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cryptocurrency payments – where will the dust settle?

by David Irish | July 27, 2021

The objective of this article is to cut through the fog and hype to give you a concise summary of the competing innovations in international trade settlements with references to where you can find a more in-depth understanding as required/should you so wish. But we will first need to understand the legacy process that fintechs intend disrupting.

What do most businesses and individuals want when it comes to paying and receiving foreign currency?

  1. Fast and secure settlement
  2. Low, predictable and transparent fee structures
  3. Traceability when things go wrong
  4. Comprehensive and accurate transaction data

How do business foreign currency payments currently work and why does it generally take 2 business days to complete?

Each country has their own domestic payment system. Unfortunately, these systems are not directly linked which means that an intermediary process is required. This is generally achieved by a combination of banks having bank accounts with overseas banks and the communication of instructions via a messaging service; SWIFT being the predominant provider.

The simplest transaction is where your bank has an account with your customer or supplier’s bank overseas. Let’s use a simple example:

  • You export a consignment of wine to a customer in Germany for EUR1,000.
  • You bank with Nedbank and your customer banks with Deutsche Bank in Berlin.
  • Nedbank has an account with Deutsche Bank in Berlin and vice versa.
  1. When payment is due your customer will instruct Deutsche Bank, Berlin to pay you EUR1,000.
  2. Having ensured your customer has sufficient funds to cover the transaction,
  3. Deutsche Bank will send a SWIFT message to Nedbank instructing Nedbank to debit their (Deutsche Bank’s) account at Nedbank and credit your bank account.
  4. Nedbank will then check that Deutsche Bank has sufficient funds in their account before effecting the transaction.
For cross border payments to be this simple Nedbank would need to have bank accounts with every other bank in the world and vice versa. This is clearly impossible, and so banks utilize “correspondent banks” to make payments.

The following example illustrates this process:

  • Again, you export a consignment of wine to a customer in Germany for EUR1,000.
  • You bank with C Bank (one of SA’s smaller banks) and your customer banks with B Bank in Bremen, Germany.
  • C Bank and B Bank do not hold bank accounts with each other. In fact, B bank has no overseas bank accounts and neither does C Bank
  • However, C bank does have an account at Nedbank and B Bank has an account with Deutsche Bank in Berlin. Nedbank and Deutsche Bank, Berlin have the same relationship as in the previous example.
  • Deutsche Bank and Nedbank can therefore act as intermediaries in the transaction.
And so,
  1. When payment is due your customer will instruct B Bank to pay EUR1,000 to your bank account at C Bank.
  2. B Bank will then send a SWIFT message to Deutsche Bank, Berlin instructing them to debit their (B Bank’s) bank account with EUR1,000 and pay it into your account at C Bank.
  3. Having ensured B Bank has sufficient funds to cover the transaction,
  4. Deutsche Bank will send a SWIFT message to Nedbank instructing Nedbank to debit their (Deutsche Bank’s) account at Nedbank and credit your bank account at C Bank.
  5. Having ensured Deutsche Bank has sufficient funds in their account,
  6. Nedbank will send a SWIFT message to C Bank instructing them to debit their (Nedbank’s) account at C Bank and credit your bank account at C Bank.
  7. C Bank will then check that Nedbank has sufficient funds in their account before effecting the transaction.
The number of steps in the chain can increase quite substantially as more correspondent banks are required, such as with less commonly traded currencies.

At each of these steps the SWIFT messages will need to be checked against the relevant financial crime laws and regulations and each bank will need to update the balances in the accounts of the incoming and outgoing payees using their domestic payment systems which are only open during normal business hours. These are called “friction points”.

All these checks and balances increase risk, cost time and money for which fees will be charged. The longer the chain of transactions the less certain the final fee tally will be, and for which the sender’s bank will need to hold enough cash to cover these unknown costs until the payment is complete (called settlement finality).

What are the main innovations for international trade settlements of the future?

Clearly this process needs to change as the volume of international payments grows. With the significant technological advancements over the past few decades innumerable fintechs have emerged offering solutions to these problems. Significant innovations include:

SWIFT enhancements

SWIFT has long been the dominant international payments messaging provider. Since 2017, SWIFT has been growing its adoption of SWIFT gpi (Global Payments Innovation) and conversion to the ISO20022 standardised messaging format. Using new technologies SWIFT gpi aims to eliminate or reduce many of the key frictions inherent in cross-border transactions making payments faster, fully traceable and transparent. More than 65% of all cross-border payments on SWIFT are now sent via gpi, representing more than US$300 billion in daily value.1

In late 2020 Swift’s gpi Instant service went live in the UK. The final leg of a cross-border payment often gets delayed by the recipient country’s domestic clearing system. Swift’s gpi Instant connects gpi to regional and domestic instant settlement systems with the aim of getting around this issue.2

Cryptocurrencies

Cryptocurrencies are digital currencies not backed by real assets or tangible securities. This contrasts with “fiat” currencies that are issued and backed by central bank reserves. They are traded between consenting parties with no broker and tracked on digital ledgers.

Bitcoin is by far the most well known and “valuable” cryptocurrency followed by the likes of Ethereum’s Ether, Litecoin, and Ripple’s XRP.
Bitcoin was initially defined by its founders to be “A Peer-to-Peer Electronic Cash System”3 but has since also become regarded as a store of value and inflation hedge. The fundamental basis for Bitcoin’s rise is its followers’ belief that Bitcoin will eventually replace other forms of payment throughout the world.

Headwinds to Bitcoin and other crypto’s proliferation as a payment system

The reality is that there are several and significant obstacles to Bitcoin (in particular) becoming a ubiquitous payment mechanism. Whilst the Bitcoin community will no doubt apply significant efforts to overcome or mitigate these obstacles, the alternatives discussed here are more likely to grow to scale before this is achieved.

The Environment

Much has been made of Elon Musk’s exuberant endorsement of Bitcoin and dismissal soon thereafter citing the massive carbon footprint generated by Bitcoin miners. The Global Times has reported that annual energy consumption by bitcoin mining4 in China is expected to peak in 2024 at 296.59 Twh and generate 130.50m metric tons of carbon emission (about the same as the whole of the Philippines).5

What many people do not know is that the Bitcoin algorithm is structured so that as the total computational power of all miners grows, so too does the difficulty of mining coins increase. This creates an ever-increasing demand for more servers with even more powerful specifications to remain competitive. This is not carbon friendly. In an April 2021 article Bloomberg reported that the Taiwan Semiconductor Manufacturing Company (TSMC) overtook General Motors in green house gas emissions in 2016 and now generates almost 50 percent more than GM each year.6 And then there is the issue of increasing ultra-pure water usage required as microchips become smaller and more powerful.7

With so much focus being placed on corporate responsibility towards the environment it is unlikely that most global businesses will want to make Bitcoin settlement a significant part of their payments function.

Costs and speed of transactions

Despite one of the prime motivators for cryptocurrencies being to reduce payment friction and thus lower transaction costs, this has not been achieved to date. In fact, the opposite is true. The significant volatility in crypto asset values affects the buying power of the consumer, and the exorbitant charges merchants must pay to facilitate the acceptance of crypto payments has to be passed on to consumers.

As a simple example, a friend’s barber offered to accept crypto as payment for his haircut. My friend happens to be co-founder of a leading international blockchain payment solution company. He gently explained that after factoring in all the ancillary costs a R100 haircut would end up costing him an additional R800. Needless to say, the haircut was paid for in cash.

With respect to speed, the Bitcoin network can barely process five transactions per second. Ethereum’s rate per second is improving but still insignificant compared to over 20,000 for the Visa network.

The charts below clarify this problem of cost and transactions speed:

The maths

Apart from its payment settlement prospects, cryptocurrencies have become an investment asset class that is the prime driver of its stellar returns for some since the beginning of 2017. But these returns are extremely volatile8 and the recent sell off is a sign of things to come.

BCA Research’s9 Crypto Impossibility Theorem states that cryptocurrencies will be viable only if they offer a higher return than equities. The assumption that cryptos can generate a higher return than equities is almost certain to be false since it would require that cryptocurrency holdings rise more quickly than income in perpetuity.

Unlike dividend-paying stocks, cryptocurrencies do not provide any income to their holders. Thus, even if cryptos were just as risky as stocks, the price of cryptos would still need to rise more than the price of stocks to ensure that investors remain indifferent between the two asset classes. In practice, as the experience of the pandemic demonstrates, cryptos are even riskier than stocks. Thus, the expected return on cryptos must exceed the expected increase in stock prices by more than the dividend yield.

The problem for crypto holders is that this is not mathematically possible. Even if one controls for the rise in price-earnings multiples over time, equity returns have generally exceeded nominal GDP growth. Hence, if cryptos need to offer superior returns to equities, and if the return on equities is at least equal to nominal GDP growth, then the market capitalization of cryptocurrencies will not only end up rising faster than for stocks, it will rise faster than aggregate national income. In a digital world where people need ever-less money to facilitate transactions, there is no good reason to expect this to happen.

As this realization spreads, the view is that investors’ interest in crypto’s as an investment asset will wane.

For a further expansion on this theorem, we have included an edited extract here from the original report published by BCA Research on 21 May 2021.

Regulation

Will governments and central banks really allow unregulated, anonymous, and environmentally damaging virtual currencies to persist? Governments’ ability to control their currency is a fundamental basis for economic sovereignty.
  • If cryptocurrencies proliferate, central banks lose their ability to manage money supply and price stability.
  • The anonymity of cryptocurrencies inhibits tax authorities to identify sources of tax revenue which affects governments’ ability to fund themselves.
  • Combating money laundering and terrorist financing activities is another key motivator for governments to bring cryptocurrencies within their realm of control.

Unregulated money flows will impact monetary stability in terms of inflation and interest rates. Does business really want this? A key investment case requirement is financial system stability. So, banks and large corporations who drive the economy are more than likely to support governments’ moves to regulate.

And it has already started. The below table demonstrates the moves being made around the world by the major economies.

central bank digital currencies (CBDCs)

Apart from regulatory advances into the cryptocurrency space, central banks, together with banking consortiums are progressing towards offering their own blockchain based payment settlement vehicles. For the most part these are referred to as Central Bank Digital Currencies (CBDCs).

CBDCs are a form of digital money denominated in a country’s national unit of account and represent a liability on a central bank’s balance sheet. It is different from cryptocurrencies because there is a central authority behind a CBDC. There are also synthetic CBDC’s which are commercial payment platforms established by largely banking consortiums but whose tokens are backed by central bank reserves.

Significant progress has been made in the CBDC space and will be the subject of a separate article.

In conclusion, it is our view that a combination of SWIFT and CBDC linked innovations will lead to the demise of autonomous cryptocurrencies over the course of the next decade. Accordingly, crypto settlement options by retailers and fund managers’ investment vehicles can be viewed as purely short term speculative and vanity projects. What do you think?

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References:

  1. For a pdf download explaining SWIFT gpi: https://www.swift.com/swift-resource/249536/download
  2. https://www.gtreview.com/news/global/swift-gpi-instant-goes-live-in-the-uk/
  3. https://bitcoin.org/bitcoin.pdf
  4. the mechanism by which Bitcoins are “created” through solving transaction verification algorithms
  5. https://treasury-management.com/articles/crypto-treasury-options-considered/
  6. https://www.bloomberg.com/news/articles/2021-04-08/the-chip-industry-has-a-problem-with-its-giant-carbon-footprint
  7. In 2019, for example, company disclosures show that Intel’s factories used more than three times as much water as Ford Motor Co.’s plants and created more than twice as much hazardous waste.
  8. To counter this potential volatility “stablecoin” cryptocurrencies have emerged whose value is pegged to a specific currency or underlying security. These have their own specific risks but in some quarters are viewed to have promise.
  9. https://www.bcaresearch.com/

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