This article first appeared in Forum, The Edge Malaysia Weekly on June 21, 2021 - June 27, 2021

In 1994, Bill Gates made his famous statement, “Banking is necessary, banks are not.” In other words, the function is more important than the institution. Today, banks are still important, accounting for US$133 trillion in assets or roughly one-third of global financial assets, but non-bank financial institutions have grown to account for half of global financial assets, arising from higher tech valuations in securities markets and new non-bank players with digital products.

Banks, which provide traditional bank deposits, payment and credit services, have seen their market share erode. Banking power is still strong, but the digital barbarians are now at the gate. Watch out for the new money, power and technology game.

Gates understands technology. Silicon Valley, which made money on technology, totally misread power and politics, thinking that their brand of techno-mass consumerism would guard their backs. Unlike billionaires like Jeff Bezos, who think buying newspapers will retain their hold on wealth, Gates has judged that giving away his money through charity is a better way of keeping his money.

One should never forget that the internet was a by-product of military research to improve telecommunications. By allowing selected software (now called apps) and hardware to be commercialised, this created a wave of global innovation in technology that is still transforming society.

What US defence planners did not anticipate was how the internet also created new rivals and competitors through technology. This explains why the US is clamping down on technology sales to China, Russia and anyone that can challenge the US order. Fintech means that money is directly related to technology and information. So, digital money is another global battleground for superiority.

Finance, money, information and power are inseparable. Life has always been about arbitrage — buy low, sell high; buy where it is cheap, sell where it is expensive; make the margin. Finance works on the same principle — make financial transactions cheaper, more trustworthy, less risky, and the middleman (the banker) will become rich. In every Gold Rush, it is rarely the gold miner who makes the money, it’s the trader who sells the food and tools to the miners and gets the gold in exchange.

Digitisation essentially makes transactions smaller, and cheaper to trade and avoid official taxation and detection. Governments have always controlled banking because it is a good source of taxation and funding for government debt. Control the debt and you control the people — hence the meaning of the term “debt bondage”.

The 1762 French revolutionary Jean-Jacques Rousseau’s dictum, “Man is born free, but everywhere he is in chains”, did not foresee that today we are all in supply chains, bonded to student loans, credit cards and mortgages. The word “mortgage” comes from the French “mort” (dead) and “gage” (pledge), meaning that you pledge a right (land or your freedom) upon the promise to repay. If you do not, the right is forfeit, so in the old days, either the pledged land was lost or the debtor became a slave.

Digital finance has not set man free. If anything, the level of debt has climbed to the highest in history. And blockchain technology and digital currency, such as Bitcoin, is rapidly transforming the finance landscape. In finance, the big power players, banks and central banks, need to meet the digital barbarians with new products and tools if they are to control the new landscape.

Time to see if the barbarians are going to beat the defenders.

In 2009, the first Bitcoin was created by a mysterious geek called Satoshi Nakamoto, who also contributed to inventing blockchain technology. Because the first blockchain text included a reference to the bailout of banks in 2009 by the UK’s Chancellor of Exchequer, it suggested that Bitcoin was an effort to replace fiat money (created by state fiat) with private money. This was a real challenge to state money, which central bankers ignored.

Prior to blockchain, digitisation speeded up transactions but digital accounts were also vulnerable to hacking. Blockchain technology, involving the movement of data encrypted in blocks of data, created “flat” distributed ledger systems that were very difficult to hack. This was architecturally very different from the conventional hierarchical, centralised banking or stock market trading, payment and clearing platforms.

In short, blockchain digital currencies created decentralised finance or DeFi, a new power landscape in which private tech investors are rebelling against the power of the government to control finance.

The old order is definitely changing. Today, cryptocurrencies, which were zero value before 2009, are valued at a whopping US$1.4 trillion, roughly half of the value of gold, the oldest money available. This was created by technology, but not everyone appreciated that cryptocurrencies are the unintended by-product of the zero-interest rate policies of the reserve currency central banks!

Two underlying factors drove the rise of cryptocurrencies.

First, the current top-down, centralised financial structure does not necessarily benefit the users, because the few key hubs and platforms can extract both information and value from the many market players. Financial systems are networks, with Metcalfe’s Law at work — the value of the network rises exponentially with the number of users. The more the users, the higher the monopoly value of the network as a whole, meaning “winner wins more”.

So banks and brokers fight to gain market share, with the biggest banks, brokers and clearing houses having scale and power, because they not only have scale, speed and scope, but also the information advantage of Big Data. They see market moves before any of the retail players. Big players like Goldman Sachs and JP Morgan have few equals. They have a huge market and political power.

These key hubs and links will begin to lose the trust and faith of the masses when they extract too much from the system. Thus, when the US starts using the US dollar payment system to collect information for anti-money laundering and national security purposes, imposing sanctions on users, then users will have incentive to move out of the US dollar.

Similarly, the retail shareholder revolt in GameStop shares against hedge funds shorting the stock reflect the retail sentiment of many that hedge funds are playing dirty to stop them from making money.

The internet is flat, and the bottom is revolting. DeFi is a shifting power game.

Second, if interest rates were positive and not zero, a normal asset allocation portfolio would hardly put any money in weird, new alternative assets such as cryptocurrencies. Prudent investors do not like high volatility plays, which is exactly what cryptocurrencies are. They offer spectacular returns (Ethereum last year offered returns of over 250% per annum) but also the highest volatility. Highly respected analyst Nouriel Roubini famously noted that “bitcoin and other cryptocurrencies have no income or utility”.

But it is not true that they have no utility. Cryptocurrencies are precisely alternative assets to established currencies like gold and Swiss Francs, which also have zero or negative interest rates. But their utility is that their usage completely avoids official monitoring and transaction costs are cheaper and faster.

As a former central banker, I saw the risks that cryptocurrencies posed to established currencies. In early 2018, when I was asked about Bitcoin hitting US$8,000, I asked whether cryptocurrencies were hackable. This is because if they were hackable, then with no transparent register or record of ownership, the system was open to massive theft and fraud.

Today, Bitcoin has touched over US$80,000 and has settled at US$40,000. My young friends who made their first serious money trading cryptocurrencies do not care about the risk of hacking. A high return gets you quick profits so you can get out fast. So if the number of investors rises to hundreds of thousands of retail investors, and mainstream companies like Walmart or Tesla consider accepting cryptocurrencies for payments, then cryptocurrencies have become serious assets.

In short, when people believe something is money, it becomes money. The economist Paul Samuelson told the story of how two Pacific Islands traded with each other, with the annual settlement paid by shipping a huge stone statue between the islands. One year, the statue sank during shipment. Trade did not stop because both islanders simply treated settlement as ownership of the statue, even though it was at the bottom of the ocean. The statue became a trusted “token” by both parties. It was not necessary to have physical delivery for the statue to function as money.

DeFi is moving so fast, as the latest trend of cruptocurrencies is both Stablecoin and central bank digital currencies (CBDC). Stablecoin is a digital currency that is backed with a reserve currency. It combines instant processing, security and privacy of transactions, and stable valuations of reserve currencies. Stablecoin is privately mined, whereas CBDC is an official fiat currency. Both may be moving to the mainstream very soon.

Since official money and private cryptocurrency both offer no interest rates, then the one with the greatest “utility” will win in the long run.

The US Federal Reserve is finally beginning to realise the threat to the US dollar. It was the combination of US dollar sanctions and massive quantitative easing (QE) that made many users become wary about using dollars for payment and settlement. Who needs actual US dollars if all transactions can be effected instantly using Stablecoin or non-USD CBDC? Country A may ban Stablecoin, but the transaction can be settled today offshore or netted in such a way that Country A’s central bank or tax authority cannot monitor or control.

Last month, Fed Board member Lael Brainard made an important speech on Private Money and CBDC, highlighting four developments: growing role of digital private money; migration to digital payments; use of foreign CBDCs in cross-border payments; and concerns about financial exclusion. The US Inland Revenue Service (IRS) is also treating cryptocurrencies as assets, which means that trading and owning such assets would be subject to taxation and reporting.

Put simply, this is a battle between private versus public money. But it is also part of the geopolitical battleground. Hence, digital money is here to stay and will eventually become a mainstream asset class. Which national currency wins or loses is another story.

Watch this space.

Andrew Sheng is a former central banker whose views are personal to himself

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