By Anne Sherry, J.D.
The fifth chapter of the Bank for International Settlements’ Annual Economic Report takes on cryptocurrencies, putting them in historical perspective and concluding that challenges such as energy requirements and valuation fluctuations make them an unlikely substitute for fiat currency. However, distributed ledger technology itself could be applied elsewhere, such as simplifying administration in the settlement of financial transactions, although this potential still needs to be tested.
Shortcomings of cryptocurrencies. First, the chapter takes a lesson from previous episodes of monetary instability which show that “the institutional arrangements through which money is supplied matter a great deal.” Key to this is trust in the stability of money’s value and its ability to scale along with the economy. Central banks stabilize the value of their sovereign currency by adjusting the supply in line with demand. Cryptocurrency requires that supply be predetermined by a protocol, which prevents it from being supplied elastically in response to demand. A fluctuation in demand means the value of the currency changes, leading to high volatility.
Furthermore, blockchain-based cryptocurrencies do not scale to meet economic conditions. A currency’s blockchain would quickly exceed the storage capacities of a typical computer and even a server if the currency were used for all digital retail transactions currently handled by selected payment systems. Only supercomputers would be able to verify transactions involving such enormous files. Bitcoin-like cryptocurrencies limit the rate at which transactions are processed, so during periods of high activity, transactions may not be verified for several hours. “Thus, the more people use a cryptocurrency, the more cumbersome payments become,” the report states. “This negates an essential property of present-day money: the more people use it, the stronger the incentive to use it.”
Finally, there is an issue of trust with cryptocurrencies, both in individual payments and in the currency itself. Dueling ledgers can lead to payment reversals when one is chosen over the other; cryptocurrency miners holding substantial computing power can manipulate payments by confirming their own version of the ledger. And forks in the currency’s ledger and protocol demonstrate the fragility in the consensus underlying the cryptocurrency.
Other applications of distributed ledger technology. The report suggests that DLT can have applications in fields other than cryptocurrency, for example in low-volume cross-border payment services. Compared with mainstream solutions, DLT can be efficient in niche settings where the benefits exceed the high cost of maintaining multiple copies of the ledger.
The Building Blocks system used by the World Food Programme to handle payment for food aid serving Syrian refugees in Jordan is based on blockchain. The system is centrally controlled and uses sovereign currency as the unit of account and means of payment. DLT also holds promise in trade finance, which currently involves multiple document exchanges between the exporter, the importer, their banks, and agents checking goods ate each checkpoint, as well as customs agencies and credit agencies or insurers. DLT-based smart contracts can simplify the execution of the contracts by, for example, automatically releasing payment to the exporter when a valid bill of lading is added to the ledger. The documentation of which shipments have already been financed could reduce the risk of exporters obtaining credit from multiple banks for the same shipment.
Regulatory approaches. The use of DLT raises policy implications and regulatory challenges, according to BIS. A key challenge is combatting illicit usage of funds through anti-money-laundering and counter-terrorism policies. Another challenge is protecting consumers and investors by preventing digital theft and fraud. In the longer term, it is unclear whether widespread use of self-executing financial products will give rise to systemic risk.
The report lists three considerations for regulators wishing to address these concerns. First, regulators should redraw boundaries to account for the fact that regulatory responsibilities are becoming blurred. “Since cryptocurrencies are global in nature, only globally coordinated regulation has a chance to be effective.” Second, regulators should address the interoperability of cryptocurrencies with regulated financial entities. Finally, regulation can target specific services. For example, to counter money laundering and terrorism financing, regulators could focus on the point at which a cryptocurrency is exchanged into a sovereign currency.
Central bank digital currencies. Finally, BIS addresses the question of whether central banks should issue digital currencies (CBDCs). Once issued, a CBDC would circulate between banks, non-financial firms, and consumers without further involvement by the central bank. A general purpose CBDC could affect payments, financial stability, and monetary policy. The BIS report cites a joint report by the Committee on Payments and Market Infrastructures and the Markets Committee, which concludes that such an instrument would carry substantial vulnerabilities and unclear benefits.
Banks are exploring the idea of issuing narrowly targeted CBDCs limited to wholesale transactions among financial institutions. Experiments run by central banks, including the Bank of Canada, ECB, Bank of Japan, and Monetary Authority of Singapore have succeeded in replicating existing high-value payment systems, but the results have not been clearly superior.