Central bankers don’t like cryptocurrencies. They are after all an intrusion on their own turf, offering an alternative money. So it is hardly surprising that the Bank for International Settlements, the central banks’ bank, takes a dim view of the innovation. New research in its annual report offers a particularly cogent attack on the viability of cryptocurrencies—digital forms of money based on encryption techniques.
The BIS goes back to basics, arguing that money is fundamentally about trust. That trust underpins how money fulfils its three central functions, as a store of value, unit of account and medium of exchange. It enables the use of what are essentially tokens in the form of banknotes and coin and facilitates payments from one account to another.
With conventional money that trust comes from the imprimatur of governments. Independent central banks commit to price stability, thus avoiding the erosion of money through inflation over time. And they play a vital role in payments systems (which they oversee) since the transactions between individuals and firms through their banks are settled ultimately in central bank money.
By contrast, cryptocurrencies are a decentralised way of creating trust. Instead of centralised validation cryptocurrencies share authority within their network. Instead of the centrally-held ledgers of banks and central banks there is one distributed (across users) ledger that records all transactions in an ever lengthening set of digital blocks called a blockchain. Bookkeepers called “miners” update the distributed ledger by adding another digital block, involving expensive computational effort for which they are paid a fee, and that is then verified by the network of users and miners.
The rollercoaster ride of bitcoin, currently trading at around a third of the heady price of close to $20,000 for each bitcoin reached at the end of last year, has made a mockery of cryptocurrencies as a store of value. Its extreme volatility also compromises any meaningful role as a unit of account. The BIS report highlights the weakness of cryptocurrencies as a medium of exchange.
The underlying problem is that the new model of decentralised trust is laborious and expensive. The updating of the ledger by miners requires so much computation that cryptocurrencies are potentially ruinous for the environment. As the BIS points out the electricity devoured by bitcoin mining alone is already comparable to that used in a mid-sized economy such as Switzerland.
Quite apart from the environmental damage that would be wreaked if cryptocurrencies were to expand, the underlying processes would run into the buffers. With conventional money vast numbers of payments can be made at very low cost either through cash, accessible on demand by users, or increasingly through digital transfers. For example Visa alone handled 3,500 transactions a second in 2017. That dwarfed the rate on Bitcoin or Ether, in each case of three transactions a second.
“The electricity devoured by bitcoin mining alone is already comparable to that used in a mid-sized economy such as Switzerland”Scaling up these low rates to rival current retail digital payments systems would test even today’s gargantuan reserves of computer storage. The BIS says that if a cryptocurrency were handling such a volume in say the American or eurozone economy the size of the ledger would swell beyond the storage capacity of a typical personal computer within a matter of weeks. Processing capacity would be an even bigger bottleneck: “only supercomputers could keep up with verification of the incoming orders.” As millions of users exchanged massive files, the sheer volume of communication “could bring the internet to a halt.”
The overall judgment of the BIS is that “the decentralised technology of cryptocurrencies, however sophisticated, is a poor substitute for the solid institutional backing of money.” In effect, they are little practical use as a medium of exchange whereas conventional money backed by central banks works.
And yet despite such warnings—and setbacks such as thefts at markets where they are traded, most recently at Coinrail in South Korea—cryptocurrencies are proliferating. According to CoinMarketCap there are now over 1,600. The lure is the fortunes made in investing in the likes of bitcoin with little heed paid to the fortunes lost in these extraordinarily volatile markets.
There may be a more profound reason for the resilience of cryptocurrencies. Nobel-laureate economist Robert Shiller calls them “a statement of faith in a new community of entrepreneurial cosmopolitans who hold themselves above national governments.” Not the least of their allure he argues is their link to advanced science. Since the inner workings of cryptocurrencies are unfathomable to all but the few, “that mystery creates an aura of exclusivity, gives the new money glamour, and fills devotees with revolutionary zeal.”
If Shiller is right then it will take more than strictures from central bankers to undermine cryptocurrencies. A regulatory crackdown will probably be essential. But for that to work it must be concerted globally—and that is hard to achieve. Despite their inadequacies, cryptocurrencies may continue to worry and annoy central bankers for years to come.
