FWIW # 23 CRYPTOCURRENCY February 2022

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This FWIW is devoted to cryptocurrencies. To save me from having to type that long word over and over, I’m going to abbreviate it as the acronym CPTO. This will be a long FWIW because CPTOs are complex when considered to be something besides a foolish way to throw away money. The basis of this FWIW is a document released by the Federal Reserve in January 2022: Money and Payments: The U. S. Dollar in the Age of Digital Transformation. If you are interested in reading the full report, it can be found at federalreserve.gov. Before getting into the serious discussion of government sanctioned CPTO, you need to understand a few facts about the current CPTO world.

First, understand there is no such thing as the shiny gold and/or silver coins commonly used to portray bitcoin or any other CPTO. Those images were created to meet people’s expectations that currency, such as bitcoin, is tangible. The only things tangible about CPTOs are the 0’s and 1’s digitally recorded on a server or multiple servers somewhere on earth. People are accustomed to feeling money, either as paper or metal coin, and that’s why the CPTO industry came up with these interesting, misleading, and false pictures.

Second, a person who wants to participate in the CPTO world must set up an account, often called a digital wallet, with an exchange and deposit a form of sovereign money in that account, such as the US Dollar, British Pound, Euro, or some other government-issued currency. This deposit is then used to buy one of the stablecoin CPTOs. The stablecoin CPTO can then be used to buy other digital CPTOs. A reverse transaction is necessary to reconvert the CPTO back to sovereign currency. Both transactions are slow and expensive. The direct exchange rate set between a CPTO and any good or service is not a set number. It will depend on the condition of the market when the exchange for goods and services or reconversion is made, and, just as importantly, what the other party to the transaction believes the value of the CPTO will be when they want to convert it to sovereign money.

Third, the Fed report touches on several risks about CPTO; however, the real “black swan” risk is barely mentioned. To me, this critical risk is the one reason CPTO will not be used in true investors’ portfolios. An exception is if the Fed issues central bank digital coins (CBDC), their name for CPTO, which has the same risk but also enjoys the US government’s backing.

Fourth, this week it was announced the US Justice Department seized $3.6 Billion in stolen CPTOs. In the announcement, it was disclosed the US clawed back the $2.3 Million in CPTO paid to extortionists of the Colonial Pipeline. Previously, the US had seized $1.6 Billion in CPTO the convicted founder of the Silk Road dark website tried to hide. Two thoughts come to mind: (1) governments can track and seize CPTO if they feel it is appropriate, and (2) criminals can hack and steal CPTO at their pleasure.

Now, to the serious issues about CPTO. This FWIW’s format will be the format of the Fed discussion paper. I’ll use the same subheadings they use, point out what I think is important in each section, and then give you another viewpoint. To make sure my opinions are not confused with the Fed’s work, my opinions will be in italics.

INTRODUCTION

A CBDC would be a direct liability of the Fed. Other than physical paper and metal coins, which are currently a direct liability of the Fed, most money today is a liability of a commercial bank. The Fed sees a range of benefits associated with having a CBDC: The public would have what the Fed considers to be money that (1) is free of credit and liquidity risk and therefore supports newly created financial products and services, (2) supports faster and cheaper cross-border payments, and (3) expands consumer access to the financial system. The Fed considers the risks to be (A) to monetary policy development, (B) changes in the structure of the financial system, (C) the cost of credit, (D) the safety and stability of the financial system, and (E) the efficacy of monetary policy. Importantly, the Fed has put the political authorities on notice that they will not create a CBDC without legislation from Congress that authorizes such.

This was the first place I noticed the Fed sidestepping the black swan risk of CPTOs or a CBDC. It was also the first place the Fed introduced the concept of a CBDC being a step in the direction of a one world currency.

EXISTING FORMS OF MONEY

The Fed correctly defines money as a store of value, means of payment, and a unit of account. They list three types of money in the US today: (1) Central Bank Money, which is physical currency issued by the Federal Reserve and reflected in digital balances held by commercial banks at the Fed; (2) Commercial Bank Money, which is the digital money used by the public in the form of commercial bank accounts; and (3) Nonbank Money, which are digital money balances held by nonbank financial services providers, such as brokerage firms, credit card companies, and the newer fintech firms such as PayPal and others.

The Fed’s perspective focuses on the credit and liquidity risks for each of these types of money. There is no credit or liquidity risk for central bank money; these risks are greater for commercial bank money but lessened by FDIC insurance. There are very few protections for nonbank money.

Most, if not all, brokerage firms have some insurance through the Securities Investor Protection Corporation (SIPC), as well as private insurance. If a brokerage firm was completely wiped out, there would be huge losses, but that possibility is remote. Historically, brokerage firms in financial trouble are forced into mergers with solvent firms, and the federal government assists those forced mergers by absorbing some or all losses sustained by the surviving firm. The other nonbank fintech actors are a real risk for anyone doing business with them; however, people don’t think of or understand these unnecessary risks.

Two of the major reasons for CPTO coming into existence are people’s deep-seated fears concerning (1) fiat money and (2) government-created inflation. These are real fears that can be dealt with in several ways. Creating a CBDC does not alleviate these fears, and it could exacerbate them.

THE PAYMENT SYSTEM

Most payments in the United States rely on interbank payment services. The anchors of this interbank system are commercial banks subject to federal supervision. The interbank payment systems may settle in commercial bank money or central bank money, but, either way, the central bank money backstops the system. Recent innovations have made payments faster, cheaper, more convenient, and more accessible. The Fed is working on a system that will improve what is in place today. The use of mobile apps for financial services could pose financial stability issues, questions about the payment system’s integrity, and other risks. Shifting from commercial bank monies, which are insured to some extent, to nonbank balances, which are not insured, will raise risks and potentially the cost of credit. The Fed discussion paper states that a significant number of Americans lack access to digital banking and payment services and some payments are costly for many Americans. The Fed estimates 5% of households do not have bank accounts and an additional 20% use money orders, check cashing services, and payday loans that operate outside of the regulated financial system.

The concerns the Fed has for Americans that are not banking in the financial system or are using other facilities rather than interbank transfers, particularly immigrants and small businesses, are legitimate; however, a CBDC will not cure this problem because the problem rests on a long history of distrust of bankers and monetary authorities. Without FDIC insurance, a person in the US today, looking back on the last 70 years of financial history, would have either no or low trust of monetary authorities and banking and nonbanking financial services. FDIC insurance and the intervention of unprecedented monetary authority in times of crisis are why the fragile US financial system is still operating. A CBDC will not improve the situation, and as can be seen later in the Fed paper, could destabilize the financial system.

DIGITAL ASSETS

CPTOs are a foundation of peer-to-peer payments. Nevertheless, CPTOs are subject to extreme volatility, are difficult to use without service providers, and are slow to process payments. The Fed mentions the energy footprint of CPTOs. (I believe they are referring to the “mining” process of creating new coins.) The Fed also recognizes the high potential for loss, theft, and fraud when using CPTOs. The advent of stablecoins, CPTOs backed one-for-one with a deposit of sovereign currency or a commodity, is the latest version of private CPTOs. These are used to buy other CPTOs, and they act the same way the sovereign currency would act, i.e., they provide a mechanism where other CPTOs could be converted back into government currency. The Fed recognizes the threat to central banks and the financial system posed by stablecoins, and a separate study group is focused on the risk of stablecoin use from a regulatory perspective.

This section of the report finally gets to the heart of the issue. Any firm that issues a stablecoin is in effect in direct competition with the Fed’s function as monetary authority. If that same firm expanded from one-for-one backing of their stablecoin to issuing more CPTOs than they had currency backing, they would, in effect, become a bank without regulation. A likely outcome, and a serious fear of the Fed, is that the creator of stablecoin will use their reserves of sovereign currency to invest in assets, such as bonds, stocks, gold, or oil, and the earnings from these reserves will accrue to the stablecoin issuer and not the people who own the CPTO stablecoin.

What is hard to understand is why someone would want to own a stablecoin. Other than a mechanism for buying other CPTOs, what is the point? If the sovereign currency is debased, and the stablecoin CPTO is convertible into the sovereign currency on a one-for-one basis, the value of the CPTOs will then be debased as well. The term “stable” is false and misleading. Many people will tell you the point of CPTOs is to avoid fiat sovereign money where the authorities can debase the currency through inflationary policies. If a person gives a stablecoin issuer their sovereign dollars, there are no assurances that the firm will not debase the stablecoin quantities issued, and, even more likely, use the sovereign currency deposit to speculate, potentially losing the money, and not being able to redeem the stablecoins when requested. In other words, the stablecoin concept increases the potential for CPTO runs on the issuing firm. Do you think this is illogical? Consider any financial crisis in history. What was a major cause of the subsequent financial collapse? It was regulated bankers speculating with depositor’s money that resulted in large losses leading to bank failure without the intervention of federal monetary authority. A CPTO does nothing for a user except raise their potential for unnecessary and permanent loss of capital.

CENTRAL BANK DIGITAL CURRENCY

The Fed indicates that a reason for instituting a CBDC is that the implementation would be superior to other methods that would address the issues that they raise in their discussion. They believe a CBDC would be the safest form of digital asset available to the public. They see four important aspects of a CBDC as being necessary for it to work correctly: (A) It must protect the public’s privacy, while at the same time deterring criminal activity. (B) Since current legislation does not allow Fed accounts for individuals, the private sector would create and have “digital wallets” holding the CBDC for individuals and thus facilitating payments using the CBDC. These private sector firms could be commercial banks as well as regulated nonbanks (notice the word regulated). (C) The CBDC would be transferrable. (D) A CBDC-regulated private sector firm would have to verify the identities of their customers to prevent money laundering and the financing of terrorism. The CBDC would be used like any other form of money, likely in the same way that individuals use commercial bank money in checking accounts today. The Fed believes a CBDC would maintain the centrality of safe and trusted central bank money as the economy digitizes. The CBDC would be superior to all other CPTOs because the CBDC would be free of credit and liquidity risks. Thus, the serious threat that CPTOs might pose to monetary authorities and stablecoins, with their promise of having one-for-one backing of a sovereign currency for every CPTO issued, could be negated. The Fed would want Congress to pass a comprehensive federal regulatory framework to ensure market integrity and investor protection, as well as hinder illicit finance. The Fed is convinced the proliferation of private digital money could present risks to both individual users and the financial system. They feel a CBDC could mitigate some of these risks. The Fed feels a CBDC could be designed to speed up payments and help small firms handle small payments easier and faster.

In the memo, the Fed casually mentions that a CBDC could improve cross-border payments, i.e., immigrants sending money back to their country of origin, individuals and businesses purchasing and selling goods around the world, and other such transactions, by setting up common standards and infrastructure, standardizing the types of intermediaries that would be allowed to use the new infrastructure, creating legal frameworks, and preventing illicit transactions. (This seemingly casual issue comes into focus when (1) examining the bibliography of the discussion paper, (2) thinking about Fed activities in past financial crises, and (3) realizing globalization is the end objective of the multinational businesses and political elite around the world. CBDC’s from developed countries’ central banks are another step closer to one world government.)

A major worry for the Fed is that other countries (such as China) will set up a CBDC, thereby challenging the position of the US dollar as the world’s reserve currency. According to the Fed, the dollar is the global reserve currency because of the liquidity of the US financial markets, the size and openness of the US economy, and trust in the US rule of law.

The Fed memo also discusses how good financial inclusion would be for lower-income families. Cash is the only central bank money available to everyone. In 2020, US consumers used cash in 19% of transactions. The Fed indicates they would be committed to keeping cash available to the public if a CBDC is enacted. They mention the experience of Sweden, where cash payments fell from 33% to 10% between 2012 and 2020. (This is a critical issue, see my comments below.)

In this same section, the Fed discussed potential risks and policy considerations. They say that a CBDC could fundamentally change the structure of the US financial system, altering the roles of the private sector and the central bank. If a CBDC paid interest, the safety and liquidity of the CBDC could shift deposits from commercial banks to the CBDC, thus raising the cost of credit and even the availability of credit. An interest-bearing CBDC could draw money from other non-bank low-risk assets such as money market funds, treasury bills, and other short-term instruments. The paper raises the issue of the central bank limiting the amount of an interest-bearing CBDC that a single user could have. The Fed believes that during times of financial market stress, even a non-interest-bearing CBDC would attract risk-averse money, causing a serious disruption of the financial system. A CBDC could have a major impact on the efficacy of monetary policy implementation. In a global crisis, foreign demand for a US CBDC could be huge and have an even more complex impact on the global financial system as foreign actors rush to get a US CBDC.

Finally, in the memo, the Fed addresses consumer privacy and the prevention of financial crimes. The paper points to the current regulatory-financial-crimes framework as being the basis of any CBDC framework. They recognize the difficulty of being protected from cybercrimes and the need for operational resilience, even going so far as to say that the CBDC system should have a way of working offline, i.e., without a connection to the internet. (This is their only recognition of the ultimate risk.)

The rest of the paper discusses the types of questions the Fed wants interested parties to address and provides appendices giving definitions and diagrams of the current payment system.

This section is the heart of the paper and gives the reader a glimpse of what is on the Fed’s mind. When identifying the three types of money, central bank, commercial bank, and non-bank money, they tout the fact that a CBDC would be credit and liquidity riskless. To keep the current financial system in place and address the fact that the Fed is not allowed to have individual accounts, they indicate any CBDC would use intermediaries between the central bank and consumers in the same way that commercial banks and nonbanks are intermediaries now. It’s interesting that most people don’t understand the current system. Let’s go back in history prior to the Federal Reserve. There were many forms of money being used. There was a federal government money, backed by gold, that was legal tender. There were also monies issued by local banks that were used in certain localities. None of these privately issued monies were insured. They were accepted based upon the belief that the institution issuing the money was sound and the consumer had the ability to redeem it at any time. When a financial crisis arose, many of these financial institutions did not survive, thereby causing depositors to lose their deposits and holders of these private monies to have worthless paper. What appears to be going on today is the beginning of a similar financial environment. Competing with government-issued sovereign fiat money (worthless other than the belief in the government issuing the money) are private monies in the form of CPTOs. This latest challenge to sovereign money comes because monetary authorities are willing to debase the fiat currencies to benefit the government, as the largest debtor, and their debtor/speculator supporters. The primary reason for the rise of private monies has always been the loss of confidence in the sovereign central bank. How will a CBDC restore that confidence? It won’t.

The paper pays lip service to helping the lower-income consumer be included in the financial system. It speaks of 19% of all transactions being done with cash. It’s likely that percentage would be substantially higher if lower-income consumers were the only ones included in the survey. The central bank believes these people are not properly using the financial system. This is a disputable belief. Lower-income consumers strongly distrust of banks and other aspects of the financial system. Inclusion of under-banked and non-banked consumers is not a valid reason for establishing a CBDC. What the Fed paper does not fully address is the fact that digital wallets are vulnerable to serious loss, fraud, theft, and other criminal activity, and there is no protection for the consumer experiencing these crimes. The authors recognize cybersecurity must be improved, but they don’t give ideas for how that can be done.

The paper indicates that a CBDC with an intermediated model would have the potential to reduce the possibility of there being destabilizing disruptions to the US financial system. However, the paper doesn’t explain how a CBDC can improve the system, and it acknowledges the specter of serious financial system disfunction in times of crisis, as individuals and businesses flee other forms of money, i.e., commercial bank money and nonbank money, into a US CBDC.

One of the key footnotes in the discussion about using paper currency is the point about 19% of US transactions being done in cash. It discusses the dramatic drop Sweden experienced in the use of paper money in favor of digital money. In 2010, Sweden announced and then implemented a redesign and replacement program of paper currency that rendered all their old currency worthless. A major reason for Swedish citizens switching from cash to digital. This activity should be a red flag for everyone. Even though the Fed says they intend to leave paper currency in circulation, they don’t say if they would replace current paper currency at the same rate as they had before (which, if not, would in time lead to less paper currency being in circulation).

At the beginning of this FWIW, I told you that the Fed discussion did not fully address the most critical risk of having a CBDC at the center of the US financial system. Presently, if someone finds their bank account has been drained through fake signatures on checks, the bank restores the missing funds. Credit card companies absorb most if not all fraudulent purchases on a credit card. If a digital wallet is invaded and the funds disappear, the account holder absorbs the loss—not the exchange or intermediary who set up the account. These are all common practices of which anyone using these various accounts are aware. The fact is, though, that if you have paper money in your possession, the only risks are inflation and robbery. You can use the paper currency to secure whatever goods and services are available and needed. Going to a CBDC and shifting much, if not all, central bank money from paper/coin currency to a CBDC makes all forms of money be subject to the unsecure internet. In that situation, the unnecessary risks of fraud and theft would become more likely. More importantly, governments can shut down or restrict the internet. This is the risk a CBDC carries that the Fed has not addressed. They say they have no intention to do away with paper currency. However, that is not a decision the Fed can make. It is a decision of the federal government and whatever nameless crisis-committee Congress may set up. The likelihood of all paper money going away is slim for three reasons: (a) there are too many low-income households who don’t make enough to use a banking relationship, (b) street crime will always use paper money, and (c) many less developed countries around the world use US Dollars as the principal means of exchange. Paper money can be restricted, however, and so can the internet.

Think the federal government won’t ever shut down the internet? Think about these actions, already taken: (A) The Fed confiscated rightful earnings on bank deposits and other low-risk investments for 13 years in the name of the “national best interest.” (B) The federal government and some state governments confiscated the time value of real estate by suspending a property owner’s right to collect rent and/or evict tenants who do not pay their rent, all in the name of national best interest. (C) At the federal government’s urging, state and local governments are imposing laws that restrict rebuilding property destroyed in a natural disaster, such as a hurricane. (D) The federal government dictated that a lockdown of citizens to fight the pandemic was in the national best interest, causing substantial financial hardship for citizens. (E) The federal government sharply curtailed energy production in this country, causing a significant increase in energy costs for lower-and middle-class consumers and businesses in the national interest as determined by climate change advocates. The point is this: We have entered an era where individual freedoms are restricted in the interest of what some elites profess to be in the national interest. In actuality, the national interest as they define it is the interest of multinational companies and political establishment elites.

I’m confident there will be a CBDC in the United States. Why? Because there are several countries exploring a CBDC, including China and other developed countries. Without a US CBDC, the Fed and federal government are concerned that another country’s CBDC could undermine the reserve currency status of the US dollar. The Bank for International Settlements (BIS) is actively working with central banks to ensure the internal mechanisms and functions of various CBDC’s are as compatible as possible. Why? Because future financial crises will be even more global than those of 2008 and 2020, and a crisis will be the excuse to take another step along the path toward a single global currency. Globalization preempting national interests continues. It is a myth that the Federal Reserve is only concerned about the US economy. The last two financial crises (2008 and 2020) brought to the forefront the significant emergency credit and currency assistance that the Fed has implemented around the world. One perspective is that the Fed’s overseas assistance kept the US economy from imploding more than it did. That is debatable. The fact is the Fed cannot serve two masters. They can either serve US citizens, as their charter dictates, or they can bail out non-US governments in response to their irresponsible activities. Currently, activities at the Fed clearly point to a global perspective. Finally, a concerted effort by monetary authorities to centralize CPTO usage in a US CBDC will give monetary and taxing authorities deeper insight into all taxpayer’s financial affairs.

Actions to protect your family’s net worth and purchasing power in this tranformative period are needed; however, CPTO and a CBDC are not them.

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