Cryptocurrency: don't look up

Tragically this has cost space jockey and Tesla founder Elon Musk about $US25 billion but it is hardly unusual in the short history of cryptocurrencies. For those with the risk appetite, the attraction of cryptos is precisely that they are untethered to the real world and hence inherently volatile.

"Why would central banks, those bastions of conservatism and stewards of national – and global – financial systems be dabbling in something at the Pluto end of the financial galaxy?”

Chris Joye, portfolio manager at Coolabah Capital Investments, laid out the context very succinctly in his latest newsletter: “Bitcoin is almost 6 times more volatile than US equities and 18 times more volatile than the US dollar. Bitcoin, and other correlated crypto currencies, appear to be trading not as inflation hedges, but rather as simple equity risk proxies. In the last year, the correlation between Bitcoin and US equities has jumped to north of 50 per cent.”

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If you’re a crypto investor, the salient points are – and this is hardly a massive shock – these assets are high risk stores of value. They are – not yet – widely accepted as a means of payment. And – perhaps more of a wake-up – they are not uncorrelated with other markets. That is, they have not proved to be a good hedge nor counter-cyclical like, for example, gold.

But obviously there remains a huge appetite for speculation in the class. The interesting question however is why would central banks, those bastions of conservatism and stewards of national – and global – financial systems be dabbling in something at the Pluto end of the financial galaxy?

Why this ongoing fascination with central bank digital currencies? CBDCs?

Out of orbit

Well there are a couple of clear distinctions to make. First of all, not all cryptocurrencies are the same. Some, like Bitcoin, are designed to orbit outside the gravitational pull of existing systems. That’s their point.

But another class, “stablecoins”, while sharing the structure of other cryptos, do actually respect astrophysics – they are valued against and in the orbit of a traditional asset or basket of assets like fiat currencies.

Then there are digital currencies which are really just digital versions of physical currency and we’ve been using them for ever. We use a digital dollar when we buy online or transfer money to a friend.

Central banks don’t actually “issue” this digital currency as they do physical notes and coins, the private sector “creates” this money when they make a loan. When you take out a loan the financial institution facilitates the loan by crediting your account with digital money you can use to buy a home or a car or a company.

Central banks are, depending on the country, responsible for only around 5 to 10 per cent of the currency in use – and that actually is one of the genuine challenges for those banks if they do issue their own digital currencies.

That’s because if a central bank issues its own digital currency, and hence companies and individuals can transact directly with the central bank, the existing banking system could be taken out of the system, disintermediated.

So what? Well that would make it much more difficult for central banks to manage monetary policy – the price of money – which they currently do by raising and lowering the official interest rates they charge commercial banks and which then flows into the broader economy.

No clear economic case… yet

Australia’s banking supervisor, the Australian Prudential Regulation Authority (APRA), has warned of the risk of disintermediation.

APRA and the Council of Financial Regulators – which includes the Reserve Bank of Australia (RBA) and the securities regulator – have been researching a CBDC version of the Australian Dollar (eAUD) issued by the RBA. They flagged the risks of direct deposits with the central bank.

The RBA too has concerns and is talking to other central banks about safeguards, such as capping the amount of funds that can be shifted into CBDCs during a crisis – causing a run on commercial banks. That concern was echoed by the British House of Lords who raised concerns of “significant risks” posed by CBDCs in times of stress although the Bank of England is involved in pilots.

“APRA is yet to see the clear economic case for a CBDC, and it is worried about some customers bypassing banks, if they could hold digital cash in an RBA account. This could reduce the capacity of commercial banks to lend to support the economy,” said APRA chairman Wayne Byres.

“If the community embraces CBDCs then we need to think about the implications, the way a digital currency might be used can have very, very big implications for the structure of the rest of the financial system. If for example individuals were able to have their own accounts with the central bank, you could find a situation in which large parts of the financial system just get bypassed and that could have some very, very big structural implications.”

There is also an overlap here with the challenge of cryptocurrencies because if crypto became widely used in the ordinary economy that would have implications for fiscal policy – tax would be easier to avoid – while there could also be an unbundling of the existing system which, while having room for improvement, is well regulated and secure.

Efficient and distributed

A more structural overlap between CBDCs and cryptocurrencies is the possibility the central bank version might also use the same distributed ledger technology – of which Blockchain is the highest profile – to underpin the currency.

The attraction of platforms like Blockchain is their efficiency and “distributed” nature of authorisation, via a vast network rather than a single chain between particular institutions.

Cross border payments are one area in which there appears to be much potential for a more efficient system as traditionally this process contained many time consuming and often error-prone links. Joint research is underway to investigate how distributed ledgers and CBDCs may improve this system.

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Ironically, in the mythology of Bitcoin, mysterious “founder” Satoshi Nakamoto was apparently incensed by the fees he had to pay banks to facilitate cross border payments for his model train hobby.

The global banking supervisor, the Bank for International Settlements (BIS), is running a pilot of a DLT-enabled wholesale digital currency – wCBDC - for cross borders.

Project Jura complies with current regulatory requirements and is a public-private collaboration involving the Banque de France, the BIS Innovation Hub Swiss Centre, the Swiss National Bank and a private sector consortium.

But the BIS notes: “Issuing wCBDC on a third-party platform and giving non-resident financial institutions direct access to central bank money raises intricate policy issues. Jura explores a new approach including subnetworks and dual-notary signing, which may give central banks comfort to issue wCBDC on a third-party platform and to provide non-resident financial institutions with access to wCBDC.”

It may well be cryptocurrencies go down in history as the latest of the great financial bubbles along with Dutch Tulips and the late 80s Japanese economy. But perhaps the space jockeys are right and the financial system is about to boldly go where no man has gone before.

Central banks however will play a central role. Whether they will actually be central players with their own digital currencies will be one of the big stories of 2022.

Andrew Cornell is Managing Editor of bluenotes