The Bank for International Settlements (BIS) has warned that cryptocurrencies such as bitcoin are a poor substitute for money issued by central banks.
The Basel-based BIS, an international financial institution which has traditionally acted as central bankers’ think tank, has devoted a chapter of its widely followed annual economic report to cryptocurrencies.
“Cryptocurrencies promise to replace trusted institutions with distributed ledger technology. Yet, looking beyond the hype, it is hard to identify a specific economic problem which they currently solve,” the BIS says.
“Transactions are slow and costly, prone to congestion, and cannot scale with demand. The decentralised consensus behind the technology is also fragile and consumes vast amounts of energy.”
Earlier this year the general manager of the BIS, Agustín Carstens, described bitcoin as “a combination of a bubble, a Ponzi scheme and an environmental disaster”.
“History is a graveyard of currencies”
In its annual report, the BIS argues that that the essence of good money has always been trust in the stability of its value. However, the BIS points out, history is full of episodes of failed currencies, whether issued by private entities or sovereigns. As a result, successful money is rarer than we think.
“Sustained episodes of stable money are historically much more of an exception than the norm. In fact, trust has failed so frequently that history is a graveyard of currencies,” the BIS says.
In its report, the BIS concedes that decentralised, permissionless cryptocurrencies such as bitcoin—whose transaction records are distributed across all the nodes in the network and maintained according to a set of rules—are a radical departure from the prevailing institution-based monetary setup.
In almost all modern economies money is currently provided through a joint public-private venture between the central bank and private banks, the BIS says, with the central bank at the system’s core.
Under this two-tier system, electronic bank deposits are the main means of payment between members of the broader economy, while central bank reserves serve as the means of payment between banks, the BIS notes.
By contrast, in permissionless cryptocurrencies, the ledger recording transactions can only be changed by the consensus of the participants in the currency. And while anybody can participate in the network, nobody has a special key to change the ledger.
In its annual report, the BIS makes some familiar criticisms of bitcoin and other cryptocurrencies, describing their energy usage as wasteful, pointing out their volatile price and noting that settlement in cryptocurrencies is only probabilistic, rather than final at a point in time.
In conventional monetary systems, settlement is considered final when a payment takes place in reserve money: in other words, when it cross the books of the central bank.
“Coordination on how the ledger is updated could break down at any time, resulting in a complete loss of value”
But the BIS also claims that decentralised cryptocurrencies have a more fundamental shortcoming, inherent in the mechanism used to update their transaction ledgers.
“Coordination on how the ledger is updated could break down at any time, resulting in a complete loss of value,” the BIS says.
The BIS notes that cryptocurrencies are subject to repeated “forking”, as some miners of a cryptocurrency coordinate to change the protocol to a new set of rules that is incompatible with the old one.
January 2018 alone saw ten forks of bitcoin, the BIS notes: Bitcoin ALL, Bitcoin Cash Plus, Bitcoin Smart, Bitcoin Interest, Quantum Bitcoin, BitcoinLite, Bitcoin Ore, Bitcoin Private, Bitcoin Atom and Bitcoin Pizza.
“Frequent episodes of forking may be symptomatic of an inherent problem with the way consensus is formed in a cryptocurrency’s decentralised network of miners, the BIS argues.
“The underlying economic issue is that this decentralised consensus is not unique. The rule to follow the longest chain incentivises miners to follow the computing majority, but it does not uniquely pin down the path of the majority itself,” the BIS says.
A less sceptical view on the prospects for cryptocurrencies as money comes from an official at another supranational institution, the International Monetary Fund (IMF).
Writing in the June 2018 issue of Finance and Development, Harold James, a professor of history and international affairs at Princeton University and IMF historian, argues that the emergence of cryptocurrencies may mark a new age in monetary history.
“Bitcoin marks a transformational shift in the perception of fundamental value,” writes James.
“Blockchain technology means that value reflects a combination of stored energy and intelligence, none of it human. It may point to a new age when most and eventually all value may be created by the nonhuman interaction of machines and energy.”
“Decentralised ledger technology can be efficient where the benefits of decentralised access exceed the higher operating cost of maintaining multiple copies of the ledger”
However, while the BIS’s stance on cryptocurrencies as money is critical, it still sees applications for the underlying technology.
Decentralised ledger technology (DLT) may help reduce transaction fees in the $540bn a year remittance payments business, the BIS says, or improve efficiency in global trade finance, which the BIS describes as cumbersome, complex and costly in its current state.
“DLT can be efficient in niche settings where the benefits of decentralised access exceed the higher operating cost of maintaining multiple copies of the ledger,” the BIS says.
However, says the BIS, it expects successful applications of DLT to be via permissioned, rather than permissionless networks.
By contrast with permissionless cryptocurrency ledgers such as that of bitcoin, permissioned ledgers are updated by a central node, or a subset of nodes, with trusted status.
These use cases “are likely to combine cryptopayments with sophisticated self-executing codes and data permission systems,” the BIS says.
“Some decentralised cryptocurrency protocols, such as ethereum, already allow for smart contracts that
self-execute the payment flows for derivatives,” the BIS notes.
However, it adds, “at present, the efficacy of these products is limited by the low liquidity and intrinsic inefficiencies of permissionless cryptocurrencies.”
Instead, DLT could be used in permissioned networks that use sovereign money as backing, to help simplify settlement execution, the BIS argues.
In March this year, for example, the Bank of England announced it was undertaking a Proof of Concept (PoC) to understand how its real-time gross settlement (RTGS) system, which guarantees wholesale payments between financial institutions, could be capable in future of supporting settlement in systems built on DLT.
“There’s a realisation at central banks that their own RTGS systems are going to have to change. If they don’t engage with DLT initiatives like ours, central bank money may stop being used for final settlement and we’ll go back to the older world of private money settlements,” Robert Sams, CEO at Clearmatics, one of the companies working with the Bank on the Proof of Concept, told New Money Review.
Clearmatics, which is backed by several banks, is developing a DLT platform to enable custodians and end-users to settle securities trades and automate the performance of derivatives and other financial contracts.
