Institutions must avoid Thucydides’ trap
Anton Chashchin is managing partner at the digital assets platform Bitfrost.io.
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The days when cryptocurrencies were reserved for the underground are quickly becoming history. But the power dynamics in finance are all too familiar.
As cryptocurrencies enter the mainstream – with global adoption up 881% in June 2021 compared to the previous year – opinion in the institutional world remains divided. While some financial managers – like Micro strategy – is adding to its crypto holdings, general support for adoption among the rank and file continues to be overridden by skepticism. The recent crypto crash has only exacerbated this, with many institutions pulling out of the market and fostering cynicism.
Older institutions in particular feel compelled to defend the foundations of traditional finance against the more radical features of the crypto movement: decentralization, anonymity and, in their eyes, instability.
Faced with a challenge to the status quo, institutions now find themselves on a historically precedent-setting path: Thucydides’ trap.
The Thucydides Trap is a political theory that describes a scenario where a rising power challenges the dominance of an existing power. The dominant power, when threatened, becomes paranoid and likely to respond with war.
Although the original was about Sparta and Athens in ancient Greece, this applies to the relationship between the crypto industry and financial institutions.
This sentiment is encapsulated by the comments of the well-known opponent of cryptocurrencies and the embodiment of traditional finance, Warren Buffett, who said in an interview with CNBC: “Cryptocurrencies basically have no value, and they produce nothing. I have no cryptocurrency, and it comes I never to do.”
This paranoia has grown as institutions have realized that the world of cryptocurrencies can create not only competition for them, but even a significant threat. Cryptocurrency markets are constantly expanding, both in size and sophistication.
Some have accepted the rise of crypto as inevitable. 52% of financial institutions now own cryptocurrencies and many have recently launched crypto capabilities, including investment banking giants such as JPMorganwealth management-faithful likes Black stoneand infrastructure payments pioneers like Visaas well as established Fintechs which Revolut.
But for those financial institutions preparing for war, they need not fall into the trap. Institutions that can put their egos aside and open up to the possibilities that lie in crypto will be able to leverage the rise of digital assets to drive their own growth.
However, to encourage a fruitful relationship between institutions and the crypto industry, four key changes must occur.
1) Strengthen knowledge with third-party expertise
Cryptocurrencies are fundamentally new and evolving assets, which means that institutions can find it difficult to keep up with the latest features – especially newer players. Many people ask many of the same questions: what is Bitcoin? What is blockchain? Is it safe? How can they get involved?
In response to a general lack of crypto knowledge and skills among institutional investors, Wall Street has amassed an army of crypto experts, with thousands of new crypto jobs at top firms since 2018.
But the demand for knowledge is far greater than the supply.
There is a lot to learn and it is difficult to find the right talent to support pilot projects. Not all institutional investors have the time to train their staff to successfully branch out into the space.
Also, the current market downturn is forcing many crypto companies to lay off employees – with the largest US crypto exchange, Coin base, let go of 1,100 employees. Top bankers are optimistic that this round of cuts will expand the pool of crypto talent available, resulting in many returning to banking, a sector that remains desperate for tech talent.
Additionally, to supplement a staff-focused approach, institutions can request external support from a variety of third-party companies, which have emerged as institutional demand for expertise has increased.
Such companies can support firms in building crypto services and integrating crypto into their business. By choosing reliable partners and hiring experienced consultants, institutions can realize their crypto ambitions.
2) A robust, globally coherent regulatory framework
Prevailing suspicion among institutional leaders is motivated, at least in part, by a need to protect the customer at all costs. The recent market volatility has heightened suspicions that cryptocurrencies are a scam, or a bubble that could burst and harm their customers, businesses and the wider economy.
Considering that every move in crypto follows extensive risk assessment, business planning and board approval, these concerns are stalling adoption, and explain why some firms have yet to take their first steps.
In many ways, that’s a legitimate concern. Cryptocurrencies come with their fair share of compliance headaches, coupled with a general lack of governance.
International regulation ranges from supportive but incipient – as in the case of US Securities and Exchange Commission (SEC) and UK Financial Conduct Authority (FCA) – to actively condemning – as in the case of China, which has banned digital assets outright.
On top of this, the crypto ecosystem is rapidly evolving, making it difficult for regulators to keep up. For example, most markets have yet to implement policies for Bitcoin and Ethereum, let alone newer digital phenomena such as Non-Fungible Tokens (NFTs) and decentralized finance (DeFi).
As traditional financial companies have both a responsibility to their customers and strict standards to uphold related to investment and trading, they must remain compliant, making them nervous about volatile, undefined and uncontrolled assets such as cryptocurrencies.
While crypto may be perceived as a wild and unregulated asset – and perhaps even a dangerous one, given the recent crash in valuations – Russia’s recent invasion of Ukraine has shown otherwise, providing vital financial services to Ukrainians.
Yet despite the volatility and fears surrounding a “crypto winter”, a recent report showed that investor interest in the sector has not frozen – suggesting that the momentum for mainstream adoption of digital assets is set to continue.
As client engagement grows and the use of cryptoassets continues, major crypto exchanges and other players in the space are already working with lawmakers on sanctions and other monitoring tools.
This already indicates the beginning of the formation of a common set of rules that can no longer be denied.
Rather than responding to uncertainties by avoiding cryptocurrencies altogether, institutions should take the reins in advocating for stronger protections and more robust regulatory frameworks that will allow them to launch digital assets more confidently.
3) Address environmental concerns
Financial companies have a growing list of voluntary and mandatory environmental standards to uphold in an increasingly ESG-focused landscape. Many institutions cannot therefore invest in areas or cooperate with companies that are not environmentally friendly.
This is problematic from a crypto perspective in light of recent revelations surrounding Bitcoin mining, found to use the same amount of energy as a small country.
Research from the European asset manager Candrium in 2021 has meant that cryptocurrencies more broadly have a long way to go to satisfy ESG criteria.
But this is only the beginning of the story. Recognizing the need to reduce the carbon footprint of the technology, the market has already begun to explore ways to reduce energy consumption by making upgrades to the network or by other means, such as offsetting carbon usage as some cryptominers have done.
Progress has been made by some blockchains, such as Ethereum, migrating away from the notoriously energy-intensive proof-of-work (PoW) model. The transition to the proof-of-stake (PoS) mechanism is set to make Ethereum’s carbon footprint over 17,000 more efficient than Bitcoin.
While this should be championed, more needs to be done across the industry to offset crypto’s environmental impact.
Tipping the balance on the ESG scale and allowing institutional involvement requires greater investment as well as a regulator-led approach in this area – and institutions can play an important role in driving this forward.
4) Greater awareness of crypto’s social benefits
While the environmental aspect currently dominates conversations around ESG, the social and governance aspects should not be forgotten as they are areas where cryptocurrencies are superior to fiat money.
The fundamentally open source, borderless nature of the blockchain technology on which crypto is built means it has the potential to create more inclusive, democratic financial systems.
Institutions looking for a non-environmental leg up in the ESG space would do well to keep this in mind.
Time for a choice
Institutions have a choice to make: give in to the hubris of hegemons throughout history and push back against crypto, or form an alliance with the rising power. Many large financial firms have slowly come around, but there is still a level of Thucydidean paranoia.
As the market expands, and the solutions and surrounding regulatory ecosystems along with it, institutional trust can and will increase.
By partnering with an established partner in the space, institutions can make the most of crypto’s new dawn and ensure they come down on the right side of history.
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