So Much Hot Air About Virtual Currencies

Rhetoric on virtual currencies has centred on risks and threats. But the technology also has the potential to promote financial inclusion. Over the past ten years since the global financial crisis and against a background of enforcement action and increased regulatory scrutiny, banks have revisited their portfolios of clients.  By Tom Keatinge of RUSI

Often this has led to drastic action: restrictions placed on account activity, and many account holders, particularly those perceived to operate in risky environments, have faced the closure of their banking facilities and even the loss of financial access. 

The issues of this process of de-risking and de-banking have been widely reviewed and have been the focus of a range of policymaker-bodies such as the UK’s Financial Conduct Authority, the Financial Action Task Force, the Financial Stability Board (FSB, the international body that monitors and makes recommendations about the global financial system) and the G20 group of the world’s biggest economies.

NGOs and charities have been particularly adversely affected by this de-risking process. Some actors from these sectors represent a perfect storm of risk for many banks: cash-based operations, with varied governance standards, active in high-risk jurisdictions, often in close proximity to designated terrorist groups where the beneficiaries of aid might be impossible to determine in advance. 

Given such circumstances, banks’ determination to reduce their exposure to the NGO sector was understandable, but the adverse consequences for those affected (and their beneficiaries) has been significant.

Recently, the situation has improved somewhat. As banks have gained control of their financial crime compliance obligations, restoring the confidence of regulators, and their de-banking projects have subsided, those higher-risk customers, such as NGOs, are again facing a less uncertain relationship with their bankers. 

Furthermore, certain banks should be commended for their willingness to engage with the NGO community, developing dedicated teams that understand NGO governance to handle relationships and help NGO clients to maintain their financial access.

Yet problems persist. Notwithstanding the increased willingness of banks to provide account holders’ services to NGOs and to execute payments on their behalf, friction remains in the system. Money moves around the world via a chain of banks (so-called correspondent banks) which often know neither the sender of the funds, nor the intended recipient. 

While risk tolerance has increased, correspondent banks remain a bottleneck in the global financial system. As the FSB noted in March, the number of correspondent banking relationships is declining, and this in turn restricts the ability to send and receive international payments, driving some payments underground, ‘with potential adverse consequences on international trade, growth, financial inclusion, as well as the stability and integrity of the financial system’.

Some efforts are being made to reduce the risk that payments are delayed or returned. For example, increasing and standardising the information provided in payment messages, the interbank communications that instruct banks to make transfers between accounts, such as proposed in the ISO 20022, the universal financial industry’s message scheme, may help remove some frictions.

But the most effective means of removing the risk that links in the payment chain will disrupt payment flows is to remove them from the system entirely. 

NGOs are already doing this, disintermediating correspondent banks and the risk that their payments will be blocked by using cash couriers to move funds to where they are needed to support their programming. This is clearly a far from ideal solution, but is often nonetheless necessary.

Enter virtual currencies and other Blockchain-based solutions. Peer-to-peer transfers remove the need to interact with the correspondent banking network. Cash held in a bank account can be converted, via a regulated exchange, into virtual currency and transferred to the online wallet of the recipient. From there they can make purchases of required goods or be cashed out as required.

There are of course issues to address: 
Will the original bank allow the account holder to transfer cash to an exchange to buy the required virtual currency? Do the vendors of required supplies accept virtual currency? Can the recipient of the virtual currency exchange the value they receive back into fiat currency at their local bank or via a reputable agent to meet their cash flow needs? 

Nevertheless, virtual currencies offer a mechanism for moving value across borders while cutting out some intermediaries. Even marginal reductions in friction are a feature that de-risked actors such as NGOs might find useful.

Importantly, these transfers need not be secretive or anonymous as use of virtual currencies is so often portrayed. The Bitcoin blockchain allows for total transparency, allowing the flow of Bitcoin from one user to another to be observed. This transparency can also prove beneficial to NGOs as it allows them to demonstrate clearly that donated funds are being delivered to their intended recipient and that outcomes are being achieved.

However, much of the public discussion to date on virtual currencies has focused entirely on the possible downsides of the technology, with little reference to how they might improve the ability of high-risk sectors such as NGOs to obtain both reliability and transparency in international transfers.

The rhetoric surrounding virtual currencies is dominated by the risks these forms of decentralised, peer-to-peer value-transfer mechanisms represent.

The original views of the likes of J P Morgan CEO Jamie Dimon (‘it’s a fraud … it will blow up’) and Nobel Prize-winning economist Joseph Stiglitz (‘Bitcoin ought to be outlawed’), were widely reported. Thankfully, discussion of virtual currencies is becoming more nuanced (Jamie Dimon has back-pedaled saying he regrets his initial remarks), terminology is maturing: policymakers are favouring the term crypto-assets over ‘currencies’ (which Bitcoin and the like are clearly not); crypto-assets have been added to the agenda of the G20; and supervisory authorities and policymakers are (albeit in an uncoordinated fashion) turning their attention to addressing regulatory challenges.

While this moderation of rhetoric and greater policymaker engagement is welcome, thus far there has been limited engagement with the virtues of crypto-assets, in particular, as the G20 noted at its March meeting in Buenos Aires, the ‘potential to improve the efficiency and inclusiveness of the financial system’.

Ripple, the self-styled ‘enterprise blockchain solution for global payments’ argues that payments are still stuck in the ‘disco era’ and is seeking to provide a service that competes with the incumbent payment system based on the traditional correspondent bank-based network. Several banks such as Santander and Standard Chartered are already hedging as they sign up in support of Ripple’s proposal.

Across the globe, policymakers are grappling with the banking challenges faced by those deemed ‘high risk’ by the financial sector. Working groups, such as one at the UK Home Office, have been established, and considerable time is spent in high-level forums such as the G20 and the FSB attempting to identify the issues that have led to restrictions in financial access.

But perhaps rather than trying to fix the outdated ‘disco era’ technology that supports global payments, time would be better spent on advancing the ability of new technology to render these challenges obsolete.

RUSI:   

Tom Keatinge is Director of the  Centre for Financial Crime and Security Studies at RUSI.

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