Below is a transcript of remarks as delivered by Avanti CEO Caitlin Long on global standards for digital currencies at the International Council 2021, an event hosted by the Bretton Woods Committee. Additional information about the event and the Committee can be found here.
International Council 2021 Remarks
Thank you. Dr. Dudley.
As someone with substantial practical experience in both the traditional banking and digital asset worlds, and as someone who founded a now-chartered bank that has applied to the Fed for payment system access with a business model to issue a stablecoin-like instrument as a bank deposit, I’d like to focus on the three things that, in my view, really matter when it comes to the intersection of the traditional and digital asset markets: (1) settlement risk, (2) interoperability and (3) legal clarity.
Regarding settlement risk, the reality is that the vast majority of fiat-to-crypto exchange transactions occur with the U.S. dollar as the fiat leg of the transaction, but there are huge differences in both the timing and finality of settlement between the U.S. dollar and crypto transactions. Therein lies substantial risk, and firms that intermediate between the two–including central banks–must manage such risks VERY carefully. Specifically, while bitcoin and ether transactions settle in minutes with irreversibility, ACH transaction settlement is measured in days, and settlement finality can actually take up to 2 years in certain edge cases. It’s not difficult to see how such huge differences in settlement speed and finality can create problems. Indeed, these settlement differences gave rise to stablecoins in the first place, as traders needed a US dollar payment mechanism that allowed them to move dollars around the world in minutes, with finality. Proposed Basel III capital requirements for crypto are heavily focused on price volatility but are woefully insufficient, in my opinion, in reflecting settlement risk. Indeed Basel III generally doesn’t prescribe much capital requirement for settlement risk. Why? Because traditional financial markets have clearinghouses that smooth over temporary settlement failures. Examples of clearinghouses are central banks and other central counterparties that provide clearing and/or settlement services for everything from money to securities to commodities to derivatives. But here’s the problem: while the vast majority of traditional financial assets are centrally cleared and settled — including dollars at the Fed, securities at the DTC and even gold at bullion banks & the LBMA — only about 8% of bitcoins are held by centralized intermediaries right now, according to Glassnode. But, in crypto, such centralized intermediaries control only a small minority of the assets. This means it’s not possible to replicate the centralized clearing model of traditional finance for Bitcoin, because individuals own the vast majority of bitcoins and most rarely trade. But looking at this from a historical lens, what’s old has become new again. Just as J.P. Morgan (the man himself) became the lender-of-last-resort during the Panic of 1907, the so-called “crypto whales” (the large individual owners of cryptoassets) have been filling the same role as lender-of-last-resort during crypto market panics, because there are no such central clearinghouses to fill that role.
Second, let’s move to interoperability. Here, again, historical analogies apply. I’ll divide this topic into two subsections: one from the economists’ point of view, and the other from the technologists’ point of view. One of the most relevant papers on interoperability is actually from 1999 — it’s the famous Lacker, Walker and Weinberg paper called “The Fed’s Entry Into Check Clearing Reconsidered” (h/t to Dr. Manmohan Singh of the IMF, who pointed me to it). The paper traces the history of private check clearing networks in the U.S. before the founding of the Federal Reserve in 1913, before which private correspondent banks created and integrated regional check clearing networks. But these private networks were not national and they charged fees for their services, which meant none of them were able to clear checks at par (i.e., they cleared checks at par minus their transaction fees). It wasn’t until the Fed itself later started guaranteeing the payment of checks at par in 1916, thereby creating a structural advantage relative to private networks while also mutualizing the costs of check clearing infrastructure across its member banks, that nationwide network effects truly took hold and checks became a dominant payment method across the U.S. for decades. The analogy holds true in the crypto context today, especially with regard to stablecoins. Crypto exchanges serve the role of correspondent banks. They can either be centralized exchanges (e.g., Coinbase) or decentralized exchanges that run only on code (e.g., Uniswap). But, just as with the private check clearing networks of the pre-1916 era in the U.S., someone has to pay the transaction costs. Decentralized exchanges mutualize these costs by setting transaction fees as part of their smart contract, so that all users know upfront what fees they will pay (which are then deducted from the members’ trading, staking and seigniorage revenues). The stablecoin market may evolve in the same way that private check-clearing networks did, whereby a central bank guarantees payment at par and mutualizes transaction costs. But while that may be true for stablecoins, such an evolution is unlikely for a disinflationary asset such as bitcoin.
Speaking of interoperability from a technologists’ perspective, I’ll leave you with a few simple facts. Anyone can join the Bitcoin network, spinning up a node and syncing it with the network within a few hours. For Ethereum, syncing requires only a few days. But for ACH and Fedwire, though, integration takes many months to deal with all the intricate details–even when working with an approved integrator. A handful of U.S. banks have dealt with this problem by spending 3-4 years building proprietary middleware, to integrate their horse-and-buggy back-end into a Ferrari front-end. I’ve posited that the most significant change in U.S. banking recently was the Fed’s approval of API-native banking core software providers over the past couple of years, but today I’ll go a step further: while all the chatter in banking today is about the era of APIs, open blockchain protocols will quickly make even APIs obsolete. If we could peer into the future of banking a decade from now and look back at today, I suspect that the following statement will have proven true: the KISS principle, or “keep it simple, stupid” will have won. It used to be that complex, proprietary technology systems whose integration requirements were difficult, always won the day. But, to quoth the proverbial raven, nevermore — not after Bitcoin shifted the paradigm for ease of integration into a global payment network, measured in hours not months. Networks whose integration requirements are too onerous relative to the benefits of integration will lose network effects. Note to CBDC software developers: KISS, if you want other developers to use your system voluntarily.
Finally, a very quick word on legal clarity. If a regulated financial institution cannot prove that it has clear legal title to an asset, then owning it is an unsafe & unsound practice for that financial institution. I would encourage every jurisdiction globally to clarify the legal status of digital assets, and in the U.S. would encourage swift enactment of proposed UCC Article 12 to clarify the commercial and property law status of digital assets.