Crypto and the Global Financial System

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The global financial system is something that humanity controls but does not fully understand. There are many theories about how the system works, but they are all pretty abstract. And yet we have to have a global financial system, because without one it’s very difficult to have international trade, international borrowing and lending, bailouts for countries in crisis and a bunch of other things needed to operate. economy. We therefore put in place rules and institutions without really knowing whether they are optimal or when they will break down. It is therefore not surprising that the system experiences major crises and disruptions from time to time.

Recently, there has been talk of cryptocurrency disrupting the global financial system. For example, Balaji Srinivasan and Parag Khanna recently wrote a highly regarded editorial in which they claim that cryptocurrency, along with other internet technologies, will disrupt the nation-state system itself. same. Here is what they wrote on the financial side:

Already, national currencies are in competition with cryptocurrencies as individuals and institutions hold digital wallets filled with various assets that can be traded against each other …

We are about to enter an era of global monetary competition, where national currencies have to earn their place in someone’s wallet every hour of every day, even among the citizens of their own country. The digital version of the Japanese Yen will be immersed in direct global competition with the Swiss Franc, Brazilian Real, and any other asset with an open capital account, including Bitcoin. Everyone becomes a forex trader all the time, and only the best national currencies – or cryptocurrencies – are owned by anyone.

Rather than the current environment of uncontrolled inflation and competitive devaluation, the challenge [decentralized finance] matrix imposes a new kind of discipline on national currencies, as billions of people make individual choices about which currencies to hold and not to hold.

Srinivasan and Khanna’s vision for the future is very different and more sophisticated than the traditional vision of “maximalist bitcoin”. In short, Bitcoin’s maximalist view is that because Bitcoin is artificially scarce and therefore tends to appreciate rather than depreciate, it represents a better currency than inflationary fiat currencies, so people will go fiat currency to Bitcoin. This is wrong because what people want from their money is not long term appreciation but rather short term stability; that’s why no one uses gold, apple stocks, or bitcoin to buy a loaf of bread or a gallon of gasoline.

But crypto is no longer just Bitcoin. Indeed, Bitcoin itself could eventually become a beloved sort of obsolete appendix to the crypto world, as more sophisticated systems (Ether, Solana, etc.) further exploit the technological potential of blockchains. Srinivasan and Khanna actually envision government-backed cryptocurrencies competing with each other. And in the market, stablecoins blur the line between fiat and crypto.

Given this technological ferment, it’s worth considering how crypto could change the global financial system. Which is a hard thing to ask, because not only do we not know what crypto is doing right now, let alone what it will be doing in 20 years, there is a lot we don’t even know how. works the global financial system in the first place!

But we can certainly start… uh… speculate.

The Status Quo: Bretton Woods II

First, let’s talk a bit about how the global financial system works today (we don’t know everything, but we do know a few details). Usually there is a “reserve currency” – a currency that the central banks of most or all major economies keep a lot in reserve. They do this for two reasons: First, because it facilitates international transactions; Globally traded commodities like oil are generally denominated in dollars. Second, if a country goes through a financial crisis, it can sell these reserves to prevent its currency from collapsing and thus continue to import basic necessities. The reserve currency thus functions both as a facilitator of world trade and as a safe haven.

In the 19th and early 20th centuries it was the pound sterling. Right now, it’s the US dollar. This system is sometimes referred to as “Bretton Woods 2,” which refers to the post-war Bretton Woods system in which major economies agreed to use the dollar as a reserve currency. Bretton Woods was scrapped in 1973, and the dollar’s share of world currency reserves fell from about 84% to about 46%. But the dollar made a comeback in the late ’90s and early’ 00s, climbing back above 70%. Therefore, “Bretton Woods 2”.

Since the mid-2000s, however, the Bretton Woods 2 system has come under increasing pressure. The main cause is the rise of China. As the Chinese economy grows – it’s now either bigger than that of the United States, or almost as large, depending on how much you use – its potential to suck capital from abroad or to send capital abroad is getting bigger. For example, China exported a ton of capital in the 00s when its central bank bought a ton of US bonds (in order to keep its currency low and increase its exports). It also exported a ton of capital in 2015-16, when a group of investors moved their money out of the country following a stock market crash.

These capital flows must be absorbed by the US economy, which no longer eclipses China as before. And that can be unsettling. Chinese capital inflows during the 2000s are sometimes attributed to the US real estate bubble, for example. The dollar’s reserve currency status also causes the United States to run persistent trade deficits – everyone wants to hold dollars, so the demand for dollars increases, dollars become more expensive, and products made in the United States become thus unaffordable in world markets.

The less dominant the US economy, the less the dollar can function as a stable anchor for the global financial system. It was still intact in 2008-10, when a global financial crisis sent floods of capital into the safe haven of US government bonds. But in recent years people have started to wonder if Bretton Woods 2 is finally on the verge of extinction. The share of the US dollar in global reserves has been declining for years, and this fall has accelerated since the start of the pandemic.

But what can replace Bretton Woods 2? The obvious answer would be for the Chinese yuan to take over as the reserve currency in the same way that the dollar took over from the pound, that is, it shares rights with the dollar and the euro. But China appears to have no intention of easing its capital controls and allowing the world to buy as many yuan as it wants. This means that the yuan cannot replace the dollar.

So this could one day open the door to cryptocurrencies acting as reserve currencies in some ways. Probably not this year, maybe not this decade, but maybe 20 years from now? Even more drastically, crypto could remove the need for a reserve currency.

Stablecoins, the dollar and the new reserve currency

A great innovation in crypto is stablecoin. The most famous of these is Tether, but USD Coin is also growing in popularity, and there are many more as well. Stablecoins are cryptocurrencies whose value is tied to the value of a fiat currency (in fact, there are different types, but Tether and USD Coin are of this type). This means that 1 Tether or 1 USD Coin is always supposed to be worth 1 US $.

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