18 JanDo we need Central Bank Digital Money?  Stuff worth knowing from The Bankers’ Plumber

“Kerrassh”. In Jan 2018, Bitcoin (BTC) took a nose dive. In two days, the price collapsed some 25%. If you thought BTC is a means of payment, then I hope you also understood what market risk is and learned to manage it.

This week’s post is inspired by various discoveries in a current project where I am helping a client create a new digital asset. What is easy, what is not in a digital age? I hope you can spare 5 minutes to read this and share your views; the observations here are not absolutes and I’d love the benefit of improving the thinking from some feedback.

My current project is for an asset back token that my client wants to issue on the Blockchain. Distributing that coin will happen via an ICO like process. Investors can subscribe for this new digital thing, using an old digital thing, the Internet. Then comes the need to collect the funds. How do you that?

There are two ways my client can be paid for this digital asset; fiat or crypto. With the ambition to establish a product in today’s markets, the client wants to be crypto-friendly and accept some, though not all, crypto tokens.

Like me, the client has over 30 years of financial markets experience. So, not surprisingly, he says: “No market risk. We’ll take BTC & ETH, but we will not set a price until the Crypto is swapped to fiat. And, the investor has to take the market risk”.  In other words, you can have as many of this new digital token as your Euros will buy you. I will guarantee you that there are Fintechs out there sitting on piles of Crypto that are worth a lot less than when they took them in a week ago. Now many of them will also have been counting the gains when the market went up. Sadly, to misquote an old Goldman Sachs saying: “They have been confusing a bull market with brains”.

Mapping out processes is where this gets interesting. Collecting Crypto is actually faster and better than collecting fiat or Euros, the currency of the issue. The jury is out on cheaper as the costs are not so transparent. Let’s leave that to one side and look at the differences in collecting fiat and crypto.

Accepting Crypto for digital assets

Crypto currencies are transferred between wallets. Not all Crypto currencies are compatible with every wallet; if you have BTC, then the other party in the transaction needs an ERC 20 compatible wallet.  If you are compatible, then the transfer is pretty easy. But, it is still a fact that they buyer pays first. After that, the asset is delivered. I’ll confess to a degree of digital ignorance here as to whether we could make that a DVP, delivery vs. payment. There are reasons we don’t want to do this for this project. In any case, the collection process is quite simple.

But, and it is a big one, as easy as that first step is, my client would then have market risk, i.e. the risk of price fluctuations in BTC. No small risk as Jan 16th and 17th proved. Eliminating that risk requires the ability to sell that vs. fiat. There are proven pre-Crypto processes for this; send an RFQ, a request for quote, for a firm price. Well, the news from the digital Western FinTech front is that this is not so readily available and so far the best solution we have found would allow us to maybe do blocks of EUR 50k at a time.

Looking at accepting Crypto also revealed a lot of shortcomings on the control front.  If I ask my client to pay my monthly bill, which is in Swiss Francs, I share the company IBAN. At that point, he knows my company has an account with a certain number at Credit Suisse in Zurich, but he knows nothing about the current balance. DLT & Blockchain is a whole different world; once you say “deliver Crypto to my wallet”, then I know a) that you own it, same as fiat, and, and this is a very big and, b) I and the whole world can query the current balance in that wallet.

One of my very smart friends in the Crypto space told me proudly that the way Crypto brokers solve for this is to give each payer a unique wallet or address for each and every transfer. Then they move the assets along to another wallet aka a collecting pot. Identifying what is in that collecting pot is pretty easy, though it may not be obvious who owns it. But, those unique wallets are still out there and somebody might deliver an asset into them. As my smart friend told me about this, I was reminded of the challenge banks have with controlling staff opening bank accounts and securities depots all over the place. Big control issues around that. It was a case of deja vue all over again.

Worse still, it seems there is no way that Company A can stop Company B handing out the same addresses for other purposes. I have not fully analysed that one, but it made me wince.

On the privacy side, the good news about the audit trail & transparency is that this means Crypto is not going to help bad actors; see this article on Fortune. If you then couple that full history of which wallets or addresses the asset has been in, with the banking requirements of full disclosure of payor and payee, then suddenly there is TMI, too much information, floating around. Privacy goodbye.

Accepting Fiat for digital assets

Basically, there is a disconnect as soon as my client wants to take in Euros as payment. We have to look at the company bank account to see if the Euros have been credited. Very theoretically, if every bank that one or other investor used, had an API, we could make use of all this open banking stuff and pull the money out. But, the number of banks will be many and the APIs are not standardised, so the possibility is noted with interest, but not much. The investment amounts will be north of EUR 1mm, so debiting a credit card will not work, even if the client is willing to pay those fees. the system wide limit on a card payment is 999’999.99; card issuers can deal with bigger payments, but not easily. So, investors have to take credit risk; the risk of paying and not receiving the asset.

This week I was able to catch up with Richard G. Brown, the CTO of R3, the industry consortium aiming to build the digital DLT infrastructure of the future. The R3 team is involved in a lot of projects, with different collaborators. Many, perhaps not all, of those new processes need to add money to the mix. For example, banks might cooperate to work out who owes who what collateral for some OTC derivatives trades. R3’s Corda can undoubtedly do a lot to make things better, faster, & cheaper, until it comes to the money part.

Let’s say the new digital platform can enable all the banks to work out who owes net how much cash collateral to the others. Right now, that ‘last mile” has to happen in the fiat world. Very theoretically, if there were say 10 different new processes, you could use a digital token; this breaks down quickly. Imagine in process A, DB owes Citi EUR 120mm and in process B, Citi owes DB 150mm, then if DB accepts a coin from Citi, they are taking credit risk and the 30mm in digital something or others is not going to help them fund all the processes in the old, non-DLT world.

Lessons to be Learned

  1. Current Cryptos are not really suitable as a universal means of payment. They are too volatile.
  2. Great care is needed with regard to privacy. It will be possible to solve for this; one such effort is zcash (A great article from a recent Fortune magazine edition, well worth a read to understand the zero-proof concept). But, whilst it seems to offer an answer to the privacy issue, it is just another Crypto currency with zero backing. JP Morgan is apparently heavily involved; a surprise given CEO Jamie Dimon’s public pronouncements on Bitcoin.
  3. New digital assets and new processes based on DLT will be limited in their ability to deliver better, faster and cheaper solutions without there being a digital currency that ranks pari passu and is equal to today’s fiat currencies.

There are also control issues to be aware of; those who fail to learn from the mistakes of their predecessors are destined to repeat them.

About the Author: The Bankers’ Plumber. I help banks and FinTechs master their processing; optimising control, capacity and cost.

If it exists and is not working, I analyse it, design optimised processes and guide the work to get to optimal. If there is a new product or business, I work to identify the target operating model and design the business architecture to deliver those optimal processes and the customer experience.

I am an expert-generalist in FS matters. I understand the full front-to-back and end-to-end impact of what we do in banks. That allows me to build the best processes for my clients; ones that deliver on the three key dimensions of Operations: control, capacity and cost.

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