Inflation and deflation are common economic terms that can be a bit confusing. They aren’t always addressed in school, but they affect our lives in so many ways. While the causes and consequences of inflation and deflation can be complicated, their definitions are surprisingly simple. Here is what you should know about these two terms and their role in a greater economy.
What is inflation?
In the simplest terms, inflation occurs when the price of goods and services goes up over time. It can happen slowly, over decades, or with sudden and devastating effects. Not every economist agrees on the reasons for slow, gradual inflation. It’s often tied to factors like market demand or the availability of certain goods and services.
Inflation in action
A current example is the inflated price of backyard swimming pools, pool filters, and pool maintenance supplies. With COVID-19 precautions closing many local swimming pools, more people than ever decided to put up backyard pools this summer. This increase in demand forced the price of pools and supplies up; another factor was the scarcity of some pool supplies since they have traditionally been manufactured in countries that slowed or shut down production due to COVID. The combination of increased demand with a short supply led to a deep inflation in the cost of these goods.
There’s more to the story, however. When both the cost of goods goes up, and the value of the local fiat goes down, it’s often referred to as “hyper-inflation,” especially when both happen in a short time frame. Unlike standard inflation, which experts aren’t always able to attribute directly to a source, economists tend to agree on the cause of hyperinflation.
The most common cause is a sudden and excessive growth of a country’s money supply. How does this happen? The Fed usually plays a role in making more money available in a strangled economy. Additionally, it’s not uncommon for governments to step in and tinker with interest rates or offer economic cash infusions (stimulus payments) in an attempt to stop the financial bleed that frequently happens with long periods of hyperinflation. Unfortunately, the bandaids for hyperinflation can often make problems worse.
How can you know if we’re in a period of inflation or hyper-inflation?
While the Fed aims for a rate of 2–3% per year inflation, this isn’t always manageable. Venezuela, for example, has seen inflation rates of 200,000% in a single year, an obvious sign of hyperinflation. It doesn’t have to be that severe to be counted, however; experts define anything above a 50% annual inflation rate to be a form of hyperinflation.
What is deflation?
The exact opposite of inflation, deflation, is the decrease in the cost of goods and services. It is usually accompanied by an increase in the value of the fiat. While some see this as a pleasant situation, deflation can be difficult for lenders who rely on climbing interest rates to make money on the cash they lend. Too much deflation or inflation can hurt essential industries. It can also harm consumer confidence over time, as people can get used to seeing prices go lower and actually hold on to their money waiting for the absolute best price. This can further aggravate the deflation cycle, something we saw during the Recession of 2008.
Remember, the role of government, unemployment, natural disasters, and technological advances can impact the cost of products we buy. Further, in the U.S., inflation doesn’t always happen across the board; consumer categories such as food and housing may see inflation over time, while items like electronics or clothing may see deflation during the same period. While consumers can’t always do much to affect inflation or deflation, we can better prepare our investment portfolios to secure our individual economic futures.
Competition drives markets. In traditional financial markets, however, competition is limited to the production of goods and the buying and selling process. With Bitcoin, competition plays a far-deeper role. The minting of new bitcoin, as well as the processing and verification of transactions, are all made more efficient, accurate, and secure, thanks to competition. It’s no surprise, then, that game theory plays a pivotal role in the inner workings of the Bitcoin ecosystem.
A brief explanation of game theory
Game theory models the strategic interaction between players in a scenario with set rules and outcomes where the players are rational and looking to maximize their payoffs. In effect, it’s a more detailed, nuanced way of looking at how incentives affect how things get done.
For example, if your job is to shovel 100 pounds of stone into a hole and you’re all alone and have all the time you want, there’s no game theory involved. On the other hand, if someone else is given the same task and you’re each working with the same pile of stones, the dynamics of the situation change.
They change further if only the person who shovels the most gets paid. And, naturally, if you get paid according to how much you shovel, the outcome of your actions would change in yet another way. Each of these situations will be impacted by game theory and its many models.
Although Bitcoin seeks to espouse concepts like “fairness,” “transparency,” and others that are often incongruent with competition, game theory still plays a primary role in the Bitcoin universe.
How does game theory apply to Bitcoin mining?
Bitcoin mining involves solving math problems that are used to create new bitcoin and verify transactions. To continue with the stone shoveling example, if you have as long as you want to move the pile of stones, you may choose to take your time. Your shovel may move slower than if someone else were involved in the task because then the speed at which you shovel would determine whether you get paid more, less, or at all.
The fact that multiple miners compete to verify transactions and generate coins gives Bitcoin an inherent efficiency: The job gets done faster. To dig a little deeper, three types of game theory driving this process include zero-sum theory, congestion theory, and the Nash equilibrium. Let’s take a closer look at how these concepts work.
Bitcoin mining and zero-sum theory
Zero-sum theory dictates that the “winner” gets the spoils and everyone else walks away with nothing. In the mining of bitcoin, the first person to solve a problem gets the value associated with completing the task. Everyone else gets nothing. If you could take a snapshot of the nanosecond a particular hash is found, you would see one user getting rewarded for their work and the others getting nothing.
However, because the Bitcoin system requires so many problems to be solved all the time, in reality, many miners can earn a relatively steady income. The strategies they use are governed by two other game theory concepts — the congestion theory and the Nash equilibrium.
Bitcoin mining and congestion theory
Congestion theory stipulates that the amount each player gets depends on the resources they choose and how many other players choose the same resources.
For example, imagine there are two stations with trains heading to the same destination, and each train can hold only 10 people. One train station is five miles closer to the destination. If there are 100 people, and everyone goes to the closer station, one train will have to go back and forth 10 times. On the other hand, if some of the passengers go to the closest station and others go to the station farther away, there will be less congestion, and everyone will arrive at the destination sooner.
In Bitcoin mining, many of the decisions of the miners depend on congestion theory. If there was only one miner, all the spoils would go to her or him. On the other hand, Bitcoin is open to all, so each miner has to decide whether they will get in the game — and add to the congestion — knowing that more people are bound to get in the game, decreasing their chance of winning.
Once a miner decides to get involved, they then have other decisions to make regarding the equipment they choose. Faster equipment provides an advantage, similar to getting on the closer train. However, the quicker the equipment, the more electricity it takes to run, which increases the cost of mining.
If a miner’s earnings won’t sufficiently offset the cost of electricity, they may choose not to get involved. They may also choose to forego setting up a mining system and join a mining pool instead, where the electricity costs are absorbed by multiple participants. Congestion theory dictates which “train” each miner takes, as well as when and how they get involved.
In addition, the way the decisions of each miner affects the others is governed largely by another game theory concept: the Nash Equilibrium.
Bitcoin mining and the Nash Equilibrium
In the Nash equilibrium, named after mathematician John Nash from the movie A Beautiful Mind, each “player” recognizes that while they have similar goals, not everyone can get exactly what they want. Therefore, some will choose to settle for a less-desirable outcome, satisfied with the fact that they are at least getting something. All players agree to proceed, happy to share the spoils.
For example, continuing with the stone shoveling scenario, you may be stronger and faster than the other shoveler. Both of you agree to shovel for the same amount of time, but you get 70% of the money while the other shoveler only gets 30%. The other person could protest, but realizing that something is better than nothing, they agree to the terms. At this point, an equilibrium is established. At the end of the day, you both earn money and walk away satisfied.
The worldwide community of miners also follows Nash equilibrium principles. Some miners have more money than others and can afford to purchase the latest mining computers, capable of solving specific hashes faster than older models. Other miners may not have as much money, but they live in areas where electricity is less expensive. They can, therefore, spend less than wealthier miners who live in areas where electricity is more costly. Some live in places where it will never be profitable to mine, so they join a mining pool instead.
Each miner recognizes that their limitations dictate how much they will get. At the same time, all agree to participate, satisfied with their portion at the end of the day — even if it’s just a small fraction of a bitcoin.
How miners are incentivized
Zero-sum theory, congestion theory, and the Nash equilibrium only work because of the ways miners are incentivized and dissuaded from cheating the system. Before mining rewards are approved, the technical infrastructure enforces the “trustless” nature of the Bitcoin network. If miners do not adhere to protocol rules, their block submission will be rejected by other nodes in the blockchain. All network nodes including other miners verify the ledger entries packaged into a new block. If entries are considered invalid, or the block hash doesn’t meet network requirements, the miner’s result will be rejected and the 6.25 BTC will be awarded to another miner.
While the block rewards are enticing at current BTC valuations, there are other financial implications that compel miners to either continue or suspend network operations. No miner will win the worldwide competition each time a new block is added (~every 10 minutes), so they must weigh the probability of profitable successes. There are other factors to consider, too. For example, some miners may decide to bow out when electricity becomes too expensive. Others however, may have a longer time horizon and decide to accept the risk of energy expenditure, calculating that miner attrition will increase their chances of winning new block rewards. In other words, fewer miners in the network means more chances for the remaining miners to profit. For those adopting this viewpoint, the potential of solving enough blocks to maintain business profitability outweighs the risk of any short-term loss related to high energy costs.
How bitcoin is distributed
Every block consists of many small transactions. When a block is mined, the winning miner is awarded 6.25 bitcoin plus all transaction fees for each transaction they were able to package within the block. The more blocks you are able to solve, the higher your reward. In other words, you get a bigger piece of the pie. Hunger for more slices of pie incentivizes miners to purchase more powerful equipment or move to areas with lower electricity costs.
Game theory and the surety of the Bitcoin network
The Nash equilibrium helps motivate miners to do more than generate new bitcoin. Each miner has no choice but to play a role in making sure the network functions as it should. This is a part of the “pile of stones” each miner agrees to shovel.
In a Nash equilibrium, although the individual participants would like to either get more rewards or a different type of reward, they agree to settle with getting something of value rather than nothing. The Bitcoin network compels miners to play by an agreed set of rules to add transactions to the distributed ledger, or their work will be summarily rejected. At the same time miners add security to the network by expending expensive energy that chains each new block to the preceding block via a well established mathematical algorithm.
Each miner is, therefore, a generator of new bitcoin liquidity as well as an auditor, checking the details of network transactions. Even though each problem solved involves a zero-sum game and congestion theory dictates how each miner approaches the task, everyone works in a happy Nash equilibrium.
In the end, game theory is an underestimated, yet essential, element of the Bitcoin network. As each miner plays their role, historical transactions are kept secure and new transactions unanimously approved, which helps maintain Bitcoin’s position as the number one digital currency in the worldC
Cryptocurrency is a disruptor. Not only has it changed the way we conduct business, but it has changed the way we think. The most obvious manifestation of how cryptocurrency has disrupted our thought patterns is in the way we think about money — about who issues it, how to transact with it, how to put it to work and how to keep it safe. It also has changed the way we think about our government, our right to privacy and our financial freedom. What’s less obvious is how cryptocurrencies are disrupting the way we think about and participate in asset-based lending. The advent of Bitcoin catalyzed the creation of a myriad of cryptocurrencies, many of which became viewed as assets, yet at the time, there was no way for crypto investors to unlock the value of these assets without selling them. This is the problem SALT’s founders set out to solve in 2016 and in doing so successfully, made asset-based lending as we once knew it a thing of the past.
Creating a New Asset Class
As Bitcoin began to experience wider adoption following its release in 2009, it became clear that some investors were purchasing crypto to trade on a daily basis while others were choosing to invest long-term, viewing Bitcoin more as an asset than as a spendable currency. As more investors adopted this long position and began to think of cryptocurrencies as an asset class in their own right, the term “HODL” emerged in 2013 on a bitcoin-talk forum and has since become one of the most commonly used words in the crypto vernacular. This HODL culture has grown significantly over the years and has evolved to where investors are buying, selling and trading these assets not only for themselves but on behalf of others. This activity has taken the form of crypto portfolios and crypto funds, which offer access to this new asset class for individuals and allow them to diversify their portfolios while eliminating some of the overhead of learning how to purchase and safely hold cryptoassets. By providing a way to collateralize cryptoassets to secure a cash or stablecoin loan, SALT provides opportunities for individuals, businesses and capital providers to build and preserve wealth.
How to Lend Cryptoassets
As the first-ever crypto-backed lender, SALT has developed the technology and processes required to successfully lend against cryptoassets, giving borrowers a way to unlock the value of these assets without selling them. Take Bitcoin for example. It’s one of many cryptoassets we accept as collateral on our platform, yet it makes up more than 80% of the collateral securing our loan book.
What makes Bitcoin a strong form of collateral? The answer lies in Bitcoin’s combined characteristics. Like gold, Bitcoin is scarce, fungible, divisible, transferable and durable. It is also extremely liquid given it is traded on global exchanges every day. Additionally, as a decentralized asset, Bitcoin is highly secure. All of these properties make Bitcoin both a viable asset and a highly efficient form of collateral that has piqued the interest of some of the largest financial institutions in the world.
One thing to note is Bitcoin’s volatile nature, which can pose challenges specifically for the ABL market. However, SALT’s risk management technology effectively manages this volatility. Our technology includes real-time loan-to-value (LTV) monitoring, margin call and liquidation triggers, real-time notifications and the safekeeping of assets through institutional grade custody solutions. For example, our loan-to-value (LTV) monitoring system tracks the prices of assets 24 hours a day, 365 days a year, providing borrowers with the ability to monitor the health of their loan in real-time. If, during periods of heightened volatility, a borrower’s collateral declines in value and their LTV breaches our margin call threshold, we protect the borrower by issuing a margin call that prompts them to take action to restore the health of their loan. Actions borrowers may take include paying down principal or depositing additional collateral to recalibrate their LTV to an appropriate level (70%). If no action is taken and asset prices continue to decline, SALT has the ability and the right to liquidate collateral assets to preserve lender capital. The overcollateralized nature of our loans combined with our risk management technology and ability to liquidate assets enables us to protect the lender, and as a result, we’ve experienced zero losses of principal to date.
Choosing a Crypto-Backed Lender
SALT’s business model is attractive to crypto investors (e.g. traders and asset managers) and businesses (e.g. mining operations and exchanges) for a few reasons. First, we provide access to liquidity, offering loans ranging from $5,000 to the millions. Typical use cases include businesses seeking working capital to fund operational costs and large capital expenditures, or investors seeking leverage, diversification or risk management. Second, since our model is asset-based and requires overcollateralization, we do not rely on a borrower’s credit profile and can fund loans within 24 to 48 hours, assuming the borrower meets our strict AML/KYC requirements. Third, customers know their assets are safely and securely held with institutional-grade custody providers for the duration of their loan. Fourth, our loan process is straightforward and customizable. We allow borrowers to lend against a single cryptoasset or a portfolio of cryptoassets and offer flexible loan terms, including durations ranging from three to 12 months, LTVs up to 60% for individual loans or up to 70% for business loans, and competitive interest rates ranging from 5% to 12% depending on the borrower’s jurisdiction, loan amount and LTV. While we are no longer the only crypto-backed lender in the world, we are one of the few that incorporate a human element into our business model. Unlike completely automated lenders, SALT offers both phone and online support, and assigns each customer a loan support specialist at the time of loan origination. These human touches positively impact a borrower’s experience with the platform; they know that by choosing SALT, they will always have the option to speak with someone about their financial needs.
The Evolution of the Crypto Market and Tokenization
Since SALT’s founding in 2016, the crypto lending market has grown exponentially. According to a report from Credmark, the crypto lending market reached $8 billion in total lifetime loan originations as of Q4/19 and has since surpassed $10 billion following Q1/20. These numbers not only indicate the growing demand for liquidity among crypto holders but also the growing interest among capital providers to get involved in the crypto market. For example, we’ve witnessed an influx of both crypto native (BitGo Prime and Genesis Capital) and traditional financial institutions (Silvergate) that provide leverage and liquidity vehicles at the institutional level.
Another thing to consider regarding the evolution of the crypto market is that as the world becomes tokenized, the very definition of the term “crypto market” is changing. With the emergence of companies like Paxos and Harbor, we’re beginning to see increased tokenization of real-world assets like gold and real estate. At SALT we already accept Pax Gold (a gold-backed cryptoasset) as collateral on our platform and our vision for the future goes well beyond our current collateral scope.
The Role of Alternative Investments
As crypto becomes more widely accepted, a growing number of people are assessing their own risk profiles and determining the best way for them to participate in the crypto market. For those with lower risk profiles, the market has evolved in recent years to offer individuals or businesses indirect exposure to this new asset class. As previously mentioned, crypto portfolios and crypto funds are part of this evolution along with alternative investment companies like Cadence (portfolio company of Coinbase Ventures). Cadence is a securitization platform for private credit that grants access to exclusive high yield, short term investments traditionally reserved for institutions. In February 2020, we partnered with Cadence to offer prospective investors the opportunity to gain exposure to cash flows associated with a portfolio of underlying loans collateralized by cryptoassets. The first note of $500,000 was oversubscribed in five days and we have since worked with Cadence to issue $2.9 million in notes to investors to date. As more companies like Cadence provide structure, liquidity and indirect exposure to alternative asset classes like crypto, we expect to see even greater demand from investors seeking attractive risk adjusted returns.
Opportunities for Institutional Investors
There’s no doubt cryptocurrency has changed the way we think about asset-based lending. It has formed a new asset class and also has catalyzed the trend of broader tokenization — a trend that will inevitably expand the universe of collateral options and have a meaningful impact on the ABL industry. If you’re a decision maker at an institution and are interested in learning more, email [email protected] to discuss opportunities to build and preserve wealth in this rapidly evolving industry.
China’s central banking system officially launched large-scale testing of what could be the world’s first digital sovereign currency. The People’s Bank of China, the nation’s central bank, is working with main banks in major cities, with a focus on digitizing the renminbi. During this trial, users register their mobile phone numbers for access to digital wallets. Through that access, they can use digital currency, issued by the central bank, to withdraw and transfer money, and to pay bills.
If this test is successful, it means that China could be one of the first countries to develop and maintain central banking digital currency, or CBDC. But China’s move toward CBDC doesn’t necessarily mean that other countries’ central banking systems will, or can, automatically follow. Moving an economy from bills and coins — whether physical or virtual — to 100% digitization isn’t something a country just does. Furthermore, there is the question of whether central banks can — or should — work directly with consumers and businesses, in direct competition with commercial and investment banks.
As such, the CBDC reality is a few years away.
Defining Digital Currency And Central Banks
Mention the words “digital currency” and the first thought that might come to mind is Bitcoin.
Certainly, Bitcoin, Ether, Litecoin, and other cryptocurrencies are digitized value exchanges, which can be used to buy goods and services. But cryptocurrencies and central banking digital currencies are two very different sides of the digital coin. While cryptocurrencies are privately developed and distributed, CBDCs are government-backed sovereign currency systems, complete with appropriate denominations. In other words, think digitized fiat currency, overseen by the central banks.
Much like cryptocurrencies, however, CBDCs are recorded on digital ledgers, which keep track of ownership and transactions by users with ledger accounts. But unlike cryptocurrencies, these ledgers would be overseen by central banks, which would also issue the currencies and process transactions.
Speaking of central banks, these institutions have big-picture monetary goals for the nations in which they operate. The above-mentioned People’s Bank of China, as well as the U.S. Federal Reserve, Bank of England, Deutsche Bundesbank, and others are responsible for national monetary policies. They also deal with the nation’s commercial and investment banks, as lenders of last resort. They aren’t in business to work with consumers or businesses.
For example, the Bank of England conducted general business and consumer banking activities during the 17th and 18th centuries. And, in the United States, a highly successful post office savings bank system operated from 1911 through 1967, using the post office network to offer government-backed deposit accounts and other financial services. In many cases, postal banking performed central banking functions — such as funding two world wars — before the Federal Reserve stepped in to determine national monetary policy.
Digital Sovereign Currency Structure: The Theory…
Researchers and scholars have been pondering the idea of centralized digital currencies for a few years. The most recent study along these lines was released in June 2020 by the Federal Reserve of Philadelphia, and entitled “Central Banking Digital Currency: Central Banking for All?” Led by University of Pennsylvania economist, Jesús Fernández-Villaverde, the authors explored whether a central bank, such as the U.S. Federal Reserve, could successfully implement a 100% digital sovereign currency structure, which could realistically compete with commercial financial institutions without too much disruption.
The authors determined that, in theory, and absent any kind of financial panic, a digital conduit between central banks and consumers might be effective in optimizing fund allocations. Furthermore, a direct-to-consumer sovereign digital currency could help streamline and potentially eliminate current time-consuming and costly payment systems.
Bardon and Levin also suggest that central banking systems could offer digital currencies to the general public through specially designated accounts, opened in partnership with commercial banks. The banks could keep corresponding amounts of commercial funds in segregated reserve accounts at the central banks. Furthermore, setting up a CBDC infrastructure would be a straightforward process. Thanks to the internet, brick-and-mortar branches wouldn’t be necessary.
But the BIS cautions that jumping on the CBDC bandwagon right now will mean bumps in the road, mostly in the forms of security, convenience and accessibility. The current coins-and-bills banking system has sophisticated infrastructures in place to handle peak demands for money, and can support potential bank runs. Then, there are the questions about privacy and potential data breaches. Take for example, a situation in which the Federal Reserve issues $1 million to an individual’s stablecoin address. That individual then spends $100 from the same address at an online retailer.
Right now, with the way most blockchain technology functions, that retailer can look at that stablecoin address and see without question that there is nearly $1 million in the account. Cryptocurrency proves that while blockchain technology is great for anonymity, it is far from private. We must find a way to bring the same level of privacy to CBDCs as we currently experience with traditional banking, so that it is both private and public in all of the right ways. Until then, CBDC will likely remain more of a futuristic vision than become a reality.
And, from a larger-picture perspective, Fernández-Villaverde and his colleagues caution that the move to CBDCs could give central banking systems monopoly power, siphoning business away from commercial banks. Commercial and investment banks are set up to support maturity transformation — in other words, using consumer and business deposits for longer-term loans, such as mortgages. Central banks don’t have the capacity to do this; such a lack could be dangerous to economic policies.
Keeping It Cash … For Now
Though the Chinese central bank is experimenting with sovereign-backed digital currency and centralized ledgers, the CBDC concept isn’t close to implementation. Even China is phasing in CBDC very slowly. Coins and bills will be with us for a while longer, at least until security, accessibility and privacy issues — not to mention potential monopolization scenarios — can be worked out.
Still, the increasing use of cryptocurrency continues to prove that digital mediums of exchange are workable. As the People’s Bank of China continues working with sovereign-backed digital exchanges, other central banks will likely examine their own regulatory, legal and technical risks to determine the feasibility of CBDCs.
From business closures to event cancellations and stay-at-home orders, the coronavirus pandemic has had its way with the United States. Millions are unemployed, and millions of small businesses struggle to stay afloat in the punishing economic downturn.
The Federal Reserve, or “the Fed,” has been making headlines as it tries to limit the pandemic’s economic damage, including by lending $2.3 trillion that the government called for in its relief package, dubbed the CARES Act. This action has left many Americans wondering where the Fed got so much money, what the Federal Reserve can and can’t do, and what power the Fed has over our nation’s economy.
What Is the Federal Reserve, anyway?
It’s essential to define what the Fed is to understand its role in our economy. The Federal Reserve is America’s central banking system. Before the Federal Reserve, people panicked their bank would fail when a neighboring one closed its doors. Hordes of customers would run to withdraw their money, ultimately causing those banks to go belly up, too.
After a particularly terrible panic in 1907, Congress stepped in to create the Federal Reserve in 1913 through the Federal Reserve Act. The initial goal was to avoid these bank runs and provide banks with emergency funding. But today, the Federal Reserve System takes other measures to ensure the health and stability of the economy and a secure banking system.
How does the federal reserve work?
The Federal Reserve Act created a decentralized bank that functions without government financing or approval but still protects both public and private interests as a mixed organization.
It has three key entities:
1. Board of Governors
At the heart of the Fed is the Board of Governors, made up of seven officials appointed by the government and confirmed by the Senate. It acts as an independent federal agency, and its job is to direct the monetary policy — the money supply and interest rates. Its goal is to make sure we maintain a stable economy.
2. Reserve Banks
There are 12 Federal Reserve Banks spread throughout the U.S., each one having nine directors. Six directors are elected by commercial banks and three by the Board of Governors, protecting interests from both parties.
Reserve Banks are structured similarly to private corporations. They oversee member banks and carry out the monetary policy in their region. Reserve Banks act independently, but the Board of Governors supervises their actions.
These banks also have other vital roles like distributing currency to other banks, placing money into circulation, acting as a bank and fiscal agent for the U.S. government, and providing critical information about their local, national, and international economies to the Federal Open Market Committee.
3. Federal Open Market Committee (FOMC):
The FOMC is a committee comprising the Board of Governors, the Federal Reserve Bank of New York President, and four members from the other 11 Reserve Banks, who serve for one-year terms.
The FOMC’s primary role is to determine whether the Federal Reserve should buy or sell government bonds, known as Open Market Operations (OMO), to maintain the economy’s stability. It also establishes a target federal funds rate, which is the interest rate banks charge one another for overnight loans.
Where does the Federal Reserve fit into the government?
The role of the Federal Reserve within the government can seem confusing since it has public and private aspects. The Fed is accountable both to Congress and the public and maintains transparency in all its operations.
Ultimately, the Fed is a product of the government because it was created by an act of Congress, which still oversees the whole system and can amend the Federal Reserve Act at any time.
But Congress created the Fed to work autonomously and to be shielded from political pressures by using a privatized structure for the Reserve Banks. It also keeps a hands-off approach by letting the three entities carry out their core responsibilities independently of the federal government.
Can anyone override Federal Reserve decisions?
There isn’t a formal legal power that can supersede the Fed’s monetary policy decisions. Still, the Federal Reserve Act allows the Treasury to “supervise and control” the Fed where jurisdictions overlap.
But the Treasury hasn’t needed to do this because a system of checks and balances keeps the Fed’s operations transparent and answerable to the public and Congress. Just because the Fed can influence the economy, doesn’t mean it doesn’t have to follow the rules.
Independent public accounting firms audit Reserve Banks annually. The Board of Governors also gets audited by its Office of Inspector General and an outside auditor. The Board of Governors annually publishes the results on its website.
The House of Representatives and the Senate hold the Fed accountable by requiring it to report twice a year on its monetary policy and economic decisions. Fed officials also deliver speeches throughout the year to the public so that everyone understands the reasoning for its decisions and actions.
Does the Federal Reserve print money?
If you’re a Bitcoiner, or you spend a decent amount of time on Twitter, you’ve most likely seen the “money printer go brrrr” meme that went viral in March of this year. It cropped up in response to the Fed’s announcement on March 12, 2020, that it would offer $1.5 trillion in short-term loans to banks to help combat “unusual disruptions” in financial markets as a result of the coronavirus. The meme, while more of a social commentary than an accurate depiction of the Fed’s responsibilities, expresses frustration regarding the government’s role in inflation and the devaluation of the US Dollar — as evidenced by the meme’s numerous likes and shares, many Americans share this same sense of frustration. While the meme is accurate in many ways, it unintentionally brings to light the common misconception that the Fed prints money. In reality, printing money is the responsibility of the U.S. Treasury. The Bureau of Engraving and Printing prints paper currency, while the U.S. Mint makes coins. The Treasury oversees both offices.
While it doesn’t print money in the literal sense, the Fed does buy cash as needed from the Bureau at cost to put into circulation, but the monetary base in circulation and at central banks typically stays the same.
The Fed manages the money supply by creating and destroying money. It swaps old, ragged bills for fresh ones or adds and deducts from digital balances. But it also manipulates the amount of money in circulation. The FOMC decides on whether to add or remove cash from the economy by buying or selling government bonds and other securities. This influences the amount banks will lend out and keep on deposit, which then affects interest rates.
That being said, where the misconception holds some truth is in the way the Fed puts more money into circulation; the Fed can’t print money, but it does have the power to essentially create money out of thin air. As a banker’s bank, it does so by making “large asset purchases on the open market and adding newly created electronic dollars to the reserves of banks.” In exchange, the Fed receives large amounts of bonds including US Treasury securities, mortgage‐backed securities, corporate debt and other assets. Rather than paying for these bonds in cash or gold bars, the Fed instead credits the account of the bank selling the bonds so that digital money moves from one place into the other.
The process is like taking out a personal loan of $10,000 at the bank. The bank doesn’t give you a suitcase full of cash. What you get is a credit that shows up as some numbers on a screen, reflecting your new account balance.
Because the Fed operates digitally, it can create money with a few keystrokes and use it to purchase assets or lend money. On a televised interview with “60 Minutes,” Former Fed Chairman Ben Bernanke said, “To lend to a bank, we simply use the computer to mark up the size of the account they have with the Fed. So it’s much more akin, although not exactly the same . . . to printing money, than it is to borrowing.”
The Fed did this when it promised to lend Americans $2.3trillion, as called for in the CARES Act for economic relief and stability across the nation for those who were struggling because of the pandemic.
What can the Federal Reserve do or not do?
If the Fed can make money but not print it, what other actions is it able to take or is prohibited from taking?
What can the Federal Reserve do?
The Fed is an emergency lender for banks in financial distress, so it can lend money to failing banks to keep them afloat. But the Fed’s core responsibility is to manage the money supply, which has far-reaching effects on regulating the financial market.
It’s permitted to use four main tricks to change the amount of money in the economy:
1. Changing the reserve requirement
The Fed dictates what percent of deposits banks have to keep on hold. It usually ranges from zero to 10 percent and is currently set at zero because of COVID-19. The more banks have to keep on reserve, the less there is to go out into the market.
2. Changing interest rates on reserves
The Fed pays commercial banks interest rates on their required and excess reserves, a rule that went into effect in 2008. When the Federal Reserve wants to speed up the economy, it lowers the interest rate so that banks have less of an incentive to hold on to money.
3. Changing the discount rate
The Fed encourages and discourages banks from borrowing money from it by raising or lowering its lending interest rates. When the discount rate is low, banks borrow more to lend to each other and the public.
4. Conducting open market operations
The FOMC decides how many bonds to buy or sell. When it wants more money in the market, it buys these bonds from banks to put more money into their account. When it wants to slow down the economy, it sells the bonds to take away bank money.
This is the Fed’s most common tactic to influence the economy. For example, from 2008 to 2009, it bought over a trillion dollars of government bonds to inject money into the stumbling financial market. This lowered interest rates on short-term loans to almost zero percent.
But the recession went too deep. So, the Fed did something it hadn’t done before. It started buying long-term assets from banks in a process that’s known as quantitative easing (QE), boosting the money supply further and stimulating lending and investment.
What can’t the Federal Reserve do?
The Fed can only indirectly influence the nation’s economy. This means it does not have the power to take any of the following actions:
Set the federal funds rate
The federal funds rate is the amount of interest banks charge to lend their excess cash reserves overnight to each other. Banks frequently do this to meet the Fed’s reserve requirement.
While the Fed can’t set this number directly, the FOMC sets a target federal funds rate depending on what direction it wants the economy to go. Then, it works within what it’s permitted to do to influence banks and reach the benchmark rate.
Set the prime rate
Banks use the prime interest rate for commercial and consumer borrowing for things like credit cards and personal, car, and home equity loans. Banks often set the prime rate based on the Fed’s target federal funds rate.
Hike up mortgage and student loan rates
Mortgages and student loans are long-term assets whose rates are determined more by market-driven factors than FOMC decisions.
That said, the Fed purchased mortgage-backed securities to lower long-term rates on mortgages in 2008 so that banks wouldn’t need to borrow from each other to meet the reserve requirement. But these actions still affect federal funds rates significantly more than mortgage and student loan interest rates.
Use taxpayer money to fund its operations
The Fed doesn’t get any funding from taxpayers because its money comes from interest accruals on government securities and treasuries purchased through its OMO. There are other sources, too, such as foreign currency investments. After paying its expenses, the Fed turns any extra money over to the U.S. Treasury because it’s not operated for profit.
What’s the potential impact of the Federal Reserve’s powers on the economy?
Although the Fed can only work behind the scenes to stabilize the economy, it exerts a massive influence on its operations.
For example, the Fed can speed up or ease the economy by manipulating the money supply to increase or decrease consumer spending. It starts by influencing bank lending rates through selling and buying government bonds.
When banks have more excess reserves, there’s more to lend to the public, so interest rates are lower. Lower interest rates encourage people to borrow money, which is then spent on goods and services. More consumer spending generally means a better economy, while “even a small downturn in consumer spending damages the economy” and can even lead to a recession. Below is how the Fed’s actions impact specific aspects of the economy.
The Fed uses a trickle-down effect to influence interest rates. Remember, they can’t set federal funds or prime interest rates, but they can bend them to their will through OMO.
The Fed buying back government bonds from banks leaves more money for banks to play with while selling them means banks have to be more cautious about lending out their reserves. The economics of supply and demand shows excess cash in the market will drive down the interest rates banks charge to each other and the public, while a lack of money has the opposite effect.
The Fed also raises or lowers the discount rate and reserve requirements to change the interest rates commercial banks ultimately offer customers.
Inflation and deflation
When federal funds rates drop because of the Fed’s actions, prime rates usually drop with them. Consumers then borrow money for business and personal purposes to take advantage of lower interest rates. With greater amounts of money in their pockets, people spend more on goods and services, creating a spike in demand.
The larger demand pushes wages and costs higher to meet the production necessary to keep up with supply, causing a ripple effect. Prices increase across sectors, leading to reduced purchasing power. This is inflation and explains why a dollar today is worth less than a dollar last year.
Some annual inflation is good. It’s a sign the economy is doing well because consumers are spending. The Fed has a target core inflation rate of two percent. When inflation goes above or below the benchmark amount, the Fed steps in and works within its limits to move the needle toward inflation or deflation.
Although directing the U.S. monetary policy for the nation’s economic benefit is a crucial part of the Fed’s job, it also has foreign concerns.
Financial crises within our borders often have a global impact. The 2008 recession strained international markets because many countries have at least some assets and liabilities dominated by the dollar, causing them to sometimes borrow and lend in dollars.
To address the dollar scarcity, the Fed started swapping currencies with foreign economies in dire need of U.S. currency — over 583 billion dollars’ worth — at a predictable and fixed rate to keep struggling foreign banks afloat and prevent their economies from plummeting.
The Federal Reserve: A system of the People, by the People, and for the People?
The Federal Reserve’s power and influence over our economy leaves many asking if it’s an unconstitutional entity. Though Congress takes a laissez-faire approach to the Federal Reserve, the system teeters between public and private domains.
The effect of its present monetary policy decisions on the future economy could determine which direction future reform sways. It could also decide if the century-old institution modernizes into a structure more accurately reflecting the concerns and voice of the people, and one maintaining greater transparency while ensuring the long-term economic stability of the nation.
While neobanks initially emerged in response to the barriers presented by traditional banks, they have become viable businesses in their own right by offering products, services, and a level of convenience that traditional banks have been slow to adopt.
Traditional Banks Slow To Respond To Evolving Customer Preferences
Though most traditional banks have worked to add new features and services, overall they have been slow to respond to evolving customer preferences. Take mobile apps for example. Most major banks today offer a mobile app that enables customers to conduct some of their banking via their phones. But these platforms often act and feel like digital extensions of their monolithic physical branches, clumsily ported onto your phone, and unable to harness the immense power that smartphones and internet-connectivity offers.
As frustrating as it is, this lack of innovation on the part of traditional banks makes sense if you consider their history. For decades, the biggest banks in the world functioned within the structure of an oligopoly and it wasn’t until fairly recently that they ever needed to worry about new kinds of competition.
While this lack of innovation has reduced the appeal of big banks among customers and has created space for the emergence of neobanks, it is not the only contributing factor to this shift in customer perspective. Unethical behavior by banks has come to the forefront in the past decade as many of the world’s biggest traditional banks have embroiled themselves in scandals and the details of those scandals have been broadcast to the public.
To name just a few, Deutsche Bank has been linked to moneylaundering, Wells Fargo paid a $185 million fine for creating millions of accounts on behalf of customers without their knowledge, and the financial crisis of 2007–2008 reads like a murderer’s row of the biggest names in the global banking industry. Additionally, repeated regulatory attempts by world governments to rein in unethical banking practices have merely resulted in newer, more creative ways for banks to break the rules in pursuit of profits.
Now consider some of the advantages that neobanks such as PayPal, Square, Alipay, Monzo, Wealthfront, Robinhood and Simple offer.
It starts with greater convenience. By offering a way for customers to bank from the palm of their hand, neobanks are able to avoid incurring the real estate and operational costs associated with maintaining and operating physical branches. These cost savings can then be passed along to customers in the form of lower interest rates on loans.
Beyond offering lower rates, neobanks also focus on making loans more accessible. They bring with them far less bureaucracy than traditional banks offer, enabling customers to get faster loan approval. This has also been the narrow focus for my company SALT, where digital asset-backed lending has enabled us to provide our customers with access to cash and offer competitive interest rates without having to take their credit scores into account.
Unlike traditional banks, neobanks have boomed in the time of smartphones, building their platforms with a mobile-first approach. This completely digital environment produces a user-friendly interface, driven by cutting-edge APIs.
Neobanks’ systems tend to be both highly automated and scalable. They offer open infrastructures with the idea that other creative applications can be built on top of their basic banking platform to improve their offerings. This also means they can adapt quite rapidly to a fast-changing industry. It’s far more likely to see one of these newcomers start to offer cryptoasset services before any traditional institution.
While big banks seek to own as many pieces of a customer’s financial existence as possible, neobanks understand that choice is the future of finance. By offering customers the opportunity to choose from an array of creative banking solutions, neobanks are completely disrupting the banking industry. While some companies are offering microlending, others are offering commission-free stock trading, undercutting the costs of even the lowest-price discount brokers.
Combine these offerings with FDIC-insured savings accounts, checking accounts with debit cards, ATM access, credit cards, and mobile-first features such as mobile check deposits, and customers have nearly every banking service they need in one place.
Even with all of these advances, neobanks still constitute a small percentage of the overall banking and financial services space, leaving plenty of room for significant growth. How that growth manifests itself remains an open question.
That question is this: Will fintech companies overtake traditional banks, or just add competition?
The answer will likely depend largely on how quickly and extensively traditional banks evolve. Historically, they’ve been slow to change, and haven’t paid the price for that intransigence. That’s because over the years, most banking customers have been fairly inert, accepting higher interest rates on loans, recursively punitive overdraft fees, and monthly account maintenance fees because they haven’t found better alternatives that they can trust.
The current COVID-19 pandemic could force change, both among banking service consumers and the industry itself. Visits to physical bank branches were already an inconvenience to customers before the outbreak of COVID-19. Now that banks are inevitably having to focus on their digital service offerings, even traditional banking customers will get to experience fully digital banking. How well their bank performs in this aspect will determine whether a customer remains loyal to their bank following the crisis, or chooses to make the switch to a neobank that can better meet their needs.
As more customers seek better banking alternatives, the younger generation will be able to teach traditional banking customers about the benefits of neobanks. From there, it won’t take much due diligence before more people realize that neobanks offer smoother platforms, better interest rates, and more flexibility than traditional banks.
If that happens and traditional banks’ market share starts to erode at a faster pace, traditional banks will be faced with the classic build-or-buy dilemma. Will they hire the best, more forward-thinking engineers to catch up to neobanks’ superior technology and user interfaces? Will they seek to acquire leading fintech companies as a way to protect themselves? Or will they remain complacent, and let fintech upstarts pass them by?
Fintech companies’ ability to grab market share will entail overcoming significant challenges, beyond just traditional banks’ huge edge in brand recognition.
Stock-trading app Robinhood suffered multiple shutdowns as financial markets crashed in early March. Chime, a leading branchless U.S. bank, has experienced multiple outages over the past year, with the company’s five million users unable to see their balances and intermittently unable to use their debit cards. Above all other banking features, customers want to know that they can access their money when necessary, so these kinds of setbacks must subside if fintech contenders want to make serious headway.
Meanwhile, regulatory complexity within countries and across regions is contributing to “winner take most” outcomes for fintech disruptors. Neobanks need to invest more in regional compliance to gain traction, rather than trying to launch globally on day one.
The landscape is changing rapidly for neobanks, and it will keep changing. Venture capital-backed startups will try to grab a big piece of the consumer banking world, but they’ll face plenty of competition. We might also see fintech firms partner and bundle services in an effort to compete head-on with the big banks.
Ultimately, the future of banking could simply come down to consumer awareness. Take my brother-in-law for example. After recently receiving a check from his grandfather, he sent it home to his parents so they could deposit it into his bank account. Although he’s highly educated and technologically savvy, he had no idea that he could deposit the check in a matter of seconds with a mobile banking app. Instances like this demonstrate that there’s still ways to go in terms of shifting consumers’ mindsets to challenge traditional banking.
It’s something that people don’t really think about, unless they work in the industry, or need to get a mortgage or some other major service from their bank.
Just as disruption has changed consumer habits in so many other industries, it will eventually do so in banking. Neobanks are better positioned to integrate with top data transfer network providers like Plaid, as they think about service through a lens that is different from that of traditional banks. As consumers become more aware of alternative banking options, they will catch on to the advantages of neobanks and inevitably make the switch, choosing to abandon their traditional bank in the process.
For the banking industry, change is already here. And more change is coming.
About the Author
Rob Odell is Co-President & Chief Product Officer at SALT where he is responsible for developing the strategic direction of the company and managing the product and marketing teams. Rob has been a Bitcoin believer since 2013 after being introduced to it by a Bali-based coffee roaster selling his beans for Bitcoin. SALT allows borrowers to use their cryptoassets as collateral to secure cash or stablecoin loans.
In case you’re not a subscriber to our newsletter, we want to share some of our favorite highlights from March right here on our blog to help keep you up to date on all things SALT.
Need something new to binge watch?
Catch up on Season 2 of Worth Your SALT to see our discussions with industry leaders including Bill Barhydt, Shira Frank, David Chaum, and many more.
CoinTelegraph: French Court Moves the BTC Chess Piece — How Will Regulators Respond?
“France is the 7th largest economy in the world by GDP, so it certainly is likely to influence other markets, especially in the EU, initially. In such a new and emerging market and technology like Bitcoin, regulators around the world do look to how other countries’ regulators are viewing cryptocurrencies. So, any ruling France makes will be closely observed by regulators worldwide.”
— Rob Odell, co-president and chief product officer, SALT
Crypto Chat: Q&A with Dustin Hull, Co-President & CFO, SALT
As one of Cadence’s latest originator partners, we sat down with Brian Guerra of Cadence to discuss SALT’s business and how we’re able to contribute to Cadence’s efforts to give investors exposure to private credit assets linked to cryptocurrency. For full Q&A, click here.
Finance Magnates: Coronavirus & Crypto Lending: Could the Crisis Bring New Clients?
“Crypto-backed lenders are likely faring better than other crypto businesses during the global pandemic, as they offer a way for crypto holders to get cash without having to sell their cryptoassets.”
— Rob Odell, co-president and chief product officer, SALT
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Innovative industries are driven by innovative minds. There’s an array of knowledge within the blockchain ecosystem and here at SALT, we believe highlighting different understandings and perspectives can only facilitate growth within our industry. With this in mind, we’re excited to release our newest video series “Worth Your SALT,” a platform dedicated to interviewing industry leaders and trailblazers currently shaping the way we think about technology. Hosted by SALT Co-Founder Caleb Slade, these segments feature thought-provoking discussions that uncover the stories behind these crypto pioneers and explores their vision for solving problems that aren’t yet fully understood.
In the first episode of “Worth Your SALT” we had the chance to sit down with Shira Frank, Co-Founder of Maiden — an industry-backed lab for universal blockchain education and research — to discuss the importance of humanizing blockchain. Throughout the discussion, Shira tells us about her unique background that has led her to focus on the intersection of ethics/awareness and technology. She leaves us pondering the complex relationship humans have with technology: we constantly think about the ways we’ve shaped and evolved technology, but have we ever truly thought about how it’s shaping and evolving us?
Watch the full-length version to hear more from Shira Frank on the social complexities of advancing technologies.
We’ll be releasing new episodes of “Worth Your SALT” in the coming weeks to highlight perspectives from various areas of the blockchain/crypto industry. Upcoming episodes will feature thought leaders including David Chaum, Jeff Berwick, and Paul Puey, among others.
Missed an episode? You can find the short and full-length versions here. New episodes can also be found on our Twitter and YouTube channels.
A look at indicators of industry maturity and assessing the right kind of investment risk.
(This article is adapted from a keynote speech delivered at the April, 2019 Crypto Invest Summit.)
I often get asked, whether it’s by former colleagues, or people I meet at social events, or even my dad, “Why would people invest in crypto? It seems risky.”
Depending on your investment strategy, sure, it’s risky.
But…it’s a different kind of risky than it was even two years ago.
So, what’s changed?
Crypto asset performance isn’t correlated to any other asset class. It doesn’t move with fiat inflation or commodities prices. It’s not tied to the performance of a company like a security. That inherently creates risk but also opportunity for significant gain. This is a risk that we as an industry weather and accept.
The perceived risk my dad is referencing has less to do with crypto asset volatility and more to do with the perception that the crypto industry reflects the lawless, undisciplined behavior and unbridled speculation akin to the caricature of the wild west.
This perception is inaccurate.
I was having a conversation with a colleague about this very topic and he said,
“Our industry isn’t in a state of chaos like The Wild West. Our industry is more analogous to The Space Race.”
John F. Kennedy said of The Space Race, “We choose to go to the moon in this decade and do the other things, not because they are easy, but because they are hard.”
Blockchain technology attempts to solve previously unsolvable problems. The complexity of the technology and the nascent nature of the regulatory framework, requires new and emerging expertise. It requires risk takers to set new precedents.
This pursuit has resulted in a pouring in of talent and capital which have given rise to increasing competition and meaningful industry advances. We are seeing this manifest via several indicators of industry maturity.
Despite the crypto winter, or bear market, or whatever we want to call 2018, we saw a nearly doubling of the amount of individuals who hold crypto assets. A survey published by Forbes suggests that crypto holders are skewing older and more affluent than previously thought.
UTXO analysis conducted by Delphi Digital suggests that most crypto holders who held a position longer than five years largely sold off their holdings, partly contributing to the downturn, but clearing the way for new investors seeking engagement with new types of products.
From an institutional perspective, traditional financial services and crypto financial services are converging. We are seeing validation of crypto assets in traditional companies incorporating crypto services or blockchain infrastructure.
Institutional adoption also extends to partnerships and service providers for crypto companies. Just in the past 12 months, I have seen an increased willingness of vendors and service providers to work with crypto companies. Companies who were saying “no” to providing services for us 12 months ago, are now actively trying to work with us.
US-based crypto companies have made significant strides to create risk and compliance programs that are comparable to traditional financial institutions.
This includes a robust KYC/AML program, customer data protection standards, SOC compliance, compliance monitoring of blockchain addresses, and dedicated resources to oversee compliance programs.
As our industry attempts to navigate its purpose of removing barriers for transferring value, even regulatory barriers, compliance programs at this stage of our industry maturity, are a necessary step for broader adoption and mitigation of regulatory risk.
Insurance has been a hot topic as of late because it’s a relatively new advancement in our industry. But it’s meaningful.
The fact that insurance providers are willing to underwrite affordable insurance policies for crypto-specific operations is a strong indicator that we as an industry are demonstrating the safety of holding crypto assets.
I urge investors to ask critical questions about the specifics of insurance programs — the coverage amount, incidents covered, and the claims and payout process and timeline.
The good news is that as our industry continues to prove itself, the competition amongst insurance underwriters will increase, which, in turn, will drive down costs.
Market Data Integrity
Our industry is dealing with our own data integrity issues just like any other high volume, high velocity industry.
Recognizing these gaps and the dependence on reliable market data to drive participation, there has been a surge of data research companies dedicated to improving the quality of market data.
The recent incident of BitWise calling out CoinMarketCap for overstating trading volumes, is a great example of our industry’s maturity in this area.
This is significant not just because companies like BitWise are expending resources to conduct due diligence on our industry’s leading data providers, but also because of CoinMarketCap’s acceptance of accountability to address the issue and improve their product.
It demonstrates that we are holding ourselves to a higher standard, and that investors will have increasingly accurate sources of information to make informed decisions.
Response to Scalability Challenges
JPMorgan announced earlier this year that it is investing in its Quorum blockchain infrastructure to facilitate payments in a more efficient manner using its dollar-backed JPM Coin.
It’s currently being piloted with a few institutional clients but is promising to revolutionize their payment processing.
To realize this potential will require blockchains to dependably support concurrent transactions at a scale that is not yet possible, or at least not yet largely practiced and tested.
Our industry is investing significant resources to solve this problem, and promising solutions are surfacing.
A second layer protocol solution, Lightning Network, is perhaps the most exciting advancement in the race for scalability.
For crypto to deliver on its potential of revolutionizing the transfer of value on a global scale, it must rise to meet the challenges of scale.
We’re working on it.
More Sophisticated Investment Products
What I see as the most exciting indicator of market maturity is the increasing diversification of product offerings.
Interest-bearing accounts are seeing promising early performance, futures and options are now available on select exchanges, as is trading on margin, and ETFs are on the near-term horizon.
What I have seen is an industry response to the unique nature of crypto assets and the needs of crypto holders. In crypto lending, for example, simply offering a crypto-backed, USD loan, does not address all market uses cases.
If 2018 has taught us anything it’s that we need products that drive market engagement in both bear and bull markets.
Our industry now offers several ways for investors to participate — directly through investing in crypto assets, less directly by offering fiat capital pipelines for interest-based products, or indirectly through investing in the growth of crypto companies and projects.
These options are allowing for a wider breadth of investor participation with varying risk appetites.
I return to the question, “Is crypto investing risky?”
When we empower a company like Charles Schwab to manage our wealth portfolio, we know there is some risk in the investment strategy but we don’t worry about them losing or mismanaging our money.
There are enough responsible companies in the crypto industry that can provide the same amount of assurance about the handling of your crypto assets. I encourage investors to seek out reputable companies and ask tough questions about their operations due diligence. Watch how companies respond to industry incidents like a hack or key compromise event. Our industry is still young and we’re still learning our vulnerabilities. The good companies will have a disaster recovery procedure that cure customer losses.
We have seen what happens when more resources are deployed to our industry. The result is more talent, innovation, and increasing sophistication that results in better products and better opportunities for investors.
The views and opinions expressed in this article are those of the author and do not necessarily reflect the official policy or position of SALT Lending.
Disclaimer: This article is for informational and educational purposes only and does not constitute tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors when filing your taxes.
“At any time during 2019, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”
The Internal Revenue Service (IRS) isn’t referring to your Fornite or Call of Duty digital bucks — but to cryptocurrencies, which is a sign of the industry’s growth. The IRS set guidelines back in 2014 outlining how to report cryptocurrencies when it came to taxes, following existing tax reporting rules similar to real estate. In short, the IRS previously considered cryptocurrency along the same lines as property.
This year however, federal tax forms ask about your bitcoin and other cryptocurrency activities, the latest move to more directly specify details for cryptocurrencies. The IRS is focusing on those who may be underreporting their crypto transactions or not reporting them at all.
What does this new sentence in your tax form this year really mean, and how should it impact how you report crypto in your 2019 taxes? To help understand, we asked SALT experts, along with our partners and friends at Node40, TaxBit, Blox and Friedman LLP.
Know Your Cost Basis
The first thing to know is that one is taxed on profit — the key figure to find out is the gain number. The most recent set of guidance from the IRS was released in October 2019 and it included a few methods of “cost basis assignment” mentioned therein. For those who aren’t accountants, this means one of a few ways to track profits and losses. Know your cost basis and what the IRS deems taxable. Most importantly, know your “gain number.”
Cost basis means the price at which you initially acquired an asset. For example, if you hold one BTC today, which you previously purchased at $9,000, and the price today is $11,000, the cost basis is that acquisition price of $9,000. So, the unrealized gain number (without selling) and the realized gain number (if you were to sell) is the net between today’s price and the cost basis, meaning in this case $2,000.
Cost basis can also mean the fair market value of the asset on the date of acquisition. For example, you received one BTC from work as compensation for services on 1/1. The value of BTC on 1/1 is $9,000. Later when you sell one BTC at $11,000, the then fair market value of $9,000 would be the cost basis, and you would realize $2,000 gain. The fair market value can be determined using a reasonable method, such us prices on any third-party independent trading platforms, as long as the same method is applied consistently for all your crypto transactions.
Loan collateral does not count as a transaction
For SALT customers, it’s important to know that your crypto held as collateral for a cash or stablecoin loan does not count as a taxable transaction unless your collateral is liquidated; a liquidation is a taxable event. If your collateral increases in value during the course of your loan term, this does not count as a gain or taxable action unless the collateral is sold. According to Friedman LLP, should you have a business loan with SALT, take note that business interest is deductible and subject to limitations (generally 30% of adjusted taxable income if the business had more than $25 million gross receipts). While interest on personal loans is generally not deductible, it may be deductible if you are self-employed and you use the loan for your own business or if you are employed but you use the loan to make other investments that generate income (the loan then becomes a business loan or investment loan).
First-In-First-Out (FIFO) is the default accounting method. Your cost (the price at which you purchase a crypto asset) is calculated at the initial purchase date. So, if you buy a Bitcoin in January, another in March, and sell one in June, the “cost” isn’t from March, but January. The first “in” is the first purchasing transaction. First “out” is the first one sold. With digital currency the date of purchase and sale are clear in the coins and tokens themselves, making reporting much easier.
By way of example: assume you purchase one BTC on 1/1 for $10,000, one BTC on 2/1 for $15,000, and then sell one BTC on 3/1 for $12,500 — your taxable gain or loss using first-in-first-out is computed by taking $12,500 of proceeds less your cost basis of $10,000 (which comes from the earliest purchase of BTC). This results in a $2,500 taxable gain.
More details on this specific topic can be found over at Taxbit’s blog here.
Be Careful Using 1099s from Exchanges
If you have been buying crypto through exchanges, the exchange may have sent you a 1099-K or 1099-B form. Even if you did not receive these documents, all the 1099 methods of calculating income are still valid for you. The exchange calculates and reports gross proceeds, meaning that it is on the taxpayer to provide information on the cost they paid to acquire said assets and reported in the capital gains section, otherwise known as IRS 8949.
Specifically, form 1099-K reports gross proceeds, which the IRS interprets as income. The number reported on form 1099-K is not counted as income however, as cryptocurrency trading carries cost basis and is to be reported in the capital gains and losses section of a taxpayer’s tax return. Form 1099-B reports cost basis when available and makes it easier for you as a taxpayer to complete your required IRS 8949. Some cryptocurrency exchanges may not send you anything at all. Regardless of which form you receive or don’t receive, your responsibility as a taxpayer is to use the information to complete your IRS 8949, which reports your capital gains and losses.
Verify the Data You Receive
The crypto industry is still relatively new and while the exchanges and trading technology may have some advanced reporting features built in, the institutions built around that technology are still new. With traditional securities, there is a clearinghouse, a broker, and well-established financial statements that make it easy to determine your taxes. With cryptocurrency, many of the exchanges are still in the process of refining external reporting standards. This means that, as a user, the level of completeness in reporting expected from NYSE cannot possibly be replicated by virtually any new institutions.
According to data by NODE40, the reports generated by cryptocurrency exchanges will be incorrect for about 80% of cryptocurrency traders. We can’t fault the exchanges because there is simply no way for them to determine the cost basis of the assets you’ve been moving around. For this reason, it’s important to consider using a third-party platform that can calculate the gains and losses on your cryptocurrency as you move it from exchange to exchange or wallet to wallet.
Conclusion: Educating Ourselves is Essential
Crypto accounting and tax reporting can be daunting and complex, which is why staying engaged with news and trends is essential to understanding the evolving landscape of crypto taxation. Especially in the U.S, the IRS is taking more steps to introduce greater guidance and clarity. But without proper education and trained professionals, navigating crypto tax can be tough.
Tax preparers and investors rely on 1099 forms in traditional markets — crypto is no different. Without it, the burden of responsibility shifts to the investor, requiring them to keep track of all of their crypto activity for the year. This includes tracking every crypto-related transaction, like fair market value based on the date of purchase or sale of assets.
All of this information is vital for preparers to determine cost basis and properly calculate gains and losses. Therein lies the primary challenge. Some crypto accounting and management platforms have emerged to solve this growing industry need for smarter solutions. Industry giants need reliable, accurate and smart tools.
Because crypto remains a new field and exchanges are widespread around the world, not all exchanges report in the same method. This is why the savvy users will double check the work of the exchange, a task for which there are now new tools available. These errors can have a massive tax impact, particularly when it comes to tracking the cost of acquisition of the asset over time. Luckily there are tools that exist that can provide traders and crypto entrepreneurs with intelligent support.
Taxes are a part of life. This year hundreds of millions of Americans will be reminded explicitly of the existence of digital assets — a good thing for the industry that will drive greater awareness and adoption of cryptoassets. If you’re already a crypto hodler or trader, diligence is key to successfully filing your 2019 taxes this year. Whether you use a third-party tool or rely solely on exchanges to track the movement of your assets, it’s crucial that you know your gain number and verify its accuracy, that you review the IRS guidelines, and that you use trusted sources to educate yourself on what to report and how to go about it.
Salt Lending LLC: Salt Master Fund II, LLC – NMLS 1711910
This website contains depictions that are a summary of the process for obtaining a loan and provided for illustrative purposes only. For example a one year $10,000 loan with a rate of 6.00% APR would have 12 scheduled monthly payments of $861. There is no down payment required. Annual percentage rates (APRs) through the website vary. The use or access of the website or platform does not guarantee the availability of any current and/or future offer, promotion, terms, loan, or return. Additional terms, conditions, requirements, suitability, and screenings, among other restrictions, may apply at the sole discretion of Salt. Salt Lending LLC’s loans are issued pursuant to private agreements. You should review the representations and warranties described in the loan agreement.
Available rates and terms are subject to change and may vary based on loan amount, qualifications, and collateral profile. Other terms, conditions, and restrictions may apply.
Individual US citizen borrowers must be a permanent resident and at least 18 years old (or local age of majority).
Valid bank account and social security number/FEIN are required. Borrowing against collateral entails risk and may not be appropriate for your needs. Not FDIC-insured; investments may lose value; no Salt or bank guarantee. Salt does not provide legal and/or tax advice. Please consult your advisor.