Cryptocurrencies: The battle for money (Frankfurter Allgemeine Sonntagszeitung)

How much of a threat are cryptocurrencies to central banks? An opinion piece by Prof. Volker Wieland in the Frankfurter Allgemeine Sonntagszeitung.

Confronted with kryptonite, Superman loses his superpowers. All fans of the comic book have known this for many years. Today, many are asking whether the world's central banks  - confronted with the new cryptocurrencies - will lose their power just as quickly. And that is anything but a silly question.

At present, the ECB, the Fed and others are still the talk of the town. In the Corona crisis, they are producing vast amounts of money and seemingly buying half the world with it.  To put it a little less dramatically, they  buy sovereign and corporate debt instruments from the banks. In return, they credit the banks' accounts at the central bank with the corresponding amount. This is digital central bank money. The ECB's balance sheet, for example, has grown to 7737 billion euros, and the central bankers have become the most important creditors of the member states.

The global market capitalisation of the top 100 cryptocurrencies is currently just under 1100 billion euros, or about one-seventh of the ECB's balance sheet. That may still sound moderate. But the order of magnitude already corresponds to the euro cash in circulation, currently 1400 billion euros. These are the banknotes and coins that are actually used by households and companies located in the Euro zone or outside it. Digital cash does not exist. But people mostly pay digitally, whether by bank transfer, payment card, credit card, PayPal or smartphone. Traditional cash is losing importance in comparison. And now the new cryptocurrencies are competing with the digital payment options offered by the banking system, as well as with the currencies provided by the central banks.

Who will win the battle for money? Is a cut-throat competition imminent? To answer this, it is necessary to clarify whether and to what extent cryptocurrencies are money, how there is a currency competition between private and state currencies, and how central banks can hold their own with their product.

The cryptocurrency Bitcoin has become very popular as a speculative object with rapidly rising prices. It accounts for almost half of the top 100 cryptocurrencies in terms of market capitalisation. Bitcoin, created by Satoshi Nakomoto, a mysterious person or institution, offers a decentralised payment system without a government guarantee. It is based on a decentrally managed public transaction database. Nodes in the network can keep a copy, propose changes, and validate. A central authority as in conventional payment systems is no longer necessary. The network verifies the transaction using a process based on the provision of cryptographic computing power to build consensus.

Of course, bitcoin has no intrinsic value in itself, like gold or cigarettes. But that is also the case with state-issued paper money or the book money of banks. Nevertheless, it is almost commonplace that Bitcoin fulfils the traditional functions of money very poorly. Hardly anyone uses it to pay for coffee at the coffee shop or for other daily transactions. It is just too costly for that purpose and has not been accepted for that. This is even more true for major and cross-border transactions. The anonymity it offers does make it interesting for criminal transactions. But the payment flows can be traced in the public database, and so the criminal misuse of cryptocurrencies and crypto exchanges can be investigated quite successfully to a certain extent. The high volatility stands in the way of its function as a store of value. And finally, Bitcoin has not yet established itself anywhere as a significant unit of account.

It is remarkable, however, that even a cryptocurrency that manages to barely fulfil the traditional functions of money such as Bitcoin, has already been met with such great demand. How much more potential must there then be in a cryptocurrency that fulfils these functions much better. In any case, the number of cryptocurrencies is shooting up. These are, among others, Ethereum, Tether, Binance Coin, Cardano, DogeCoin, Ripple, USD Coin, Polkadot or Binance USD. They differ in technical design, consensus-building protocols, and other aspects. Among them are several stable coins that are pegged to the US dollar.

With a bang, a Facebook-initiated and Swiss-based consortium unveiled plans in June 2019 to create a stable-value digital currency called Libra, which would be tied to a basket of currencies. Libra is aimed at increasing the efficiency of retail and business payments, including cross-border transactions, by leveraging existing networks and platforms such as Facebook. It is supposed to reduce transaction fees and shorten transaction times. Especially in countries with less developed financial systems, Libra wanted to contribute to better financial inclusion. In the meantime, financial market regulators and central banks put the brakes on this initiative and the plans were scaled back to a US dollar-linked stable coin called Diem.

Competition between currencies

From an economist's point of view, it is clear that competition is good for the consumer because competition ensures that monopolistic returns disappear and innovations are made. Competition between currencies is ancient. Shells, silver, and gold fulfil the function of a medium of exchange better than barley or cattle. Paper money reduces production costs. States can mandate that the money they put into circulation must be accepted as legal tender and can at least be used to pay taxes. But if they put too much of it into circulation, it loses value, i.e. purchasing power. Then the prices of goods and services rise, expressed in the unit of account that defines that currency. There is inflation. 

Thus, there is also competition among the world's national currencies. Their relative purchasing power is expressed in the exchange rates. People who live in countries with high inflation rates or fear a sharp rise in inflation often seek refuge in foreign currency. This can be bank accounts in foreign currency or foreign cash. It is not surprising that especially dollar or euro banknotes with higher values circulate abroad, for example in Ukraine and Russia or in countries in Latin America and Africa. By issuing cash, central banks generate income, the so-called seigniorage. To the extent that they maintain confidence in the preservation of value, they retain this source of income.

In developing and emerging countries, there are many people who do not have good access to bank accounts, a stable currency, and low-cost payment systems. A digital currency that would give them access to a digital wallet and low-cost transactions would be a huge step forward and of course a huge competition for the local central banks and other banks. But it is also possible that there will be demand in industrialised nations. Anyone who has to transfer money outside the EU knows the kind of horrendous fees that are involved. In addition, the fees in the domestic banking business are rising, because the banks are struggling with the low interest rate environment and are looking to generate new income. A private digital currency that would appeal to users in advanced economies on a large scale would also have an impact on the ability of monetary policy to influence economic activity and inflation. The leverage that the central bank currently uses to keep financing costs low in the economy with liquidity support and bond purchases would be reduced.

The Empire strikes back

Batman must have once advised Superman to wear a kryptonite suit made of lead and titanium to protect him from radiation. But in the long run, that didn't work for Superman. Central banks also tend to follow the motto "attack is the best defence". The Central Bank of The Bahamas, for example, was the first to introduce its own digital currency in October 2020, which, like the Bahamas dollar, is pegged one-to-one to the US dollar. Many central banks have introduced plans to develop a digital currency. Pilot projects are underway in China and Sweden. The Governing Council of the ECB is also examining what a digital euro could look like.

Central banks are probably less concerned about competition with private cryptocurrencies than about not catching up with other central banks in time. However, central banks that are already struggling to keep inflation under control within their purview will hardly be able to put an additional attractive digital currency into circulation. They will come under particularly strong pressure from the new competition. Most recently, the Bank for International Settlements (BIS) - the club of central banks in Basel, Switzerland - sang the praises of central bank digital currencies in a pre-published chapter of its annual report. 

The first question is whether the central bank digital currency will be based on a decentralised transaction database and offer anonymity, or whether it will be an account system that the central bank manages centrally and where it knows the identities and transactions. Most of them, including the ECB, will probably go for the latter. This can work well. Central bank accounts for the general public have existed in the past. However, it is foreseeable that there will be heated discussions about the insights that central banks will gain into our privacy. Whoever knows what I buy knows who and how I am. You don't have to be a criminal to have concerns about this. It is not a surprise that traditional cash, which offers maximum anonymity, continues to be a successful model in many places, as well as here in Germany. Private cryptocurrencies, which offer more anonymity at favourable transaction costs, will probably be able to hold their own against such state-owned digital currencies.

An account-based digital currency from the central bank is above all a new competitor for banks. They will find it more difficult to hold customer deposits if you can deposit your money with the Bundesbank. That is probably the main reason why central banks have held back so far. It cannot be in their interest to jeopardise the stability and profitability of the banking system. In our country, the profitability of the banks has already been impaired due to the ECB's low interest rate policy and major interest rate risks have built up on the banks' balance sheets. That's not the place to start fiddling. But this argument is now no longer strong enough to stop plans for central bank digital currencies. It will be a question of designing these digital currencies in such a way that the banks can participate in their provision and thus retain business opportunities. After all, the necessary infrastructure does not have to be provided by the state central bank system alone. 

Finally, a digital currency would open up new possibilities for central banks in monetary policy. Traditional cash, which guarantees an interest rate of zero per cent, is the main reason why the central bank hits an interest rate floor in deflationary phases and has to resort to securities purchase programmes. Their effectiveness is controversial. A digital currency, on the other hand, could pay interest. In a recession and deflation, the interest rate policy could then be continued into negative territory. Short phases of lower negative interest rates could help avoid such prolonged periods of low interest rates as we have been experiencing in Germany for years now. When the digital currency is introduced, however, a negative interest rate would be a deterrent. But even a digital currency that guarantees an interest rate of zero would be problematic in the current environment. It would counteract the current interest rate policy and quantitative easing, which pushes longer-term interest rates into negative territory. It would also massively increase competitive pressure on the banking sector. So things will remain exciting.


The opinion piece was first published by the "Frankfurter Allgemeinen Sonntagszeitung" (€) on June 27. The full text is available in German.