This year, bitcoin has attracted many investors. It’s not just that it has doubled in price since its tripling in 2020, and that people like Elon Musk support it – last week he wrote on twitter that Tesla cars will be sold in bitcoin. What is even more remarkable is that some players in the establishment, such as Citigroup, now believe that bitcoin “may be in the best position to become the preferred world currency for future trading“, a role that the dollar currently has.
There is a second story about cryptocurrencies that is going on that most people have not paid much attention to: the experiments made by central banks. Last week, the Bank for International Settlement held an “innovation” conference at which Federal Reserve Chairman Jay Powell explained that Fed officials are working with MIT to investigate the feasibility of a central bank digital currency which will be based on the dollar.
The details are minimal, but such a digital currency (CBDC) actually enables them to use an electronic code as “money”, reflecting certain characteristics of bitcoin or the kind of cryptocurrency that Facebook is developing. This electronic code will be created and controlled by the Fed – not by Facebook or some impersonal bitcoin miners. Powell stressed that this digital dollar would not emerge quickly if it did, saying “there is no need to rush.” But the symbolism is striking, as it reflects a discreet but remarkable shift in the attitude of regulators.
When bitcoin and other fintech innovations first appeared in this century, many central bankers either rejected them or ridiculed them in the discussions they had. The same thing is happening now: Powell last week hinted that bitcoin is primarily a speculative investment substitute for gold rather than the dollar, while Agustin Carstens, head of BIS, warned that it is used primarily for regulatory arbitrage.
But what central bankers are slowly realising is that the reason such innovations have emerged is that entrepreneurs are reacting to two major flaws in modern finance.
One is something that central bankers seem reluctant or unable to deal with: the risk that fiat currencies will cease to have a basis in the future due to oversupply, i.e. quantitative easing. The other is something central bankers want to address; the cumbersome nature of the modern payment system. As Powell recently remarked, “the Covid crisis has focused even more on the need to address the limitations of our current arrangements for cross-border payments.”
So what the Fed and others are trying to do now is a mild version of the “if you can’t beat them, join them” strategy. Instead of ignoring bitcoin or Facebook experiments, they hope to get some ideas from innovations, such as blockchain ledgers on their own terms.
Will this be effective? There are reasons to be cautious. Asking cumbersome central bankers to embrace this kind of independent creativity found in fintech is like asking your grandfather to listen to rap. Even more a frightening issue is that CBDCs are creating huge policy headaches, such as the future role of private sector banks.
Commercial banks currently make a profit by “creating” money for customers (loans), using money provided (or created) by a central bank. But a CBDC would give consumers money (digitised brands) recorded in central bank electronics ledgers. This could potentially lead to “mediation” of the banks, in a way that would destroy revenues, Bundesbank chief Jens Weidmann told BIS. He says that if the eurozone creates CBDCs, it may need to maintain a two-speed distribution system to maintain the involvement of banks.
Then there are the issues of data, privacy and accountability. Central banks may not want to keep consumer data on their ledgers and investors may not want to lose the anonymity associated with their cash.
One possible solution is for CBDCs to coexist with cash, something Powell expects to see, but the logistics and legal framework for such a thing would be frightening, and not just because a recent BIS study suggests that only a quarter of the world’s central banks have clear legal authority to create such a currency.
However, it would be wrong to assume that nothing will happen, just because the logistics look scary. The same BIS study suggests that 60% of central banks are considering CBDCs and 14% are conducting pilot tests. “The Covid-19 pandemic has added new motivation to this journey,” he notes. “While most (central banks) have no plans to issue CBDCs in the foreseeable future, central banks, which collectively represent one-fifth of the world’s population, are likely to launch retail CBDCs within the next three years.”