Blockchain/Bitcoin

Central Banks Face Bitcoin Pressure

by Sacha Huber May 20, 2016

Given that the ‘distributed ledger’ technology upon which Bitcoin has been developed allows a payment system to operate without the need for intermediaries such as central banks, it is looking increasingly likely that the financial system is set to undergo a comprehensive transformation.

It also implies that centralized payment systems could begin to be phased out and replaced by decentralized ones, with trading, clearing and settlement being just three examples of processes likely to undergo disintermediation.

Whereas a centralized system relies on all parties to trust a third party (the central bank, in most cases) to keep a secure, correct digital record of transactions, the Bitcoin transaction relies on there being numerous copies of this record distributed across the network. Assuming, then, that the cryptography of the system works, the requirement for a third-party becomes largely irrelevant.

(Source)

The monetary system of Bitcoin challenges the central banks’ role

Central banks play a pivotal role in ensuring financial stability within a monetary system, however, meaning that payment innovations are being closely monitored by banks such as the Fed, the European Central Bank and the Bank of England. Indeed, central banks have a responsibility in supporting safe payment systems.

Bitcoin’s notable price volatility since its creation, for instance, is one of the key concerns for central banks – were a systematic price crash to occur, it remains debatable as to just how much responsibility the central bank could or should bear. Even the bank is technically not at fault, a widespread loss of confidence in the bank and the financial system could still arise.

More researches on digital currencies are expectedly conducted

Most central banks are in ‘monitoring mode’ at present, generally stating that more research needs to be done before policy can be considered. More recently, however, Bitcoin’s growth has prompted some central banks to express interest in possibly issuing their own digital currencies, backed by their respective country’s government. While this is yet to materialise anywhere, the Bank of Canada has been among the most open to exploring such technology.

The bank’s senior deputy governor Carolyn Wilkins stated last month that “we have to envision a world in which people mostly use e-money, perhaps even one that’s not denominated in a national currency, such as Bitcoin”, although remained wary of the ostensible risks that could arise, where central banks would struggle to implement monetary policy and where massive losses could be realized were the currency to crash. Wilkins has made clear that the Bank of Canada will explore the implications of digital currencies over the course of its three-year corporate plan.

The idea is of Government-backed digital currency

While much of the attention (and indeed, risk-aversion) on Bitcoin has primarily been concerned with the currency’s nascent price volatility, the Bank of England (BoE) has focused more on the potential impact of the distributed ledger technology. The UK central bank has provided particularly glowing feedback to blockchain, with the bank’s chief economist Andy Haldane recently praising the technology’s potential capability in solving the challenge of ‘how to establish trust – the essence of money – in a distributed network’.

Like the Bank of Canada, moreover, Haldane is also in favor of issuing a government-backed digital currency, although in the UK’s case he argues that it could be used to charge a negative interest rate on currency, a measure which is not possible at present due to the widespread use of banknotes which could simply be held in safe deposit boxes to maintain value and would thus render attempts by the central bank to implement a negative rate as useless. The shift from paper to paperless currency, however, opens up the possibility of digital currency creation.

Bitcoin circulation in the market is considerable

In the BoE’s paper published last year, The Economics of Digital Currencies, the bank estimated that the amount of bitcoins circulating within the UK economy was less than 0.1% of sterling notes and coins and only 0.003% of broad money balances. As such, the impact from any serious Bitcoin fallout on the UK’s financial and monetary systems is considered negligible.

The Federal Reserve, meanwhile, has gradually become more vocal about the subject. During Bitcoin’s early existence, the US central bank was notoriously silent about Bitcoin, but began discussing the subject soon after the FBI shut down Silk Road – the illegal online marketplace – when 26,000 BTC worth $3.6 million was seized in October 2013.

In early 2014, Fed chief Janet Yellen stated that the Fed does not have the authority to regulate Bitcoin, due to the fact that this is ‘payment innovation that is taking place entirely outside the banking industry’. She did raise concerns about the potential for money-laundering, however, and has also recommended that Congress address the legality issues for those unregulated entities involved in virtual currencies.

The Fed has also conducted empirical analysis which has sought to test the security of the cryptography for transactions and the distributed maintenance of the ledger. The US central bank has remained somewhat averse to Bitcoin, highlighting the February 2014 bankruptcy of Mt. Gox, the largest bitcoin exchange at the time, and concluding, therefore, that Bitcoin many risks “whose nature and proportion are little, if at all, understood”.

More recently, the Fed’s official position has been to quietly monitor developments as they happen, but it has not stated whether it is considering issuing its own digital currency.

Digital currency, Bitcoin, raises several potential risks

The Bank of International Settlements (BIS), however, seems to have recently shown considerable enthusiasm towards the advancement of digital currencies. Although not explicitly a central bank, the BIS holds the membership of 60 global central banks, and has been instrumental in determining much of the regulatory landscape since 2007’s financial crisis. In its November 2015 paper, the CPMI Report on Digital Currencies, the BIS states several potential risks arising from the growing use of digital currencies, such as consumer losses resulting from excessive volatility, as well as fraud – a problem which has plagued Bitcoin on previous occasions.

The report also acknowledges the diminished role that financial intermediaries could play as digital currencies and distributed ledger systems become smarter. Ultimately, though the BIS’ opinion on digital currencies remains favorable, especially pertaining to those which have a decentralized payment mechanism, describing them as “an innovation that could have a range of impacts on various aspects of financial markets and the wider economy”.

Yuan was used in 80% Bitcoin transaction

The challenge in addressing Bitcoin appears to be more complex for China’s central bank at present, however. According to Goldman Sachs research from March 2015, the Yuan is being used for 80% of global transactions into and out of Bitcoin, indicating the digital currency’s overwhelming popularity in China. This wouldn’t be so much of a problem were it not for the fact that the People’s Bank of China banned the handling of Bitcoin transactions in December 2013, before closing down more than 10 of the currency’s exchanges in March 2014.

The view from the central bank is that the currency has no ‘real meaning’, but the consensus view is that it is being used for large-scale money laundering. The huge popularity of Bitcoin in China suggests that, while some may be using Bitcoin for speculative purposes, a large proportion are using the currency to shift money illegally out of China.

Conclusion

More recently, however, it appears that China’s view towards Bitcoin could be warming. In an October publication, the Cyberspace Administration of China (CAC) stated clearly that we are now in the “post-Bitcoin era,” acknowledging the development that bitcoin has ushered in through the “expansion of distributed payment and settlement mechanism”. Whether such sentiment will ultimately be transmitted through the corridors of the central bank remains to be seen at this stage.

Given that minting and distributing a digital currency should cost a fraction of the cost of printing and distributing a physical currency note, one should also bear in mind the seignior age benefits of moving towards paperless currency – that is, the potential revenue the government will retain from such a cost-saving. Along with the fact that digital currency transactions will be easier to track and less susceptible to illegal uses, there seems to be plenty of incentives for central banks to promote the development of digital currencies like Bitcoin.