black economy to carry on finding ways round the hurdles that governments put in its way.


¹ Bitcoin futures rally to $2,000 premium over cash market in bumpy debut (11.12.2017), Financial Times

² Europe’s first bitcoin mutual fund launched by Tobam (22.11.2017), Financial Times

³ China probes bitcoin exchanges amid capital flight fears (10.01.2017), Financial Times

Beijing set to shut bitcoin exchanges to ensure price stability (11.09.2017), Financial Times

5 Central banks should embrace digital currencies, Axel Weber says (14.11.2017), Financial Times

Photo: © Niki Natarajan 2017

The views and opinions expressed in this article are those of the authors. CdR Capital Ltd is authorised and regulated by the Financial Conduct Authority. This article is for professional clients and eligible counterparties as defined by the FCA only.