Cryptocurrencies will need some rules to change the game: S&P

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JEDDAH — Financial markets are abuzz with questions regarding the nature and viability of digital currencies. As far as rated financial institutions’ risk exposure is concerned, however, S&P Global Ratings believes that it is much ado about nothing. In our opinion, in its current version, a cryptocurrency is a speculative instrument, and a collapse in its market value would be just a ripple across the financial services industry, still too small to disturb stability or affect the creditworthiness of banks we rate.

Cryptocurrencies are digital currencies that use encryption techniques to regulate the generation of units of currency and verify the transfer of funds. They have attracted a significant amount of attention from the market over the past 12 months. Cryptocurrencies are independent from central banks, and the risk of them infiltrating the traditional financial systems, exposing them to a possible bubble burst, is raising eyebrows at regulators.

We view cryptocurrencies as a speculative instrument that would have an insignificant effect on global financial stability if its value were to collapse.

If the value of cryptocurrencies dropped substantially, we expect retail investors would endure most of the impact, while rated banks wouldn’t feel the hit since they are largely insulated thanks to their limited direct and indirect exposures and cautious approach so far.

The future of cryptocurrencies will depend on the coordinated approach of global regulators and policymakers, but we note that their underpinning technology could strengthen operations, notably with regards to money transfers and financial market infrastructure companies.

“We believe that cryptocurrencies, in their current version, have many characteristics of a speculative instrument. We think that retail investors would be the first to bear the brunt in the event of a collapse in their market value. We expect banks rated by S&P Global Ratings to be largely insulated, given that their direct or indirect exposure to cryptocurrencies appears to remain limited.” If cryptocurrencies become an asset class, the impact on financial services firms will be more gradual. That is because we believe that their future success will largely depend on the coordinated approach of global regulators and policymakers to regulate and enhance market participants’ confidence in these instruments. More importantly, we believe that blockchain technology--which is what underpins cryptocurrencies, enabling the creation of a shared digital transaction ledger--could be a positive disrupter for various financial value-chains. If widely adopted, blockchain could have a meaningful and lasting impact on the celerity, traceability and cost of financial transactions. The financial market infrastructure segment might also see medium-term benefit from cryptocurrencies and blockchain through the launch of new income-generating products, such as futures or exchanges based on cryptocurrencies, or the replacement of current practices by new ones based on blockchain.

In our view, cryptocurrencies do not meet the basic two requisites of a currency: An effective mean of exchange and an effective store of value. First, cryptocurrencies are still not widely accepted as payment instruments, although the list of companies accepting them have increased over the past few years. Second, the volatility that we have observed over the past 12 months in the valuation of some cryptocurrencies and their market cap is the most meaningful evidence that they fail the test of value storage (see Chart 1). For example, in the first 10 days of February 2018, the market cap of cryptocurrencies dropped by around $185 billion from Jan. 28, 2018.

We also don’t view cryptocurrencies as an asset class. For starters, the total outstanding aren’t big enough yet. At Feb. 10, 2018, there were 1,523 outstanding cryptocurrencies with a market cap of around $394 billion. By way of comparison, at the same date, this is well below the market capitalization of Apple Inc., around $794 billion.

The oldest and most renowned cryptocurrency is Bitcoin, which emerged in the aftermath of the global financial crisis as a decentralized peer-to-peer payment instrument. It intended to restore the credibility of the payment system by removing intermediaries such as banks and central banks from the equation and relying on end users’ powered network. Bitcoin was originally used as a means of payment for transactions but its credibility dipped when it was allegedly associated with illegal transactions. Bitcoin and other cryptocurrencies reemerged in 2017 when their market cap increased exponentially. However, we believe that their usage changed from a payment instrument to a speculative instrument when buyers began to largely bet on their future value instead of using them for transactions.

Cryptocurrencies are most like a speculative instrument, versus an asset class or a currency. We are of the view that the current version has many characteristics of a traditional bubble, mainly based on the following three reasons: • The offer of the oldest cryptocurrency (Bitcoin) is limited by definition to 21 million coins of which around 16.9 million are already in circulation. One could argue that an infinite number of cryptocurrencies could be created, but we believe that this process takes time, as these currencies need to earn their credibility. As such, the top 10 cryptocurrencies represent roughly 80% of their total market cap (see Chart 3).

• The volatility of the value of cryptocurrencies is extremely high. Over the past 12 months, cryptocurrencies’ market cap has increased 33x from $17 billion to $579 billion at Jan. 28, 2018 compared with an increase of 1.4X over 2014-2016. In the first 10 days of February 2018, the market cap dropped by around $185 billion reaching $394 billion. That was reportedly underpinned by the crackdown of some countries, particularly China and South Korea.

Moreover, the single-name concentration in the holdings of these instruments is high. For example, at Feb. 10, 2018, 1,650 users (addresses) with more than 1,000 Bitcoins in their portfolio controlled as much Bitcoins as the 26.3 million users with less than 100 Bitcoins in their portfolios (Chart 4). We believe that this concentration, along with the unregulated nature of this instrument makes it prone to market manipulation for example.

• Finally, cryptocurrencies do not benefit from the backing of cash flows or a credible central issuer, which would give it an intrinsic value. Market perception/sentiment rather drives their valuation.

If cryptocurrencies were to take off and become an effective currency issued in a decentralized manner, the impact on monetary policy implementation would be deep, since central banks might lose their ability to control money supply.

Conversely, if central banks were to back cryptocurrencies, the central banks would be better positioned to predict money demand and therefore adjust supply accordingly. It is still too early to tell in which direction this instruments will move.

In the event of a correction of the cryptocurrencies’ valuation, we think that retail investors would feel most of the heat, because we understand that these investors contribute to most of the activity on this market. While there are no official statistics on the holdings of cryptocurrencies by countries, investors in the U.S., China, Japan, and South Korea are reportedly the most exposed. Positively, the relative contribution of cryptocurrencies in the global wealth formation is still limited. For example, the global stock market capitalization reached approximately $80 trillion at year-end 2017, meaning that cryptocurrencies are still a marginal instrument. Therefore, we do not foresee any systemic wealth effect risk.

From a risk perspective, because of the lack of regulation and possible use of cryptocurrencies in illegal activities, banks might expose themselves to operational and legal risks, if regulators accuse them of helping money laundering, for instance. Recent cases show how expensive this could be for banks.

Because of the high volatility of their valuations, cryptocurrencies could also pose risks for financial advisers in dealing with their clients. Merrill Lynch, for example, banned its clients’ advisors from trading Bitcoin-related investments.

Finally, other channels of transmission to banks include credit cards and brokerage operations on behalf of clients.

Whenever retail investors fund their cryptocurrencies purchases with credit cards, the deterioration of clients’ creditworthiness following a slump in cryptocurrencies prices could drive an increase in delinquency rates. Faced with this risk, many U.S. issuers--such as Citigroup, Bank of America, Discover, and Capital One--recently decided to prohibit their customers from purchasing Bitcoin with their credit cards. European banks, such as Lloyds, are also following this trend. U.S. brokers--including TD Ameritrade, which was the first to allow its clients to trade Bitcoin futures in the US – are also exposed to credit risk whenever clients trading Bitcoin futures are unable to meet their margin calls and their positions are liquidated at a loss. This risk is limited so far, however, owing to the low open interest in Bitcoin futures.

Beyond these immediate impacts, we think that the creation of a cryptocurrency backed by a central bank that gives citizens direct access to this central bank’s ledger is potentially a game-changer to banks as we know them. This does not mean that banks will disappear but it would mean significant changes in the way they do business.

Non-Bank Financial Institutions Could Benefit Because non-bank financial institutions have, generally, greater flexibility than banks, they are both more adept and more vulnerable to the rise of cryptocurrencies and bitcoin as a new instrument. From a business perspective, investment banks and stock exchanges around the world are somewhat affected by the development of Initial Coin Offerings (ICOs). ICOs allow companies to raise capital to fund, generally start-ups, at the very early stage of its creation. Currently unregulated, some market participants view ICOs as an alternative way to bypass the regulated capital raising processes (see Table 1). Non-bank financial institutions, particularly financial market infrastructure (FMI) companies, enjoy a certain level of revenue protection from the customary, standardized capital-raising process, which generally requires coordination between underwriters, investment banks, and regulators. ICOs circumvent the traditional roles of underwriting, regulatory oversight, and voting privileges. The unregulated landscape of cryptocurrencies and ICOs could threaten this. — SG


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