Martin Arnold, Foreign Exchange and Macro strategist at ETF Securities argues that widespread usage of cryptocurrencies has the potential to impair the transmission and aim of monetary policy.
Digital Vs Crypto
Digital currencies have been around since computers enabled the electronic storage of account balances online. A digital currency can be broadly defined as money stored in electronic form that can be used to make and receive payments. Crypto currencies are a much more recent phenomenon, with Bitcoin the most widely recognised. A cryptocurrency is a subset of digital currency whereby encryption techniques are used to regulate the creation and transfer of currency units. Cryptocurrency market capitalisation reached USD1.3bn by end – July 2017, according to website www.coinmarketcap.com, which is divided among about 1000 currencies. Usage is therefore growing quickly, but can they be considered money?
Is it money?
The short answer is no. In order to be considered currency, a form of money (i.e. digital currencies) must be used as a unit of account, a store of value and a medium of exchange. Cryptocurrencies are being used as a store of value (although with significantly higher volatility than traditional currencies) but broadly fail to satisfy the other two criteria.
Scale of usage is certainly an issue that is unlikely to see cryptocurrencies impact monetary policy in the foreseeable future. Cryptocurrencies do not have intrinsic value. Although limited as a resource – bitcoin and other cryptocurrencies have a finite supply – investors mainly trade on the ability to exchange the cryptocurrency for a higher value in the future rather than the ability to purchase other goods and services (although usage for other initial coin offerings are rising).
As a medium of exchange, cryptocurrencies are only used to a limited extent to purchase goods and services. Additionally, purchases are also generally transferred back to sovereign currencies, like the US Dollar or Euro, and as such crypotocurrencies are not used for accounting purposes, therefore do not satisfy the unit of account characteristic.
Trust is lacking, volatility is not
Volatility is a hindrance for the universal acceptance of cryptocurrencies to garner a wide following and for paying and settling transactions, a unit of account and a store of value. Digital currencies exhibit extreme volatility: buying power is therefore constantly changing.
Price stability is critical for currencies to be a trusted medium of exchange: if a particular basket of goods costs 100 pounds today and 50 pounds in a week’s time, then this provides disincentives to widespread adoption. If the digital currency value is dropping, it encourages consumers to get rid of it as quickly as possible, and if it’s rising, to hoard the currency.
Monetary policy implications
In contrast to sovereign payment systems and other digital currency, the innovation of the distributed ledger (that was developed for Bitcoin), whereby transactions are recorded and verified by a decentralised group of network participants called miners, digital currencies do not need a trusted third party to exchange and settle transactions between two independent parties to a transaction. Cryptocurrencies, through their decentralised nature circumvent the normal monetary channels.
In this way, monetary policy would be undermined if the scale of usage were to expand and challenge fiat currencies for dominance as a means of payment. Furthermore, cryptocurrencies are global, exacerbating the potential problem, because usage bypasses sovereign (and central bank) jurisdictions. Monetary policy would need to become more
globally coordinated in order to have an impact in a world of cryptocurrency dominance.
Another issue with cryptocurrencies in implementing monetary policy is the limited supply. Without the ability to manipulate money supply, the problems with potential hoarding being able to decrease supply are twofold. By not being able to increase money supply, the supportive nature of policy is reduced. In a world of quantitative easing, a fixed supply of (digital) money is clearly an impediment to the effective transmission of monetary policy. Moreover, the reduction of the money supply can lead to deflation by reducing demand.
Central bank digital currencies
In a time of crisis, a decentralised digital currency framework is not likely to engender confidence in the case of a financial crisis, as there is no one institution standing behind the value of the digital currency. Cryptocurrencies have a decentralised distribution network, and unlike fiat currencies or a central bank issuing digital currency, there is no trusted counterparty that, in essence guarantees, the currency. Indeed, recent ‘hard forks’ in both Bitcoin and Ethereum highlight the uncertainty of a cryptocurrency’s value.
A digital currency issued by a central authority (clearly the antithesis of the rise in popularity of cryptocurrency) but using a distributed leger framework could reduce the number of intermediaries and enhance the effectiveness and efficiency of monetary policy in several ways. Firstly, transactions would be independently verifiable and this would arguably increase transparency. Secondly, currency being settled outside of a
single entity could potentially save time and be less costly. Importantly, by funding being distributed straight to the consumers and businesses, the transmission of policy would be more direct, essentially bypassing the banking system.
The ECB highlights issues of remuneration: the interest rate for digital currency could influence demand. If the central bank remunerates at the deposit rate (for many this is currently negative) it would dissuade the usage of the currency and be more compelling to hold deposits at normal banks which generally do not charge negative interest rates.
If the central bank put the deposit rate at 0% (instead of a negative rate), this
could also cause problems: banks could set up non-bank subsidiaries that would be able to hold digital currency at the central bank for no cost, thereby undermining the effects of monetary policy.
The bottom line…
Many major central banks, including the Bank of England (BOE) the Bank of Canada and the European Central Bank, have tested or considered the ability to use digital currencies and distributed ledger technology in the monetary policy arena.
Due to elevated volatility and the lack of widespread usage, crypto (or digital) currencies will not impact monetary policy in any significant way. A central bank issued digital currency has the potential to make monetary policy more effective, however, there are many hurdles that need to be overcome in terms of the framework for pricing and distribution.