Crypto’s Emerging Influence on the Banking System

Journal of Financial Planning: September 2023

Ivory Johnson, CFP^®, ChFC, is the founder of Delancey Wealth Management LLC (www.delanceywealth.com). Mr. Johnson has a B.S. in finance from Penn State University, has been certified by the Digital Asset Council for Financial Professionals, and is a member of the CNBC Financial Advisor Council.

The Austrian economist Joseph Schumpeter is famous for his theory on creative destruction, the notion that more innovative business models render old industries obsolete. One might grapple with the particulars of his theory, but it stands to reason that the carburetor repairman has been familiarized with the concept of fuel injectors.

Our banking industry is in a race against technology, chasing the demand for expediency when the movement of capital lacks the speed of a text message. While crypto moved the needle with a peer-to-peer network, real-time settlements, and the conspicuous absence of a middleman, the legacy banking infrastructure would have us believe it is on the verge of catching up.

The automatic clearinghouse (ACH) network is an electronic funds transfer system that moves money from one bank to another for direct deposit, bill payments, and other transactions such as recurring distributions from an IRA account. When an individual or organization makes a transaction, the originating bank batches the transaction with others that are regularly sent out during the day. Either the Fed or a clearing house receives this batch, sorts the transactions out and makes them available to the recipient institution. This process can take one to two business days to consummate. If you happen to miss the cutoff time, tough luck, you may have to wait another day.

In response, the Federal Reserve has announced the upcoming implementation of FedNow, a 24/7/365 instant payment service run by the Fed to make two-business-day settlements a thing of the past. Once a payment is initiated, the bank screens the transaction with strong security features that include encryption, authentication, and fraud prevention. It then sends an ISO 20022-compliant message to the FedNow service, which validates the payment message and sends it to the recipient bank in real time. The recipient bank confirms to the FedNow service that it will accept the payment, and the FedNow service debits and credits the master accounts for both banks. Voila, the funds are settled between both parties in a matter of seconds.

The benefits are wide ranging. For instance, the distribution of emergency relief will be more efficient, overdraft and late fees less prominent, and the use of one’s money more immediate. The service was launched July 20, 2023, and will be rolled out to an estimated 50 institutions, although all 10,000 banks and credit unions regulated by the Fed will have access over time.¹  It’s important to note that the implementation of FedNow is not a groundbreaking event on the global stage, as 50 countries have already adopted a similar system of real-time payments including the U.K. and China, not to mention emerging economies such as Brazil and India.

These protocols differ from cryptocurrency in that crypto miners validate a bitcoin transaction versus the Federal Reserve or a clearing agent. Said another way, the legacy system still retains the services of a middleman in lieu of the financial freedom bitcoin advocates long for. The FedNow service is also not borderless and is limited to customers of financial institutions, leaving the unbanked in the same sordid position they find themselves in now—relegated to expensive and inefficient banking options.

The influence of cryptocurrencies, however, is unmistakable. To begin with, FedNow transactions are settled in real time and can happen at any hour of any day. In fact, the end user may not even notice a difference between each platform except that fiat currency is less volatile than crypto, and FedNow will be integrated into an existing system that consumers are already familiar with.

For these reasons, some believe FedNow to be a crypto killer, eliminating the need for stable coins that have a difficult time maintaining their peg. Early indications are that the FedNow service will be cheaper and just as reliable as a digital asset that trades on a blockchain. Nevertheless, it will still facilitate payments in fiat currency under the control of a central bank that is prone to diluting the U.S. dollar during periods of economic uncertainty.

This was always the rub on central bank digital currencies (CBDCs), which is a digital version of a country’s national currency issued and backed by the central bank whose transactions would be consummated on a blockchain. One could argue that the benefits of a CBDC were faster settlements and the ability to allow more people to participate in the digital economy, although said benefits would now be encompassed by the new FedNow service.

Long Road to CBDCs

It remains to be seen if FedNow makes a CBDC unnecessary. Please note that the legal, compliance, financial, technology, and regulatory burden required to launch a central bank digital currency in the United States is not insignificant. There would also be the spectacle of congressional hearings and the painstaking passage of a specific CBDC law required before a digital dollar would be approved.

An overriding concern about a CBDC is that it may facilitate the government’s ability to monitor every transaction you make, which may provoke concerns of privacy. The notion that the Fourth Amendment will protect us from government overreach has become a matter of folklore,²  our nation’s drug laws less nostalgic for constitutional protections than advertised. In this sense, we should hope that the U.S. financial system retains the principle that law-abiding citizens are free to engage in anonymous transactions without a digital currency standing in the way of discretion.

On the other hand, there may be practical benefits to the government. For instance, a CBDC would seemingly capture all transactions that currently operate in the black market, an underground economy not monitored by the taxing authorities. Your neighborhood repairman will continue to accept Cash App with the intention of not paying taxes until the platform is required to provide a 1099 for accumulated payments of more than $600 in a calendar year in 2024.³  Similarly, the black market is estimated to be 11 percent of U.S. GDP.⁴  That’s some motivation for Uncle Sam who must refinance 51 percent of the $31 trillion of debt (and counting) he managed to accumulate that matures between 2023 and 2025 at higher rates and will likely require additional revenue.⁵

Other Payments Standards

An evolving comparison will include the SWIFT network and ISO 20022. For starters, SWIFT stands for the Society for Worldwide Interbank Financial Telecommunications and is the system that powers most international money and security transfers. According to the United States Treasury, SWIFT moves $5 trillion per day. It is not an institution, but rather a messaging system. When somebody wants to send money overseas, their bank enters the bank account, registration, routing number, SWIFT code, and other important information. Once the recipient bank approves the transaction, the money is sent and settled within one to four business days.

Aside from the settlement time, SWIFT has raised eyebrows with its penchant for using the service to render sanctions. In 2022, for instance, Russia was shut off from SWIFT. This has the effect of weaponizing the dominant fiat currencies because Russia can no longer use the preeminent messaging service to send or receive money internationally. In response, China, Iran, and Russia have created workaround solutions that are not embraced internationally and are less efficient.⁶ A more effective workaround would likely solicit interest from wealthy individuals and countries exposed to future sanctions.

In contrast, ISO 20022 is a more flexible standard for payment messages that improves interchange communication between a financial institution and its customers because it is a universal messaging system. Specifically, the data is more structured and the service has increased the field size, which should increase transparency, security, and a reduction of processing delays. In short, banks expect to spend less time manipulating data with the new standard while at the same time transforming payment data into business information through intelligent analysis and the use of artificial intelligence.

As it stands, over 70 countries have already adopted this new protocol, but it will take several years before it completely replaces the SWIFT network. The incentive, however, is clear as day: real-time payments with more data to facilitate KYC objectives, AML initiatives, and fewer mistakes. Our banking system is on the precipice of a major overhaul, FedNow or not.

Post-FedNow Future for Crypto

What does this mean for cryptocurrencies and alt coins in particular? One coin that comes to mind is Ripple’s XRP, which, like many other cryptocurrencies, is designed to enable fast and secure cross-border payments. The company uses XRP as a bridge currency between transfers from one fiat currency to another, thereby eliminating the need to pre-fund accounts on the other end of a transaction and wait for the money to be processed. For the sake of this discussion, Ripple has joined the ISO 20022 standards body to provide enhanced interoperability between different financial systems, making them the first member of the ISO organization focused on distributed ledger technology.⁷

This development would allow institutions and individuals to send money internationally through XRP by way of blockchain technology outside of the legacy banking system. Concerns of crypto volatility are somewhat mitigated because XRP settles within three to five seconds,⁸ which means a company can consummate an international transaction in the time it takes to hug your favorite aunt during the holidays. The transactions are fast because the supply of the coin is fixed and there are no miners, which also improves XRP’s energy efficiency. The use of blockchain also adds scalability, reduces transaction costs, and makes transactions more secure.

The SEC believed XRP to be a security, arguing that profits were generated from the efforts of others, and the company failed the Howey Test. It was announced on July 13, 2023, however, that XRP is not a security if sold on an exchange and is exempt from the lofty regulatory oversight of the agency.⁹  This is good news for a long list of banks like Bank of America, PNC Bank, and Santander that have had an existing relationship with Ripple for years.¹⁰

The way we send and receive money will look remarkably different in the years to come, with Western Union and wire transfers joining the storage bin of nostalgia, reminding us of rotary telephones and AOL. There will of course be unintended consequences, most notably how banks will navigate liquidity crises that stem from depositors’ ability to move money in real time. If you recall, bank runs are akin to dialing a number or playing a record since customers now tap mobile apps instead of running to withdraw money from a failing institution.¹¹

These developments will also foster speculative behavior and false hope with investors in search of easy money. Unfortunately, the math ain’t mathing—XRP has a supply cap of 100 billion coins. If your thesis suggests that XRP will offer 1,000× returns, you’d have to believe it will be worth as much as the entire global stock market. Along these same lines, FedNow alone will not preserve the dollar’s reserve currency status because that matter will be adjudicated by the American economy, the government’s willingness to stop accumulating debts that it cannot repay, and the storied tradition of debasing the currency.

Innovation often takes the shape of water that cannot be stopped. The wisest among us would instead attempt to reroute it, to collect it, to use it for more beneficial purposes. Blockchain technology and the digital assets that represent them are increasingly being seen as useful, as an industry of practical utilities that facilitate commerce. Investors should do with them what they will. 

Endnotes

1. Hardy, Adam. 2023, July 10. “What Is FedNow? The Government’s First Instant Payment Service Launches Soon.” Money. https://money.com/what-is-fednow/.
2. Michel, Norbert. 2023, June 9. “Financial Privacy and The Fourth Amendment: Restoring Balance to The Crypto Universe.” Forbes. https://www.forbes.com/sites/norbertmichel/2022/06/09/financial-privacy-and-the-fourth-amendment-restoring-balance-to-the-crypto-universe/?sh=145fde615f48.
3. Washington, Kemberley. 2023, Mar 23. “IRS Delays Requiring Venmo, Cash App and Other Payment Apps to Report Payments Of $600 Or More.” Forbes. www.forbes.com/advisor/taxes/cash-apps-to-report-payments-of-600-or-more/.
4. International Monetary Fund.
5. Kozlowski, Julian, and Samuel Jordan-Wood. 2023, June 2. “Assessing the Costs of Rolling Over Government Debt.” St. Louis Federal Reserve. https://research.stlouisfed.org/publications/economic-synopses/2023/06/02/assessing-the-costs-of-rolling-over-government-debt.
6. Tan, Huileng. 2022, April 28. “China and Russia Are Working On Homegrown Alternatives to the SWIFT Payment System. Here’s What They Would Mean for the US Dollar.” Business Insider India. www.businessinsider.in/politics/world/news/china-and-russia-are-working-on-homegrown-alternatives-to-the-swift-payment-system-heres-what-they-would-mean-for-the-us-dollar-/articleshow/91168432.cms.
7. Martin, Jack. 2020, May 6. “Ripple Joins ISO Global Standards Body on Cross-Border Payments.” Cointelegraph. https://cointelegraph.com/news/ripple-joins-iso-global-standards-body-on-cross-border-payments.
8. Rodeck, David. 2023, July 13. “What Is XRP (Ripple)?” Forbes. www.forbes.com/advisor/investing/cryptocurrency/what-is-ripple-xrp/.
9. Michaels, Dave, and Paul Kiernan. 2023, July 15. “SEC’s Strategy for Regulating Crypto Stumbles in Ripple Case.” Wall Street Journal. www.wsj.com/articles/secs-strategy-for-regulating-crypto-stumbles-in-ripple-case-a003c057.
10. Knight, Oliver. 2020, April 11. “Bank of America Exec Lifts Lid on Ripple Partnership.” Yahoo. www.yahoo.com/video/bank-america-exec-lifts-lid-140019347.html.
11. Wallerstein, Eric. 2023, July 9. “Banks’ Newest Fed Headache: Nonstop Instant Payments.” Wall Street Journal. www.wsj.com/articles/banks-newest-fed-headache-nonstop-instant-payments-8ac97c15.