Part 1: Cryptocurrency, BIS looks beyond the hype
A summary of the 2018 BIS Annual Report chapter on cryptocurrency
By Ingrid Abraham, Eternic
On June 24, 2018, the Bank for International Settlements (BIS) released their Annual Economic Report 2018, with a chapter specifically focused on cryptocurrencies. This chapter is, in essence, a proclamation of the BIS’s position on cryptocurrencies, whether they can and/or should be viewed as a viable currency, and the potential and impact of surrounding technologies. Given the position of BIS as the glue between central banks and an authority on international settlement, we see their findings and position as highly relevant and significant, so in this report, we summarise the 21-page Chapter V. Cryptocurrencies: looking beyond the hype to distill the key takeaways.
What is money: A historical context
The report opens by providing a brief history of money, to give context against which to understand the discussion of cryptocurrencies.
They lay out the three fundamental and complementary roles of money: a unit of account, a medium of exchange, and a store of value, before performing an analysis of how monetary arrangements through history have succeeded or failed to fulfill these roles in different economic contexts. They conclude that fiat money has emerged as the dominant form of money, but it is not without shortcomings, such as vulnerability to abuse by the sovereign. The modern arrangement with independent central banks has been designed to mitigate these and has largely succeeded.
Cryptocurrency: Viable as money or not?
One binary along which it is often useful to divide cryptocurrencies is permissioning. Cryptocurrencies can either be permissioned, in which case only pre-approved actors can perform validation, or they can be permissionless, in which case anyone can. Permissionless cryptocurrencies are the classical case we think of, including examples such as Bitcoin and Ethereum, which run a proof-of-work algorithm, where whichever party is the first to solve a cryptographic puzzle gets to “mine” the next block of transactions on the ledger. Permissioned cryptocurrencies, on the other hand, make a trade-off, where the trustless nature of the network is lost by virtue of having to trust the validators, but great gains are made in scalability, cost, and privacy.
In this context, permissionless cryptocurrencies come out looking worse for wear. Their instability makes them a poor unit of account or store of value, and lack of settlement finality makes them a poor medium of exchange. Furthermore, it is pointed out that trust in individual crypto-payments is very fragile, depending on:
- Honest miners controlling a majority of computational resources: this was intended to be assured by self-interest incentives for miners, but the centralization of mining pools calls that back into question.
- Users verifying the ledger: as the ledger grows this becomes more and more unrealistic, bitcoin has already long breached the threshold where everyday users can simply verify the ledger, and if the full volume of national fiat transactions were committed to the ledger, it would quickly become only feasible for supercomputers to verify.
- Not breaching scalability limits: When the network has a higher demand of transactions than it can handle, transactions can pool unmined indefinitely, not to mention soaring transaction fees.
Beyond their utility as money, other issues are noted with cryptocurrencies, such as excessive energy use, and the lack of ability to enforce anti-money laundering and know your customer (KYC) regulations.
Some of these shortcomings might be solved by novel protocols and other advances, but others are seen as inherent to such systems, and as such the Bank of International Settlement does not seem to see a future for such cryptocurrencies.
As for permissioned cryptocurrencies, these are seen as largely similar to conventional payment mechanisms, relying on trust in and oversight of a central authority, with the only difference being the decentralized nature of transaction record storage.
Distribute Ledger Technology (DLT): Where the real value lies
Despite the scathing critique of cryptocurrencies as money and permissionless cryptocurrencies in general, promise is seen for the underlying technology distributed ledger technology (DLT) in other areas, such as in cross-border payments. However, this promise is seen in a fundamentally different context to cryptocurrencies, an example is the Building Blocks crypto-payment system controlled by the World Food Programme, where the unit of account and ultimate means of settlement is a fiat currency. The Building Blocks system runs on a permissioned version of Ethereum, a blockchain platform with smart contracts, and ultimately achieved a reduction of transaction costs of about 98% relative to bank-based alternatives.
The greatest potential of the underlying technology is seen in the ability for self-executing codes, such as smart contracts, to simplify administrative processes, which drive down costs and improve trust, without the use of cryptocurrency.
Initial Coin Offerings (ICO): You say “tomato”, we say IPO
The report notes the fraudulent nature of many initial coin offerings (ICOs), and that many ICOs are being used to raise funds for projects entirely unrelated to cryptocurrencies. They go on to assert that the only difference between most ICOs and an initial public offering (IPO) is semantics and that ICOs should, therefore, be regulated as such. The exception to this being ICOs that double as “utility tokens” which instead call for the application of consumer protection laws.
Central Bank Digital Currency (CBDC): Yes, no, maybe
The significance of any introduction of central bank digital currency (CBDC) is noted, but also that there is currently no sufficiently strong incentive to create one. The report discusses ongoing experiments by central banks with wholesale CBDCs, with initial results showing success in replicating existing high-value systems, but not clearly exceeding them. While wholesale CBDCs are seen as viable in the short term, general-purpose CBDCs are seen as much more heavily wrought with considerations in payments, financial stability, and monetary policy that as yet have no answers.
In summary, the Bank for International Settlements sees cryptocurrencies as inherently inviable as a form of money, initial coin offerings (ICO) as unregulated and scam-ridden, central bank digital currencies as viable but currently unnecessary, and distributed ledger as promising technology if taken outside the realm of cryptocurrency. The promise seen in distributed ledger technology lies in three facilities: tokenization (not directly addressed but implied through praise of the WFP’s Building Blocks system), the simplification of administrative processes, and self-executing codes, and the possibilities brought by the intersection of all three.
Since the release of this report, we have begun to see financial institutions adopting DLT in production, such as J.P. Morgan’s JPM Coin — see What the JPM Coin means for the Future of Payments, as well as big tech companies expanding their purview to include financial services with Libra, Facebook’s cryptocurrency initiative. These and similar others indicate that adaption within the financial sector is already at hand. Whether or not the BIS will embrace cryptocurrency as well, remains to be seen.
For more information on current distributed ledger technology projects and their suitability for the financial service sector, see our latest research report: Distributed Ledger Technologies for International Banking — Concise Analysis of Applicability
To learn more about BIS positions related to financial technology developments, such as Big Techs entry into finance, read: Part 2, Big Tech in finance, BIS on the opportunity and risk.
Ingrid Abraham is a Business Analyst for Eternic, The Fluid Solution for Global Payments and Settlement.