"As a central banker interested in information technology, should I regard this prospect as a dream or a nightmare? Perhaps the answer is that central bankers should enjoy life today"
(King 1999)
This question was posed over twenty years ago by a group of economists who wondered whether there was a threat of obsolescence posed on central banks from the innovations of information technologies. While a decline in the role of central banks has not been observed yet, the increasing adoption of crypto-assets relying on blockchain technology, and removing intermediaries from transactions, should not be overlooked.
European Central Bank President Lagarde called for more regulation of crypto-assets, which shows the breadth of the crypto phenomenon. Of course, one can not ignore the recent and significant Bitcoin and Ether crashes, nor the undeniable and massive environmental impact of crypto-assets mining.
Before diving into the question of whether crytpo-assets can substitute traditional currencies, this first article aims to identify and compare the properties of Bitcoin-like crypto-assets which led to their adoption by many, either for investment purposes or as a complement, if not replacement, to fiat money.
Bank money is the most abundant form of money today and is largely already digitized. In fact, money has been affected by information technology since the digitalization of account books and registers.
Before the invention of information technology, there were only three forms of money: coins, notes, and bank money. The first two forms of money are emitted by Central Banks of each monetary area, while the third is released by private banks, through the deposits that they hold and the credits they offer. The exchange of coins made of precious metals was one of the earliest methods of payment in the modern economy, to which gradually succeeded the notes, at first redeemable for precious metals. Today, and since the end of the Bretton Woods system and of the US Dollar’s convertibility to gold (James 1996), the notes’ value is determined by the activity of the central banks. The world’s most used currencies are not backed by commodities like precious metals anymore, but by the governments that issue them and the monetary policies that control them.
In the modern economy, commercial banks increase the amount of money in circulation every time that they lend. Indeed, banks credit their clients’ accounts with bank deposits of the size of the loans, creating new money. The amount of money created by private banks is not unlimited, it is in fact regulated by several factors. Market forces and firms' investment capabilities, risk mitigation through prudential regulation, and households’ behavior control the process of money creation. At the top of the system, central banks’ monetary policies act as the ultimate constraint - or incentive, depending on the context - on money creation. To achieve this, central banks have three tools at their disposal: the amount of minimum reserve requirements commercial banks must hold in central bank accounts, the policy interest rate at which commercial banks borrow and which is the building block of all other interest rates, and finally open market transactions in which the central bank buys or sells securities in the market. The latter has been massively expanded in its scale in the last decade through Quantitative Easing, or massive security purchase programs aiming to increase the money supply and sustain economies (McLeay, Radia & Thomas 2014).
With the rise of the internet, a fourth form of currency was created: cryptocurrency - that we shall call crypto-assets because they are not recognized as currencies by most governments - which differs from the previous types by its very essence: created and existing through computer code, it does not have any physical equivalent, unlike the other forms discussed. They are not controlled by any third party, but rather created through algorithms and the blockchain - a distributed ledger technology that records transactions as immutable timestamps, relying on a peer to peer network to validate transactions through complex computing problem-solving. Bitcoin, created in 2009, is the first crypto-asset in circulation. The creation and transaction process are quite different from that of bank money. Bitcoin is issued through the blockchain technology, which stores and transmits secure and transparent information, acting as a higher authority. New Bitcoins are created through the verification process of new transactions: to be effective, each transaction must be publicly verified by miners, through a series of complex algorithmic calculations which results in the storage of the transaction inside the blockchain. Mining is a laborious process that requires high computing power to solve the extreme complexity of the cryptographic puzzles. To acquire Bitcoin, one can either successfully mine transactions, or simply buy some on exchange platforms using Euros or Dollars for example.
Interestingly, Bitcoin has been programmed as a finite resource, like gold, silver, or oil: its total supply equals 21 million coins, expected to be all in circulation in 2140. Here, there is an interesting parallel to be made with other finite resources on earth, and the consequences on their values - this point of view on Bitcoin-like crypto-assets will be explored later in the article.
There are two major differences between crypto-assets and bank money, like the Euro for example. The first difference is of course the verification process of the transactions. For a currency like the Euro, the control of transactions is made possible through its centralization within commercial banks and the European Central Bank. For Bitcoin, transactions are, as we discussed, public and verified by miners, which can, in theory, be anyone willing to provide computing power to solve complex algorithmic problems in exchange for remuneration. The second major difference is how the system’s stability and security are guaranteed. On one hand, they depend on a higher authority, may it be commercial or central banks, on the other hand, they are based on information technology and high-level cryptographic security. The trust component is extremely important in guaranteeing the stability of a currency. In countries in which the government issues the currency, not backed by a physical commodity, the currency is fiat money. Most currencies today are fiat money. Their value and stability lie in the central bank’s policies and the control of inflation, and also in the trust that users place in them. As an example, the Euro is fiat money: its users trust Europe’s Eurozone economy and monetary policy, largely guaranteed by the European Central Bank.
Nevertheless, by their decentralized nature, crypto-assets remove from the system the very components dedicated to maintaining currency stability, and therefore trust. Bitcoin supporters argue that information technology and the blockchain are better guarantors of stability - of the system, the prices and the security of transactions - than the state or monetary authorities acting as regulators, for they are not subject to political influence and do not concentrate control over the money in the hands of a few, but rather give it to anyone wanting to contribute with their computing power. Considering that Bitcoin was created in 2009, at the heart of the global financial crisis, we understand that this innovation appeared as a result of a loss of confidence in the financial system and a will to break free from state authorities.
However, the stability of a fiat currency does not come solely from trust in the institutions backing it, but also from the economy to which it is attached to, and how deep and diversified it is. The liquidity of a currency is also of critical value to economic agents as they convert money into and from assets. Maybe the reasons for the observed relative instability of crypto-assets is that they are hardly linked to any economic zone, and are therefore not entrenched in any underlying local economic reality. After the recent crypto-asset crash of May 2022, ECB President Christine Lagarde said about crypto in general that “it is worth nothing, it is based on nothing, there is no underlying asset to act as an anchor of safety “. Of course, it is in the interest of Central Banks around the world to warn the populations of the speculative nature of crypto-assets and redirect financial transactions towards traditional currencies and their future digital form (central bank digital currencies). Nevertheless, the question remains: can crypto-assets claim the title of currencies, even when being exposed to what seems to be inevitable instability.
Bitcoin and other crypto-assets are not officially recognized as currencies by the IMF as they are not issued by central banks nor authorized by governments, in most cases (cf. later example of El Salvador). Nevertheless, the question of the classification of Bitcoin and similar assets as financial or nonfinancial assets is debated and debatable. To determine whether an asset behaves like a currency, an economist’s approach would be to ask if it functions as a medium of exchange, a unit of account and a store of value. Although the definition of a currency seems clear, opinions on how Bitcoin is defined diverge and do not find a consensus. Different views argue about whether or not Bitcoin is a medium of exchange. Since the first good bought in Bitcoins in 2009 - a pizza, acquired for 10,000 Bitcoins - crypto-assets have been used for acquiring goods and services all over the world (Yermack 2013) but its overall adoption level for transactions compared to traditional currencies remains low. In theory, crypto-assets offer advantages as mediums of exchange, amongst which pseudonymity, as practically no information is necessary to buy and transfer crypto-assets - although this is to be nuanced, as the blockchain stores all transactions ever made, allowing for traceability (the monero is incidentally replacing Bitcoin in criminal activities financing).
For cross-border transactions, crypto-assets offer the advantage of cutting processing time from days to a few hours through the lack of intermediaries, as well as low transaction fees (He 2018). The quality of Bitcoin as a medium of exchange is naturally debated as the high volatility that it is subject to makes it inconvenient for daily transactions. Yet, the role of Bitcoin as a store of value and as a unit of account is questioned more broadly. The IMF recognizes Bitcoin both as a medium of exchange and as a store of value, comparable to holding precious metals, especially in countries where central and commercial banks’ credibility is low (IMF 2021). JP Morgan compares Bitcoin to gold and shows how both are stores of value. Others disagree, putting forward the high volatility as the main argument. Views on the use of Bitcoin-like crypto-assets as a unit of account are less divided and tend to agree that their highly fluctuating value makes it impossible to express prices in Bitcoin that would not be unstable (Banque de France, 2018).
However, there are other approaches to the definition of money than the three characteristics seen previously. One of them is of particular interest and could shed new light on the debate over the proper qualification of crypto-assets. In one word: energy. This approach was developed at length in Octavian S. Ksenzhek’s work entitled Money: Virtual Energy. Economy through the Prism of Thermodynamics (2007). In this specific book, he makes a very elegant case for the similarity between energy and money. Energy, like money, is hard to define, and scientists, like economists, focus on determining its qualities or characteristics. Perhaps the most practical way to think about energy is as the capacity to produce work. Work here can be defined as an action of a system upon an external object followed by the production of certain changes in its structure or position. For instance, an athlete lifting a weight is performing work on the weight against gravity. This shift always requires an energy transfer from the system to the object, which usually means a conversion of energy into another form (from mechanical to electrical in a turbine for instance).
Now, let’s take a step back and see how relevant these concepts might be with respect to human societies and economies. All goods and services exchanged in economies require energy to be produced and delivered where they are needed. As seen previously, money quickly emerged as a necessary unified equivalent allowing for practical exchanges of such goods and services. In primitive societies, any object was used: shells, rams, grains and feathers. However, and as early as the 3rd millennium BC, precious metals were introduced as unified equivalents. Their unique properties, such as their scarcity, their durability or purity (difficult to corrode) and the ease with which they can be transformed, made them very efficient units of account, and later an ideal medium of exchange as they were turned into standardized coins.
Looking at it more closely, money based on precious metals share many properties with energy: money determines the capability to perform work (purchasing goods or services), money is always conserved -at least if the economic system that supports it is stable- and exists in different forms, and the process of energy dissipation is akin to money spending (as we spend money, it is getting more dispersed and less useful). Furthermore, when humans extract precious metals from the earth, they essentially transfer a massive amount of energy required for the mining process into the metal itself. Regardless of their practical utility for manufacturing or their social utility as wealth displays, the mere act of extracting and refining metals is sufficient to give them their value likely because of all the energy spent in the process. It is therefore interesting to ponder on the extent to which money is, from this perspective, a vector of condensed energy.
Unsurprisingly, this approach of money as a quantity has also been entertained by many economists, from Monetarists to Neo-Keynesians. For instance, Bill Philips, most famously known for his Philips Curve illustrating the relationship between unemployment and inflation, was also interested in physical and quantitative representations of money. He built a kind of early computer, simulating the economy using water as the physical representation of money flows. As such, this approach could shed a new light on crypto-assets. Indeed, their whole concept is based on the blockchain and usually the Proof of Work paradigm, which is a highly energy-intensive process. High amounts of electrical energies are converted by computers into information about transactions, giving value to crypto-assets such as Bitcoin. This is directly comparable to what was outlined above with precious metals. If it remains difficult to consider crypto-assets as currencies from the point of view of classical economics, the argument developed here gives further credence to the idea that crypto-assets are very similar to gold and other precious metals, which were used as currencies not so long ago.
However, this analogy, like all analogies, remains limited. First, it does not explain how humanity has moved away from using currencies requiring high amounts of energy. Fiat money, no longer tied to the value of gold, has been widely adopted all over the world because of its high efficiency and despite its value being detached from physical properties. Instead, its value comes from trust in institutions and the strengths of the underlying economy it is linked with. Likewise, not all crypto-assets are based on the high-energy Proof of Work paradigm, and a lot of them are trying to move to more energy efficient money creation and transaction processes (Proof of Stake for example). In this sense, crypto-assets could be just like other historical currencies and follow the same evolution.
As mentioned previously, markets in which the central bank has limited credibility and the banking system is weak - typically financially unstable countries - see users consider crypto-assets as a store of value on top of a medium of exchange, and thus drive adoption rates up at a faster speed than in more stable financial markets. There are many examples of countries where the population, unable to access the most basic financial products like bank accounts, turn towards crypto-assets. Financial instability can be the result of political instability and/or armed conflict, erosion of trust in the financial system (1997 Asian crisis), natural catastrophes or health crisis, and Bitcoin repeatedly plays the unprecedented role of the resource of reference in times of crisis. The return of the Taliban to Afghanistan in August 2021 resulted in a national cash shortage, closed borders, and a plunging local currency. Several banks closed their doors and most money transfer services stopped functioning. What resources did people turn to as their government and monetary institutions were failing them? The internet and crypto-assets, inevitably. The country saw a sharp rise in crypto adoption following the start of the conflict. Similarly, the mass adoption of crypto-assets in Lebanon resulted from central bank mismanagement and corruption, and therefore an important loss of trust in the system. A somewhat different example is that of Ukraine, which started accepting crypto donations in February as tensions with Russia rose, even before the war started. Indeed, the speed of transfers and the ability to cope with the rising inflation were all convincing arguments to turn towards crypto-assets.
One step further, El Salvador became the first country to recognize Bitcoin as a legal tender, to facilitate international remittances, tackle the problem of underbanking and mitigate the risk of dollarization (Arslanian and others 2021). The lesson is that crypto alternatives are positioning themselves as a great resource to fill the gaps in weakened economies. We can wonder whether the country will rule out this payment option once/if local fiat money finds more stability and people regain trust in monetary institutions, or whether the population will adopt crypto-assets in the long term and stick to its use even in a more stable environment. The answer is probably not, as naturally the majority of people are risk-averse and will prefer stability over speculation. Nevertheless, as we saw, trust is at the base of a strong economy, and people who were let down by their government and their monetary institutions might place more trust in crypto-assets despite higher volatility. We can imagine that owning crypto-assets could for instance be a risk mitigation or hedging strategy in countries with heavy economic distrust in the past, leading to limited demand for central bank money, which would then have difficulty setting interest rates freely. Just like dollarization can be a threat to local economies in emerging countries with weak foreign exchange and monetary policies, cryptoization represents a risk for macro-financial stability, consumer protection, and the environment (IMF 2021).
While economists, digital experts, and governments endlessly debate its nature and whether to regulate it, crypto is undeniably making a significant impact on the entire world’s economic system and is already instrumental in many further developments around the digitization of the economy (NFTs, metaverses and decentralized finance). Precisely because of their difference with regard to traditional currencies, they are unlikely to replace them entirely, at least for as long as sovereign states will exist. However, by removing part of the issue of trust inherent to any centralized currency system, they offer a useful alternative and complement to fiat money, as seen in unstable countries or in some specific ecosystems where their decentralized nature creates value.
There is no doubt that crypto will continue to evolve on adjacent paths to traditional currencies, perhaps with similar historical trajectories as explored in this article, and hopefully in a more sustainable direction both from a social and environmental standpoint. What is certain is that current financial institutions and central banks are paying a lot of attention to these new assets and how they might challenge their role and place in the economy. Following this trend, many central banks are hard at work on the creation of digital currencies and exploring how best to integrate them into the actual financial system, as we shall explore in our next issue.
Banque de France (2018). The emergence of Bitcoin and other crypto-assets: challenges, risks and outlook.
Fried, T. (2021). El Salvador has adopted Bitcoin as official legal tender - but will other countries follow? World Economic Forum. Available at: https://www.weforum.org/agenda/2021/09/el-salvador-officially-adopts-Bitcoin-as-legal-tender-but-will-other-countries-follow/
He, D. (2018). Monetary Policy in the Digital Age. International Monetary Fund, Finance and Development, Vol 55, No 2.
International Monetary Fund. (2021). Global Financial Stability Report. Monetary and Capital Markets Department.
James, H. (1996). International Monetary Cooperation since Bretton Woods. Oxford University Press. Chapter 8, “The End of Bretton Woods?”. DOI: https://doi.org/10.5089/9781475506969.071
Kim, P. (2022). What are the environmental impacts of cryptocurrencies?. Business Insider. Available at:https://www.businessinsider.com/personal-finance/cryptocurrency-environmental-impact?r=US&IR=T#:~:text=But%20in%202020%2C%20the%20US,by%20US%20Bitcoin%20mining%20alone.
King, Mervyn. (1999). “Challenges for Monetary Policy: New and Old.” Speech delivered at a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, WY, August 27. Available at: https://www.bankofengland.co.uk/-/media/boe/files/speech/1999/challenges-for-monetary-policy-new-and-old.pdf
McLeay, M., Radia, A. et Thomas, R. (2014). Money creation in the modern economy. Bank of England Quarterly Bulletin, Q1
Yermack, D. (2013). Is Bitcoin a Real Currency? An economic appraisal (Working Paper no 19747). National Bureau of Economic Research
Octavian S. Ksenzhek (2007). Money: Virtual Energy. Economy through the Prism of Thermodynamics