Much heat, not much light - yet

Media coverage focuses on privately developed cryptocurrencies …

The debate over digital currency has proceeded by leaps and bounds in the last couple of years. Although Bitcoin (BTC) continues to grab the headlines, largely due to its position as the original disruptor, I have long maintained that it is unlikely to be the currency of the future. Indeed I pointed out in 2017 that although there may be a future for digital currencies, BTC may go down as the currency equivalent of the Betamax video system – the first mover which was supplanted by a cheaper, more flexible alternative. Nothing that has happened in the interim has caused me to change my view.

The price of BTC has fluctuated in line with comments by high profile proponents such as Elon Musk, further making it hard to take its claim seriously to be a currency that will one day supplant the fiat money issued by central banks. Earlier this year I noted that a reasonable guess for BTC “fair value” was somewhere below $10,000. Although it has subsequently fallen by 40% from its mid-April highs, it remains well above these levels at just below $40,000.

But the real action in the digital currency space has concerned Dogecoin (DOGE) – currently the sixth largest digital currency by market cap which has increased by a factor of almost 67 since the start of the year versus 33% for BTC, and whose price versus the USD has massively outstripped that of BTC (chart). Ironically, DOGE initially began life as a spoof with the purpose of breaking the stigma surrounding cryptocurrencies. It is designed to be unattractive to investors by keeping a permanently low value due to its mining algorithm which is unlike BTC in that it is not subject to a limit for the number of coins mined. It is also more energy efficient, both in the amount of computing power required to mine each unit and the power consumed in doing so. Although DOGE is accepted as a means of payment by a small number of merchants, it is hard to see it making significant ground as a challenger to BTC let alone conventional forms of money.

… But there are more cons than pros

At the current juncture digital currencies face great difficulty in breaking out of the niche position which they currently occupy largely because they are regarded as extremely volatile vehicles for speculative investment. BoE Governor Andrew Bailey told a parliamentary committee earlier this year, “I'm sceptical about crypto-assets, frankly, because they're dangerous and there's a huge enthusiasm out there.” He went on to say “they have no intrinsic value” and investors should “buy them only if you're prepared to lose all your money.”  

This has not stopped El Salvador from adopting BTC as legal tender, partly to facilitate foreign remittances which are equivalent to 20% of GDP. However, the IMF has pointed out that there are “macroeconomic, financial and legal issues that require very careful analysis.” There certainly are! As this article in Foreign Policy notes, “El Salvador runs on physical cash; 70 percent of the adult population don’t even have a bank account … Only 45 percent of Salvadorans have internet access, and around 10 percent in rural areas.”

… And it may be that central banks will be the saviour of digital currencies

Whilst cryptocurrency proponents continue to extol the virtue of a currency system outside the control of central banks, it is difficult to avoid the conclusion that their breakthrough into the mainstream will be facilitated by central banks themselves. China has already begun experimenting with a digital yuan, having expanded its pilot programme in the spring. Central banks in the UK, US and euro zone are running much more slowly, largely because financial systems are rather more sophisticated and as a result there are huge implications for settlement systems, the nature of the banking  system (issues such as funding costs and balance sheets) and the smooth operation of financial markets – and that is before we consider privacy concerns.  

The BIS recently published a paper which argued that any central bank digital currency (CBDC) should be “minimally invasive.” This is an important issue because a digital currency “represents a claim on an intermediary, [whereas cash] is a direct claim on the central bank” thus changing the fundamental nature of the claims process. As the BIS points out, the Wirecard fraud last year highlights the problems of relying on an intermediary.

Whilst a CBDC would avoid relying on an intermediary it would create other problems. For one thing the conditions required to ensure that a central bank can guarantee the security of a digital asset would be very onerous (quite the opposite of “minimally invasive”). Secondly, as I highlighted last year, the adoption of a CBDC could lead to increased systemic volatility if asset holders opt to seek the safety of central bank-backed assets at the expense of bank deposits at times of financial stress. Faced with these concerns, it is perhaps no surprise that central banks are being forced to proceed relatively slowly.

The race to be first

My view a year ago was that the case for a CBDC was weak from a consumer perspective. However, there are good reasons why central banks in the industrialised world do not want to get left behind in the race with China to develop one. For one thing there are concerns that a digital yuan could undermine the dollar’s role as the global reserve currency. A large proportion of international transactions use the dollar as an intermediate currency which requires access to the SWIFT system. In recent years, the US has increasingly politicised access to SWIFT and efforts to bypass it by using a digital currency such as the yuan would reduce US leverage over the global payments system, particularly since China is the biggest trading partner for a growing number of countries.

In addition, it is clear that there is a demand for digital currencies but they are subject to all sorts of security concerns which would be better managed in the public interest if central banks had a stake. There is also the not-inconsiderable threat that if digital currencies were to increase in popularity, they could threaten the control that central banks are able to exert via traditional monetary policy instruments. As it happens, this is not an argument that rates high on the list of central bank concerns but it cannot be totally discounted.

It is clear, however, that the race to develop a CBDC has gained momentum in recent months and it is not a topic to be dismissed lightly. I remain of the view that Bitcoin will not be the digital currency of the future and agree with the BIS that careful consideration has to be given to the design of a CBDC. But if digital currencies are a fad which is not about to disappear, I am increasingly of the view that society is better off if they are regulated by central banks rather than allowing even less accountable market forces to make our monetary choices for us.