bank for international settlements

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The Bank for International Settlements (BIS), which serves central banks in their efforts to promote monetary and financial stability, claims permissionless cryptocurrencies are not suited to serve as the basis of a monetary system, although the bank acknowledges there are niche areas where cryptocurrency can provide improved efficiencies.

The bank also acknowledges the possibility of central bank issued digital currencies, which several central banks are presently exploring.

Central Banks Provide Stability

The bank offered its assessment on cryptocurrencies and distributed ledger technology in its annual economic report.

According to the report, for a monetary system to successfully facilitate transactions, it must be elastic to address demand and must be able to scale with the economy, a function central banks have successfully provided, the report noted. The central banks ensure the payment system operates efficiently and ensure the supply of reserves responds properly to shifting demand.

Cryptocurrencies’ decentralized technology, by contrast, offers an insufficient substitute for the traditional, institutional backing of money.

Decentralized Consensus Risks

A decentralized consensus through which transactions are verified can undermine trust in the system, the bank contends. A breakdown in trust will cast doubt on the finality of individual payments, meaning the system could stop functioning, causing a loss of the currency’s value.

Beyond the issue of trust, cryptocurrencies are subject to inefficiencies and extensive energy consumption. Such currencies are unable to scale with rising transactions, making them subject to congestion and value fluctuation.

Matching the supply of the means of payment with transaction demand requires a central authority, such as a central bank, to expand or contract the supply. The authority has to be able at times to trade against the market, even if this means absorbing a loss. In a decentralized network, by contrast, no central agent exists with the incentive or mandate to stabilize the currency’s value.

The speed at which new cryptocurrencies come into existence further contributes to unstable valuations, the bank noted.

Transaction Finality An Issue

Bitcoin cash hard fork
The BIS identified software forks that divide a cryptocurrency network into multiple blockchains as one drawback to decentralized, permissionless cryptocurrencies.

In mainstream payment systems, once a payment makes its way through the central bank’s books, it becomes final and cannot be revoked.

Permissionless cryptocurrencies, the BIS report argues, cannot guarantee such finality since there can be rival versions of the ledger. This can cause transaction rollbacks, as happens when two miners update the distributed ledger simultaneously. Only one of the two can survive, making payment finality in each ledger probabilistic.

Cryptocurrencies can also be manipulated by miners who control large amounts of computing power.

“Forking,” a process in which a group of cryptocurrency holders use a new version of the ledger and protocol while others stick to the original version, can also undermine trust in the system, the bank noted.

Forking is also problematic from the perspective that it could be symptomatic of the fragility of the decentralized consensus used to update the ledger.

Some of the issues described above could be addressed by new protocols, the report noted. Some, however, are inherently linked to the limited scalability and fragility of decentralized systems. The lack of an adequate institutional arrangement emerges as the fundamental shortcoming.

Niche Applications For Cryptocurrencies

While cryptocurrencies don’t work as money, the technology has promise in other areas, such as cross-border payment systems, the report noted. Distributed ledger technology can be efficient in niche environments where decentralized access benefits surpass the cost of sustaining numerous copies of the ledger.

Future use cases will likely combine crypto payments with data permission systems and self-executing codes. The technology’s value will likely derive from the streamlining of administrative processes of complex financial transactions like trade finance.

Regulatory Challenges Call For Action

Regulatory challenges also need to be addressed with respect to cryptocurrencies, the report noted, such as anti-money laundering and terrorism financing. The extent to which cryptocurrencies have allowed these standards to be evaded is a matter of debate. Some cryptocurrencies are anonymous, making it hard to determine if they are being used to avoid taxes or to engage in illicit transactions.

Consumer and investor protection poses another challenge for cryptocurrencies, the report noted. Fraud has been an issue for initial coin offerings (ICOs).

A longer-term challenge is the financial system’s stability. Whether the widespread use of cryptocurrencies and self-executing financial products will present new systemic risks remains to be seen, the report noted.

The effective deployment of strengthened standards challenge the regulatory sector since existing regulatory definitions do not always address new realities. Multiple economic activities use the technologies, activities regulated by different oversight agencies. ICOs, for example, are used to fund projects that are not related to cryptocurrencies.

Permissionless cryptocurrencies do not fall into existing legal frameworks and exist in their own digital realms outside of existing institutional environments. Their legal domicile can be impossible to determine, meaning they can only be regulated indirectly.

Also read: Central banks could use crypto to force negative interest rates on public: Morgan Stanley

Central Bank-Issued Crypto?

Whether or not central banks should issue digital currencies (CBDCs) is another issue that needs to be examined, the report noted.

CBDCs could function like cash, with the central bank issuing a CBDC, then allowing banks, non-financial firms and consumers to use the currencies without further central bank involvement other than determining who acts as a trusted node.

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