Why Cryptocurrencies are considered threat to the Central Banks

Central banks are aware of the threat posed by cryptocurrencies and are considering a range of responses, from forbidding private issuance to welcoming them.
Why Cryptocurrencies are regarded as a threat to Central Banks | Coinscreed

The rise of bitcoin and other digital currencies has been widely reported, and it has the potential to have a significant impact on financial institutions and central bank operations.

Will paper money eventually be phased out? Will bitcoin and its brothers eventually supplant the dollar, euro, and yen? Is it appropriate for central banks to create their own e-currencies? What are the advantages of digital currencies? What are the dangers?

The risks of establishing a central bank digital currency are significant, but the efficiency gains appear to be small, according to this commentary.

Current payment infrastructure can be improved to create a more efficient system.

Central banks and financial intermediaries may face issues as a result of the quick rise of cryptocurrencies.

At least, these are their supporters’ aims and objectives: to develop private currencies that can compete successfully with official fiat currencies while also disrupting bank business practices.

We looked at the merits of cryptocurrencies as money substitutes in our earlier Coinscreed column, “4 ways to start investing in cryptocurrencies“, and concluded that they are unlikely to accomplish their lofty goals.

However, we acknowledge that they have revealed inefficiencies in payment systems, particularly in cross-border transactions, and that they may contribute to redefining money as a means of payment.

Plastic and paper are rapidly becoming obsolete in China, with vendors refusing to take them in favour of phone-based payment systems.

It’s worth noting that the lack of well-integrated and globally accessible electronic payment systems allowed internet giants (Tencent and Alibaba) to jump ahead in the fintech race.

The central banking community is aware of the threat and is considering responses that range from outright bans to open embraces of private issuance.

For example, the Riksbank in Sweden is considering introducing an e-krona, an electronic version of the Krona that might be anonymous like cash – or, more specifically, pseudonymous like bitcoin – if cash continues to decline at such a rapid rate that it becomes the only legal tender.

Why are central banks concerned?

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When central banks in industrialized nations collectively found themselves at the zero lower bound and wondered how much further they could reduce rates before triggering a flight to cash, interest in electronic forms of money as a substitute for physical cash gained traction.

In a cashless society, monetary policy rates would not be subject to an effective lower bound, obviating the need for quantitative easing.

Furthermore, mounting evidence that anonymous currency is prized by individuals who engage in an unlawful activity or try to avoid paying taxes has fueled calls for its abolition.

Private currencies, on the other hand, are posing a new threat to central banks’ issuance monopoly in the following ways:

  • If cash disappears, people and businesses will be left without access to risk-free central bank money.
  • Private money is not backed by a central bank, whether it is issued by a bank or mined in a crypto community.
  • The former is exposed to counterparty risk (which is partially mitigated by deposit insurance), whereas the latter is exposed to stability and currency rate risks.
  • The introduction of rival currencies has the potential to impact central bank activities on a variety of levels.

This issue is comparable to the position of central banks dealing with partial dollarization of their economy. And some core considerations from the government are:

  1. First, if the new currency becomes widely used, it may become impossible for the central bank to set acceptable interim monetary policy aims.
  2. Second, unless the central bank can discover measures to stabilize liquidity in those currencies, as individuals, firms, and possibly financial institutions grow their holdings of the new currency, the financial system may become less stable.
  3. Finally, it can increase the exchange rate’s volatility and unpredictability

What choices does the central bank have?

The only agreeable choice most central banks have right now would be to develop central bank digital currency (CBDC).

Why Cryptocurrencies are regarded as a threat to Central Banks | Coinscreed

They might offer a digital payment system based on claims against the central bank.

The most straightforward approach would be to allow individuals and organizations (rather than only financial intermediaries) to open direct accounts with the central bank, which could even pay interest.

Central banks might even issue their own cryptocurrency, perhaps employing decentralized and near-anonymous technology to replicate and replace banknotes.

The case for digital currency issued by central banks

Why Cryptocurrencies are regarded as a threat to Central Banks | Coinscreed

Individuals should benefit from central bank digital currency because of the efficiency of payment systems and risk management in deposit accounts.

The general population would be able to hold legal money in electronic form if they had direct access to central bank accounts.

If central banks choose to make central bank accounts ‘open to all,’ they will build a centralized ledger that will make payment settlements exceedingly fast because all accounts will be in the same system, eliminating the need for middlemen.

Deposit insurance would become unnecessary if most deposits were stored at the central bank.

Retail cross-border payments may potentially benefit if they were made directly through central banks, with central banks cooperating on payment processing procedures.

Setting standards would be considerably easier if each country had only one centralised system.

Some central banks may even open accounts for non-residents in order to provide their currency as a vehicle for foreign payments, resulting in negative international spillovers, as we will discuss further below.

The case against digital currency issued by central banks

A central bank cryptocurrency based on technologies comparable to bitcoin and other cryptocurrencies would face some of the same issues as existing currencies, according to the two ideas we’ve considered (the decentralised validation process is inefficient and slow, and anonymity more a disadvantage than an advantage).

Since many of their projects demand additional centralization, central banks appear to be coming to this conclusion as they experiment with cryptocurrency-type technology.

Furthermore, while duplicating the secrecy of cash in an electronic version may sound enticing, central banks would not want to make cryptocurrencies available as vehicles for unlawful activity.

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The case against central bank cryptocurrencies appears to be strong on numerous fronts. We have explained them below.

What about the other CBDC option, which is for central banks to take deposits “from all”?

The impact of a CBDC on financial stability and financial intermediaries is a major concern.

The inclusion of a central bank safe deposit might make commercial bank deposits extremely volatile, and bank heists could occur at the click of a mouse (or a nod to a mobile phone).

As a result, there may be a significant increase in volatility and intermittent panic flights to safety.

Furthermore, moving deposits to central banks may pose a challenge to banks’ present business models, since they may lose a reliable and inexpensive source of funding, namely deposits.

The strength of the competition will be determined by how those accounts are managed. Is it possible that such monies would be limited? Would they be willing to pay interest?

Furthermore, banks would lose the revenue generated by facilitating payments and transactions, as well as the associated network of interactions with their clients in the form of gas fees.

The rivalry for money from central banks may have even more disruptive repercussions to the degree that such services, networks, or even customer information are complementary to other banking services such as lending and wealth management.

A general-purpose CBDC may offer hazards to the central bank’s balance sheet from a narrow perspective.

Because of the increased demand for central bank money, it may be necessary to own more hazardous assets (sovereign debt or private assets).

This might expose central banks to political pressure and impair their independence by expanding their role in maturity and credit risk transformation to banks and markets.

Profits from seignorage could be harmed if deposits at the central bank were interest bearing.

Finally, the central bank would be responsible for KYC (know your customer) and AML (anti-money laundering) compliance.

These activities could be outsourced to private operators, but unlike the current arrangement, the deposit would remain the central bank’s liability, and mistakes would – at the very least – result in reputational risk.

Allowing non-residents to own the CBDC could result in cross-border externalities, as it would increase global liquidity and provide safe assets.

Capital flight from weak countries to safe-haven central banks might be amplified in times of crisis, putting pressure on exchange rates and asset prices.

Central bank accounts ‘for all’ would appear improbable in the face of such uncertainty. That is not the case.

This summer, Switzerland will hold a referendum on a bold proposal: the ‘sovereign money’ initiative proposes transferring 100% of all deposits to the central bank and prohibiting commercial banks from producing money.

Overall, the risks and uncertainties associated with CBDC adoption, whether in the form of decentralised cryptocurrencies or centralised provision central bank accounts, appear to exceed the benefits.

This begs the question of whether payment mechanisms, which are the current infrastructure’s fundamental vulnerability, can be addressed in other ways.

Without a CBDC, it’s impossible to improve payment systems.

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The demand for speedier and more efficient payment solutions is growing. The complex and obsolete infrastructure that banks utilize is to blame for the lack of innovation in payment systems.

However, as we previously stated, fundamentally overhauling the bank deposit paradigm comes at a price. Is it possible to incorporate innovation without jeopardizing the bank deposit model?

Recent regulatory reforms are likely to have this effect because they require banks to grant access to payment technology providers (‘apps’).

By requiring banks to give access to consumers’ accounts via APIs, the UK’s open banking program and the EU’s associated PSD2 law actively promote innovation.

Another example of how regulation and coordination may make a big difference is India’s recent successful implementation of a united payments interface to support real-time payments.

Individuals can use their favourite smartphone app to make payments in all of these scenarios without having to accept a world with distinct money balances and possibly separate currencies.

They employ traditional currencies, and commercial banks (with deposit insurance) continue to keep money balances, but transactions are routed through small and major actors in the payment arena.

With the continuous improvement of existing Real Time Gross Settlement Systems (RTGS), we will have a system that meets the needs increasingly driven by new technologies while keeping the backbone of bank deposits and traditional central banks.

Because national closed-loop solutions could lead to fragmentation, smooth and low-cost cross-border payments networks are critical for the euro area’s functioning.

As a result, the European system is being improved, and the new TARGET immediate payment settlement (TIPS) service was recently introduced, with full functionality adopted by the end of 2018.

Outside of the eurozone, however, central banks and authorities may struggle to improve cross-border retail payment networks.

On the one hand, dealing with settlement systems across different currencies is complicated, and on the other, there is no worldwide regulator or central bank that can impose a standard or a certain technology.

New players may have greater room to question the status quo in this universe.

Conclusion

The risks of introducing central bank digital currency are substantial, while the benefits appear to be modest.

Central bank-issued cryptocurrency would suffer from all of the drawbacks of cryptocurrencies while providing no evident benefits.

Digital money ‘for all’ on central banks’ balance sheets could cause financial system disruption without providing significant benefits over a well-regulated two-tier structure.

A more efficient system can be achieved by innovation in the present payment infrastructure, which is aided by regulation that allows new companies and technologies to compete while preserving the backbone of bank deposits and traditional central banks.

Some major implications of cryptocurrencies on central banks:

1. A substantial amount of money has already been converted to electronic form.

Although most countries still use real currency (with the exception of Sweden, where cash usage is fast declining), consumers all across the world commonly conduct transactions without it, paying using credit cards or mobile phones.

Furthermore, much of the money issued by central banks (bank reserves) is only available electronically. As a result, the concept of digital currency is not entirely new.

2. Cryptocurrencies are unlikely to take the place of government-backed money very soon

Bitcoin and other cryptocurrencies are popular, but most people do not trust them as much as they do the US dollar, euro, or Japanese yen, which are all backed by a central bank.

Despite the loss of trust in political institutions, the vast majority of people still prefer money backed by a central bank, and this is unlikely to change very soon.

3. Nonetheless, digital currencies have the potential to fundamentally alter the financial system.

Digital currencies and other payment system advances might speed up domestic and cross-border transactions, lower transaction costs, and eventually provide poor and rural households more access to the financial system.

4. However, these new technologies also pose significant obstacles.

Digital currencies and related technologies are anticipated to lower transaction costs and the cost of gathering and sharing information, which sounds wonderful but has the potential to destabilize financial markets and increase contagion from one market to the next.

They could jeopardize traditional banks’ business models and function in the financial system, making it difficult for central banks to maintain financial stability, as they rely heavily on the banking system.

5. Should central banks issue digital currencies of their own?

Few central banks are genuinely considering establishing their own digital currencies—that is, allowing the general public to make electronic deposits at the bank—but several are exploring it.

Only a few central banks, including Ecuador and Tunisia, have launched their own digital currencies thus far. Sweden is considering issuing an e-krona, as the use of cash is dwindling faster than in virtually any other large economy.

In addition to preventing a central bank from losing market share to bitcoin, issuing its own digital currency could make it easier for a central bank to pursue negative interest rates (charging depositors a fee rather than paying interest) during a slump.

However, if depositors withdraw money from traditional banks to deposit it at the (safer) central bank, an official digital currency might eliminate the function of traditional banks as intermediates and lenders, posing significant concerns during a financial crisis.