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2018: The End of Cryptocurrencies?
January 22, 2018

2018: The End of Cryptocurrencies?

By: Steven Eichorn

Cryptocurrencies (e.g. Bitcoin) took the broader public by storm in 2017 and had a breakout year. There were outsized and even unprecedented returns, along with extreme volatility and even more extreme volatility.  The question for 2018 is whether cryptocurrencies had their “fifteen minutes of fame” or they are here to stay?

Blockchain technology (which is widely understood to have huge upside benefits) is distinct from the associated cryptocurrencies (whose value is widely debated). Blockchain technology allows people to complete transactions in a peer-to-peer fashion and avoid intermediaries (like central banks), which cuts down on transaction time and costs. It also eliminates the potential for fraudulent transfers. The peer-to-peer transaction is enabled by blockchain technology that utilizes a shared ledger to authenticate, record, and complete transactions in a cheap and fast technique.

The peer-to-peer blockchain technology also provides anonymity to “currency” transactions that was previously only available to cash transactions- indeed, some of the earliest adopters and drivers of the blockchain technology were people seeking to avoid regulatory oversight and scrutiny (or countries seeking to avoid economic sanctions). The tremendous growth of cryptocurrencies raises the question of what will be the reaction of central banks in 2018 and beyond to blockchain technology and cryptocurrencies.

In the most fundamental sense, cryptocurrencies and central banks are at opposite ends of the spectrum. Central banks print money (i.e. fiat currency) and control the monetary system through various measures that expand or tighten the money supply (e.g. in the U.S., the Federal Reserve is the central banker and it controls the monetary system through its purchase or sale of U.S. Treasuries, the rates it pays to its depositors banks, and other measures). There is no inherent value in the currency of a sovereign nation, but the fact that its laws require people to accept it as a form of payment in exchange for goods allows it to function as a medium of exchange. Further, the fact that its central bank will respond to pressures in the currency markets to reduce large fluctuations in price allows it to function as a storage of value. These two points allow fiat currencies to flourish and enabled central banks to shift from the gold standard ((i.e. where all printed money is backed by gold reserves and possesses the right to redeem the printed money for gold) to fiat currencies (where all printed bills are backed by the government simply stating that it is so).

Many people question what are cryptocurrencies backed by? The answer is not much, and that is by design. Cryptocurrencies were significantly driven by a desire to eliminate the reliance on central banks and sovereign nations to provide value to a currency. People sought a medium that was free of the influence of central banks or any single nation and would be valued solely by the natural supply and demand by consumers for the cryptocurrency. (As an aside, there really isn’t a structural defense in cryptocurrencies to a central bank’s attempt to influence the cryptocurrency with its purchases/sales, in a similar fashion to the method that central bank’s influence their own currencies). So, central banks exist to control monetary supply, while cryptocurrencies aim to avoid that very same control- truly opposite ends of the spectrum.

Although central banks no longer have significant amounts of gold to back up their printed currency and do not print money on the gold standard, they still control their respective monetary systems by tightening or expanding their monetary supply (working together with their depositor banks). Nevertheless, a number of central banks (e.g. China, Israel, Japan, Netherlands, Scandinavia and Sweden) have announced they are exploring the viability of an official state cryptocurrency. This would mean that central banks would have both official hard fiat currency and digital fiat currency. This would have a significant advantage over the current cryptocurrencies because it would be backed by the sovereign laws that mandate its currency- whether hard currency or digital currency- as legal tender for all transactions and act as a medium of exchange, and, simultaneously serve as a stable storage of value.

However, there are some unique dangers to a central bank cryptocurrency. For instance, the central bank could accumulate large amount of deposits that need to be diversified into different asset classes. There are also significant Know-Your-Customer and Anti-Money Laundering (“KYC/AML”) concerns. The very attractiveness of cryptocurrencies is the anonymity and frictionless transactions that central banks have no way of monitoring for compliance purposes, which leaves them ripe to exploitation by money launderers and other criminal elements. This issue may force central banks to conclude that digital fiat cryptocurrencies are not feasible. Nevertheless, there are likely some workable solutions to this issue. For instance, if all users were required to use an online wallet before purchasing the digital fiat currency, then the central bank could require the KYC/AML due diligence prior to opening an account at the online wallet.  This would greatly prevent the abuse of digital fiat cryptocurrencies and would be a good starting point to enabling their viability, while still resolving the legitimate KYC/AML concerns.

Further, and perhaps most troubling, because there is no financial intermediary in the cryptocurrency system, people would be able to directly hold the central bank’s cryptocurrency and could open accounts with the central bank themselves. This dynamic creates the potential for a bank run on any central bank at any given moment- without the built-in preventive measures currently in place in a central bank system that limits withdrawals, controls sufficient levels of deposits at all times, and provides assurance to depositors by guaranteeing their ability to withdraw funds. In the plain sense, whenever there is a whiff of concern with a specific central bank, then all the depositors would withdraw their funds (nearly instantaneously) and leave the central bank at risk of financial ruin. An official cryptocurrency is essentially granting individual depositors access to the central bank and it would likely require a fundamental review of the current central banking structure.

Assuming the central banks enact adequate safeguards to address these concerns, then their adoption of an official cryptocurrency may mean the downfall of cryptocurrencies in their current alternative format. As noted earlier, the main benefit of cryptocurrencies is they run on the blockchain and that offers reduced transaction costs, faster transactions, and the lower likelihood of fraudulent transfers. Bitcoin is currently the dominant medium that allows blockchain transfers, so it is enjoying some heady valuations. However, if central banks adopt cryptocurrencies operating off the blockchain for their own national currency, then their official cryptocurrencies would gain all the benefits of operating off the blockchain while still preserving the benefits of dealing with an actual fiat currency. Presumably, this would severely hamper any benefits of using alternative cryptocurrencies and tremendously reduce their value.

Of course, there is the underbelly of the cryptocurrency world (e.g. money laundering, illicit transactions, sanctions avoidance) that desires the anonymity afforded by cryptocurrencies and would be unlikely to accept a central bank supported cryptocurrency. However, illicit activities are unlikely to sustain a viable cryptocurrency model because that would leave criminals as the main users of alternative cryptocurrencies (i.e. not the official cryptocurrencies). If so, then it is highly likely that countries would act to shut down alternative cryptocurrencies because there is no legitimate, legal value for them.

If 2018 realizes its potential and brings the formal adoption of cryptocurrency by central banks, then those official cryptocurrencies could provide all the blockchain benefits of cheaper transaction costs, no fraudulent transfers, and quick settlement time while still providing a central bank supported currency. This could mean the end of any legitimate business purpose for the existing alternative cryptocurrencies in that scenario and 2018 may signal the end of alternative cryptocurrencies “fifteen minutes of fame”.