Cryptocurrencies are criticised for their volatility, exposure to hacking and manipulation, and potential facilitation of money laundering
It is quite common for innovations to encounter hesitant starts, and yet bring enormous economic and social benefits and change.
Thirty years ago, or even more recently amid the dot-com collapse, it would be difficult to imagine that there would be a small number of dominant technology companies, notably Google, Apple, Facebook and Amazon (GAFA), bringing such social and economic change. Furthermore, the challenges they are bringing along with these benefits were not always those that would have been imagined.
All this is probably relevant for crypto assets. Some of the concerns that people worry about – volatility, exposure to manipulation, lack of acceptability – are unlikely to be long-term issues. They stem from illiquidity. Once there is enough liquidity, these issues will disappear and there are good reasons why liquidity for the “winning” cryptocurrencies is likely to improve in the near or medium term.
Digital currencies paving the way for cryptocurrencies
One reason sits with central banks, where two distinct shifts may have a big impact. One is that leading merchant and international banks are starting to offer services involving crypto assets, for example offering exchange-traded futures on crypto assets when requested by customers, which in turn is putting pressure on central banks to develop prudential rules for the treatment of crypto assets on bank balance sheets.
A critical side effect of this activity is that the introduction of formal regulatory approved valuation and risk-measurement techniques, aimed at ensuring the resilience of the banking sector, will bring cryptocurrencies into mainstream banking and legitimise them. The other is the role of digital currencies in central banking payment systems. Central banks are all actively looking at introducing digital currencies and it is not if, but only a question of when this will happen.
The entry of central banks into the digital currency arena will bring the general populace into using digital currencies on a daily basis, from which the jump to using cryptocurrencies becomes a much smaller step.
The arrival of well-functioning cryptocurrencies could, for example, be a boon for users of retail banking services enabling them to use low-cost, fully verifiable transaction mechanisms to replace the existing expensive payment services offered by banks. But this is essentially replacing existing systems with cheaper alternatives and the potential for innovative services is probably where the long-term benefits lie.
Insurance one of the key sectors to benefit from cryptos
The benefits for insurance markets are often cited as an area that will benefit greatly since cryptocurrencies and the underlying blockchain should enable the exact price of insured items to be verified, rapid and precise public verification of events triggering insurance payments, and provide the relevant payment, all on one platform.
However, the ability for cryptocurrencies to include insurance-like contracts triggered by specific events, so-called smart contracts, appears to be even more exciting. It could enable small firms to borrow more easily and at lower rates because they will be able to publicly offload certain risks that depend on well-identified outcomes, such as currency exchange-rate triggers and prices of commodities futures. Such smart contracts could also be used to affect bond ratings and essentially could be useful in all sorts of investment opportunities.
Given the need for liquidity, we will probably end up with a small number of very large cryptocurrencies, but many smaller niche ones that are used extensively by particular industries and social networks, where the concentration on a specific industry or network provides a degree of protection against lower liquidity, all sitting alongside central banks digital currencies.
At the end of the day, as with the GAFA example, it is difficult to be sure where all this will land, but there is no reason to let short-term concerns cloud our view of the future.