The economist Joseph Schumpeter created a term called “Creative Destruction," as can be seen in cases such as Netflix vs. Blockbuster, department stores vs. Amazon, taxis vs. Uber and so on. Cryptocurrency could be brewing another creative destruction in the financial markets.
The current payment system is too slow and expensive. Fintech, including digital currencies, wants to make the system fast and inexpensive. And the digital currency can be a possible alternative to the dollar.
Merchants like digital currencies because payment comes instantaneously, transaction costs are very small compared to credit cards, and purchases can’t be reversed.
There are problems with digital coins. Volatility is one challenge. In a single day the price of a coin could go through the roof or crash. The value of the Dogecoin, for example, has jumped around 20,000% in a matter of a few months. Most cryptocurrencies such as Dogecoin, which was created as a joke, have no collateral and no guarantees.
Even the value of bitcoin, the largest of the coins, has been more volatile than almost any asset class in the financial markets. The extreme volatility disqualifies digital coins as a currency or stable investment.
Cryptocurrencies can also be unfriendly to the environment. About two-thirds of Bitcoin have been mined (electronically) in China using massive amounts of electricity generated by air-polluting coal. Recently Tesla announced it will no longer accept bitcoin as payment for the car due to environmental concerns. Regulation is another concern. In most countries crypto currencies are subject to little or no government regulations. With growing prominence of crypto currencies, restrictive government regulations are sure to follow. Then, owning digital assets could become less attractive.
And most cryptocurrencies have no cash flow like bonds. Crypto neither generates earnings nor has collateral behind it. The only return comes from the Greater Fool theory; someone is willing to pay a higher price than you did.
Stablecoins are designed to diminish some negative aspects of cryptocurrency. The value of a stablecoin is tied to another asset, such as the U.S. dollar. Other forms of collateral can include precious metals like gold or silver, as well as commodities like oil. Such reserves are maintained by independent custodians and are regularly audited for adherence to the necessary compliance. Tether (USDT) is a popular stablecoin that has a value equivalent to that of a single U.S. dollar and is backed by dollar deposits.
Are there tax implications of owning crypto currencies? The U.S., for example, taxes these virtual currencies as property. The federal tax form asks whether you've “received, sold, sent, exchanged or otherwise acquired a virtual currency." You must report gains if you sold a cryptocurrency, exchanged cryptocurrencies or used crypto to purchase goods or services. You can deduct your losses if you sold or spent a cryptocurrency that lost value. You can take a charitable contribution deduction if you donate your crypto to an eligible nonprofit.
Cryptocurrencies are not only an asset but a part of a sea change occurring in the global financial system. As pointed out above, moving money in the existing payment system is expensive and slow. Digital transfer is inexpensive and fast. All you need is a smartphone and the entire financial system is at your fingertips.
Fintechs have become popular, enough to take a growing share of payments from the traditional banking system. PayPal, Venmo, Stripe, Ant Group, Grab, Mercado Pago and e-wallets have been processing billions of transactions every year.
In 2019, Facebook combined crypto currency and safety, and introduced a digital currency project called Libra, now renamed Diem. This was a wakeup call to many central banks. Some 50 central banks around the world, including the Federal Reserve, are considering a central bank digital currency, or a substitute for traditional currency like the U.S. dollar. In October 2020 the Bahamas became one of the first countries to issue a CBDC. The People’s Bank of China has been experimenting with small amounts of CBDC.
The central banks have reasons to worry about the growing influence of creative destruction taking place in the payment and credit system. As the role of the traditional financial institutions in the payment system diminishes, the power of monetary policy to dampen economic cycles becomes less effective. Theoretically, everyone could use the CBDC and its plumbing system for free.
There are many advantages of using CBDC instead of a traditional currency. CBDCs are safe, instant, free and universal. The estimated 7 million unbanked households in the U.S. could have free access to the financial network of the central bank.
Eventually, the central bank could take over the depository function of the banking system. How would the banking system support the loans without deposits? Would the central bank extend credit as well? The government could engage in credit allocation.
The CBDC could be programmed to prevent certain transactions not allowed by the government. It could be used by the governments to advance certain social and political agendas. Not too many people think this is a good idea. Even the People’s Bank of China seems reluctant to go that far.
Creative destruction is taking place in the financial system. There will be winners and losers. Digital currency will become an important part of our financial system and an asset class. It is time for financial institutions to figure out its role in the future financial ecosystem to avoid becoming a casualty of the creative destruction process.
