The future of digital currencies

Digital currencies – sometimes called cryptocurrencies – are suddenly much in the news.  The price of the best-known digital currency, Bitcoin, has exploded from under $500 at one point in 2015 to over $5,000 briefly earlier this year, and there has been a rash of copycat issues of other cryptocurrencies by people keen to cash in on the craze – they vary in the detail of their design, but all seek to offer electronic tokens of some form or other to “investors” in exchange for hard cash.

What is behind this, and what is the future for digital currencies?

Certainly, the subject has begun to attract the attention of central bankers and regulators.  In early September, the People’s Bank of China banned ICOs (“initial coin offerings”, the digital currency equivalent of a new share issue) in China.  The announcement did not mince words, stating that such offerings are “essentially a form of illegal public financing behaviour” which raised suspicions of fraud and “criminal activity” (translations courtesy of the Financial Times), though an equally likely reason for the Chinese authorities’ dislike of them is their high volatility, lack of susceptibility to central control and potential as a vehicle for evading Chinese capital controls.

This official disapproval matters, because China is the home of the great majority of the world’s cryptocurrencies and digital currency exchanges.  The price of Bitcoin dropped from around $5,000 to below $4,000 on the Chinese action before recovering slightly.

More recently, the Chinese have furthered their assault on cryptocurrencies, with reports last week of plans to close the digital exchanges completely.  Nor are they alone in voicing their disapproval; the UK’s Financial Conduct Authority weighed in with a warning that the world of virtual currencies was wide open to fraud and scams, and Jamie Dimon, chief executive of JP Morgan Chase, told a banking conference in New York last Tuesday that Bitcoin “is a fraud, worse than the tulip bulb mania”.

But despite this chorus of disapproval – and despite some high-profile losses where investors have lost almost their entire investments – digital currencies cannot be ignored.  Rather like nuclear weapons, they cannot be uninvented and have the potential to change the world radically.  As Huw van Steenis, global head of strategy at Schroders, wrote in the FT two weeks ago in an article headlined “The penny drops for central banks on cryptocurrencies”, the disruptive potential of financial technology and the possibility of cryptocurrencies emerging as parallel currencies has moved beyond science fiction and into the main risk matrices of central banks.

But while digital currencies cannot any longer be ignored, there is still substantial confusion about what the phrase means.  Sometimes it is taken to mean all digital currencies, regardless of issuer; sometimes it refers to privately issued currencies only; and sometimes it doesn’t actually refer to cryptocurrencies at all, but rather to blockchain, the technology underlying digital currencies, their storage, transactions and accounts.

In this article we will not discuss blockchain at all (partly because we don’t have the technical knowledge, partly because we don’t dispute that this is a ground-breaking technology with uses far beyond cryptocurrencies).  Instead, we will concentrate on privately issued cryptocurrencies, and the likelihood that they can emerge as genuine and widely used parallel currencies in the foreseeable future.

This currently seems highly unlikely, for three reasons.

First, although cryptocurrencies have mushroomed since Bitcoin appeared in 2008, they are still far from being in any sense of the word money.  Rather, they remain something like glorified air miles – you need to buy them or earn them, and you can only use them in certain transactions.  Crucially, it is still relatively complicated to transfer them between persons, though in time this will presumably get easier – Sweden’s widely used Swish app already makes interpersonal money transfers almost as easy as handing over cash, and a similar system could be adapted to cryptocurrencies very easily.

Second, although in theory anything can be used as money, whatever is used has to fulfil three functions.  It has to be a store of value, a unit of account and a medium of exchange. Anything that fluctuates in value as wildly as cryptocurrencies is almost by definition not a store of value[1].  Nor can it be used as a unit of account, except in terms of itself – ie, one Bitcoin today will indeed be one Bitcoin tomorrow, but its value or purchasing power is anyone’s guess.  If it is neither a store of value, nor a unit of account, its value as a medium of exchange also becomes highly dubious, if for no other reason that its volatility means that neither buyer nor seller can have any reasonable certainty of being satisfied with the transaction.

It is no great surprise therefore that the main area where the use of cryptocurrencies as a medium of exchange is growing is in the criminal world, where the advantages of being outside the oversight of the world’s central banks and taxation authorities are perhaps sufficient to outweigh the many and varied disadvantages of such a poor transaction system.

Third, and perhaps most importantly, there has up to now been little incentive for any central bank or government to facilitate the use of cryptocurrencies, whether as parallel currency, replacing the national currency or even becoming legal tender.  And their positive facilitation is necessary:  ultimately, governments can always control which currency generally circulates in their jurisdiction, by the simple expedient of insisting that taxes are paid in the national currency.

In a modern functioning economy, where the government collects a “normal” share of GDP (anywhere between 20% and 50% nowadays) in tax, insisting that taxes must be paid in the national currency will automatically mean that this currency becomes dominant.  Obviously, in countries with hyperinflation (eg Venezuela or Zimbabwe, to take recent examples), other currencies take over (reversing Gresham’s Law); but even there the governments are unlikely to acquiesce in the replacement of the national currency.  In addition, of course, governments profit by issuing a currency of their own, again something they are unlikely to wish to give up.

Allowing, say, Bitcoin, to be legal tender, would mean that the monetary authorities lose control over monetary policy.  And governments and central banks are not known for their willingness to give up any power, particularly not over something as crucial as economic policy in any way, shape or form.   (It is this, as much as anything, that probably lies behind the Chinese authorities’ hostility to the concept).

This leaves cryptocurrencies essentially as an alternative asset class among many; but as a very peculiar asset class.  Like gold, there is (at least for the moment) no yield – digital currency accounts do not pay interest.  Moreover, unlike shares, bonds or real estate, there is no underlying value or (relatively) guaranteed income stream.  Nor does anyone stand behind them and offer guarantee of ongoing value.  It is, literally, impossible to say what the fair value of a Bitcoin or whatever is.

In short, it is hard to avoid the conclusion that cryptocurrencies are a classic “greater fool” scheme.  You buy cryptocurrency because you hope that someone else (ie the greater fool) will at some stage in the future pay you even more for it.  And that, in the final analysis, is the long and short of it.

If that was all that cryptocurrencies were, then they would no doubt continue to exist in their own part of the financial ecosphere without ever moving into the mainstream.  Or, just possibly, too many people will be burnt and they might end up being shunned completely.  The history of finance is full of scams, fraudsters and gullible investors, from the Dutch Tulip mania and the South Sea Bubble onwards; as the saying has it, “A fool and his money are soon parted”, and no doubt if cryptocurrencies pass into history there will be other and wholly new ways for fraudsters to find ways to prosper by taking money off fools.

But there is one aspect of the current debate that is altogether more interesting, and that is the potential for central banks not to seek to abolish digital currencies, but issue them themselves.

There are a number of reasons why central banks might wish to do this.  One is that it would lower the cost of financial transactions (not to mention save the cost of providing the notes and coin in the first place).  Other reasons have to do with the ability to cut interest rates well below zero; or to trace payments, hence fighting tax evasion, corruption and crime.  But the most intriguing reason is that cash – notes and coin – may be about to disappear.  Not overnight, but already in Sweden and Norway, shops increasingly do not accept cash and across the economy cash is rapidly being phased out.  Indeed the Riksbank, Sweden’s central bank, now expects the last Swedish banknote to be withdrawn from circulation by 2028 – not too far in the future[2].

But without cash, households and companies will no longer have any absolutely safe asset. Bank deposits are theoretically safe, of course – but at the end of the day, they are a claim on the bank in question, not on the central bank and hence on the government, and private sector banks can fail, with as we have all seen disastrous consequences.  For many in central banking, the idea of a world where private banks had no part to play in the day-to-day economy – where the public turned to then for investments and loans but not day-to-day banking and payments – has its attractions, not least in potentially solving the challenge of “Too Big To Fail”.

But in order to provide the general public with a payment system that does not use the private banks, and in order to give them somewhere to keep their cash balances safely, central banks may have to issue their own digital currencies.

At the moment, this is still at the discussion stage, although a number of central banks – including the People’s Bank of China – are currently investigating issuing their own digital currency.

What form these will take – accounts with the central bank, or perhaps digital wallets which allow users to download e-currency but still use it anonymously – is still not clear.  Issues like privacy, security and access still remain to be solved.  But the advantages of reducing the role of the private banking system and the urgency of dealing with a cashless society mean that the Nordics at least are likely to move ahead rapidly.

Cryptocurrencies are still likely to be around for some time, not least as speculative investments and for legal and illegal internet transactions.  From time to time, there will be articles about cryptocurrencies achieving what might be called “full currencyhood”.  But in terms of digital currencies actually coming to pass and being widely used, look to central banks issuing digital versions of their already existing national currencies.


[1]               Bitcoin has over the past two years gone from under $500 to just short of $3,000, then down below $2,000, up to $5,000 and down below $4,000; Ethereum, another cryptocurrency, has over the same time gone from about parity to close to $400, then down below $280, back to $340 and down below $300 again.  And so on.

[2]               Our non-Scandinavian readers may find this hard to believe.  But anyone using London’s buses will find that while one can pay using credit and debit cards, or can load cash onto the prepayment Oyster card, on the bus itself one cannot use cash to pay a fare.