Cryptocurrencies aren't really a solution to our problems

Cryptocurrencies were alleged started because public lost trusts in banks and other financial institutions as a result of the subprime mortgage crisis in 2007-08.

In the height of a lot of people trying to claim that cryptocurrencies would change how we do banking and financial transactions, I wish to express my personal thoughts about its limitations (as of now). Of course, technology changes and in future, the limitations can be addressed easily. This article addresses why banks aren't afraid of cryptocurrencies (otherwise, they would have made a cryptocurrency of their own before most of the people even came to know about it).

Bitcoin, the most famous cryptocurrency's paper describes bitcoin as:

A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution.

As described in the paper, bitcoin does exactly the same thing and nothing else.

Definition of a bank as provided by wikipedia:

A bank is a financial institution that accepts deposits from the public and creates credit. Lending activities can be performed either directly or indirectly through capital markets.

Did you notice the remarkable difference in both the definitions?

Wikipedia and research papers can often be obscure and a definition doesn't really help a lot. So let me explain.

Banks provide liquidity in capital markets

What "providing liquidity" means is that can either take money or provide money whenever needed.

The main purpose of banks is to take public money and lend to the needy. In return, they give the public an interest on the money deposited as an opportunity cost and against inflation. If you have money tied up under carpets like a Gujju or Pablo chachu, the inflation rate is going to eat up the value of the money (but won't be your major issue if you are Gujarati or Pablo).

Commercial banks

Commercial banks mainly offer savings account and fixed deposit for earning interest and current account for businesses to operate where they don't charge any interest and neither do they charge any fees for that. With the deposits they take, they invest it in debt which people want in the form of mortgage, vehicle loan, and up to some extent to companies.

Super interesting fact: Have you seen the TV show Medici Masters of Florence? It describes the rise of The Medici family in late 1300s starting with Giovanni di Medici at inception and Cosimo de Medici in its prime stage. The Medici family controlled The Medici Bank which was the first formal bank the world has ever seen and which has said to introduce the concept of credit in this world. They were the ones who fueled renaissance through their ingenious financial innovation to support entrepreneurs to take risk to earn return and be supported by the other citizens who's deposits will be kept at the bank and earn the dividends/interests. They invented the concept of limited liability in setting up bank brances as independent from their parent entity so as to mitigate risk and having local stakeholders who run the operations overseas hold substancial stakes for skin in the game. They proved that they could scale the banking business as much as to capture and create new trade and convince The Pope to be his personal banker in the age where Church was the highest corrupt authority (Middle Ages is 1300s).

Investment banks

Investment banks help companies raise money through IPO or bond issues. They also have a network of HNIs (High Net worth individuals) and institutions who want to park money in order to generate returns. They also act as market makers in exchanges and buy/sell assets when no one is willing to. They help to provide a route for retail investors to invest in public companies and charge brokerage for that.

Well, you would be now thinking that all of this can be done through blockchain technology (not essentially cryptocurrency), right?

If yes, then you might be a blockchain developer. Kudos, but do read the entire thing. I promise you would learn something from it and it would be fun.

Let's talk about the origin of money, banking system and others. To read in more detail about origins of money, read the book "The Ascent of Money: A Financial History of the World" by Niall Ferguson.

Elizabethan Era

This period is regarded as the "golden period" in the English history. If you are good at history, you would remember that Shakespeare lived in this era and if you are one of his fans, you might have read the book "The Merchant in Venice". Lending in this era was mostly peer to peer like Shylock gave money to Bassanio while Antonio (his friend and a wealthy person who currently had his money parked in outside waters) would cover it in case of default.

So to be historically precise, banking and lending were always done peer-to-peer. But something happened where people realized the need for a bank.

As the story of "A Merchant of Venice" unfolds, a rumour spreads out that Antonio's ships have wrecked and thus he has lost most of his investment. This triggers a default of the debt. I hope you see an issue over here.

Antonio was a person with an extremely good credit history but he still defaulted because of something beyond his control. Peer-to-Peer lending had failed because it had failed to diversify. What are the chances that shipwrecks? Had Shylock given his money to a million people, the losses would be minuscule and could be easily covered up with risk premiums in the interest rate.

Federal Reserve of United States

The concept of Federal Reverse Bank in the United States was borrowed from European countries in the 1910s. What was happening is that some people with malicious intent would declare that a bank is going to go bankrupt even though it was actually quite healthy. No bank keeps deposited money in lockers and pays interest on them. Instead, a major portion of the money is invested. When all the people rushed to take their money out, the bank would be unable to clear it's current liabilities and would go bankrupt. The Federal bank became the liquidity provider since it could inject money whenever it wished and give it to the bank to cover up for their short-term liabilities. This is the current solution to the age-old banking problem.

I have presented an extremely simple model and of course this isn't quite true. If you are interested in reading more about this please read this paper published by Bank of England pointed out in the comments below by Rohan.

Subprime Mortgage Crisis

This is said to be fueled because of the extremely low interest rates during the tenure of Alan GreenSpan since he strongly believed in deregulation and that market is the best decider of the price. To the blockchain folks, what this means is that a common consensus can't always work better for themselves. When dealing with humans, we always have to take into account the human emotions like fear and greed otherwise, we would end up like Long Term Capital Management and as much as smart as they were, they ended up losing money for their investors.

There are many more such stories to include to prove why a central regulation system is required but then this already long article would become even longer. The book "The Ascent of Money" already describes why Free Markets failed to solve this issue.

As for the current state, the blockchain industry has no solution in the near term and in fact is already showing problems.

Dominance in Cryptocurrency market

An article in medium with the title "Stop. Calling. Bitcoin. Decentralized" explains the concentration of bitcoin miners. Heck, even democracy is supposed to be decentralized where "every citizen gets an equal vote", but we all know how rigged our system is. It's time we start accepting this fact for cryptocurrencies as well.

Cartels in Cryptocurrency markets

There are already many cartels in the futures market of Bitcoin operating via CME which because of their leveraged position are manipulating cryptocurrency prices. Here is a medium post explaining this.

Your broker/exchange isn't decentralized

Many people who buy cryptocurrency from an exchange or broker don't realize that the transaction they just did while purchasing the asset is in fact the same old transaction. One first deposits money in the broker/exchange's bank account. The broker then arranges for the asset at market price and takes a commission. After the asset is bought, it can be transferred to anyone which is decentralized. Of course, if you have mined the cryptocurrency, then you shouldn't be worried about this except when to try to sell it in open market.

The brokers/exchanges are unregulated private companies. Their balance sheets are not publicly available. You might never know when the broker/exchange might go bankrupt. They don't have to follow rules like other national exchanges do. They don't invest enough in security of their platform. They might be using the idle cash in your account to buy cryptocurrency for their account, and guess what, you would never know. How is that bad? Well, if the asset prices go down, the broker/ exchange made a loss on a trade where they didn't even have to put a collateral, which could be a serious issue if the broker has a high leverage. White collar crimes like spoofing in cryptocurrency exchanges are extremely common. And did I mention about the huge bid ask spread they charge? Ouch, 3-5% of the trade amount would definitely hurt your pockets.

High Volatility

The cryptocurrency markets at this point in time are extremely volatile. Let's say a merchant sold some goods worth $8000 and according to the current BTC price, the buyer paid 1 BTC. Now, the merchant has an open position in BTC. He can either go in the market and quickly sell it and pay the broker/exchange fees of around 3-5% or it can carry forward the open position where he runs the risk of the currency being devalued. If the next day, BTC prices drop to $7000, then the merchant took a loss of $1000. Of course, if you are a derivatives trader, you could argue that you can hedge the open position using futures and options (one of the strategy being gamma scalping), but then think about it again, should a simple merchant be involved in complex derivatives transactions (and pay a hefty fee for that too)? Probably no, right?

Economic Benefit

Remember, the 51% attack wouldn't be fruitful because the computing power would just be wasted and bitcoin's worth will drop? Well, things just changed thanks to the introduction of Bitcoin futures in CME. Now you can have a short position in bitcoin, perform a 51% attack (even easier now because of consolidation of miners) and gain a huge profit. As of now bitcoin futures are thinly traded instruments but they are leveraged instruments. Anytime in future, if the volume of such contracts increases, it will be a good opportunity.

All of these obviously shows that cryptocurrency doesn't solve nor it intends to solve such problems and that it should be just seen as a computer science marvel solving a lot of problems that already existed with our current set of distributed systems rather than a game-changing future.