The crash in crypto currency valuations may trigger a radical reassessment. But, just as excessive hype fuelled speculation, a collapse in valuations may lead to an indiscriminate condemnation of digital money and an underestimation of its potential benefits. This column takes stock of developments over the last five years in an attempt to separate fact from exaggeration and fiction.
Jean-Pierre Landau, who has had posts at the IMF and the Banque de France, is currently at the Economic Department of Sciences Po in Paris
Cross-posted from VoxEU
The current crash in crypto valuations is a wakeup call. Should it amplify, it will trigger a radical reassessment. But, just as excessive hype fuelled speculation, a collapse in valuations may lead to an indiscriminate condemnation of digital money and an underestimation of its potential benefits. In this column I try, in twelve brief points, to take stock of developments over the last five years. Looking at the mix of technological and monetary innovations, it is important to separate truth from exaggerations and manifest errors.
1. Starting from current events, Terra, which collapsed one month ago, was a pure Ponzi scheme. Basically, Terra was anchored to – and redeemable into – Luna, another stablecoin which, itself, was anchored on nothing. As if the obscure technicalities of conversion were not enough, a mechanism offered a 20% annual interest rate for deposits in Terra. That it was allowed to prosper and grow to an outstanding amount close to $12 billion does not reflect well on supervisors.
Terra belonged to a category of so called ‘algorithmic’ stablecoins whose viability is highly problematic. Their stability comes from an algorithm implementing open market operations. But open market against which assets? If those assets are issued inside the same stablecoin system, there is an obvious circularity and stabilisation is an illusion (Cochrane 2018). If they are issued outside, then the whole scheme is equivalent to backing. Algorithmic stablecoins are a very good example of technological innovation ignoring or distorting money fundamentals, therefore serving to mask ignorance or deception.
2. Other stablecoins are designed to be more robust. They are backed and, in their purest form, redeemable in other fiat official currencies. But, as experience has shown, eveything depends on their precise design. All too often, the temptation to create and appropriate seignorage leads to approximations or fraud in the modalities of backing. Stablecoins raise two concerns. The first relates to their basic integrity and the reality of backing. There are recurrent doubts on Tether, the biggest stablecoin. Should they materialise, they would prove lethal for the whole ecosystem. A second, more traditional, concern relates to maturity transformation and the capacity of stablecoins to face redemptions in case of runs.
3. Stablecoins were developed to serve as payment instruments in a new digital environment known as decentralised finance, or ‘Defi’. Defi designates digital platforms operating financial contracts such as lending, hedging, or derivatives. Their structures are very opaque, but appear to be built upon considerable leverage and significant maturity transformation (as attested by the high returns offered to depositors). Financial fragility is intrinsic to Defi, and many schemes may not resist the ongoing normalisation of monetary policies.
4. Stablecoins are only the latest form of crypto currency. Former generations, of which Bitcoin is the leader, are not backed – they are pure ‘outside’ money. Where do they derive their value from? The dominant selling point emphasises their embedded scarcity. The protocol irrevocably caps their issuance to a ceiling. This scarcity is contrasted with the monetary expansion undertaken by all major central banks over the last ten years. It is presented an essential foundation of Bitcoin’s value, itself assimilated to ‘digital gold’. This whole narrative on crypto value has fuelled speculation on Bitcoin and other crypto currencies. But is deeply flawed:
- Bitcoin does not behave as a safe asset, but as a very risky one; its price falls when risk aversion increases.
- As in many bubbles, valuations have been sustained by new entrants. Regulators have been unequally rigorous in preventing retail investors from getting exposure to crypto currencies. In some countries, future markets and collective investment vehicles, such as ETFs, have been allowed to develop. Fidelity Investments is reportedly considering allowing holders of individual retirement accounts to allocate up to 20% to Bitcoin (Tegersen 2022). Its newfound financial strength allows the crypto industry to lobby forcefully for access to the mainstream investment world.
- At its heart, the argument that scarcity by itself creates value is obviously wrong. Any first-year student in economics knows that prices result from an interaction between supply and demand. Scarcity does not create value if there is no demand, i.e. if the product or asset is considered useless. The question therefore becomes: is there a demand for crypto currencies, other than for speculative purposes?
5. The use case for pure crypto currencies is elusive. Their ‘moneyness’ ultimately depends on their ability to serve as a medium of exchange. Crypto currencies bring a new technology of payments and therefore one must examine its characteristics, benefits, and costs. It is well known that Bitcoin is slow and terribly inefficient. Understanding the sources of that inefficiency is important. The design of Bitcoin is the result of four successive technological choices. They are usually presented as a whole, but are clearly separate and independent. Many mistakes can be made when looking at cryptos as a bundle of inseparable innovations.
6. First and foremost, all digital currencies – Bitcoin and others – are digital tokens. Those can be defined as digital files representing value that can be transferred safely over the internet due to recent progress in cryptography. Digital tokens are ‘electronic cash’. They form the basis for mobile money. They allow for instant, peer-to-peer payments over long distances. They potentially help financial inclusion and retail cross-border payments. They may also prove deeply disruptive for traditional bank models.
7. Contrary to physical cash, however, digital tokens have to be recorded on a ledger. Technological choices on ledgers shape the operational features of digital money systems. Any digital money architecture is defined through three levels of choices.
- First, the ledger can be centralised or built around a decentralized ledger technology (DLT). DLTs keep and update in real time a large number of identical copies of the ledger. This makes the system very secure and resilient to failures and attacks. Keeping many identical copies, of course, has a cost.
- Second, inside the DLT space, the ledger can be a blockchain or not. In a blockchain, new entries are sequentially added to past data according to a process that makes them immutable once recorded. Accordingly, a blockchain provides a fully reliable history of data entered into the ledger (or of transactions if the blockchain is used as a payment system)
- Third, Bitcoin operates with a fully decentralised consensus protocol. Transactions must be approved with no fraud through a process that potentially involves hundreds of participants (the ‘miners’). Those participants compete for validating transactions and getting the associated reward, in the form of newly created Bitcoins. Bitcoin’s protocol of ‘proof of work’ ensures the total safety of transactions, but also comes with an enormous consumption of electricity and very low speed.
Figure 1 describes the sequence of choices that define different digital currencies.
As illustrated, those choices are separable. In particular:
- Digital money can perfectly be operated on a centralised ledger. In fact, more than 95% of digital payments in the world are made through tokens registered on such centralised ledgers.
- A blockchain can be centrally managed (permissioned) by one or several participants. Most existing stablecoins supported by a blockchain operate with one single entity validating transactions.
Bitcoin, therefore, is very specific: its decentralised consensus mechanism is the source of all of its difficulties. Bitcoin is honest: all revenues coming from seignorage are allocated to financing the functioning of the system. Bitcoin is safe: all the frauds that occurred took place on peripheral platforms and custodians. But, as a payment instrument, Bitcoin is terribly inefficient. For digital money in general, there seems to be a triangle of incompatibility linking efficiency, safety, and decentralisation.
8. As a payment system, Bitcoin is a niche product. It can serve for illicit transactions and some retail cross-border payments. It is hard to see how those use cases justify its current valuation.
As inefficient as they are, however, crypto currencies, play an indirect and crucial role in the evolution of payment systems. They introduce some currency competition in countries where trust in the central bank has evaporated. They have drawn attention to the difficulties and costs of cross-border retail payments. They have triggered a wave of innovation and projects in fast payments.
9. Looking to the future, it is clear that digital money (in the form of tokens) is here to stay. For the general public, the aspiration for immediate peer-to-peer payments, possible across large distances, is irreversible. For corporates and financial institutions, the token form of money offers the possibility of fast and trustable intra-firm or intra-sector payments (Deutsche Bundesbank 2021). For governments, direct access to the beneficiaries of welfare or stimulus payments will improve the efficacy of distributive policies, or ‘helicopter money’. The most likely scenario is that digital money will expand and develop on centralised or tightly permissioned ledgers.
10. The digitalisation of money will bring several major transformations to monetary systems (Brunnermeier and Landau 2022):
- First, money will become more diverse. Money in digital form is easy to create. It can be tailored to almost any shape. It can be made ‘programmable’, i.e. usable only under specific circumstances and pre-defined purposes.
- Second, money may become more segmented. Digital money often prospers inside large ‘platforms’ that aggregate many activities (e.g. commerce, entertainment, social media) and exploit their synergies. Those platforms tend to be organised as ‘closed-loop’ ecosystems. The money they use and, possibly, create may not be easily transferable into other environments.
- Finally, money is becoming more competitive. In a digital world, (almost) anybody with some expertise in cryptography and computer science can create money. Currency competition may develop inside and across borders, with some countries – or private operators – using their digital networks to circulate their currencies in other jurisdictions, creating so-called global stablecoins.
11. Digitalisation also raises many challenges for public policy. Beyond the traditional concerns over money laundering and illicit transactions, there are deeper questions:
- What kind of money do authorities want people to hold – bank or token? What will be the consequences for banks’ business models? What kind of monetary architecture do authorities want to promote? What place will they give to stablecoins?
- What role for public money in a digital world? Central bankers are currently divided on the opportunity to promote their own digital currency (central bank digital currency, or CBDC). While some are very active, others have more doubts. These differences may be explained by two factors. The first is differing visions on the future of cash – currently the only public money directly available to whole population. The second is differing assessments of the current transformations. Are they just a phase of modernisation of payments or do they herald a new era in monetary arrangements? Will the ability of central banks to ensure the uniformity of currency and control the unit of account be threatened?
12. Finally, what is the future of blockchain? Some of its promoters seem to realise that it will never be operational as a payment system. They are now coming up with inventive new use cases. Clearly, blockchain offers interesting possibilities as an immutable and transparent record, for instance in the management of global supply chains, or keeping land and property registries in countries where governance is weak. Other, intriguing, developments are more speculative. Recent applications use blockchain to establish a parallel and semi-legal system of property rights. The current wave of ‘non-transferable tokens’ (NFTs) applies this principle to digital artworks. NFTs are deemed to belong to the person or entity that possesses cryptographic proof of property (although, as digital objects, they are not designed to be excludable and can be watched in their original form by everybody). In a recent paper, Vitalik Buterin, the creator of Ether, envisages a world where trust in social identities, relations, and commitments could be embedded into blockchains (Weyl et al. 2022). The future will tell whether such a vision can realistically materialise.
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