ANZ Finance blog | The Road to Cryptocurrency

The Road to Cryptocurrency, Instalment # 1

Published 7 May 2021

By Dr Peter J Phillips, Associate Professor (Finance & Banking) University of Southern Queensland

The Road to Cryptocurrency part 1-- McGraw Hill ANZ Finance Blog

Everyone is talking about it. Crypto. After thinking about it for a while, it is clear to me that one cannot understand cryptocurrency in the absence of an understanding of the financial system because it is only with reference to existing institutions and conventions such as cash, money (more broadly), payments, central banking and monetary policy that the crypto-enthusiasts’ arguments can be made sense of and weighed against opposing views. In short, if you want to understand what cryptocurrencies are and how they may be used for payments now and in the future, the first thing to come to grips with is the nature of the existing payments system.

The payments system is the collection of processes that allows people to pay one another. The most basic arrangement, of course, is to pay in cash. This means notes and coins.

"…In short, if you want to understand what cryptocurrencies are and how they may be used for payments now and in the future, the first thing to come to grips with is the nature of the existing payments system."

Some people hold erroneous beliefs about cash. First, they believe that cash is backed up by something (usually gold). That is, they think that if a government has issued $100 in cash, there is $100 in gold in a vault somewhere. There isn’t. Modern economies work almost exclusively with ‘fiat currency’. Fiat currencies are established by government law (i.e., a declaration that something will be the country’s legal tender) and they are unbacked by any underlying commodity. Second, they believe that banks have in their possession enough notes and coins to meet depositors’ demands. They don’t. If every depositor went down to their bank and tried to withdraw all the money in their accounts, the bank would have to close [this is why, to prevent a ‘run’, the Australian government guarantees deposits up to $250,000 per person per bank]. In fact, banks aren’t required to keep any set ratio of deposits in cash and coins. Banking regulations impose capital requirements on banks but not reserve requirements.

The unbacked nature of fiat currency and the fact that governments are always inclined to print more of it, is a key determinant of crypto-enthusiasm. This is something that we will come back to in future instalments.

For now, let’s explain how payments are made and how the payments system works. People pay or accept cash. Traditionally, people also use credit and debit cards, cheques, and electronic funds transfers (EFT). These methods encompass older or established innovations such as BPAY and EFTPOS. There are some newer innovations that we will also discuss in future instalments. For now, it is sufficient to note that all the non-cash methods involve issuing an instruction to shift funds from one account to another. What happens behind the scenes once an instruction is issued? When you use EFTPOS, say, what happens next?

"If every depositor went down to their bank and tried to withdraw all the money in their accounts, the bank would have to close"

What happens next is that the payment is ‘cleared’. The first thing the system needs to do is to make sure you have sufficient funds or sufficient credit. Then, once that is confirmed, funds move out of your account (or a debit is placed on your credit card balance) and into someone else’s account. Obviously, this can involve different credit card companies and banks. This ‘clearing’ and ‘settlement’ takes place through several different systems overseen by the Payments Systems Board (PSB) at the Reserve Bank of Australia.

Clearing for cheques, ATM transactions and debit cards is facilitated by AusPayNet, which is a company whose board members are drawn from banks, building societies and credit unions that was set up to facilitate payments in Australia. AusPayNet clears most payments in Australia. AusPayNet is complemented by other payments systems. For example, there is MasterCard, Visa and American Express. There is also eftpos Payments Australia Ltd (ePAL) which clears debit card payments not cleared by AusPayNet. More recently, the payments industry has participated in the development of the New Payments Platform (NPP) which allows funds to be transferred instantly, rather than the few days it once took for a funds transfer to be finalised.

Once the payments are cleared, they must be settled. Banks, for example, settle with each other through the accounts that they hold with the Reserve Bank [called exchange settlement accounts or ESAs]. If I make a transfer of $100 from bank A to you at Bank B and, that same day, you make a transfer of $100 to someone else who, like me, holds an account at Bank A then the net settlement is zero. There’s no need to pass the $100 from A to B and back to A. If your transfer was $200, then Bank B would transfer the net amount ($100) to Bank A. This net settlement arrangement works across the board.

"In many matters, as we shall discover, crypto-enthusiasts share the same concerns as libertarian economists and the Austrian School of economics."

As will become clear in future instalments, the presence of another entity, whether AusPayNet, ePAL or Visa or the PSB in the transfer loop is something that crypto-enthusiasts want to avoid. As such, we have already identified two points that are critical to understanding the crypto-enthusiast’s position: (1) fiat currency unbacked by gold is susceptible to government money printing; and (2) some other entity facilitating and overseeing funds transfers (and recording funds ownership for that matter) is something that crypto-enthusiasts would like to avoid.

In the next instalment, we will investigate the nature of fiat currency and how monetary policy and central banking can slide into the temptation of money-printing and why this can lead to runaway inflation. In many matters, as we shall discover, crypto-enthusiasts share the same concerns as libertarian economists and the Austrian School of economics. It is no surprise that the Nobel winning Austrian economist, Friedrich von Hayek, has become linked to crypto-currency and the idea of sidestepping central banking which, according to the Austrian School, is often the source of financial crises, not the free market. They argue, for example, that if the Federal Reserve hadn’t artificially lowered interest rates in the early 2000s, the mortgage crisis could never have occurred.

Discussion Question

Murray Rothbard was a prominent Austrian School economist, along with von Mises, Hayek, and others. What can you find out about the Austrian School and, especially, about Rothbard’s arguments for a 100% gold-backed US dollar?

Further Reading

The payments system is explained in more detail in Chapter 12 of the textbook.