Renowned historian Niall Ferguson wrote: Cryptocurrencies and the dollar are partners, not competitors

Original Author: Niall Ferguson, renowned historian, professor at Harvard University’s Department of History and Business School

Original Title: “Crypto and the Dollar Are Partners, Not Rivals”

Compiled by: Hu Tao, Chain Catcher

"I hope it can create world peace, or help create world peace." This is what former Twitter CEO and current head of digital payment company Block, Jack Dorsey, said about Bitcoin during a webinar in July 2021.

However, it is more likely that war will increase the global appetite for Bitcoin. Turbulent times are often associated with currency transformations. A typical example is the fundamental changes in the British monetary system during the Black Death and the Hundred Years' War.

After the plague, commodity prices soared—especially salt, which increased sevenfold from 1347 to 1352. Meanwhile, survivors of the Black Death were able to leverage the tight labor market to exchange feudal servitude for cash wages. The British economy became increasingly monetized.

At the same time, European merchants developed a new form of peer-to-peer credit instrument, namely bills of exchange, which facilitated trade between England, the Low Countries, and Northern Italy.

Recent examples abound. Spain's conquest of the New World changed the global economy by increasing the supply of silver and gold, much of which was used to pay for Habsburg wars in Europe. The expansion of the British Empire exported the gold standard, creating a new, more stable international monetary system dominated by the pound. World wars left Britain heavily indebted and ushered in the first era of dollar dominance, with the dollar pegged to gold and all other major currencies pegged to the dollar to a lesser extent.

In 1971, the Bretton Woods system ended again due to conflict. As the Vietnam War dragged on, President Nixon broke the dollar's peg to gold, ushering in an era of floating fiat currencies characterized initially by high inflation and exchange rate volatility, followed by a series of international agreements (the Plaza Accord in 1985 and the Louvre Accord two years later), and later more ad hoc and opaque arrangements in an environment of declining inflation and rapidly increasing capital flows.

The events of the past two years—first the Covid-19 pandemic, now the Russian invasion of Ukraine—are sufficiently disruptive that a shift in the global monetary order seems possible once again. But what form will it take? Two hypotheses emerge, which are by no means mutually exclusive.

First, the era of cryptocurrency has arrived. In the words of Michelle Ritter, CEO of tech company Steel Perlot Management LLC, "The key moment for social media came in 2011, when videos, tweets, and other posts from Libya, Egypt, Yemen, Syria, and Bahrain sparked the Arab Spring… [Now] we find ourselves at a similar turning point with cryptocurrency." Hedge fund Bridgewater Associates LP points out, "The Russian invasion of Ukraine is the first major event to incorporate cryptocurrency."

The second hypothesis is that we are witnessing the decline of the dollar. Zoltan Pozsar of Credit Suisse Group states that the decision by the U.S. and its European allies to freeze most of the Russian central bank's foreign reserves is a watershed moment. He believes this will "encourage central banks to diversify away from the dollar or attempt to re-anchor their currencies to assets less susceptible to U.S. or European government influence."

According to Pozsar's report on March 7 titled "Bretton Woods III," we will abandon Bretton Woods II, which followed 1971, where "internal currency" (U.S. Treasury bonds) replaced "external currency" (gold). As the world reduces its reliance on the dollar and dollar-denominated bonds, Bretton Woods III will take us back to external currencies (gold and other commodities).

Arthur Hayes, founder of BitMEX, expressed similar views in his March 16 article “Energy Cancelled.” "Why should any central bank 'save' in any Western fiat currency when their savings can be arbitrarily and unilaterally confiscated by the operators of the fiat currency network?" In “The Doom Loop”, he predicts "a million-dollar Bitcoin and gold at $10,000 to $20,000 by the end of the century."

These scholars are certainly not the first to predict the demise of the dollar. But whenever I hear such arguments, I am reminded of an old saying by Larry Summers. The former Treasury Secretary said in a speech at Harvard's Kennedy School in November 2019: "You cannot replace something that does not exist." He asked, "What currency is better suited as a reserve and trade currency than the dollar when Europe is a museum, Japan is a nursing home, and Bitcoin is an experiment?"

First, let’s look at what happened in the cryptocurrency industry when the war broke out. At the onset of the Russian invasion, there was much discussion about how the Kremlin might use cryptocurrency to evade Western sanctions. Of course, the volume of rubles buying Bitcoin initially surged.

However, regulators in the U.S. and Europe have notified major cryptocurrency exchanges. Coinbase blocked over 25,000 addresses linked to Russia that were associated with illegal activities. In any case, as Binance's Tigran Gambaryan pointed out, "Cryptocurrency is not a very effective way for governments and nation-states to evade sanctions."

Cryptocurrency has played a greater role in facilitating private donations to the Ukrainian government. As Gillian Tett of the Financial Times wrote on March 10, "About $106 million in cryptocurrency donations have poured in." Ethereum founder Vitalik Buterin tweeted, "Reminder: Ethereum is neutral, but I am not." His co-founder Gavin Wood stated that he would "personally contribute $5 million" if his new token DOT was accepted. Sergey Vasylchuk, CEO of blockchain company Everstake, initiated a Solana-based decentralized autonomous organization to raise funds for the Ukrainian military.

Glory to Ukraine! But note that $106 million is a rounding error compared to the amount of military aid Ukraine is receiving from the U.S. government, which could total $19.67 billion if the Biden administration's latest proposal is approved by Congress.

Let’s simplify things. Cryptocurrencies like Bitcoin and Ethereum are attractive assets to hold in unstable regions and times. Certain types of stablecoins (pegged to the dollar) may be even more appealing. As Sirio Aramonte, Wenqian Huang, and Andreas Schrimpf pointed out in a recent report from the Bank for International Settlements, this is why there was so much stablecoin trading in Turkey in 2020 and 2021, as the pandemic combined with the Turkish government's reckless monetary policy devalued the lira.

At the start of the pandemic, you were advised to put some money into Bitcoin and Ethereum. Relative to January 2020, your investments have increased 21.7 and 5.4 times, respectively. Your gold position has only risen 25%. Even in wartime, cryptocurrencies have outperformed gold. Since the eve of the Russian invasion, Bitcoin is up 3.8%, Ethereum is up 9.1%, and gold is down 1%.

But in war, people need more than just assets that preserve or gain value. It is more important to be able to pay domestic and foreign suppliers for what you receive from them. It is well known that Ethereum can only process about 15 transactions per second, while Visa can handle thousands of credit card transactions per second.

For Russia over the past two months, it has been more important that Western credit card companies cannot prohibit Russians from paying than that Russians can buy Bitcoin. This is because since 2014 (when they first invaded Ukraine in a more limited way), Russians have built their own national card payment system (NSPK) to handle transactions and a domestic card system called Mir, which operates on the NSPK track—just like the bank cards issued by China UnionPay.

In the grand scheme of the global economy, digital payments are more important than cryptocurrencies. This is because payment systems utilizing artificial intelligence—such as Ant Group's Alipay and Tencent's WeChat Pay—can process more transactions faster than any blockchain-based system, and then derive credit ratings based on the data they aggregate and analyze.

A few years ago, I was very concerned that these Chinese payment systems would swallow the world—or at least dominate emerging markets. Fortunately for the Western world, China deemed the scale of Alibaba founder Jack Ma too large and terminated his and Eric Jing's plans to rule the world.

However, China's challenge in payments is far from over. The popular TikTok platform from ByteDance is implementing payment features. Companies from 19 countries, including Kenya's fintech giant M-Pesa, Ethiopia's state-owned Ethio Telecom, and Pakistan's telecom provider Jazz, are using Huawei Technologies' Mobile Money platform. In terms of scale and value, China's OPay, a mobile payment platform in Africa, is now the second-largest fintech startup in Africa.

But China's new policy thrust is to persuade the central banks of other countries to develop digital currencies interoperable with China's central bank digital currency, the digital yuan, through "bridges" between central banks. Thailand, Hong Kong, and the United Arab Emirates are collaborating with China to build such bridges. China's SWIFT alternative—a cross-border interbank payment system denominated in yuan—currently has 1,200 member institutions in 100 countries.

Another Chinese initiative is the state-supported Blockchain Service Network (BSN), aimed at creating a digital architecture that connects public and private blockchains. In 2021, BSN launched a universal digital payment network designed to establish "standardized methods for digital currency transfers and payment procedures."

According to reports from China last August, at least three foreign banks were planning to access the digital yuan through a private clearing platform established by Shanghai City Bank. As demonstrated during the 2022 Beijing Winter Olympics, foreigners in China have already been able to create their own digital yuan wallets without a Chinese bank account.

However, if China plans to establish an alternative payment architecture dominated by U.S. and European institutions, it has a long way to go. According to U.S. Treasury data, in January of this year, just before the Russian invasion of Ukraine, China held just over $1 trillion in U.S. Treasury bonds out of its approximately $3 trillion in foreign exchange reserves. According to the latest data released by the State Administration of Foreign Exchange, more than half of China's foreign exchange reserves are denominated in dollars.

Beijing is clearly shocked by the U.S. decision to freeze Russian central bank reserves. "Chinese economists… are shocked by the U.S. taking such measures against Russia," wrote Yu Yongding, a Chinese economist at the Chinese Academy of Social Sciences, last month in a commentary. "The international financial system is built on the trust that all participants will abide by the rules, and fulfilling debt obligations is one of the most important rules. Freezing a country's foreign exchange reserves, for whatever reason, is a blatant breach of trust… Since the U.S. has demonstrated its willingness to stop acting according to the rules, what can China do to protect its foreign assets? I don't know."

I don't know either. The problem for China is that predictions about the dollar's demise have been proven wrong repeatedly since the late 1960s. Admittedly, as Barry Eichengreen of the University of California, Berkeley, points out, the dollar's share of allocated international reserves has declined from 71% to 59% since the beginning of this century. But central banks are not converting dollars into yuan.

Currencies from Canada, Australia, Sweden, South Korea, and Singapore are increasingly favored by foreign exchange reserve managers. This does not undermine the dollar's dominance, significantly weakening the U.S.'s ability to impose financial sanctions. As the Russians have found, even the Swiss are willing to participate in the freezing of Russian reserves.

This is not the only metric for measuring the dollar's dominance. In 2021, 40% of international payments were made in dollars by total transaction value. The euro ranked second. The yuan ranked fourth, at only 2.7%, even trailing the pound.

In the words of the Council on Foreign Relations' Sebastian Mallaby:

Dollar pessimism is greatly exaggerated. Globally, nearly three-fifths of private foreign currency bank deposits are held in dollars. A similar share of foreign currency corporate borrowing is done in dollars… The Federal Reserve estimates that foreigners are hoarding about half of the issued dollar bills… [Foreign central banks] hold dollars knowing that others will be happy to accept them, just as many learn English because others speak it… The long-term creditworthiness of the yuan is akin to fluency in Esperanto.

As the prolific economic historian AdamTooze points out, other central banks issuing reserve currencies are on the other end of the Federal Reserve's swap lines, which are a major source of liquidity during financial crises like late 2008 and early 2020. Meyrick Chapman convincingly argues that for the global economy, "the U.S. remains the 'ultimate consumer.' Until that changes, the dollar will maintain its advantage."

All of this helps explain the unusual rebound of the dollar we have seen this year, with the dollar significantly strengthening against most other major currencies, especially the yen, which has depreciated nearly 27% since early 2021. The euro is down 16%, and the pound is down 10%.

So can we, like Larry Summers, view cryptocurrencies merely as an experiment? Some might go further and condemn them as no better than many Ponzi schemes. According to CoinMarketCap, there are now 10,000 to 20,000 different cryptocurrencies. Even if their design and management were impeccable, that would be excessive.

There is a lot of chatter among cryptocurrency supporters. For example, when Mike Novogratz of Galaxy Digital talks about his favorite stablecoin UST, one might think, "Everything is fine as long as there is no bank run." What, like Lehman Brothers?

Or consider the view from Sam Bankman-Fried, founder of cryptocurrency exchange FTX, who was asked to explain yield farming on Bloomberg's "Oddlots" podcast. Bankman-Fried said:

It's like this valuable box that people have clearly decided should have money put in it. What right do we have to say they are wrong?… Then, the [governance] token price goes up. Now it's a token with a market cap of $130 million because, you know, people are bullish on the box. Suddenly, smart money [keeps pouring in], and the box has another $300 million, and… it becomes infinite. Then everyone makes money.

Forget the Wild West; this is the crazy West. According to a report by blockchain analytics firm Elliptic, in 2021, DeFi projects lost about $10 billion due to various hacks and scams. In one case, members of the Bored Ape Yacht Club were tricked into handing over the passwords to their crypto wallets.

When you read stories like this, you begin to understand the strong impulse among central bankers and financial regulators around the world to shut down the entire cryptocurrency industry. Some countries have already banned the use of cryptocurrencies for payments and Bitcoin mining: not just China, but also Algeria, Bangladesh, Bolivia, Egypt, Morocco, and Nepal.

There are European and U.S. officials eager to impose stricter regulations on the crypto industry, even banning cryptocurrencies, such as Fabio Panetta of the European Central Bank, Gary Gensler of the U.S. Securities and Exchange Commission, and Michael Hsu, the U.S. Acting Comptroller of the Currency, who recently compared the current state of the crypto industry to the "fool's gold rush" before the 2008-9 financial crisis.

We already know where Brussels is headed. The European Commission's regulation of the crypto asset market is under review by European bureaucrats, which will require crypto exchanges to fully disclose the identity of everyone buying and selling digital assets. In contrast, the British government clearly hopes to attract more crypto business to London—hence Chancellor of the Exchequer Rishi Sunak's suggestion that the ancient Royal Mint should develop NFTs, a whimsical idea that met with strong opposition from Patrick Jenkins of the Financial Times ("The crypto cult exudes oligarchic arrogance").

But what will the U.S. choose to do? Last year, Genslerites seemed to be on the rise, and European-style regulation was just a matter of time. All of this changed with the infrastructure bill fight that erupted last year, which made a large number of Democratic legislators realize that the U.S. crypto community now has both votes and dollars.

According to a recent Morning Consult survey, 20% of American adults and 36% of millennials own cryptocurrencies. As Kevin Roose pointed out in a lengthy introductory article in The New York Times, cryptocurrencies have suddenly become ubiquitous, with Matt Damon and Larry David advertising, mayors of Miami and New York City touting their Bitcoin credentials, Colorado and Florida competing to be the top crypto state, two NBA arenas named after crypto companies, and Pepsi and Applebee's offering their own NFTs. Most importantly, "crypto entrepreneurs are donating millions to candidates and causes, and lobbying efforts have unfolded nationwide to win support for pro-crypto legislation."

The first result of all this lobbying was the executive order released by the White House on March 8, 2022, regarding "responsibly developing digital assets."

The hostile language of last year is gone. "The rise of digital assets creates opportunities to strengthen the U.S. leadership in the global financial system and technological frontier," the executive order states. "The U.S. must maintain its technological edge in this rapidly evolving space, support innovation, while mitigating risks to consumers, businesses, the broader financial system, and the climate."

This is a pleasant and confident morning for cryptocurrencies in Washington. "Similar to the early days of the internet 30 years ago," Democratic Senator Ron Wyden recently stated, "we are at a similar moment with cryptocurrency." I often hear this sentiment in Silicon Valley as well. But what does it really mean?

It is widely believed that the U.S. largely owes its success in the first two eras of the internet—Web 1.0 (the nerds with email and web pages) and Web 2.0 (the nerds making money by building platforms)—to the relatively lax legislation passed by Congress in the 1990s, particularly the Communications Decency Act of 1996 and its Section 230.

Essentially, Section 230 created a special regulatory space for the rapid development of internet platforms, exempting them from legal liability associated with publishers while also granting them the right to moderate content as they see fit. For today's legislators, the truly interesting question is: What would Section 230 look like for DeFi/Web 3.0? In an engaging new blog post, Manny Rincon Cruz proposes three elements:

• Developers of decentralized protocols do not have virtual asset service provider (VASP) identities. Code is protected as free speech, and decentralized protocols do not provide intermediaries for trading, custody, or transfer services, as DeFi users trade directly with each other.
• Exclude DeFi "exploits" from the Computer Fraud and Abuse Act (CFAA). Exploit attacks occur when users interact with protocols while writing code and profit by exploiting arbitrage opportunities or design weaknesses. As long as users do not violate other criminal laws, these exploit attacks help DeFi by exposing faulty code.
• No banking charter requirements for stablecoin issuers like Circle and Tether. Unlike bank deposits, users can sell their USDC or USDT without redemption. Since these stablecoins cannot create "bank runs," they should not be subject to bank-specific regulations.

Undoubtedly, this is just the beginning of the debate about the preliminary regulatory approach to Web 3.0. The key point is that the dollar's dominance and the thriving cryptocurrency ecosystem are not mutually exclusive but rather complementary. Just as Bitcoin was never intended to—and will never become—a replacement for the dollar, DeFi is a complement to the existing financial system rather than a substitute, and we will undoubtedly continue to use it for decades to come to pay our taxes and possibly to pay our employees and utility bills.