Thematic Blogspot - Digital Currencies : Risks and Opportunities
Introduction
Virtual currencies (VCs), i.e., decentralized and electronic currencies, have an increasing role as a new way to transact between people. In January 2015, Coinbase – a Californian bitcoin wallet- received a US$75 million investment from the New York Stock Exchange, and several banks, "apparently the first time any traditional financial institutions have taken direct stakes in a bitcoin enterprise”, according to the WSJ. The New York Department of Financial Services created recently a BitLicense to regulate virtual currencies (see the International Business Times), and CoinBase became the first Bitcoin company to be licensed under this regulation. Bitcoin is the most valuable of the digital currencies in capitalization as reported by the Blockchain website, and could even be a solution to the Greek debt crisis according to Greek finance minister Y. Varoufakis and The Guardian.
So what are the roles of these VCs, why do they exist? What are the risks and opportunities they offer compared to fiat money or gold?
I. What is Bitcoin?
A. Definition and characteristics
Bitcoin is a form of digital currency, created and held electronically, created in 2009 by a software developer named Satoshi Nakamoto. It is the first example of a growing category of money known as crypto-currency. The idea was to produce a currency independent from any central authority, transferable electronically, instantly, with very low transaction fees. In practice, Bitcoin has several important features that set it apart from normal fiat currencies.
A decentralized network:
The architecture of a traditional financial network is built around a central authority such as a clearinghouse, with security and authority vested in that central actor. As described by BitcoinMagazine, Bitcoin, based on block-chain architecture, is decentralized: the core security functions are put in the hands of the end users of the system through strong cryptography—removing the threat of default by the central actor. Bitcoin works as an open ecosystem: open source, with open standards, and open networking. The difference with traditionally closed currency systems is important as it helps foster innovation.
Anonymity and transparency
Bitcoin is anonymous and transparent, as explained by CoinDesk. Users can connect to the network and have as many anonymous Bitcoin addresses as they want. However, every single transaction is recorded in a general ledger, called the “blockchain”, which is public and distributed amongst all the network users. It can be considered as the generic innovation behind Bitcoin--illustrated by Satoshi Nakamoto:
In the traditional privacy model, a trusted third party (typically a bank) knows the user identity and authorizes the transaction to the recipient. Neither the sender nor the recipient nor the public know the details of the transaction as it is written in the bank’s ledger. With Bitcoin, the transaction itself becomes public knowledge through the blockchain, with information on specific (anonymous) Bitcoin addresses. This feature is key according to Marc Andreessen (NYT), as a way to prevent frauds and protect personal information.
A limited supply generated by its users
Unlike traditional currencies that are issued by government authorities, Bitcoins are generated out of computers’ work—through a “mining” process. As described by The Economist, mining rewards “miners” with fresh Bitcoins for maintaining the network, i.e., for reviewing and running the open-source algorithm that defines Bitcoins, publicly available on Github. This makes Bitcoin trustable and provides it an edge compared to other crypto-currencies.
The Bitcoin algorithm defines a fixed supply of VCs (21 million) as explained by Pierre Rochard, and an issuance pace (50 Bitcoins per 10min initially, divided by two every 4 years). This graphic shows the Bitcoin’s asymptotic money supply targeting over time:
A non forgeable and non repudiable transaction system
Blockchain technology is based on extremely strong cryptography (see Khan Academy) protecting users’ addresses, preventing forgery. As a single transaction does not authorize future transactions, if the sender has no “access” to the address where he has sent bitcoins then there is no getting them back, unless the recipient returns them to the sender.
B. Bitcoin as money
While, in theory, digital currencies could serve as money for anybody with an internet-enabled computer or device, their current use is more limited. Widespread acceptance will be key for its “monetary” status, according to the Economic Policy Journal. So how does Bitcoin fulfil the three economic functions of money?
Is bitcoin money?
Mises defines money as the most liquid good, therefore the most universal medium of exchange. The other functions of money are considered secondary to the defining function as a medium of exchange but these other functions of money may emerge as money gains a higher liquidity, consequence of the acceptation as money according to Schlichter. White thinks that money as “a unit of account emerges together with and wedded to a medium of exchange”.
Konrad Graf says that bitcoin is used as a medium of exchange now, but will be used as a unit of value later. This graphic from Peter Surda shows the potential money’s status evolution over time and liquidity.
Rothbard insists on marketability: some goods are so easily marketable that they rise to the status of quasi moneys—making Bitcoin a perfect candidate.
Bitcoin and functions of money
Store of value—VCs appear to be poor short-term stores of value given the significant volatility in exchange rates with traditional currencies, with daily moves up to 40 percent.
The worth of bitcoin as a medium or long-term store of value will depend on demand over time according to the Bank of England.
Unit of account—The BoE writes that retailers that quote prices in bitcoins appear to usually update those prices at a high frequency so as to maintain a relatively stable price when expressed in traditional currencies such as US dollars, i.e., Bitcoins are not the actual unit of account.
Medium of exchange—with several thousand retailers worldwide willing to receive payment in bitcoins, and constant growth in the daily number of transactions, Bitcoins are increasingly used as a medium of exchange as shown in this graphic from Blockchain.info:
Bitcoin’s benefits:
Bitcoin’s main benefits are:
- Resilience and democracy—as explained by Andreas Antonopoulos, from being programmable money, open to improvements and innovations, with updates to be accepted by an 80% majority of miners.
- Low transaction costs—This is particularly relevant when we consider the relatively high cost carried out on remittance markets (BitcoinFees.com).
- Stable and predictable quantity of money—possibly preventing overheating in consumer or asset prices.
Another characteristic of Bitcoin is that fractional reserve banking is impossible if users decide to keep their Bitcoin on an address that they directly control. As explained by the Nakamoto Institute, the Bitcoin network enforces the strictest deposit regulations in the world by requiring full reserves for all accounts. This is the digital equivalent of the Chicago Plan or the Austrian 100% reserve gold standard. Under this regulatory regime, money is not destroyed when bank debts are repaid, so increased money hoarding does not cause liquidity traps, instead it increases real interest rates and lowers consumer prices. This is a self-stabilizing process: higher interest rates incentivize hoarders to invest, while deflation increases consumption due to the wealth-effect on hoarders. This This table from the Nakamoto Institute shows a relevant quick comparison between gold, fiat money and bitcoin.
One clear advantage, low transaction costs, could also be a weakness, illustrated in recent events (see FT Alphaville).
II. A Macroeconomic View
The emergence of VCs raises concerns about financial risks associated with this new monetary vehicle. While the schemes are currently small, bubble situations (described by J. Colombo from Forbes) or deflationary impacts (Y. Varoufakis) could be negative side effects.
A. Instability risks
Financial volatility
Central Banks are interested in VCs as these could be a substitute to fiat money for transactions due to low fees, as Y. Merch explained in a speech to the ECB. There are three scenarios that seem risky according to BoE.
- The first one is if a holder of digital currencies had increased their exposure by first borrowing money from someone else. A price crash in this scenario would have negative spillovers to the initial lender.
- The second would occur if a systemically important financial institution were to have a significant unhedged exposure to a digital currency.
- The third, and most likely to appear, would happen if a digital currency were to become entwined with financial instruments such as derivatives contracts, creating a mechanism whereby both the direct users of a digital currency and other financial market participants could hold leveraged positions against the currency. This could result in the total market exposure to digital currencies far exceeding the market value of digital currencies. However, the BoE views this as unlikely.
Monetary volatility
The greatest risk that could, for FT Alphaville’s economist J. Cotterill , be posed by digital currencies to monetary stability is an erosion of the ability of Central Banks to monitor and influence aggregate demand. Both the extent and the distribution of usage of digital currencies are of relevance in evaluating any risk to monetary stability. In the extreme case of ‘Bitcoinisation’ of the economy as S. Watson study in his book, central banks’ ability to influence price-setting and real activity would be severely impaired.
Threats and opportunities for banks: VCs as competitors?
UBS considers that two important threats that Bitcoin poses to banks are disintermediation and competition over transaction fees. For disintermediation, widespread bank insolvency and/or deposit taxes and levies could drive customers to use Bitcoin in lieu of traditional bank deposits. In the case of transaction fees, if Bitcoin transaction fees are consistently lower than existing fees, banks may see increased competition in this space. However, banks consider Bitcoin has a limited viability as a currency.
B. Regulation
A solution to potential risks could be greater regulation, as proposed by the European Bank Authority purposes. Bitcoin faces challenges that could be affected by regulation:
- Bitcoin's speculation-driven volatility prevents it from being a stable store of value or unit of account.
- Its semi-fixed supply exacerbates volatility and deflationary pressure.
- Bitcoin also exists in something of a regulatory vacuum, or in some jurisdictions it is restricted or outright banned (e.g. in China, Russia) – which can be damaging to trust and sentiment.
Regulation on supply
Regulating VCs supply could prevent volatility and deflation effect. T. Jensen explains that social welfare would be lower in a hypothetical economy based on a current digital currency compared with a second hypothetical economy based on a fiat money system—though, as noted by P.Surda, this virtual currency can be closer to the Austrian ideal of money than either gold or fiat currencies.
In most existing digital currency schemes, the future path and total quantity of supply is pre-determined—removing discretion from the determination of the money supply. This would pose a number of problems for the economy: from deflation to welfare-destroying volatility in prices and real activity resulting from the inability of the money supply to vary in response to demand shocks.
- Solution: to grow at a constant annual rate, as Milton Friedman advocated—avoiding both supply shortages and discretion.
- Solution: a more flexible supply rule—adjusted for demand shocks or developed around a decentralized voting system. Variant schemes could match broad money data or to target a fixed exchange rate, although this would abandon part of the scheme’ original ideology.
Fiscal regulation
VCs escapes to the fiscal net. Fiscal regulation would have three goals: protect users (see Banque de France), prevent money laundering and illegal activities, and control fiscal earnings (VAT on sales for instance). EU legislators consider making VC exchanges ‘obliged entities’ under the EU Anti Money Laundering Directive and thus subject to its anti-money laundering and counter terrorist financing requirements.
A global transparent regulatory approach
VCs would require a globally coordinated regulatory approach to achieve a successful regulatory regime as explained by the European Bank Authority. Without a global approach, national regulators will be required to issue regular warnings to potential users to make them aware of the risks of VC schemes that do not comply with the regulatory regime.
Conclusion
While VCs could increasingly be used in the future, including as quasi money, there may be a variety of incentive problems that could prevent their widespread adoption in the long run. However, crypto-currencies could act as an open laboratory allowing financial experimentations.
