BIS: Cryptocurrencies like Bitcoin promise to replace trusted institutions with distributed ledger technology. Yet, looking beyond the hype, it is hard to identify a specific economic problem which they currently solve. Transactions are slow and costly, prone to congestion, and cannot scale with demand.
Cryptocurrencies' decentralised model of generating trust limits their potential to replace conventional money
Abstract
The decentralised consensus behind the technology is also fragile and consumes vast amounts of energy. Still, distributed ledger technology could have promise in other applications. Policy responses need to prevent abuses while allowing further experimentation.
By Hyun Song Shin (Economic Adviser and Head of Research BIS)
Less than 10 years after their inception, cryptocurrencies1 have emerged from obscurity to attract intense interest on the part of businesses and consumers, as well as central banks and other authorities. They garner attention because they promise to replace trust in long-standing institutions, such as commercial and central banks, with trust in a new, fully decentralised system founded on the blockchain and related distributed ledger technology (DLT).
This chapter evaluates whether cryptocurrencies could play any role as money: looking beyond the hype, what speci c economic problems, if any, can current cryptocurrencies solve? The chapter rst reviews the historical context. Many episodes of monetary instability and failed currencies illustrate that the institutional arrangements through which money is supplied matter a great deal. This review shows that the essence of good money has always been trust in the stability of its value. And for money to live up to its signature property – to act as a coordination device facilitating transactions – it needs to ef ciently scale with the economy and be provided elastically to address uctuating demand. These considerations call for speci c institutional arrangements – hence the emergence of today’s independent and accountable central banks.
The chapter then gives an introduction to cryptocurrencies and discusses the economic limitations inherent in the decentralised creation of trust which they entail. For the trust to be maintained, honest network participants need to control the vast majority of computing power, each and every user needs to verify the history of transactions and the supply of the cryptocurrency needs to be predetermined by its protocol. Trust can evaporate at any time because of the fragility of the decentralised consensus through which transactions are recorded. Not only does this call into question the nality of individual payments, it also means that a cryptocurrency can simply stop functioning, resulting in a complete loss of value. Moreover, even if trust can be maintained, cryptocurrency technology comes with poor ef ciency and vast energy use. Cryptocurrencies cannot scale with transaction demand, are prone to congestion and greatly uctuate in value. Overall, the decentralised technology of cryptocurrencies, however sophisticated, is a poor substitute for the solid institutional backing of money.
That said, the underlying technology could have promise in other applications, such as the simpli cation of administrative processes in the settlement of nancial transactions. Still, this remains to be tested. As cryptocurrencies raise a host of issues, the chapter concludes with a discussion of policy responses, including regulation of private uses of the technology, the measures needed to prevent abuses of cryptocurrencies and the delicate questions raised by the issuance of digital currency by central banks.
Putting the rise of cryptocurrencies into perspective
A good way to examine whether a new technology can be a truly useful addition to the existing monetary landscape is to step back and review the fundamental roles of money in an economy and what history teaches us about failed attempts to create new private moneys. Then one can ask whether money based on this new technology can improve upon the current monetary landscape in any way.2
A brief history of money
Money plays a crucial role in facilitating economic exchange. Before its advent millennia ago, goods were primarily exchanged for the promise to return the favour in the future (ie trading of IOUs).3 However, as societies grew larger and economic activity expanded, it became harder to keep a record of ever more complex IOUs, and default and settlement risks became concerns. Money and the institutions issuing it came into existence to address this growing complexity and the associated dif culty in maintaining trust.
Money has three fundamental and complementary roles. It is: (i) a unit of account – a yardstick that eases comparison of prices across the things we buy, as well as the value of promises we make; (ii) a medium of exchange: a seller accepts it as a means of payment, in the expectation that somebody else will do the same; and (iii) a store of value, enabling users to transfer purchasing power over time.4
To ful l these functions, money needs to have the same value in different places and to keep a stable value over time: assessing whether to sell a certain good or service is much easier if one is certain that the received currency has a guaranteed value in terms of both current and future purchasing power. One way to achieve this is by pure commodity moneys with intrinsic value, such as salt or grain. But commodity money by itself does not effectively support exchange: it may not always be available, is costly to produce and cumbersome in exchange, and may be perishable.5
The expansion of economic activity required more convenient moneys that could respond to increasing demand, be ef ciently used in trade and have a stable value. However, maintaining trust in the institutional arrangements through which money is supplied has been the biggest challenge. Around the world, in different settings and at different times, money started to rely on issuance by centralised authorities. From ancient times, the stamp of a sovereign certi ed a coin’s value in transactions. Later, bills of exchange intermediated by banks developed as a way for merchants to limit the costs and risks of travelling with large quantities of coinage.
However, historical experience also made clear an underlying trade-off, for currencies that are supplied exibly can also be debased easily.7 Sustained episodes of stable money are historically much more of an exception than the norm. In fact, trust has failed so frequently that history is a graveyard of currencies. Museums around the world devote entire sections to this graveyard – for example, room 68 of the British Museum displays stones, shells, tobacco, countless coins and pieces of paper, along with many other objects that lost their acceptability as exchange and found their way to this room. Some fell victim to the expansion of trade and economic activity, as they were rendered inconvenient with a larger scale of use. Some were discarded when the political order that supported them weakened or fell. And many others fell victim to the erosion of trust in the stability of their value.
History proves that money can be fragile whether it is supplied through private means, in a competitive manner, or by a sovereign, as a monopolist supplier. Bank- issued money is only as good as the assets that back it. Banks are meant to transform risks, and therefore, under certain extreme scenarios, con dence in privately issued money can vanish overnight. Government-backed arrangements, where assuring trust in the instrument is a centralised task, have not always worked well either. Far from it: a well known example of abuse is the competitive debasement of coins issued by German princes in the early 17th century, known as the Kipper- und Wipperzeit (clipping and culling times).8 And there have been many others, up to the present-day cases of Venezuela and Zimbabwe. Avoiding abuse by the sovereign has thus been a key consideration in the design of monetary arrangements.
The quest for solid institutional underpinning for trust in money eventually culminated in the emergence of today’s central banks. An early step was the establishment of chartered public banks in European city-states during the period 1400–1600. These emerged to improve trading by providing a high-quality, ef cient means of payment and centralising a number of clearing and settlement operations. Such banks, set up in trading hubs such as Amsterdam, Barcelona, Genoa, Hamburg and Venice, were instrumental in stimulating international trade and economic activity more generally.9 Over time, many of these chartered banks functioned in ways similar to current central banks. Formal central banks, as we know them today, also often emerged in direct response to poor experiences with decentralised money. For example, the failures of wildcat banking in the United States eventually led to the creation of the Federal Reserve System.