Can central banks be even more cryptic?

Whether it was Elon Musk waking up to the environmental disaster of cryptocurrency mining or the Chinese government crackdown or that old fashioned sign of doom feared by chartists - a “head and shoulders” price formation - the latest spike in crypto speculation has reversed.

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Given the nature of the speculation and the inherent opacity of the market, including the likely significant involvement of the black economy, it is foolhardy to make predictions on where to from here.

"If crypto becomes more palatable to central banks it will be because it is more regulated… and hence less palatable to those… who see it as a way to go off the grid.”

But the increasing likelihood of central banks introducing their own digital currencies with crypto characteristics (CBDCs) is just one more cloud on the horizon for crypto revolutionaries looking to over-throw the system.

Some fundamental issues remain with cryptos: they still don’t meet the definitions of viable currencies. They are not a store of value, they are not widely used – yet – in the global payments system, transactions using them are not “cleared and settled” in a manner which ensures trust in the final exchange of value.

It is true crypto has become vastly more mainstream since the days three years ago when the Bank for International Settlements (BIS) - the “central bank for central banks” - opined crypto was “a combination of a bubble, a Ponzi scheme and an environmental disaster”. Although the latest financial stability review from the European Central Bank (ECB) maintains crypto still looks like a classic bubble of the South Seas and tulip kind.

Off the grid

Yet there is a paradox here: if crypto becomes more palatable to central banks it will be because it is more regulated, more transparent, more taxed, more integrated into the traditional economic system. And hence less palatable to those true believers and conspiracy theorists who see it as a way to go off the grid.

(Ironically, last week’s crypto collapse proved some of these issues: exchanges struggled to complete transactions and traditional markets crypto is supposed to be distinct from, such as bonds and “official” fiat currencies, rose.)

The evolution of Bitcoin, Ethereum, Binance Coin, Dogecoin – which actually started as a joke – Cardano, Tether will be fascinating, volatile and potentially a dead end but as with many evolutionary false starts, cryptos will have changed the pattern of currency exchange.

Money isn’t just money. It may no longer be cowrie shells or gold doubloons but nor is it just the paper or polymer or nickel stuff still carried around in wallets and purses. That “official” stuff actually only makes up less than 10 per cent or even less of money in circulation.

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Conventional economy

Public money is the physical stuff but the bulk of the money we use is actually private and digital – created by banks as deposits. When we borrow money, the loan is actually money the lender has issued by creating a deposit in your account which you can then go off and spend.

Just as various proxies for physical currency have long been used – promissory notes, letters of credit, bank cheques etc – so too now do we have vastly more digital alternatives that are still linked to the conventional economy. They have made the system faster, more efficient, more secure.

Cryptos promise further advances: even faster, with potentially even better security due to the “blockchain” or distributed ledger system they are built upon which means the risk of a transaction being fake is diversified across thousands and thousands of computers.

There are clear advances in the crypto ecosystem. Which is another reason why central banks are looking at them so closely. What if the official system simply adopted those elements of the crypto world which have enduring value and don’t simply facilitate speculation and the black economy?

There are now dozens of central bank digital currency projects underway globally with China being the highest profile. In Australia, the Reserve Bank announced in November a limited project with private sector partners for wholesale banking.

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In a fascinating recent address, “Do we need "public money?”, Sir Jon Cunliffe, Deputy Governor for Financial Stability of the Bank of England, addressed not just whether central banks should have their own digital currency but whether “public money” was needed at all.

“Even without the new, technology enabled forms of money that are on the near horizon we are seeing accelerating changes in the way we live and transact that will greatly reduce and perhaps eventually eliminate the role that public money plays in the economy today.”

In Australia, RBA Assistant Governor (Financial System) Michele Bullock says “with this project we are aiming to explore the implications of a CBDC for efficiency, risk management and innovation in wholesale financial market transactions”.

According to Fitch Ratings, “the key benefits of retail CBDCs lie in their potential to enhance authority-backed cashless payments with innovations in step with the wider digitalisation of society”.

In a report entitled "Central Bank Digital Currencies: Opportunities, Risk and Disruption", Fitch noted CBDCs “may open up new policy options, such as transfers into CBDC accounts as part of disaster relief or stimulus efforts. The programmability of CBDCs offers further avenues for flexibility – including the potential to influence social behaviour. However, attaching such features to CBDCs may make them less attractive to users, relative to cash”.

Moreover, “widespread adoption of CBDCs may be disruptive for financial systems if associated risks are not managed. These include the potential for funds to move quickly into CBDC accounts from bank deposits, causing financial disintermediation, and for heightened cybersecurity threats as more touchpoints are created between the central bank and the economy”.

Those findings reinforce a key challenge for CBDCs is they won’t offer the anonymity and near invisibility of cryptos.

Two probable outcomes

There’s a long history of financial innovations growing unfettered until they reached a certain threshold – when they were fettered. In the relatively recent past the growth of another virtual currency – card-based credit – was reigned in when regulators decided the card schemes were charging too much for processing interchange fees.

There are two probable outcomes for crypto currencies: they will be incorporated as viable payment and value store entities into the financial mainstream via regulation; or they will be absorbed, piecemeal, into the financial system as other institutions – including central banks – utilise the underlying technology and platforms.

As Katie Martin wrote in the Financial Times, “If and when central banks and regulators do assume control, it will probably bite a chunk out of the value of cryptocurrencies and leave some holders with substantial losses. But anyone left out of pocket will not be able to complain that they were not warned”.

However, this doesn’t mean conventional financial institutions have nothing to worry about. While they can exploit new platforms like blockchain, many won’t. So these new technologies, along with the cloud, machine learning and artificial intelligence could still enable new institutions to enter the market.

Technology intelligence sheet CB Insights provides just an introductory list of services which could be disintermediated including payments, clearance and settlement systems, capital raising, securities and their exchanges, bank lending, trade finance and security management.

So while cryptocurrencies as they exist today will struggle to go beyond the speculative fringe, many of the foundational elements of those currencies may well truly re-shape financial services.

Andrew Cornell is managing editor of bluenotes

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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