Are Cryptocurrencies Ready to Replace Central Banks?

Beginner’s Guide / 31.10.2019

There is undoubtedly a lot of noise in the cryptocurrency space, and not all of it constructive. Narratives projecting Bitcoin as a global panacea; the “decentralize everything” movement; or the infinitely faster, more scalable and secure blockchain…the list goes on. Separating true from false is an incessant task, and one that this article intends to do for another of these claims: cryptocurrencies are ready to replace central banks (CB). 

To begin, let us take a step back and understand what CBs are. Broadly speaking, CBs are responsible for monetary stability in a given jurisdiction. They create the rules and regulations under which national banks should function. Incidentally, there is a CB of CBs, called The Bank of International Settlement (BIS), whose mission is to “serve central banks in their pursuit of monetary and financial stability, to foster international cooperation in those areas and to act as a bank of central banks”. Essentially, the BIS is to CBs what CBs are to private and regional banks (and other organizations). 

How do Central Banks Function?

One way to understand CBs is in terms of their functions: 

  1. Monetary stability: establishment and regulation of monetary and exchange rate policy.
  2. Financial stability and regulation: prudential policy supervision and market oversight.
  3. Policy management: foreign exchange intervention and reserves holder, as well as lender of last resort.
  4. Financial infrastructure provision: fiat currency provision, banking and accounting services, inter-bank payment and settlement services, and registry provision. 

Bearing this in mind, the question to ask is if cryptocurrencies are able to perform these functions more effectively than CBs? At the moment the answer is a resounding No! Let us see why:

  1. Monetary stability: liquidity is a prerequisite for stability, and cryptocurrencies are infamously illiquid. For reference gold is measured as a $7 trillion market, and forex is 10x that of gold, whereas the entire cryptocurrency market sits at $250 billion. 
  2. Financial stability and regulation: there is no regulatory oversight codded into cryptocurrency protocols.
  3. Policy management: no policy management fit for a national economy coded into cryptocurrency protocols. 
  4. Financial infrastructure provision: new technology infrastructure, payment models and protocol stack ushered with cryptocurrencies. 

We can see simply that cryptocurrencies are not on par with CBs…yet. Currently, the vast majority of cryptocurrencies provide only a few of the functions of CBs, including an unpegged monetary policy (initially fixed, but later can be changed by miners), payment services, and money supply (block rewards). This is of little surprise given the near-nascence of Bitcoin, although CB’s around the world are already considering the relevant implications of cryptocurrencies (for example, Central Bank Digital Currencies are being researched and developed in some countries like China).

Although cryptocurrencies are not poised against CBs currently, the question still remains if they will successfully compete in the future. This is a difficult observation to make presently because there are numerous variables and assumptions to take into account, including the effects of disintermediation and the decentralized finance movement on global economics; how currencies will be redefined; and not to mention whether one follows the Keynesian or Austrian school of economics. Furthermore, this analysis would include the more socio-politically oriented questions about self-sovereign identity, centralized governance, privacy etc. and their effects on the economy. 

Despite this, one thing is certain: if cryptocurrencies are to replace CBs, they will first have to successfully compete as alternative monetary systems ensuring price, financial and payment stability. 

Featured image courtesy of Shutterstock.

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Patrick is a third culture kid born to Brazilian parents, who enjoys reading, writing and thinking. He believes we need to be relentlessly improving models for investing in good ideas and moving them from the lab to the market, which naturally draws him to the cryptocurrency and blockchain space.