6.1 – Are Bitcoin and other digital currencies the future of money?

The rising price of Bitcoin during the pandemic has renewed interest in private digital money. While it is unlikely that Bitcoin will replace existing currencies, the emergence of ‘cryptocurrencies’ and ‘stablecoins’ has prompted exploration of central bank digital currencies.

Bitcoin is a decentralised virtual currency or ‘cryptocurrency’: in the words of its anonymous founder, ‘a purely peer-to-peer version of electronic cash [that allows] online payments to be sent directly from one party to another without going through a financial institution.’ When you own Bitcoin, you own the ‘key’ (or password) to an ‘address’ (or account) that contains the virtual currency. Bitcoin can be sent from one address to another by generating a transaction, which is then recorded on an immutable public ‘block’. These blocks are then chained together, creating a ‘blockchain’ – apublicly available record of all historical Bitcoin transactions.

These ‘blocks’ are generated around once every ten minutes by a user of the network, who receives a reward in the form of newly issued Bitcoin. Which user generates this block, and therefore receives the reward, is determined by ‘proof of work’: using computing power to guess repeatedly a very large random number, with the new Bitcoin awarded to the user who guesses closest to this number. This process is known as ‘mining’ Bitcoin. The size of the reward tends towards zero over time, ensuring an absolute limit of 21 million on the quantity of Bitcoin in existence.

What are the advantages of Bitcoin over existing currencies?

According to its supporters, Bitcoin has two advantages over existing currencies. The first is that its supply is limited, making it impossible for a central authority to issue it in quantities that would devalue it. This means it is much less vulnerable to hyperinflation crises, such as those seen in Weimar Germany, Zimbabwe or Venezuela. But a limited supply can also be a weakness, as it makes it impossible to control deflation – a phenomenon that can also lead to very severe economic consequences (Bordo & Filardo, 2005).

The second claimed advantage of Bitcoin is that all transactions are permanent and immutable. When money is held in a bank account, that bank could theoretically expropriate the money from its user and claim that it never existed. With Bitcoin, this is impossible, because the database on which transactions are recorded cannot be edited by any central authority. Bitcoin is thus often described as ‘trustless’, because it does not require its holder to trust a financial institution not to expropriate it.

These advantages are very much theoretical. Hyperinflation is not currently a major problem in advanced economies, and while financial institutions have been known to engage in fraudulent practices, they are typically more subtle than simply to seize their customers’ funds and deny that they had ever existed.

In practical terms, the main advantage for users of Bitcoin is its anonymity, which allows it to be used to break the law with a lower risk of prosecution. One 2019 study found that 46% of all Bitcoin transactions involved illegal activity, accounting for around $76 billion per year (Foley et al, 2019). The most common forms of illegal activity using Bitcoin are the purchase of illegal drugs and money laundering. It is also frequently used to solicit anonymous payments during blackmail and extortion schemes.

Banks dealing with cryptocurrency platforms have historically struggled to comply with ‘know-your-customer’ regulation and several governments – most recently the French Minister of the Economy and Finance – have sought to crack down on the anonymity afforded by Bitcoin.

What are the disadvantages of Bitcoin compared with existing currencies?

In economic theory, money is said to have three primary functions: a medium of exchange; a store of value; and a unit of account. How well does Bitcoin fulfil these roles?

As discussed, Bitcoin is an excellent medium of exchange for transactions that require anonymity. But using it for other transactions is often prohibitively expensive. The average Bitcoin transaction fee during 2020 has ranged from 28 cents on 2 January to $13.41 on 31 October.

Furthermore, transferring Bitcoin without going through a third party, such as a crypto exchange, can be logistically challenging for those without a background in computer science. Most traders therefore use an exchange or a virtual wallet handled by a third party. But this means that the currency is no longer trustless, and Bitcoin holders have historically lost large sums of money to careless or fraudulent third parties. The most famous such episode was the theft of $460 million worth of Bitcoin held in the Mt. Gox Bitcoin exchange in 2013.

The usefulness of Bitcoin as a store of value is limited by its volatility. In the year to 9 December 2020, the US dollar value of Bitcoin – and therefore the quantity of goods that can be bought with Bitcoin – changed by an average of 2.22% per day. The price of Bitcoin has risen considerably in that time and advocates often argue that the cryptocurrency is a good store of value because its price will continue to rise over time.

The future price is inherently unpredictable, but even if optimists are correct that its price will rise, this is only an argument that Bitcoin is a good speculative investment – not that it is a useful form of money (Baur et al, 2018). Countries typically aim to have a stable currency rather than an appreciating but highly volatile currency, because the former is much more conducive to a healthy economy. This volatility also limits the effectiveness of Bitcoin as a unit of account: denoting the value of an asset in Bitcoin makes little sense when the real value of Bitcoin changes by an average of 2.22% per day.

See graphical representation of bitcoin prices at coindesk.com [New Tab].

These problems are significant, but may be surmountable in the long term. Perhaps a much more profound barrier to the widespread adoption of Bitcoin is the scalability of the blockchain. Each block is currently equipped to handle 1MB of data, meaning that it can only process between 3.3 and 7 transactions per second (Croman et al, 2016). During a period of intense speculative trading in 2017, the blockchain was overwhelmed by the quantity of requested transactions, causing the average Bitcoin transaction cost to rise to over $55.

This limit is several orders of magnitude too low for Bitcoin to function as a country’s main currency. For comparison, Visa alone handles around 1,736 transactions per second, and the company claims that its network can handle over 24,000 transactions per second. Despite several proposals to alleviate this scalability problem, it is not clear that a solution exists, or that any solution could gain the confidence of enough Bitcoin stakeholders to be implemented successfully.

These problems with Bitcoin resulted in several attempts to create new digital currencies that solve these volatility and scalability problems – some of which have come to be known as ‘stablecoins’.

What are stablecoins?

A stablecoin is a cryptocurrency that has its market value pegged to another asset or basket of assets. If traditional cryptocurrencies could be said to have a floating exchange rate, in that their price is allowed to fluctuate, stablecoins have a fixed exchange rate, in that their price is held constant by the guarantee of a central authority.

The most widely used stablecoin is Tether, which is purportedly pegged to the US dollar at a 1:1 ratio by the Tether Corporation. While the corporation’s original ‘white paper’ stated that Tethers would be fully backed by US dollars, this is no longer the case. But Tether still trades at very close to $1 on secondary markets.

Why do people use Tether rather than the US dollar? Buying or selling cryptocurrency with traditional money, especially in large quantities, can incur considerable compliance costs. By holding Tethers rather than US dollars, frequent crypto traders do not have to incur these costs as often. Major financial institutions have often been reluctant to deal with the Tether Corporation because of the potential for Tether to facilitate money laundering, and the corporation is currently under investigation by the state of New York.

Another well-known stablecoin is Facebook’s Libra, which has recently been rebranded as Diem. This is a proposal for a virtual currency, run by a conglomerate of firms led by Facebook, which would be pegged to a basket of major currencies. As of December 2020, this stablecoin has not yet been launched, and the response from regulators has been so hostile that it may never be launched. Steven Mnuchin, US Secretary of the Treasury, responded to the initial white paper with the comment ‘I hate everything about this [New Tab]’, and Libra was later criticized in a tweet by President Trump.

Partly in response to the perceived threat posed by private currencies, central banks around the world have begun to research ways in which these technologies could be used to create state-controlled digital currencies.

What are central bank digital currencies?

A central bank digital currency (or CBDC) is a form of electronic money issued by a central bank. Existing national currencies can be traded electronically, so what is the benefit of a CBDC? This varies from one proposal to the next: it might be to allow the public to access central bank lending or to facilitate a move to a smoother payments system. A more sinister possibility is that a CBDC could allow an authoritarian government to record all transactions on a blockchain for the purposes of law enforcement.

To date, only a small number of CBDC schemes have been attempted. Finland’s ‘Avant’ digital currency was rendered obsolete by improvements to the debit card system in the early 2000s. Uruguay has issued ‘e-Pesos [New Tab]’ in a successful trial of the concept of a CBDC, and is currently considering whether to continue the project on a larger scale. The largest project in development is the People’s Bank of China’s ‘digital cash/electronic payments’ project, which is intended partly to replace physical cash and has been piloted in several regions.

While a successful CBDC would lead to economic gains from a more efficient payments system, a botched implementation could pose risks to financial stability (Kumhof & Noone, 2018). For this reason, central banks globally are proceeding with caution. As of January 2019, only a small number of central banks in countries with atypical monetary circumstances had plans to implement a CBDC in the short to medium term (Barontini & Holden, 2019).

What else do we need to know?

A common mistake in media coverage of Bitcoin is to assume that a change in its price is indicative of a change in the long-term probability of its adoption. But Bitcoin market movements are rarely related to economic fundamentals, for two reasons:

• First, prices are highly sensitive to the issuance of additional unbacked Tethers (Griffin & Shams, 2020).
• Second, the ownership of Bitcoin is highly concentrated: by one estimate, 2% of accounts control 95% of Bitcoin. As a result, many significant price changes are simply the result of large trades by a single investor (Shen et al, 2020).

Attribution

Except where otherwise noted, this chapter is adapted from “Are Bitcoin and other digital currencies the future of money?” by William Quinn, licensed under CC BY-SA 4.0. / Adaptations include removal of coindesk graph.

Original Source References

Barontini, C. & Holden, H. (08 January 2019). Proceeding with caution:  a survey on central bank digital currency. BIS Working Papers, 101. https://www.bis.org/publ/bppdf/bispap101.pdf

Baur, D.G., Hong, K. & Lee A.D. (2018). Bitcoin: Medium of exchange or speculative assets? Journal of International Financial Markets, Institutions and Money, 54, 177-189. https://doi.org/10.1016/j.intfin.2017.12.004

Bordo, M., & Filardo, A. (2005). Deflation in a historical perspective (BIS Working Paper No. 186). Bank for International  Settlements. https://www.bis.org/publ/work186.pdf

Croman, K., Decker, C., Eyal, I., Gencer, A. E.,  Juels, A., Kosba, A., Miller, A., Saxena, P., Shi, E., Sirer, E.G., Song, D., & Wattenhofer, W. (2016). On scaling decentralized blockchains. In  Clark, J., Meiklejohn, S., Ryan., P. Y.A., Wallach, D., Brenner, M., Rohloff, k. (Eds.), Financial cryptography and data security: FC 2016 Lecture notes in computer science: Vol. 9604 (pp. 106- 125). Springer. https://doi.org/10.1007/978-3-662-53357-4_8

Foley, S., Karlsen, J. R., & Putniņš, T.J. (2019). Sex, drugs, and bitcoin: How much Illegal Activity Is Financed through Cryptocurrencies? The Review of Financial Studies, 32(5), 1798-1853. https://doi.org/10.1093/rfs/hhz015 

Griffin, J.M. (2020). Is bitcoin really untethered? The Journal of Finance, 75(4), 1913-1964. https://doi.org/10.1111/jofi.12903

Kumhof, M. & Noone, C. (2018).  Central bank digital currencies: design principles and balance sheet implications.  (Staff Working Papers No. 725). Bank of England. https://www.bankofengland.co.uk/-/media/boe/files/working-paper/2018/central-bank-digital-currencies-design-principles-and-balance-sheet-implications

Shen, D. , Urquhart, A., & Wang, P. (2020). Forecasting the voltatility of bitcoin: the importance of jumps and structural breaks. European Financial Management, 26(5), 1294-1323. https://doi.org/10.1111/eufm.12254