Weighing up the risks of cryptocurrencies

As the Treasury Select Committee holds an inquiry into the opportunities and risks crypto-assets bring to both consumers and businesses in the UK, Phil Hall AAT Head of Public Affairs & Public Policy, takes a close look at what has rapidly become a multi-billion pound industry.

As a Treasury Select Committee inquiry gets underway, Phil Hall analyses the benefits and drawbacks of crypto

Innovation vs Regulation

In April 2022, the Government confirmed it wishes to ensure Britain becomes a global hub for crypto assets technology and investment. This bold approach could provide many opportunities but equally comes with inherent risks.

Appreciating the requirement to balance the need for regulation and the encouragement of innovation, AAT believes that more regulation (perhaps just better enforcement) is needed in this area.

For example, although the Financial Conduct Authority (FCA) states that 90% of crypto firms seeking FCA approval for anti-money laundering controls have either withdrawn their applications or been refused because they could not meet the required standards, this does not mean money laundering is being prevented, it simply means firms are unapproved.

At the same time, it is easy to sympathise with FCA Chair Charles Randell who recently said he was opposed to including crypto firms under the Financial Services Compensation Scheme (FSCS) as this would mean the fees paid by regulated financial services firms from banks to financial advisers would be available to compensate the victims of failing crypto firms.

Against this backdrop, the need for innovation and the need for regulation, the opportunities for the UK as well as the risks, it is essential that policymakers take an independent, evidence-based approach to this issue.

Cryptocurrency benefits

Job creation is often claimed as a benefit of increased investment in crypto, and has been frequently referenced by the UK Government as it attempts to turn the UK into a crypto hub. However, the loss of thousands of jobs in the cryptocurrency market over the last six months undermines this justification.

Another much-heralded opportunity is the possibility for investors to make outsized investment returns. Some consumers have been lucky enough to do so, but many have also realised substantial losses as a result of the inherently risky nature of crypto assets and the fact that despite being designed as a currency for payment, many consumers simply view private cryptocurrencies as an investment opportunity.

Historically low-interest rates have made crypto investments particularly attractive to those unable to obtain reasonable returns in recent years. Although this is now changing as interest rates repeatedly rise both in the UK and abroad, crypto investment may continue to be attractive as a means of keeping pace with record inflation.

The opportunity for short settlement times is clear but this is now increasingly the case with standard banking payment systems. Where crypto does have a tangible advantage is cost, given its comparatively low fees when used as payment.

Myriad crypto risks

In 2019, a report from the G7 on stablecoins found that they pose a serious threat to a range of public policy areas, including “challenges to fair competition, financial stability, monetary policy and, in the extreme, the international monetary system”.

The FCA and Bank of England have long warned that cryptocurrencies are such a high-risk investment. Therefore, if consumers invest in these types of products, they should be prepared to lose all their money. These words have not deterred UK consumers, over 2 million of whom now own digital currencies. A vast number lost significant sums when the cryptocurrency market lost more than 50% of its value in 2022.

Will cryptocurrencies ever replace traditional payment methods?

Private crypto-assets are unlikely to be used as digital currencies on a large scale in the short to medium term.

It is clear that the majority of the 2 million-plus consumers who hold cryptocurrencies in the UK are doing so as an investment opportunity rather than holding currency for utilisation as a payment method. 

The likes of Amazon and Microsoft have decided to accept cryptocurrency payment, as have EY and PwC in relation to accountancy services. But discussions with AAT Licensed Accountants – who provide tax and accountancy services to over 600,000 small businesses – reveal their belief that there is very little appetite for small businesses, especially small accountancy firms, to do the same.

This is primarily due to the high degree of risk involved given the wild fluctuations in price (although it could be argued this is little different to other currency exchanges).

The key question in determining whether or not cryptocurrency will become a widespread payment method, let alone replace traditional payment methods, is what additional or different benefits it can offer its users. That question is very difficult to answer because it is far from clear if there are any significant advantages.

Speaking to AAT Licensed Accountants, they report a small degree of client usage, and this is being driven by the end user, for example, digital-only businesses who felt it provided them with greater access to a specific consumer group but otherwise demand as a payment method was very, very limited.

Whilst private cryptocurrencies like Bitcoin and Ethereum may never replace traditional currencies, a Central Bank Digital Currency (CBDC) represent a very different proposition. Increased trust, reduced risk, greater stability and government backing make a CBDC a much more attractive proposition.

Advantages of Central Bank Digital Currencies

Replacing cash with a CBDC could reduce money laundering, tax evasion, and other illegal transactions, including the use of forged notes. In the first half of 2021 there were 58,000 notes taken out of circulation by the Bank of England (and many more that were not). In contrast, the largely cashless South Korean economy reported just 272 such notes. 

There would also be benefits for cross-border payments. In 2018, a joint study by the Bank of Canada, the Monetary Authority of Singapore and the Bank of England, concluded that a CBDC would lead to improvements in counterparty credit as well as a reduction in payment and settlement risks.

Improving the efficiency of processes to make payments is another factor, likely to be especially notable with regard to wholesale or large-value payment systems.

The eventual replacement of notes and coins would also save millions of pounds in production and transportation costs.

Notwithstanding the 2022 losses endured by many cryptocurrencies, as Bitcoin and other private cryptocurrencies continue to increase in usage, central banks are effectively losing market share, a CBDC could help reverse this

The risks of a CBDC

CBDCs are very different to private cryptocurrencies but the seriousness with which CBDCs are being treated inadvertently gives credibility to private cryptocurrencies.

Data protection and privacy risks are significant and whilst they may not feature prominently in countries like China, in the UK these could prove considerable.

Earlier this year, the World Bank asked what are the potential risks/challenges associated with introducing a CBDC. It concluded:

“The introduction of CBDC could disrupt the existing financial-intermediation structure. In addition, depending on design and country context, CBDC could pose risks to financial stability, financial integrity, data protection and privacy, and cyber resilience. Further, it can have implications for the legal and regulatory framework, increased responsibilities of the central bank, and could also lead potentially to currency substitution, especially in the context of cross-border CBDC.”

These are significant risks that provide food for thought for consumers, businesses and of course policymakers.

AAT will continue to make the case for tighter regulation where necessary and increased innovation where tangible consumer/business benefits are likely to follow. It’s a tricky balancing act but one that the UK could benefit from if properly managed.

Phil Hall is AAT's Head of Public Affairs and Public Policy.