With cryptocurrencies weathering a big storm, it may seem delicate to analyze this market without falling into the stereotypes about an inevitable crash or the dangers of uncontrollable mechanisms implemented on some of the so-called “stablecoins”. There is a lot of talk about the speculative madness that is dragging millions of investors into an esoteric market that was originally intended to concern only a few thousand “geeks” from the most technical sphere of the digital industry; no need to add to this. On the other hand, recalling the genesis of cryptocurrencies, understanding their limits, and examining some of the applications that may have emerged and could remain after the current fever is salutary for understanding the consequences for banks.

Cryptocurrencies, the enfant terrible of technology

A cryptocurrency cannot exist without a blockchain… since it is technology that first generated cryptocurrencies. The blockchain technology was created as a way to avoid centralized control systems (stock exchange, bank, central bank), generally necessary to recognize the ownership of a financial asset. Basically, the blockchain technology aims at storing sensitive information, for example a transactions chain, by relying on a network of validators who each keeps a version of this information. Indeed, hacking a central registry is not completely impossible, but simultaneously hacking all its copies distributed on computers all over the internet seems totally unfeasible. Initially the crypto-currency is just a medium of exchange used by the participants in this techno-system for data integrity validation. Paying for these services in normal currency would mean that the cost would be borne by the users of the blockchain, which would make the system unattractive. A new currency has therefore been created that validators who operate many digital services for each other will soon exchange within the community of technical providers in the digital industry. This is how Bitcoin emerged in geek communities as a currency for bartering digital services.

Soon enough, some players made Bitcoin convertible into dollars, a convenient service for the digital community. Bitcoin gradually became accepted as a means of payment outside the digital world. This funny little story has remained in people’s minds: the first real-world transaction using crypto was to buy two pizzas for 10,000 Bitcoins, i.e., at the current price, … several tens of millions of Euros! If we only had known…

Following Bitcoin, many digital service projects have developed with blockchain technology by taking up the idea of a cryptocurrency. The number of cryptocurrencies has exploded with all the phenomena that occur in gold rushes: real business opportunities, but also a dark side whose perverse effects we start seeing today…

The dark side of cryptocurrencies: dirty money, speculation, Ponzi schemes…

Bitcoin was quickly associated with grey or even undeclared trade, avoiding traceability… Logically, since it was precisely intended to be free from any banking authority and therefore from any control capacity. But this has naturally led, albeit with some delay, to the regulation of services related to crypto assets. Thus, in Europe since 2020, cryptocurrencies come under the regulation on Service Providers on Digital Assets (DASP) or the PACTE2 law on money laundering. Most importantly, the Markets in Crypto-Assets Regulation (MiCA) aims to best cover the major risks identified, including investor protection, authorized crypto asset service provider statuses, traceability of cryptocurrency transfers, the ecological impact of validation systems…

The development of grey trade has naturally driven up the value of cryptocurrencies, in unexpected proportions. The rise in prices has gradually attracted all kinds of investors. First, those who understood the risks of this digital economy, but then gradually the public who saw it as a type of diversified asset offering significant returns. Everything concurred in stirring up the financial imagination to attract massive capital to this new Eldorado. For example, the popular “stablecoins” are assets that are supposed to be exchanged in dollars at a fixed rate, but which are not always guaranteed by an equivalent account in dollars. Then as an incentive, some new currencies promised to remunerate investors who keep their crypto assets beyond a given period of time… This was enough to convince the most skeptical!

Two figures reflect the unprecedented and irrational interest for these new assets: in just twelve years, the cumulative valuation of cryptocurrencies has reached the CAC40 market capitalization. At the beginning of 2022, there are more than 300 million investors in the world in the blockchain market. A market whose underlying economic mechanisms remain difficult to understand, even for the most seasoned finance specialists… A sign of poorly controlled speculation, there has been much talk recently of a “money tree”, but also of a Ponzi scheme, which is traditionally detected only when the inflows of new investors dries up. Great storm ahead! …

A light in the darkness …

Trying to predict the future of cryptocurrencies when the storm is still raging would not help. But it is useful to explore new trends driven by crypto assets that may remain of interest once the speculative period is over. As was their original vocation, cryptocurrencies were first used to develop digital entrepreneurship. For example, Ethereum is a decentralized opensource platform for transaction verification, which offers digital developers a set of services based on blockchain technology to operate their activities (smart contracts, decentralized finance, digital assets…). Ether, the Ethereum cryptocurrency, can be used to pay for digital services used by developers. In this case, the cryptocurrency is not just a way to pay validators, but it gives access to an entire ecosystem of services, making its value less virtual and based on very real economic needs. Some start-ups create their own cryptocurrency at launch and use it to raise funds: investors who subscribe to the project buy through the cryptocurrency rights to use the future service, providing the start-up with an alternative funding mode to traditional venture capital.

The blockchain was then adopted by several central banks who see it as a solution for the future, allowing them to process financial transactions without depending on centralized clearing systems. For example, the Bank of France is experimenting with a digital currency (CBDC-Central Bank Digital Currency) for interbank settlements, while studies are being conducted in the United States for the development of the digital dollar. And the e-yuan was showcased at the Olympic Games in Beijing. We are still far from a generalized use of CBDCs, but their development gives a reassuring institutional visibility for the future of blockchain technology. Perhaps this marks the beginning of widespread regulation of cryptocurrencies, which central banks have long disregarded, to the benefit of investors.

Finally, another notable use has emerged in the wake of cryptocurrencies: asset fragmentation which uses the legal flexibility of blockchain. The idea is to offer the possibility of investing in fractional shares of assets (real estate, fine wines, works of art, vintage cars …) that are normally only accessible to investors who can make a large down payment or via expensive and illiquid structures such as REITs (Real Estate Investment Trusts). Technology can potentially reduce the costs associated with the legal structuring and custody of assets and make transactions more fluid. But the actual liquidity of an asset also depends on the volume of demand. The true potential for assets fragmentation products can likely only be assessed after the crypto assets markets stabilize.

A boon for banks ?

European banks have been rather cautious about cryptocurrencies, but they could not ignore the demand from their clients to be able to invest in such assets as part of their diversification. No doubt, investing in cryptocurrencies for projects that make economic sense, even out of speculation, will require expert advice. Just like other asset classes, the issue is to know how to assess the risks, understand the economic underpinnings and appreciate the nature and relevance of the diversification provided. After the subprime crisis, it took a few years for investors to return to securitized assets, whose interest was not ultimately questioned. But the strong role banks played in the speculative bubble undoubtedly weighed heavily in the market’s mistrust for securitization. Hopefully, this time the cautious attitude of banks can pave the way, once the storm has passed and the cryptocurrency ecosystem has been cleaned up, for the creation of investment services around crypto assets that are relevant for investors and create value for financial institutions.