Central Bank Cryptocurrencies: The Next Step for Crypto?

When most people think about the relationship between government and cryptocurrencies, it’s more often than not from a regulatory standpoint. As millions were made and lost as Bitcoin rose and fell, most people viewed the government as a regulator — a policer of IPOs and fraud, ensuring investors were protected. However, in this article, I want to explore the question of the government donning another cap and explore the role of central banks as issuers of cryptocurrency. I’ll begin by giving an overview of academic studies concerning central banks issuing cryptocurrency, followed by an analysis of what academics call the “Central Bank Digital Currency Trilemma” and a brief discussion of the Venezuelan Petro.

One of the first mentions of central bank cryptocurrencies (CBCCs) is from the Bank of International Settlements (BIS), specifically from their Committee on Payment and Market Infrastructures (CPMI). In a 2015 report entitled “Digital Currencies” [1], the CPMI called specific attention to having central banks go beyond acting as mere regulators and consider issuing a cryptocurrency. It appears that the impetus behind this is to avoid challenges with regulation and fraud in what was then an extremely nascent field. The report believed that the evolution of payment settlements could create a “hypothetical challenge” [2] to central banks, as the need for a central issuer of coin is not needed in a decentralized system. It went on to note that “[Distributed ledger technology] reduces the functions of a central body and, in an extreme case, may obviate the need for a central body entirely for certain functions.” [3]

On a more fundamental level, the “Digital Currencies” paper identified three broad characteristics of all cryptocurrencies: they are electronic, not the liability of anyone, and feature peer-to-peer exchange. This is in contrast to fiat money, which is by definition a liability of the central bank. Turning to how CBCCs fit into this picture, subsequent academic research such as Bjerg (2017)[4] has identified some similar broad characteristics that CBCCs must abide by. In contrasting a CBCC to money in one’s bank account, the money in one’s bank account is the liability of the bank in which it is held, as opposed to a direct liability of the central bank. Bjerg points to “universal accessibility”[5] as an integral characteristic of CBCCs. Items like central bank settlement accounts are only available to banks and are thus not universally accessible. Contrarily, for a CBCC to exist parallelly to cash, it must have the universal accessibility property. As the BIS summarized, the following is a Venn diagram illustrating these principles of cryptocurrencies. [6]

Figure 1: Cryptocurrency vs. Central Bank Digital Currency[7]

Although Bjerg’s indicates that CBCCs are universally acceptable[8], other scholarship on the topic actually indicates two potential avenues for CBCCs. CBCCs could be either “retail”, a customer-facing application, or “wholesale”, exclusive to banks and other financial institutions as a settlement and remittance network. Thus, combining the figures from CPMI (2015) and Bjerg (2017) to reflect these two types, the figure becomes the following, taken from the BIS. This figure, referred to as the “Money Flower”, sees the retail and wholesale versions identical but for the universal accessibility parameter.

Figure 2: Diagrammatic Representation of Wholesale and Retail CBCCs[9]

Turning to the implementation of each of these types of CBCCs, the most iconic proposal of a retail CBCC was the Fedcoin, proposed in Koning (2014).[10] As the name may suggest, the intent behind Fedcoin was to have the Federal Reserve issue a cryptocurrency that functionally paralleled Bitcoin. The hypothesis was that bitcoin was far too volatile to be used as a decentralized currency, so having the Fed as a backer and central point of control would offer the advantages of lower transaction costs and greater stability. [11] Unlike Bitcoin, Fedcoin would not have a finite cap on the number of tokens in existence. It would simply exist parallel to the existing currency. In his paper, Koning parallels it to the creation of a new $200 bill, with a pegged 2:1 rate to the $100 note. As he notes, “Should demand for converting $100 bills into $200 bills explode, the central bank can effortlessly maintain the peg by having as many $200s printed as necessary to satisfy demand while shredding $100s as they pour into Fed vaults.” [12] Thus, Koning’s proposition ensures price stability.

The most notable significance of implementing a retail CBCC is with respect to negative interest rates.[13] Currently under the cash system, having negative interest rates creates arbitrage opportunities, as keeping cash under the proverbial mattress earns a 0% nominal interest rate. However, as the BIS points out, a complete replacement of CBCCs in place of cash would mean that depositors cannot avoid negative interest rates (without forgoing all of their central bank holdings, of course). This would give central banks far greater flexibility to stimulate economies, specifically during recessions, when interest rates are close to zero as it is. In terms of evaluating whether retail CBCCs should be implemented, a key risk is the impact it would have on the financial services industry. Evidently, the disintermediation of banks may hurt their balance sheet, potentially causing the sector to decline.

On the other hand, wholesale CBCCs are a payment system designed to clear payments between a central bank and other financial institutions, thus lacking the “universal accessibility” that retail CBCCs have. Wholesale networks tend to be permissioned blockchains, as only select participants like banks should be able to access the network. The most promising example of this is Project Jasper by the Bank of Canada, which offers “real-time gross settlement” systems.[14] The advantages of this are typical of decentralized systems — reduced fraud and transaction costs. A key barrier to this adoption is liquidity risk — while settlement systems like this make settlements more efficient, they also are more demanding in terms of liquidity, a common barrier to adoption of such systems. [15]

Will it Happen? The Monetary Policy Trilemma, Examples from Venezuela

While retail and wholesale CBCCs offer myriad benefits on paper, whether they will actually be implemented relies on a number of other considerations. This section will talk about some of the factors that hamper the adoption of CBCCs, and also consider the case of Venezuela and their new state cryptocurrency, the Petro.

One of the most interesting factors hindering the adoption of retail CBCCs is the monetary policy trilemma, adapted to cryptocurrencies. In macroeconomic theory, there is a trilemma that a government can only pick 2 out of free capital flows, a fixed exchange rate, and sovereign monetary policy. To illustrate this principle, the only way to have an exchange rate that stays fixed while market forces are in play is to either place capital controls or to implement monetary policy.[16] Bjerg (2017) adapted this to the case of CBCCs, redubbing stable exchange rates as “parity” and “free capital mobility” as free convertibility between conventional money and crypto.[17] Seeing as how the purpose of coins like Fedcoins are to avoid fluctuation of exchange rates, the trilemma indicates that the Fed cannot have simultaneous free conversion between crypto and fiat as well as independent monetary policy at the same time. This could be a potential obstacle to the adoption of retail CBCCs. Furthermore, most retail blockchains are permissionless and rely on proof-of-work algorithms, which are relatively more energy intensive. Wholesale ones, on the other hand, as permissioned networks, can rely on simpler, less energy-intensive consensus algorithms like Corda’s.[18] All of this leads me to believe that wholesale CBCCs are more likely to be adopted quicker as compared to retail ones.

However, there is one retail CBCC currently being implemented today — the somewhat infamous Venezuelan Petro. Facing hyperinflation and a spiraling debt burden, the Venezuelan government decided to announce the creation of a cryptocurrency called the “Petro”, backed by the country’s oil and gold reserves.[19] The Petro is now accepted legal tender in Venezuela, and recently had their ICO. The intent is to offer an alternative currency to the rapidly depreciating fiat and benefiting from low transaction costs and the other benefits of crypto in the process. While this might be seen as an adoption of a retail CBCC, the international community views the Petro largely as a sham for a number of reasons. For starters, with over $140 bn in foreign debt, the value of Venezuela’s reserves are inadequate to cover the supposed market cap of the Petro.[20] Additionally, a technologically unsound whitepaper coupled with misleading information from the Venezuelan President Maduro makes it seem like little more than an attempt to circumvent American sanctions.[21] In fact, organizations that evaluate cryptocurrencies call the Petro a scam.[22] Thus, it may still be some time until we see a proper implementation of retail CBCCs.

On the whole, CBCCs are a fascinating and as yet relatively unexplored dimension of the dynamic between cryptocurrency and the government. There is tremendous opportunity on both the retail and wholesale side of CBCCs, each coming with their own upsides. A more detailed analysis seems to indicate that the permissioned blockchains characteristic of wholesale CBCCs seem relatively simpler to implement in the short run. It is true that Venezuela currently operates a form of retail CBCCs, however a lack of transparency and dubious technical specifications do not make it an exemplar of the promise of the technology more broadly.

Bibliography

1. Al Jazeera, “What is Venezuela’s New Petro Cryptocurrency?” https://www.aljazeera.com/news/2018/02/venezuela-petro-cryptocurrency-180219065112440.html, Accessed on Dec 1 2018

2. Bank for International Settlements Committee on Payments and Market Infrastructures, “Digital Currencies”, November 2015

3. Bjerg, “Designing New Money — The Policy Trilemma of Central Bank Digital Currency”, Copenhagen Business School Working Paper, June 2017

4. Bloomberg, “Crypto Rating Sites Are Already Calling Venezuela’s Petro a Scam”, https://www.bloomberg.com/news/articles/2018-04-03/crypto-rating-sites-are-already-calling-venezuela-s-petro-a-scam Accessed Dec 1, 2018

5. Chapman et. al, “Project Jasper: Are Distributed Wholesale Payment Systems Feasible Yet?”, Bank of Canada, June 2017

6. Investopedia, “Impossible Trilemma” https://www.investopedia.com/terms/t/trilemma.asp Accessed Dec 1, 2018

7. JP Koning, “Fedcoin: A Central Bank-Issued Cryptocurrency”, R3 Report 2014

8. Time, Russia Secretly Helped Venezuela Launch a Cryptocurrency to Evade U.S. Sanctions, http://time.com/5206835/exclusive-russia-petro-venezuela-cryptocurrency/, Accessed Dec 1, 2018

[1] Bank for International Settlements Committee on Payments and Market Infrastructures, “Digital Currencies”, November 2015

[2] Ibid.

[3] Ibid.

[4] Bjerg, “Designing New Money — The Policy Trilemma of Central Bank Digital Currency”, Copenhagen Business School Working Paper, June 2017

[5] Ibid.

[6] Bech and Garatt, “Central Bank Cryptocurrencies”, Bank of International Settlements Quarterly Review, September 2017

[7] Bech and Garatt, “Central Bank Cryptocurrencies”, Bank of International Settlements Quarterly Review, September 2017

[8] Bjerg, “Designing New Money — The Policy Trilemma of Central Bank Digital Currency”, Copenhagen Business School Working Paper, June 2017

[9] Bech and Garatt, “Central Bank Cryptocurrencies”, Bank of International Settlements Quarterly Review, September 2017

[10] JP Koning, “Fedcoin: A Central Bank-Issued Cryptocurrency”, R3 Report 2014

[11] Ibid.

[12] Ibid.

[13] Ibid.

[14] Chapman et. al, “Project Jasper: Are Distributed Wholesale Payment Systems Feasible Yet?”, Bank of Canada, June 2017

[15] Bech and Garatt, “Central Bank Cryptocurrencies”, Bank of International Settlements Quarterly Review, September 2017

[16] Investopedia, “Impossible Trilemma” https://www.investopedia.com/terms/t/trilemma.asp Accessed Dec 1, 2018

[17] Bjerg, “Designing New Money — The Policy Trilemma of Central Bank Digital Currency”, Copenhagen Business School Working Paper, June 2017

[18] Bech and Garatt, “Central Bank Cryptocurrencies”, Bank of International Settlements Quarterly Review, September 2017

[19] Al Jazeera, “What is Venezuela’s New Petro Cryptocurrency?” https://www.aljazeera.com/news/2018/02/venezuela-petro-cryptocurrency-180219065112440.html, Accessed on Dec 1 2018

[20] Ibid.

[21] Time, Russia Secretly Helped Venezuela Launch a Cryptocurrency to Evade U.S. Sanctions, http://time.com/5206835/exclusive-russia-petro-venezuela-cryptocurrency/, Accessed Dec 1, 2018

[22] Bloomberg, “Crypto Rating Sites Are Already Calling Venezuela’s Petro a Scam”, https://www.bloomberg.com/news/articles/2018-04-03/crypto-rating-sites-are-already-calling-venezuela-s-petro-a-scam Accessed Dec 1, 2018

--

--

Get the Medium app

A button that says 'Download on the App Store', and if clicked it will lead you to the iOS App store
A button that says 'Get it on, Google Play', and if clicked it will lead you to the Google Play store