Cryptocurrencies, often depicted as an escape from fiat currency and legacy banking, have become a constant focus of bank and government activity. The most recent Executive Order from the U.S. President is just one example of governments carefully considering how to deal with cryptocurrencies. With all the news, it’s easy to lose sight of the fundamentals of monetary policy and currency, and why cryptocurrencies (or “cryptos”) are not a likely replacement for fiat currencies.

In 2021 the Bank of International Settlements (which is owned by, and provides financial services to, central banks) commissioned an academic research paper entitled “Distrust or speculation? The socioeconomic drivers of U.S. cryptocurrency investments.” The research found that crypto investors were more likely to be digital banking users, male, young, and educated. More surprisingly, it found that cryptocurrency investors and users were not motivated by a distrust in traditional banking and payment services. This touted raison d’être for Bitcoin and other early cryptos seems to be a myth.

Crypto’s limits as a form of payment

Of course, the popularity of cryptos has partly been driven by high valuations and volatility, attracting attention from traders, the media and the public. But this volatility makes cryptos less than ideal for payments. Companies like Tesla and Amazon, after initially stating they would accept some cryptos as currency, have since backtracked. Why would they want to accept a currency whose value can fluctuate so dramatically on a daily basis?

Why, indeed, would anyone? Will cryptos find their way into mainstream payment systems, or will they remain a speculative investment? Much of the answer rests on an understanding of how governments, regulators, and central banks act to protect their economies and citizenry. Why “protect”? Let’s explore that with a brief look at the role of central banks.

How unstable crypto prices challenge central banks

Key roles of any country’s central bank are to:

  1. Govern the safety and soundness and stability of the economy and its systems (the authority for this varies by country, but for the purposes of this piece, it’s a sufficient generalization)
  2. Help to ensure the country is a safe place in which to invest for the longer term by controlling inflation

The most direct method of controlling inflation and the relative value of a currency is by setting the interest rate provided to commercial banks for their deposits and borrowings from the central bank. This largely determines the interest provided by commercial banks to their depositors and borrowers, which in turn has a direct effect on economic behaviors such as spending and saving.

Some central banks set an overt inflation target: the Bank of Canada, for example, has set one since 1991, and it resets that target with the federal government every five years. Some governments and central banks tie their economy to another economy by setting a fixed exchange rate between their fiat currency with another, such as USD or EUR. Either way, the goal is to control inflation by managing the value of the currency. A central bank’s power to control a fiat currency is largely derived from the sovereignty of the country in which it operates, with a taxable population that supports the economic and banking systems and governing structures.

Now if you, as a central bank, don’t control the value of the currency used by your population, you can no longer control inflation or the safety, stability and soundness of your economic and financial systems. Cryptos are not directly affected by any particular country’s interest rates, at least not more than myriad other factors that send their values swirling.

For a central bank, if the actors involved in valuing and distributing the currency are beyond your control, then you’ve essentially ceded control of monetary policy to those actors and their activities. The system will become susceptible to rapid inflation or deflation. The same unit of cryptocurrency may buy a smartphone today and a sandwich tomorrow. Individuals and businesses will begin to distrust the system, and the economy will suffer.

The potential of centrally backed stablecoins

This is not to say that the technology used by cryptos cannot also be used by central banks to provide, regulate or monitor stable digital currencies for the populations and economies they protect. Central banks and governments, including the U.S. Federal Reserve, are currently exploring central bank digital currencies (CBDCs). Some have worked for several years with the cooperation of commercial banks. The topic is now prominent for many legislators and bureaucrats involved with financial systems. In January 2021, the Office of the Comptroller of the Currency in the United States released regulatory guidance around the use of blockchain technologies in financial systems, and some central banks have already established proof-of-concept activities with central banks. The most recent U.S. Presidential Executive Order, and the two bills recently introduced in the U.S. House of Representatives and the U.S. Senate, also demonstrate the concern governments have about digital assets and currencies, and they attempt to standardize definitions and protections. Many believe it’s only a matter of time before currency does become purely digital.

CBDCs would behave differently from the most popular existing cryptos: if they are directly tied to a fiat currency, like a “stablecoin,” their value remains as stable as the fiat currency. If they can easily be traced from user to user, they are no longer viable for money laundering, underground economic behaviors, or the financing of other illicit activities. While the usage of cryptos for illegal purposes is perhaps overstated (usage of cash for criminal activities is still more prevalent), there is a considerable appeal for central banks and governments in luring away legitimate crypto users and devaluing less traceable cryptos.

When you take away the pundit opinions, the recent Executive Order from the U.S. President is really asking for some thoughtful consideration of how digital assets should be regulated. With respect to cryptos, governments are in a tricky position: since so many people have invested (some of them their life savings) in cryptos or other digital assets, governments now have to consider how to protect their citizenry. If governments do nothing to regulate the cryptos market, and they instruct or allow central banks to issue their own CBDCs, the resulting impact on cryptos could be catastrophic for some parties, and could have an impact on the economy as a whole. That impact could sway the electorate to make certain decisions about a government they don’t see protecting them (even if from themselves). If the government does regulate cryptos with a heavy hand, and the valuations subsequently decline, the impact to individuals and the economy could be similarly catastrophic and electorate-swaying.

Notwithstanding the regulatory issues regarding cryptos, banks could gain other benefits by tracking currency flows and usage. Certainly, it could help the central banks’ objectives of monitoring and influencing economic growth.

How will this affect the current crop of several thousand cryptocurrencies? Only time will tell. If you like speculative, risky investments, cryptos may be for you, but choose carefully. The day may come when the actions of those with the mandate to protect their sovereign economies and markets will render some cryptos irrelevant or of limited value, and only good as relics for hobbyists and historians.

The IBM Payments Center™ helps financial institutions and businesses modernize their payments platforms and capabilities to reduce their infrastructure costs. Find out what they can do for you.

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