Swiss-based BIS says cryptocurrencies have design flaws and cannot replace current payment system load. The Bank for International Settlements told the cryptocurrency world it’s not ready for prime time.
Most modern-day transactions occur through means ultimately supported by central banks, over time a wide range of public and private payment means has emerged. These can be best summarised by a taxonomy characterized as the “money flower”.
The money flower distinguishes four key properties of moneys: the issuer, the form, the degree of accessibility and the payment transfer mechanism.
The issuer can be a central bank, a bank or nobody, as was the case when money took the form of a commodity. Its form can be physical, eg a metal coin or paper banknote, or digital. It can be widely accessible, like commercial bank deposits, or narrowly so, like central bank reserves. A last property regards the transfer mechanism, which can be either peer-to-peer, or through a central intermediary, as for deposits.
Money is typically based on one of two basic technologies: so called “tokens” or accounts. Token-based money, for example banknotes or physical coins, can be exchanged in peer-to-peer settings, but such exchange relies critically on the payee’s ability to verify the validity of the payment object – with cash, the worry is counterfeiting. By contrast, systems based on account money depend fundamentally on the ability to verify the identity of the account holder.
Are Cryptocurrencies a new petal in the money flower?
Cryptocurrencies aspire to be a new form of currency and promise to maintain trust in the stability of their value through the use of technology. They consist of three elements. First, a set of rules (the “protocol”), computer code specifying how participants can transact. Second, a ledger storing the history of transactions. And third, a decentralized network of participants that update, store and read the ledger of transactions following the rules of the protocol. With these elements, advocates claim, a cryptocurrency is not subject to the potentially misguided incentives of banks and sovereigns.
In terms of the money flower taxonomy, cryptocurrencies combine three key features.
1. they are digital, aspiring to be a convenient means of payment and relying on cryptography to prevent counterfeiting and fraudulent transactions.
2. although created privately, they are no one’s liability, ie they cannot be redeemed, and their value derives only from the expectation that they will continue to be accepted by others. This makes them akin to a commodity money (although without any intrinsic value in use).
3. they allow for digital peer-to-peer exchange.
Compared with other private digital moneys such as bank deposits, the distinguishing feature of cryptocurrencies is digital peer-to-peer exchange. Digital bank accounts have been around for decades. And privately issued “virtual currencies” – eg as used in massive multiplayer online games like World of Warcraft – predate cryptocurrencies by a decade. In contrast to these, cryptocurrency transfers can in principle take place in a decentralized setting without the need for a central counterparty to execute the exchange.
Distributed ledger technology in cryptocurrencies
The technological challenge in digital peer-to-peer exchange is the so-called “double-spending problem”. Any digital form of money is easily replicable and can thus be fraudulently spent more than once. Digital information can be reproduced more easily than physical banknotes. For digital money, solving the double-spending problem requires, at a minimum, that someone keep a record of all transactions. Prior to cryptocurrencies, the only solution was to have a centralized agent do this and verify all transactions.
The main complicating factor is that permissionless cryptocurrencies do not fit easily into existing frameworks. In particular, they lack a legal entity or person that can be brought into the regulatory perimeter. Cryptocurrencies live in their own digital, nationless realm and can largely function in isolation from existing institutional environments or other infrastructure. Their legal domicile – to the extent they have one – might be offshore, or impossible to establish clearly. As a result, they can be regulated only indirectly.
While the distinction between a general purpose CBDC and existing digital central bank liabilities – reserve balances of commercial banks – may appear technical, it is actually fundamental in terms of its repercussions for the financial system. A general purpose CBDC – issued to consumers and firms – could profoundly affect three core central banking areas: payments, financial stability and monetary policy. A recent joint report by the Committee on Payments and Market Infrastructures and the Markets Committee highlights the underlying considerations. It concludes that the strengths and weaknesses of a general purpose CDBC would depend on specific design features. The report further notes that, while no leading contenders have yet emerged, such an instrument would come with substantial financial vulnerabilities, while the benefits are less clear.
At the moment, central banks are closely monitoring the technologies while taking a cautious approach to implementation. Some are evaluating the pros and cons of issuing narrowly targeted CBDCs, restricted to wholesale transactions among financial institutions. These would not challenge the current two-tier system, but would instead be intended to enhance the operational efficiency of existing arrangements. So far, however, experiments with such wholesale CBDCs have not produced a strong case for immediate issuance