Cryptocurrencies the barbarians at central bank gates

The boom in cryptocurrencies and their underlying technology is becoming too big for central banks, long the guardian of official money, to ignore.

Until recently, officials at major central banks were happy to watch as pioneers in the field progressed by trial and error, safe in the knowledge that it was dwarfed by roughly US$5 trillion (S$6.7 trillion) circulating daily in conventional currency markets.

But now as officials turn an eye towards the increasingly pervasive technology, the risk is that they're reacting too late to both the pitfalls and the opportunities presented by digital coinage. "Central banks cannot afford to treat cyber currencies as toys to play with in a sand box," said Mr Andrew Sheng, chief adviser to the China Banking Regulatory Commission and Distinguished Fellow of the Asia Global Institute, University of Hong Kong. "It is time to realise that they are the real barbarians at the gate."

Bitcoin - the largest and best-known digital currency - and its peers pose a threat to the established money system by effectively circumventing it. Money as we know it depends on the authority of the state for credibility, with central banks typically managing its price and/or quantity. Cryptocurrencies skirt all that and instead rely on their supposedly unhackable technology to guarantee value.


If they don't get a handle on bitcoin and their ilk, and more people adopt them, central banks could see an erosion of their control over the money supply. The solution may be in the old adage: If you can't beat them, join them.

The People's Bank of China has done trial runs of its prototype cryptocurrency, taking it a step closer to being the first major central bank to issue digital money. The Bank of Japan and the European Central Bank have launched a joint research project which studies the possible use of distributed ledger - the technology that underpins cryptocurrencies - for market infrastructure.

The Dutch central bank has created its own cryptocurrency - for internal circulation only - to better understand how it works. And former chairman of the Federal Reserve Ben Bernanke, who has said digital currencies show "long-term promise", will be the keynote speaker at a blockchain and banking conference next month hosted by Ripple, the start-up behind the fourth-largest digital currency.

Russia, too, has shown interest in ethereum, the second-largest digital currency, with the central bank deploying a blockchain pilot programme.

In the United States, banks and regulators are studying distributed ledger technology and Fed officials have made a couple of speeches on the topic in the past 12 months, but have voiced reservations about digital currencies themselves.


Fed Governor Jerome Powell said in March there were "significant policy issues" concerning them that needed further study, including vulnerability to cyber attack, privacy and counterfeiting. He also cautioned that a central bank digital currency could stifle innovations to improve the existing payments system.

At the same time, central bankers are obviously wary of risks posed by alternative currencies - including financial instability and fraud. One example: The Tokyo-based Mt Gox exchange collapsed spectacularly in 2014 after disclosing it lost hundreds of millions of dollars' worth of bitcoin.

But for all their theoretical tinkering, official money guardians have largely stood by as digital currencies took off. The explosion in initial coin offerings, or ICOs, is evidence. Investors have poured hundreds of millions of dollars into the digital currency market this year alone.

The dollar value of the 20 biggest cryptocurrencies is around US$150 billion, according to data from Bitcoin itself has soared more than 380 per cent this year and hit a record - but it is also prone to wild swings, like a 50 per cent slump at the end of 2013.

"At a global level, there is an urgent need for regulatory clarity, given the growth of the market," said Mr Daniel Heller, Visiting Fellow at the Peterson Institute for International Economics and previously head of financial stability at the Swiss National Bank.


Rather than trying to regulate the world of virtual currencies, central banks are mainly warning of risks and attempting to garner some advantage from distributed ledger technology for their own purposes, like upgrading payments systems.

Mr Carl-Ludwig Thiele, a board member of Germany's Bundesbank, has described bitcoin as a "niche phenomenon" but blockchain as far more interesting, if it can be adapted for central bank use.

In July, Austrian economist Ewald Nowotny said he is open to new technologies but doesn't believe that will lead to a new currency, and that dealing in bitcoin is effectively "gambling".

There could also be a monetary policy aspect to consider. ECB governing council member Jan Smets said in December that a central bank digital currency could give policymakers more leeway when interest rates are negative. Policymakers have long been concerned that if they cut rates too low, people will simply hoard cash. The ECB's deposit rate is currently minus 0.4 per cent.

Other central banks see the uses of distributed ledger technology, but worry about the abuses virtual money can be put to outside the official system - like criminal money laundering and the sale of illegal goods. That's not to mention the risk that virtual currencies could pose to the rest of the financial system if the bubble were to pop.


Bank of England governor Mark Carney - who has said blockchain shows "great promise" - also warned regulators this year to keep on top of developments in financial technology if they want to avoid a 2008-style crisis.

While Mt Gox cast a shadow over bitcoin in Japan, it now has many supporters in the world's third-biggest economy. Parliament passed a law in April making it a legal method of payment. Japan's largest banks have invested in bitcoin exchanges, and small-cap stocks linked to the cryptocurrency or its underlying technology have rallied this year as it begins to win favour with some retailers.

With the nation's Financial Services Agency responsible for bitcoin's regulation, the Bank of Japan remains focused on studying its distributed ledger technology.

"Central banks are not ready for regulating digital currencies," said University of Hong Kong's professor of finance and public policy Xiao Geng. "But they have to in the future, since unregulated digital currencies are prone to crime and Ponzi-type speculation."

To be sure, for many , the attraction of virtual currencies remains speculation, rather than for households or companies buying and selling goods. Professor Sumit Agarwal of Georgetown University, previously a senior financial economist at the Federal Reserve Bank of Chicago, said: "It is a fad that will die down and it will be used by less than 1 per cent of consumers and accepted by even fewer merchants... Even if we can make the digital currency safe, it has many hurdles."


A version of this article appeared in the print edition of The Straits Times on September 08, 2017, with the headline 'Cryptocurrencies the barbarians at central bank gates'. Print Edition | Subscribe