CRYPTO AND CENTRAL BANKS

Ban them? Block them? Back them? 

Governments and central bankers have long been exercised by the disruptive nonsense of cryptocurrencies.

Some countries are actively experimenting with cryptocurrencies with rather unimpressive results. These include Uruguay, Senegal, Tunisia, and Venezuela. Venezuela’s cryptocurrency, the petro, backed by the country’s petroleum reserves, has been variously described as “a scam on top of a scam”, and the “most obviously horrible investment ever.” 

Others, such as Estonia, Switzerland, and Germany, have shelved the idea, at least for now. There are well developed payment systems available today on a global basis facilitating secure, traceable, and reasonably efficient payments between people and businesses. Why develop a new one which is riskier, more volatile, and costly?

Central bank issued digital currency

Two central banks have tasked their best and brightest to probe the unexplored monetary frontier of Central Bank (issued) Digital Currencies (CBDC).  Sweden’s Riksbank and the Bank of England, the oldest and the second oldest central banks in the world respectively have published papers on the topic that are fairly detailed. They are both off-track.

The Swedish paper comes in two parts published just over a year apart. The second part was published in October 2018. The Bank of England paper was published in May 2018.

 Both come heavily caveated. The Bank of England paper is positioned as a “didactic exercise” to help researchers in the CBDC field. The Swedish paper clarifies in its introduction that the paper does not provide answers to all the questions surrounding future payment systems. 

Serious economic papers inevitably resort to complex mathematical representations to quantify unquantifiable things. The Bank of England paper resists the mathematical calculus for the first 9 pages. But sure enough, on page 10, an obscure formula appears which gradually crystallises and expands till it succinctly covers the width of the whole page. The paper’s focus is on economic implications of digital currencies. These are important. But there is no explanation, not even a hint, of how a digital currency could overcome its hardest challenges. 

The Challenges

Counterfeit currency

The first challenge is the most obvious one. A digital currency token or unit – let’s call it a digital dollar - is made up of bits and bytes like any other digital record such as an app, a song, or a movie. Even with code that makes it difficult to copy, it can be hacked, duplicated, and used to pay for things more than once. 

A unique serial number will not help because counterfeiters will create digital dollars identical to the original token making it impossible to distinguish between real fake. Possibly secure software (or hardware) wallet only obtainable from or approved by the central bank could store a digital dollar and transfer it to another similarly approved wallet. All this would make a digital currency system too complicated, cumbersome, and untenable as was the case with Mint Chip, a failed digital currency system developed in 2012 by the Canadian Mint and backed by the government of Canada.

Ownership

When a person receives a digital dollar, they will have to ensure it is not fake and that it has been paid to them by the rightful owner, not a hacker, nor someone who has already used it before. In real life with physical cash, possession is ownership. But not so in the cyber world where someone may pretend to be the rightful owner and each transaction has to be verified individually.

Working by consensus

Bitcoin solved these problems, bigger for a decentralised system, by coming up with the idea of a chain of digital blocks that validate transactions “by consensus” across a network of multiple “distributed” computers. Consensus lends legitimacy. 

A central bank on the other hand may not be comfortable with a consensus led approach. Without a decentralised consensus-based system, the digital currency issuing authority – a central bank - will have to maintain accounts for everyone centrally otherwise it will be difficult to ascertain the rightful owner.

Stable coins

Cryptocurrency prices subject to the vagaries of supply and demand of an illiquid market fluctuate significantly something which cannot be characteristic of a CBDC. A new type of crypto called “stable coin” have appeared on the scene where the value of a digital dollar is pegged to the value of the real dollar. The company issuing a stable coin keeps a collateral – 100% (every digital dollar backed up by a real dollar in the bank) or partial, say 50% (two digital dollars backed by a real dollar). Central banks may have to use some form of crypto that is pegged to their “fiat” currency.

Off-track

The Bank of England paper does not even mention double spending even once. It is concerned with traditional economic risks of a centrally managed currency, it is only concerned with “sectoral and aggregate balance sheet dimension” of central bank issued digital currencies – entirely academic if you don’t even know what your CDBC will look like.

The two papers from the Riksbank acknowledge double spending but astonishingly offer only the value register approach which would require the “bearer of value” such as a digital wallet or stored-value card to be registered with the central bank. In other words every transaction for the possible future currency, the “e-krona” will have to be between central bank approved wallets or accounts It may be possible for bank to bank transactions but not for a system that aims to mimic physical cash in the digital world for general use. 

Summary

The counterfeit and double-spending problem was always the major proof of the crypto-pudding and Bitcoin and now others provide a blockchain-based consensus-driven solution which works adequately at least for limited purposes for which cryptocurrencies are being used today. Even as long ago as the 1990’s pioneering cryptologists such as David Chaum with his “blind signatures” had offered solutions to overcome this problem.

It is difficult to see if central banks will ever embrace decentralised approaches or solve the double-spend problem without making the whole system cumbersome and unusable. Unless central banks change their attitudes and adapt to at least some form of decentralisation where digital currencies are concerned, they will not be able to overcome the main challenges involved.