Of bitcoins and money lenders

Danduvam Mudalali saga is a case study no business student must miss. If it happened in the Western world, it would definitely be the subject of a Netflix mystery documentary movie. Piyadasa Ratnayaka was from a village in the South. His first job, they say, was repairing damaged fishing nets in his hometown. The knots in the nets were called ‘Danduvam’ – which later became his brand. That identity followed him even after he switched vocations to become a money lender. He was rich and a businessman, so naturally a ‘Mudalali’.

Nothing about informal money lending is illegal, even if the interest rates were high. At micro level, it happens in many rural communities. However, our protagonist took it further. He commenced accepting deposits too. Now, that is illegal, unless you are licensed by the financial regulator to do so. Most of his depositors would have overlooked the fact, or probably didn’t consider it at all.

The returns were attractive. They say he offered interests of 8% per month. The business model was so popular it got replicated. There was another guy offering a 6% a monthly interest rate. He was called ’Lihil Danduvam’. Another offered 9% per month – ‘Dadi Danduvam’. The grandmaster, who offer 10% a month, had the most apt name – ‘Marana Danduvam’. These could be exaggerations. Anyone who has been in the financial system knows these figures are absurd and impractical in the long term. Nevertheless, Danduvam Mudalali thrived and the fact: These deposit takers offered rates far above the market set by the formal financial sector.

On April 9, 2021 Central Bank of Sri Lanka published a public interest notice strictly warning against investment in VCs and their use

How did they pull it off? Their lending rates too may have been high. They might have lent to cash-hungry industries like construction. One thing was clear: their operation happened outside the regulated financial system. They didn’t redeposit their money in banks. As far as the financial system was concerned Danduvam Mudalalis didn’t exist.

The failure of an illegal deposit taker would never have resulted in the feared domino effect by bankers. Despite the risk in the business they were doing a good job too. Danduvam Mudalali, they say, was in business for 20 long years, before his forced exit. It was a viable model. There were no complaints against him. No cases. Like every good business person, he kept to his word . Our protagonist’s downfall was not the result of his own mistake. Sakvithi Ranasinghe, someone who ran a similar model failed. The Central Bank of Sri Lanka, closing the stable door, decided to name and shame ten others engaged in the same illegal business (unauthorized of course, but with no issues). Danduvam Mudalali had no financial depth to resist the run on his deposits. He paid the first ones in cash and others received his household furniture. Angry depositors took even the doors and windows of the house. However, all that was still inadequate to repay all the depositors.

As legend has it he was abducted by an unknown gang later. A body was found in a secluded estate in Ratnapura. It was never identified but presumed to be his. Now to Virtual Currencies (VCs) – a type of unregulated digital currency that is not issued or controlled by a central bank. Examples include Bitcoin, Ethereum, Litecoin, and XRP. They can be obtained online through mining, Initial Coin Offerings (ICOs) or through Virtual Currency Exchanges. While VCs have their own value denominations (such as Bitcoins for Bitcoin and ethers for Ethereum), they are also valued in VC Exchanges in normal currencies issued by central banks. They are not generally backed by underlying assets but values are determined by speculation of the public on VC Exchanges. VCs are borderless. It could be possible that VC transactions already happen around us, without the knowledge of central banks.

On April 9, 2021 Central Bank of Sri Lanka published a public interest notice strictly warning against investment in VCs and their use. This notice, in black and white, said that no regulatory safeguards exist relating to the usage, investment or dealing in VCs in Sri Lanka. Therefore, it further warned investing or using VCs in Sri Lanka poses significant risks such as;

1. Users/investors will have no regulatory or specific legal recourse in the event of any user or transaction related issues or disputes.

2. High volatility of the value of the VCs, as it is dependent on speculation, exposing the investment of VCs to a risk of making large losses.

3. High Likelihood of VCs being associated in financing terrorist activities and used by criminals to launder criminal proceeds.

4. Violation of Foreign Exchange Regulations. As VCs are traded as assets in Exchanges, purchasing VCs from abroad would lead to a violation of Foreign Exchange Regulations, because VCs are not identified as a permitted investment category in terms of the Foreign Exchange Act No. 12 of 2017 (FEA). Electronic Fund Transfer Cards (EFTCs) such as debit cards and credit cards are also not permitted to be used for payments in foreign currency related to virtual currency transactions, in terms of the Foreign Exchange Regulations in Sri Lanka.

Interestingly this comes just two weeks after Elon Musk, having acquired $ 1.5 billion worth of them, announcing one could purchase a Tesla with bitcoin. He also assured that Tesla will not convert the bitcoin it receives into fiat currency. A fact worth noting is this comes from someone who is serious about reducing space transportation costs to enable the colonization of Mars, but he is also the one of the richest persons in the world. Musk moves markets. He did it for sure this time.

Bitcoin is in a steep rise now starting having moved from around $100 in 2013 to $19,000 by December 2017. Then its value fell followed by another rally. By mid April 2021 its value had surpassed $60,000. Part of that was Musk’s own doing, but that is not the point. VC business model has many similarities with Danduvam Mudalali’s, though in scale they differ. Both operate in unregulated markets. There is no ‘government backup’ for VCs, as in the case of fiat money (One can argue that even fiat money now is not backed by a sovereign, but at least we have a perception that it will work). If somehow the model fails nobody will step up to make good your investment. Thus, while returns are high, they attract a fair risk.

In both cases, the Central Bank of Sri Lanka is wise to warn the public – irrespective of consequences. Educating the public against the use of high risk investments is important – particularly when the Central Bank is blamed for failures. There is another dimension. Virtual Currencies lead to the spread of black money. Today unrecorded transactions or cash transactions of significant value are rare. Utility of currency notes are limited. There is no evidence that virtual currency is used for moving black money in Sri Lanka, but it should not come as a surprise to find such transactions either. Of course, the Central Bank can eliminate an institution like Danduvam Mudalali’s, from the system. He was a small fish. Can VCs be banned? Some have done so. Kyrgyzstan, Iran, Nepal and Thailand are examples. In Bangladesh, financial investigators have commenced working together with the Computer Crime Unit of the country’s police investigating those who are involved in buying or selling bitcoin or other cryptocurrencies. India, just like Sri Lanka, has followed a ‘wait and see’ approach by only offering a warning.

However, bans nor warnings have limited effect as VCs are borderless. Particularly, as long as they continue to be accepted within other economies they will be used here too. The other alternative: If you cannot fight, why not join them? China has issued its own Digital currency – Digital Yuan – a first for any major nation. They are controlled by its Central Bank. China also plans to use new tools to monitor the usage. By design, the Digital Yuan will negate one of Bitcoin’s major draws: anonymity for the user, while maintaining all other advantages. This is beating the VCs in their own game.

So, the Central Bank’s recent warning, in these circumstances, will be a beginning than an end. We are yet to see how exactly Virtual Currencies will co-exist with their elder siblings, fiat money – physical or digital.        

However, bans nor warnings have limited effect as VCs are borderless