Project Syndicate: In March 2020, you, Juergen Braunstein and Sachin Silva predicted that the Covid-19 pandemic would “accelerate an ongoing shift among younger populations toward digital payments”, though Asia would move faster than the West. In your new book “Democratizing Finance: The Radical Promise of Fintech”, you and Nicolas Deffrennes note that while many people – particularly in the West – still want cash, new means of payment are nonetheless emerging. Which new means of payment are gaining traction in societies enamoured of cash, and why? Has economic uncertainty, stemming from, say, the US-China decoupling or the Ukraine war, affected the shift?
Marion Laboure: We have to distinguish between cash as a store of value and cash as a means of payment.
As a store of value, cash has not lost its position just yet. In the United States, Europe and Japan, cash in circulation has nearly doubled over the last 20 years, and it reached a new high during the pandemic, driven mostly by large banknotes. This is due to people withdrawing cash, which they view as “a safe heaven” to store value, especially during crises.
As a payment method, however, cash is losing ground. This trend has accelerated significantly over the last two years, driven largely by the pandemic. By raising fears that physical cash could act as a vector of virus transmission and requiring people to make more online payments amid lockdowns and social distancing, the crisis spurred the wider embrace of card and mobile payments. Sweden is the most extreme example, with cash in circulation now representing only 1% of GDP.
But a pivotal moment came even before the pandemic began: in June 2019, Facebook announced that it would launch its own stablecoin, Libra, spooking the world’s major central banks and spurring them to act. Over the past three years, central banks and governments worldwide have multiplied and sped up their digital cash initiatives. In a survey by the Bank of International Settlements published in May 2022, 90% of central banks are exploring digital currencies. The US-China decoupling and the Ukraine war have also reinforced this trend.
PS: In May, you noted that, if crypto is to gain wider adoption over the long term, its proponents will have to get serious about reducing its energy usage. In “Democratizing Finance”, you point to other factors that will help determine the speed with which digital currencies move into the mainstream, including whether governments back them and they become more stable. Today, crashing crypto prices are fuelling a massive sell-off, China has debuted its digital renminbi, and dollar inflation is rising. What do such developments mean for the future of crypto? Does the recent crash vindicate sceptics?
ML: The cryptocurrency market cap fell sharply, from US$1.57 trillion on May 8 – before the TerraUSD crash – to below US$1 trillion as of June 14. This was part of a broader decline in technology stocks, with the Nasdaq Composite falling 31% year-to-date as of market close on June 13.
But this decline should be put into perspective. In 2017, the overall crypto market cap was US$18 billion, and one bitcoin was worth US$1,000. In 2021 – the peak – the market cap of cryptocurrencies was US$2.9 trillion, and one bitcoin was worth US$67,000. These days, these values lie somewhere in between, at US$1 trillion and US$23,000, respectively. This highlights the crypto market’s extreme volatility.
The price of bitcoin is highly correlated with Nasdaq fluctuations, indicating that sentiment toward cryptocurrencies in general is strongly correlated to tech stock performance. This has been further reinforced in the last six months, as the correlation between bitcoin and the Nasdaq Composite returns increased from 20% in November to nearly 80% in May. It has since fallen, but remains elevated, at 60%.
Both tech stocks and cryptocurrencies are highly exposed to the outlook for monetary policy. The recent sharp drop mostly indicates that cryptocurrencies will increasingly be affected by macroeconomic policies, especially interest rate hikes. Such hikes, together with tighter liquidity, will force businesses to cut back expenditures, because financing will be more expensive. Investors will reduce their equity and cryptocurrency exposure due to a worsening growth outlook and higher volatility. Likewise, some pension funds, insurers, and other investors favouring stability and liquidity reallocated their exposure to fixed-income assets, at the expense of equities and alternatives.
PS: In Democratizing Finance, you tout the potential of fintech to mitigate inequality, though you also present case studies demonstrating the difficulty of achieving this goal. What would improve the chances that fintech innovations are implemented effectively, boost financial inclusion, and reduce inequality?
ML: Financial literacy is a problem everywhere, including in the advanced economies. In a recent survey, only one-quarter of all adults in the 38 Organization for Economic Cooperation and Development (OECD) countries responded correctly to questions about simple and compound interest. Only 53% of all surveyed adults – and 57% in the OECD countries – achieved the minimum target score.
This highlights the importance of financial education, which should be an integral part of school curricula. It is also a reason why regulation is so vital to protect consumers, firms and governments.
In developing countries, governments must play a central role in creating inclusive financial ecosystems. Consider India’s ambitious Aadhaar programme. This centralized digital identification scheme was initially intended to facilitate the delivery of government benefits. But it now also helps banks to verify customers seeking to open accounts. This has helped to bolster financial access and paved the way for several innovative financial services in India.
PS: Calls for stronger regulation of crypto – and fintech more broadly – grow louder by the day. What must governments understand as they attempt to devise “smart regulations” that, as you put it in your book, “enable sustained fintech growth while also ensuring equal access to benefits”?
ML: Collectively, cryptocurrencies still comprise a tiny part of financial markets. But bitcoin’s US$430 billion market cap (as of June 14) puts it among the world’s 15 largest companies by market capitalization. Cryptocurrencies can no longer be ignored.
Many tend to regard the 10,000-plus existing cryptocurrencies as a homogenous group. But there are immense differences among them, with some having real useful applications and others acting more as fragile speculative plays. Periods of economic and financial stress will continue to highlight these differences.
Tighter rules are coming, including for those cryptocurrencies aiming to match and even rival the fiat system in terms of importance in the global economy. As regulation is introduced, speculative excesses will likely be curbed significantly. Many historical examples highlight the power of regulatory bodies to maintain financial stability. The most recent examples are China’s ban on cryptocurrencies last September and the failure of Libra/Diem.
PS: Your book highlights a number of financial innovations, from digital wallets to robo-advisers. Is there a particular innovation that you have your eye on?
ML: I’m watching stablecoins closely.
The recent devaluations of cryptocurrencies have been partly driven by stablecoin turmoil – specifically, the meltdown of TerraUSD. Theoretically, stablecoins are always supposed to keep a 1:1 peg to a currency or a commodity. This provides those who buy cryptocurrencies with an alternative way to “stay in cash” without relying on the fiat financial system. Stablecoins can also be used to facilitate payments and operate across different exchanges.
The TerraUSD crash illustrates several vulnerabilities, including the lack of liquidity, the propensity of spillovers amid changes in investor sentiment, and the geographically fragmented nature of trading regulations and asset availability.
A history of major peg breakdowns, including those in Latin America and Asia, may offer a lesson for stablecoins. Macro liquidity withdrawal and rate hikes by the US Federal Reserve and the European Central Bank, along with regulatory pressures, will likely test confidence in the main issuers of stablecoins and the value of those coins. The ghosts of past episodes of capital flight and depleting reserve coffers linked to foreign exchange pegs may come back to haunt stablecoins.
Marion Laboure is a lecturer at Harvard University and a senior economist at Deutsche Bank Research.
Copyright: Project Syndicate