Opinion – Martin Wolf: Cryptocurrencies are not the new currency system we need

Money has already evolved from coins to bills, balance sheet entries and computer bits. The institutions that provide, operate, guarantee and regulate money have evolved with it. So how should it evolve in the digital age? The invention of cryptocurrencies forced everyone involved and especially the central banks – the agents of the State in the management of the public good of money – to face this issue. If encryption isn’t the answer, what is?

The Bank for International Settlements (BIS) – the club of central banks – has been leading the way in the effort to answer this question. The latest result is in its Annual Report, which looks at the emerging ecosystem of cryptocurrencies, stablecoins and exchanges.

This brave new system is inherently flawed, he concludes. The cryptocurrency crash (and the bubble before it) shows that they are objects of speculation rather than stores of value. This also makes them useless as units of account. As the BIS notes, “The prevalence of stablecoins, which attempt to peg their value to the US Dollar or other conventional currencies, indicates the general need in the cryptocurrency industry to piggyback on the credibility provided by the central bank-issued unit of account. In this regard. , stablecoins are the manifestation of cryptocurrency’s search for a nominal anchor.”

However, its flaws go deeper than that. There are now about 10,000 cryptocurrencies. It could very well be a billion. But this tendency toward fragmentation, “with many layers of incompatible compensation vying for a spot in the limelight,” argues the BIS, is inherent in the system’s economic logic, not just its technological ability to multiply without limit.

In a good monetary system, the greater the number of users, the lower the transaction costs and, therefore, the greater its utility. But as more people use a cryptocurrency, the more congestion and the more expensive the transactions. This is because self-interested validators are responsible for recording transactions on the blockchain. The latter must be motivated by monetary rewards high enough to sustain the decentralized consensus system. The way to reward validators is to limit blockchain capacity and keep fees high: “So instead of the familiar ‘more is better’ monetary narrative, cryptocurrency exhibits the ‘more is worse’ property.”

You can’t have all three – security, decentralization and scalability – at the same time. In practice, cryptocurrencies sacrifice the latter. The crypto system gets around this drawback with “bridges” between blockchains. But these are vulnerable to hackers. The BIS’s conclusion is: “Fundamentally, cryptocurrencies and stablecoins lead to a fragmented and fragile monetary system. Importantly, these flaws stem from the underlying economics of incentives, not technological constraints. And, no less significantly, these flaws would persist. even if regulation and oversight addressed the issues of financial instability and the risk of loss implicit in cryptocurrencies.” A fragmented monetary system is not what we need.

What should be done? Part of the answer is to insist that the cryptocurrency meets the standards expected of any significant part of the financial system. Among other things, exchanges must “know their customers”. Again, the assets and liabilities of so-called “stablecoins” must be transparent. Links between banks and crypto-agents must be especially transparent.

However, we can do better than that, argues the BIS. What we need in a good monetary system are security, stability, accountability, efficiency, inclusiveness, privacy, integrity, adaptability and openness. The current system falls short, especially in cross-border payments. The BIS envisions instead a system where central banks would continue to provide “purpose” payments on their balance sheets. But new branches can grow in the trunk of the central bank. Above all, central bank digital currencies (CBDCs) can enable a revolutionary restructuring of monetary systems.

Thus, wholesale CBDCs can offer new payment and settlement functions to a much wider range of intermediaries than domestic commercial banks. A key element, suggests the BIS, would be the possibility of executing “smart contracts”. Such changes would allow the creation of new, substantially decentralized payment systems. Meanwhile, retail CBDCs could complement the development of new fast payment systems, which are challenging the incomes of current operators. The BIS points to the success of the new Brazilian system, Pix. But the full benefits would only be realized if CBDCs revolutionized cross-border payments.

Retail CBDCs would also allow substantial separation between payments and risk-taking. Thus, the money that companies and households hold for transaction purposes could become the liabilities of central banks. Payments would then be managed by companies focused on this function, which would profit more from transactions than from loans. We would no longer need explicit and implicit state insurance for private banks. Instead of managing payments, they would focus on borrowing. Their liabilities could also become less liquid and more obviously riskier than they are today. That would be really revolutionary.

But there are also more modest options. The bottom line is that the cryptographic universe does not offer a desirable alternative monetary system. But technology can and must do it. Central banks must play a central role in facilitating a system that protects and serves people better than the current one.

It’s time to prune the crypto forest. But new branches must also grow on the money and payments tree.

Translated by Luiz Roberto M. Gonçalves