There is a stark contrast between the attitudes of fintech enthusiasts and economists towards cryptocurrencies. According to the former, cryptocurrencies are disrupting finance, privatising money, rendering old style banking and central banks irrelevant, enabling seamless, costless global transacting, and finally, democratising the financial system. By contrast, economists tend to take a thoroughly sombre view, pointing out that “cryptocurrencies don’t make sense” (Danielson 2018), that bitcoin is an inferior form of money, the latest manifestation of a ‘Dutch tulip’ bubble, and its price susceptible to manipulation (Gandal et al.2017). Bitcoin’s blockchain has been described as the “most over-hyped technology of all times” (Roubini and Byrne 2018) in addition to being an environmental disaster.
The overwhelming case against cryptocurrencies
As economists, we can easily sympathise with the view that cryptocurrencies cannot compete with traditional currencies using standard textbook arguments. Any economics textbook will state that money serves three purposes: a medium of exchange, a unit of account, and a store of value.
In the first two, traditional currencies dominate because of strong network effects. The euro or the US dollar are accepted in large geographies and therefore work very well as a medium of exchange. In addition, all prices and wages, within their respective countries, are denominated in euros or dollars, and adding other units of account (currencies) to our daily life represents a cost for economic agents. In other words, established traditional currencies have a great starting advantage relative to any competitor, including cryptocurrencies.
As a store of value, there are two dimensions that matter. The value of fiat money is a function of the ability of central banks to keep inflation low. Overall, central banks have been quite successful at maintaining a low level of inflation among advanced economies, and even globally there are very few cases of out-of-control inflation these days. By contrast, for all their promise of freedom from central authority and democratisation of money, many cryptocurrencies have performed dismally as a store of value because of the volatility of their prices. More generally, a system of competing private money is unlikely to deliver price stability (Fernández-Villaverde and Sanches 2016).
The second dimension that matters for a store of value is how much we trust the intermediaries who hold our (electronic) money. In principle, cryptocurrencies are built around strong safety measures and do not need to rely on intermediaries. But their record, because of security breaches and other scandals, is mixed. Traditional banks have an infrastructure to handle identity thefts and errors that is quite robust (at least in advanced economies). In addition, they are regulated and, typically, provide partial deposit insurance unlike cryptocurrencies. There might not be a clear winner in this second dimension and there may be future changes that would strengthen the security features of any form of money.
A feature of money typically ignored in textbooks is anonymity. Like cash, some cryptocurrencies offer near-anonymity to the holder. Whether this is an important benefit to the majority of users is at least debatable. It clearly is a benefit for all types of illegal uses, from tax evasion to the drugs trade and the ransomware industry. The pervasive use of cash to finance illegal business is one of reasons why central banks are curtailing their issuance of large denomination notes – for instance, the ECB is phasing out the €500 note.
We cannot forget a final dimension in which cryptocurrencies fail, which is not about the properties of money but about the need for a lender of last resort to stabilise financial markets, in particular during crisis times. By design, cryptocurrencies are based on formulas and algorithms, some of them including a liquidity cap, that are not capable of dealing with the day-to-day demands of the liquidity issuer. From all we know about monetary policy this is less than ideal, so traditional currencies win again.
Case closed? Long live to traditional forms of money?
Not quite. There is one aspect where the analysis of economists falls short. We talk about money, currency, and means of payment as equivalent concepts. This used to be the case when money was gold or when we relied on bank notes. In these cases, all these three concepts are identical – a €100 note is an asset, the currency is its unit of account (euro), and to use it as a means of payment you physically hand it over to a seller. But today most money is electronic and sits in bank accounts. The value of the currency is determined by the central bank’s policies. But the value of the money stored in a bank account depends on how much you trust the bank. And, more importantly, to use it as a medium of exchange you need a process that allows you to transfer your balance to someone else’s bank account. That process typically involves three parts:
- a ‘device’ that the buyer uses to make the payment (e.g. a cheque, an app in a smartphone, a smartwatch, a debit card);
- a way to authenticate the buyer (and seller) – a signature, a fingerprint, a PIN code, or a digital token; and
- an infrastructure (network) that connects the bank account of the buyer and the seller and executes the transfer.
In this environment, money might be well defined as a store of value (the balance on my account) but not as a medium of exchange. There could be multiple ways to make the payment that are not equivalent because they differently define the experience, cost, efficiency, or even usability of the asset that we call money. It might be that a business does not accept the debit card I carry. It might be that there is a large fee if I use a credit card. Talking about money as identical to means of payment in this environment can be misleading.
When technology creates its own form of money
In countries where traditional bank accounts were not ubiquitous but mobile phones were, we witnessed innovation in the form of money consisting on balances stored with a telecom company (e.g. M-Pesa in Kenya). The unit of account remained the traditional currency, defined by a central bank, but money was now being redefined by the availability and simplicity of the payment technology, the mobile phone. The traditional intermediary, a bank, has been substituted by a ‘tech intermediary’. They are not disrupting the currency but they are disrupting the traditional form of money (through bank intermediaries) and potentially the way we think about monetary policy and its transmission.
When technology cannot wait and decides to create parallel currencies
Imagine you are frustrated with slow and expensive systems of payments and bank transfers, a reality in many markets, and you decide you want to disrupt the market. Directly competing with banks is not easy because of the regulatory burden of creating a bank. What if you could produce a parallel payment service using a different infrastructure that relies on an efficient and secure technology (blockchain) and a cryptocurrency? That was the easy path taken by many fintech startups and initiatives. The advantage of Bitcoin (or any other cryptocurrency) was not in its electronic form but that it provided a unified system where all accounts resided in the same ‘institution’ (like if all of us were banking with the same bank). And because it is not regulated there was no need to overcome any of the regulatory hurdles.
Two examples of that development: Circle was founded in October 2013 with the goal of disrupting peer-to-peer transfers using Bitcoin as the vehicle of those transfers; Ripple, first released in 2012, hoped to disrupt the cross-border payment system between banks (and also large corporations). Its starting point was also to rely on a cryptocurrency (XRP) that would serve as the vehicle for these payments. All institutions would have accounts at the same ledger and the system could be fast and efficient.1
Traditional banks could have, of course, provided similar services by relying on real-time gross settlement processes via a single intermediary (such as the Central Bank) where customers use electronic devices or debit cards for payments. But banks were facing two difficulties: changing legacy systems, and coordinating across the established payment networks; both are costly and take time. And in the case of international transactions, they faced the difficulty of managing liquidity pools in different currencies, as there is no central bank of the world. In this environment, a fresh system based on a cryptocurrency (a ‘global currency’) looked like a winning proposition.
What is interesting in the three examples above (M-Pesa, Circle, and Ripple), is that the payments technology is redefining the concept of money, and in two of these cases through the introduction of a new (crypto)currency.
But adding a currency has a big cost (yes, the economists are right again)
Despite the potential advantages of disrupting payment systems by making use of a unified currency such as Bitcoin, there is little evidence that transactions in Bitcoin are displacing traditional currencies. It seems that the benefits of traditional currencies driven by network effects are much bigger than the convenience and potential efficiency gains of these new systems. The unit of account feature combined with the mandatory acceptance of established currencies, makes them a generalised medium of exchange. As cryptocurrencies are facing resistance in their adoption as a mean of payments, some of those early pioneers are rethinking their strategies. Both Circle and Ripple are moving away from cryptocurrencies and looking for ways to apply their technology to traditional currencies.2 Speed and efficiency sounded like a great idea but not if you require users to add another currency, an exchange rate, and uncertainty about its value.
So disruption will come from blockchain and not Bitcoin?
The emphasis on blockchain comes from the initial challenge that bitcoin presented as an alternative to traditional currencies. This came with a strong view that a decentralised model of storing transactional data and keeping track of accounts was superior to the traditional model of central banks and commercial banks as intermediaries in the payments system. But there is limited evidence as of today that decentralisation (as imagined in the original formulation of the blockchain) is the answer to the inefficiencies of the payment system. And there are plenty of potential technology solutions (including distributed traditional databases with real time updating) that could be part of the disruption. Many central banks and financial institutions are experimenting with various forms of distributed ledger technologies (with and without the use of new currencies) but so far they have concluded that they are not mature for taking over from established payments systems (BIS 2018).
Fintech enthusiasts see technology as a disruptive force that can make financial intermediaries and markets more efficient. Cryptocurrencies were seen as the ultimate disruptor as they allowed new entrants to quickly challenge traditional banks without having to deal with the burden of a heavily regulated sector. But despite the potential, cryptocurrencies are now facing the reality of the insurmountable advantages of established currencies, and are failing to gain much traction as a means of payment. Moreover, regulators across the world are taking a closer look at the issuance of cryptocurrencies and some have moved to prohibit or curtail them.
But, despite this lack of success, there are other ways in which technology can disrupt money. In particular, we see the growing expectation of faster and more efficient payment systems as a catalyst for innovation. This innovation will leave currencies as we know them but might redefine the way in which money balances are created and accessed as a means of payment.
-Antonio Fatás, Beatrice Weder di Mauro