The Federal Reserve Bank of St Louis, one of 12 regional Reserve Banks that make up the United States’ central bank, has conducted a study asking some of the biggest questions in cryptocurrency today – and they may have found some real answers.
Their researchers investigated the control structure of various currencies and looked into whether central banks will adopt cryptocurrencies as a form of payment.
Commodity, Cash, or Digital?
In an effort to assign Bitcoin one of the above monetary categories, the researchers concluded that Bitcoin actually defied traditional categorization – it’s none of the above, as shown in the chart below.
There are a number of dimensions used by the bank to categorize money.
The first is representation: Is the currency represented physically or virtually?
The second is transaction handling: Are transactions handled in centralized or decentralized payments?
The third is money creation: Is the production of the currency competitive or monopolized?
These dimensions make it easy to distinguish between commodities like gold, physical currencies like fiat cash, and so on. However, Bitcoin proved elusive when analyzed in the traditional manner.
The researchers pointed out that gold has decentralized transaction handling, a competitive creation process wherein anyone can mine it, and a finite supply – all traits which are shared by Bitcoin. However, it also has an inherent value as a commodity, unlike fiat currency which represents the value of a commodity (like gold, silver, etc). Gold is not a low-liquidity form of money, but it doesn’t require extensive bookkeeping or proof of ownership.
Much like fiat cash, simply being in possession of the gold at the time of transaction is enough to prove ownership. Cash is totally decentralized in this sense, with no oversight or bookkeeping required for it to be spent in most cases. The creation, however, is centralized and monopolized. Electronic cash is also monopolized with an infinite supply.
Commercial bank deposits and central bank electronic money are considered virtual money because they don’t have any physical representation – they exist as records only. On the other hand, physical forms of money like gold and cash often don’t even need a record in order to function in the market.
Which category fits Bitcoin?
The answer, of course, is none of them. Bitcoin takes on traits of all three categories and brings some brand new characteristics as well, making it a unique currency.
Bitcoin is the first virtual money for which ownership rights to the various monetary units are managed in a decentralized network. There is no central authority, no boss, and no management. And yet it still works.
The Bitcoin blockchain is the decentralized accounting system, and the so-called miners are the bookkeepers […] decentralized management of ownership of digital assets is a fundamental innovation. It has the potential to disrupt the current payment infrastructure and the financial system. In general, it could affect all businesses and government agencies that are involved in recordkeeping.
The researchers went on to point out the recognisable traits that Bitcoin does have, before moving on to whether bank-issued virtual money even has a purpose at all.
The special feature of cryptocurrencies is that they combine the transactional advantages of virtual money with the systemic independence of decentralized transaction processing. Furthermore, as with gold, the creation of new Bitcoin units is competitive. Anyone can engage in the creation of new Bitcoin units by downloading the respective software and contributing to the system.
In practice, however, a few large miners dominate the mining process. The reason is that competition has become fierce and only large mining farms with highly specialized hardware and access to cheap electricity can still make a profit from mining.
The Case for Central Bank Electronic Money
The researchers made one of their most important points here, and one that is often overlooked by the die-hard supporters of fiat over Bitcoin, or the reverse.
“Each form of money has its benefits and drawbacks. This is why many forms of money coexist.”
Cash is permissionless and anonymous, with no account and no record needed. There’s no one point of attack (like a payment processing server) that can disrupt the cash system of payment, making it a robust and decentralized system in terms of payment. There’s also no credit relationship or risk involved with cash – transactions are final and done in person, allowing people to trade even if they don’t trust each other. Of course, it’s not viable for long-distance trading such as online purchases, which is a drawback rectified by virtual money which allows for new business opportunities in new, faraway markets.
The researchers point out that cash is the only liquid asset usable for saving outside of the private financial system, and then put forward an interesting theory.
We believe there is great demand for a virtual asset issued by a trusted party that can be used to save outside of the private financial system.
To demonstrate this they tracked Swiss francs in circulation (in the form of cash) as a fraction of GDP from 1980 until 2017 (shown in Figure 2), and found three phases. Phase 1 lasted from 180-95 and marks the time when financial innovations replaced the use of cash as a medium of exchange or store of value. The Swiss population increasingly started to use debit and credit cards for payments.
The second phase is from 1995 until 2008 when card payments and online banking further expanded but, as suggested by Figure 2, the use of cash did not decline further.
The third phase lasted from 2008 until 2017 during an era of increased cash circulation, which the researchers believe is due to the global financial crisis from 2007 onwards.
“We believe that there is a strong case for central bank money in electronic form […] central bank electronic money satisfies the population’s need for virtual money without facing counterparty risk.”
They didn’t speak so highly of cash, stating that cash is inefficient, expensive, facilitates crime, and limits the bank’s ability to use negative nominal interest rates.
The bank believes cryptocurrencies are a viable alternative to cash and will be able to outperform cash when issues like scalability, high fees, and adoption are solved, citing the Lightning Network as one of the potential solutions to these problems.
The bank proposes the issuing of central bank electronic money for all as another solution, saying that this practice would help discipline commercial banks and force them to incentivize users to participate with higher interest rates to compensate for higher volatility. The St Louis researchers believe that this would simplify monetary policy by promoting the widespread use of central bank accounts with the interest rate as the main policy tool.
Because the market would be desegregated, the interest rates would be low, and because a central bank cannot become illiquid there is no counterparty risk, unlike with commercial banks. Because no credit is available for central bank electronic money, virtually no monitoring is required at all, making it very low maintenance.
In fact, the central bank wouldn’t even have to scale the infrastructure to provide everyone with central bank electronic funds and accounts – legislation could obligate commercial banks to integrate central bank accounts and store customer funds externally with the central bank, making the funds off limits in the event of the commercial bank going bankrupt, protecting customer funds.
“Naive” to Expect Central Bank Cryptocurrencies
“it makes little sense for central banks to issue cryptocurrencies even though it would be straightforward from a technological point of view to do so”.
The researchers state that no reputable central bank has a high enough incentive to issue branded cryptocurrencies in case that currency were to become linked to a crime of some sort, unfairly associating the bank with the crime and damaging the bank’s business.
“Once we remove the decentralized nature of a cryptocurrency, not much is left of it. As shown in Figure 1, virtual money that is centralized and issued monopolistically by a central bank is electronic central bank money.”
The bank feels that it is naive to expect a central bank to issue a cryptocurrency given the logistical problems and unnecessary risks involved. Because of the option of complete anonymity, the bank would risk facilitating money laundering and other crimes which commercial banks are obligated by law to take measures against. The researchers acknowledge the benefits of allowing anonymous transactions in situations where a government is oppressing citizens, but feel that it is not appropriate for any government authority to actively facilitate anonymous transactions due to their obligation to collect tax and prevent money laundering.
“On the one hand, governments can be bad actors and, on the other hand, some citizens can be bad actors. The former justifies an anonymous currency to protect citizens from bad governments, while the later calls for transparency of all payments. The reality is in between, and for that reason we welcome anonymous cryptocurrencies but also disagree with the view that the government should provide one.”
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