Cryptocurrencies are not the new monetary system we need

Money has already evolved from coins, to bank notes, entries on balance sheets and bits on computers. With it, the institutions that provide, operate, guarantee and regulate funds have evolved. How should you evolve in the digital age? The invention of cryptocurrencies forced all parties involved, and above all central banks – agents of the state in the management of the common good of money – to confront this question. If encryption isn’t the answer, what is?

The Bank for International Settlements – the club of central banks – has been prominent in efforts to address this question. The latest findings are part of its annual report, which analyzes the emerging ecosystem of cryptocurrencies, stablecoins, and exchanges.

This brave new system, she concludes, is inherently flawed. The cryptocurrency crash (and the previous bubble) shows that cryptocurrencies are speculators, not stores of value. This also makes them unusable as units of account. As BIS notes: “The proliferation of stablecoins, which attempt to peg their value to the US dollar or other traditional currencies, indicates the widespread need in the cryptocurrency sector to rely on the credibility provided by the unit of account issued by the central bank. In this sense, stablecoins are a manifestation of Manifestations of a cryptocurrency’s search for a nominal anchor.

However, their failures run deeper than that. There are now about 10,000 cryptocurrencies. There could also be a billion dollars. But this tendency to fragment, “with so many mismatched settlement layers jostling for a place in the spotlight,” argues the BIS, is rooted in the system’s economic rationale, not just its technological ability to reproduce infinitely.

In a good monetary system, the more users there are, the lower the transaction costs and thus the greater the utility. But the more people use cryptocurrency, the more congestion and the higher the transaction cost. This is because self-interested validators are responsible for recording transactions on the blockchain. The final motive should be monetary rewards high enough to maintain the decentralized consensus system. The way to reward validators is to limit the capacity of the blockchain and keep fees high: “So, instead of the familiar ‘the more the funnier’ cash narrative, crypto offers a ‘the more magician’ characteristic.”

One cannot have all three of security, decentralization and scalability. In practice, cryptocurrencies sacrifice one another. The cryptosystem overcomes this obstacle by “bridges” across block chains. But these are vulnerable to hacking. The conclusion of the BIS is: “Essentially, crypto and stablecoins lead to a fragmented and fragile monetary system. More importantly, these shortcomings stem from the economics of underlying incentives, not from technological limitations. No less important, these shortcomings will persist even if Regulation and oversight to address the problems of financial instability and the implicit risk of loss in cryptocurrencies.” A fragmented monetary system is not what we need.

Then what to do? Part of the answer is to insist that crypto meets the standards expected of any significant part of the financial system. Among other things, the exchanges must “know their customers”. Once again, the assets and liabilities of the so-called “stablecoins” should be transparent. The links between banks and cryptocurrency operators should be particularly transparent.

However, we can do better than that, argues the BIS. What we need from a good monetary system is security, stability, accountability, efficiency, inclusion, privacy, integrity, adaptability, and openness. Today’s system is deficient, especially with regard to cross-border payments. In its place, the BIS envisions a system in which central banks will continue to provide payment “finalists” on their balance sheets. But new branches can grow on the trunk of the central bank. Above all, central bank digital currencies (CBDCs) can allow for a revolutionary restructuring of monetary systems.

Thus, wholesale central bank digital currencies can offer new payment and settlement functions to a wide range of intermediaries compared to local commercial banks. One of the key elements, as the BIS suggests, is the possibility of implementing “smart contracts”. These changes will allow the creation of new, highly decentralized payment systems. Meanwhile, retail central bank digital currencies could complement the development of new express payment systems, which challenge the rents of existing businesses. BIS indicates the success of the new Brazilian Pix system. But the full benefits will only come from these currencies if centralized digital currencies revolutionize cross-border payments.

Retail cryptocurrency for banks would also allow payments to be largely separated from risk. Thus money held by firms and households for transaction purposes can become the responsibility of central banks. The payments are then managed by companies that focus on this function, which will make their profits from transactions rather than lending. We will no longer need the explicit and implicit state insurance of private banks. Instead of managing payments, the latter will focus on lending. Their liabilities could also become less liquid and take risks more clearly than they are now. This would really be revolutionary.

However, there are also more modest options. The point is that the crypto world does not provide a desirable alternative cash system. But technology can and should do that. Central banks must play a central role in facilitating a system that protects and serves people better than it does today.

It’s time to prune the crypto forest. But new branches should also grow on the money and payments tree.

martin.wolf@ft.com

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