In Dollar We Trust

Global finance refers to the financial system consisting of regulators and various financial institutions that conduct their business on an international level. To be able to foresee the future of global finance it is important to understand how the global financial systems evolved through the ages and how technology helped shape this evolution. Also, what is the future of the Dollar and more importantly where is Fed heading. Discussing these three questions together will help us understand the future of global finance. 

What is the role of technology in the evolution of global finance?

‘It’s hard to see the forest with all those trees in the way’. We’re currently going through a revolution that’s larger, arguably, than the industrial revolution. The technological revolution has transformed the way we live — how we talk, how we work, how we go about our daily business, and, yes, how we manage our finances on a global and individual level.

For decades, banks and insurers have employed the same relatively static, highly profitable business models. In fact, the financial services industry has been remarkably impervious to past assaults by innovators, partially due to the importance that scale, trust and regulatory know-how have traditionally played in this space. But today they find themselves confronted on all sides by innovators seeking to disrupt their businesses. 

It all started with various financial technologies such as alternative payment systems and lending systems, application program interfaces, robo-advisors and chatbots, big data, blockchain, cryptography and artificial intelligence, etc. being developed at the level of startups and non-financial companies, which used the recent developments to provide better financial services. However, their effectiveness, the speed and real time processing of information, the relevance and personalization of information forced the traditional participants of the world financial system mainly banks, investment companies, exchanges and insurance companies, to actively modernize their activities in order to remain competitive.

A lot of work has been done by economists, market analysts and regulatory institutions on exploring financial technologies and their impact on various sectors of the economy. The IMF representatives constantly monitor financial technologies and the dangers related to their introduction (Dong He, 2017). Neng Lai and Van Order (2017) reviewed both positive and negative effects of financial technology on the banking system in China and proposed a ring-fencing method to mitigate risks. Abadi and Brunnermeier (2018) emphasize the competitive preference of the blockchain, but they believe that it can cause instability and incorrect coordination between the participants. 

Financial technologies play crucial role in the modern transformation of the financial system, they also help improve financial activity and increase its profitability. The main characteristic of financial technologies is their ability to create innovations in the financial system. Financial assets trading, primarily securities trading, is strongly influenced by financial technology. The emergence of Internet technology has caused virtualization of exchange trading. Based on big data analytics technology, which processes huge volumes of both unstructured and structured data, passive and quantum strategies for the purchase/sale of financial assets are developed. With the help of passive strategies, more than 1,700 exchange traded funds (ETFs) with assets of over USD 3.5 trillion are managed globally. According to Bloomberg News, over the next 10 years, the passive giants Vanguard and Blackrock will manage more than USD 20 trillion.

Technology has been a major factor in the global financial system transformation. It has increased operating speed of the financial industry and its profitability, open access to the capital market for new entrants. However, the adoption of technology results in the increased complexity and unpredictability of development, as there are nonlinear correlations in the development of complex systems, which complicates the projected growth and ends up disrupting the foundations of financial systems. This does not mean disruptors will devour the old economy. incumbents are realizing that collaborating with new entrants can help them get a new perspective on their industry, better understand their strategic advantages, and even externalize aspects of their research and development. As a result, we’re seeing a growing number of collaborations between innovators and incumbents. ApplePay, the most lauded financial innovation of the past year, doesn’t attempt to disrupt payment networks like Visa and MasterCard, but instead works with them. Clearly, there is more to this story than simple disruption. How it will play out is still to be seen, although we can safely say that innovators will force incumbents to change, which should ultimately benefit the consumer.   

Currency issues (including digital)? What will happen to the dollar, and why? 

In the past 25 years over 21 countries have suffered incidents of severe inflation. In these cases, as the national currency became increasingly devalued, either due to government over-printing or large injections of counterfeit bills, citizens have privileged foreign currency in order to maintain the import of goods.

The U.S dollar, as the world’s leading reserve currency, has been that money of choice. 

Approximately 65% of all U.S. dollars are currently being used outside the United States, 80% of trade finance was conducted in dollars and close to 85% of forex trade volume involved the dollar. Globalization has intensified the financial integration of the world economy, but the dollar remains the currency of choice, whether that be for cross-border transactions, debt, or financial and foreign exchange trading. This means developments in the US that influence the dollar’s exchange rate end up having a greater impact on the rest of the world, and that’s why the US Federal Reserve (Fed) leads other central banks when it comes to monetary policy. In a nutshell, the world is far too reliant on one country’s currency and this very fact is responsible in spreading financial crises to others quickly.

Naturally, this leads to the governments having to hoard huge amounts of dollars to protect themselves against swings in the US economy. This has become more prominent during the US President Donald Trump’s trade war with China, as part of his wider overhaul of the country’s economic policy.

The increased stockpiling of dollars means borrowing costs have increased and that is why the world has suffered from lackluster inflation over the past decade. Clearly, the global currency markets need rebalancing. So, the question is ‘can Cryptocurrencies replace the U.S. dollar as the global reserve currency?’ Answer is yes, it’s possible. But for any currency to achieve that status, it needs to pass a 3-pronged test per say!

1. Medium of Exchange

For something to function as a currency, it must be an effective medium of exchange. In other words, individuals, companies and other organizations must be able to trade it for goods and services. The U.S. dollar has certainly established itself in this respect, because it's one of the most widely traded fiat currencies in the world.

The U.S. dollar loses a small amount of its buying power every year due to inflation. However, this takes place so slowly that market participants do not notice the difference. But cryptocurrencies have been extremely volatile, and this Intense volatility is a big challenge. 

Another issue is due to the very nature of the technology most of the crypto currencies are not designed to handle the traffic of a high number of users however as the technology advances this problem will subside. Further, the regulatory environment is highly complex because many nations have separate sets of rules, which means that global regulations are greatly fractured.

2. Store of Value

Another key requirement of a currency is that it must function as a store of value i.e. the cryptocurrencies must hold value over time.

Crypto currencies can be a great store of value in parts of the world that suffer from significant geopolitical turmoil, as these regions can see their native currencies experience substantial changes in value overnight. However, one of the concerns is that the digital currency's basic rules could change significantly as a result of a permanent alteration in code known as a hard fork. And even if they don't change the formula, the fact that they could? That's enough to say it's not a long-term store of value.

3. Unit of Measure

The third requirement that cryptocurrencies need to meet in order to function as a currency and possibly replace the U.S. dollar as the world's reserve currency is to function as a unit of account. At this moment, this ability is widely debated. Crypto currencies’ intense volatility is a concern and certainly undermines their use as a store of value. And to this, I think the overall generalized lack of adoption of the cryptocurrencies exacerbates the situation.

In a summary, cryptocurrencies could potentially replace the U.S. dollar as the world's reserve currency, but for this to happen, they would need to make progress in several important areas.

Longer term impact of Fed and fiscal activism?

COVID-19 pandemic and the financial shock that followed has reaffirmed that the central banks are the first responders of economic policy. They hold the reins of the global economy. But unlike national Treasuries that act from above by way of taxing and government spending, the central banks are in the market. Whereas the Treasuries have budgets limited by parliamentary or congressional vote, the firepower of the central bank is essentially limitless. Money created by central banks only shows up on their balance sheets, not in the debt of the state. Central banks don’t need to raise taxes or find buyers of their debt. This gives them huge power. How this power is wielded and under what regime of justification defines the limits of economic policy. 

The Federal Reserve has been at the center of the health crisis by actively using its full toolkit on monetary policy measures that will maintain the economy afloat while injecting enough liquidity in the financial markets. However, the harm from an inadequate response to the pandemic and the sharp economic contraction could be far more serious than in other recessions the country has faced in recent decades. The mainstream economic view now is that debt worries should not inhibit the response to the recession and that the United States has sufficient fiscal space to do so. 

The Fed has not walked away from the challenge but there is only so much it can accomplish with traditional monetary policy. The Fed must continue to act as an independent central bank from the Government, however its role needs to be “upgraded” and perhaps re-established. It can leverage technology to implement completely independent, unbiased monetary policy. Only then can we truly understand the role of the Fed in the new world of digital currency.