Will the Internet make banks obsolete? This question was one of the concerns of central bankers and economists 20 years ago when the Internet took over the world.
The rise of crypto coins may cause such concerns once again. Crypto money has the potential to reduce the demand for fiat money or even central bank money since these virtual assets may one day become an alternative way of payment.
As for now, it is safe to say that virtual currencies do not threaten fiat currencies since they are too risky and volatile. People don’t trust crypto money as much as they trust traditional money, and that’s because of all the crypto frauds, hacks, security breaches and other illegal crypto activities happening out there.
Value and Instability of Cryptocurrency
Value and stability are two important factors when it comes to adopting a currency. Dong He, Deputy Director of IMF’s Monetary and Capital Markets Department (MCM), stated that the price of Bitcoin is never stable since its value solely depends on the percentage of people who value it and use it. In the report, Dong He explains:
“[T]he value of crypto assets rests solely on the expectation that others will also value and use them. Since valuation is largely based on beliefs that are not well anchored, price volatility has been high.”
However, once the instability issue is resolved, the digital coins will likely be used for everyday transactions.
Means of Exchange
Cryptocurrencies have several advantages that could reduce the demand for central banks’ money.
When talking about money transfer, Dong He argues that the divisibility, speed, and anonymity of digital currencies are a plus. Unlike in banks, digital currencies are sent from a person to another over a common ledger, and there is no need for the interference of a third party. The ledger guarantees secured and fast transactions. It verifies all the transactions and makes the process faster.
Dong He stated that “the advantages are especially apparent in cross-border payments, which are costly, cumbersome, and opaque.”
And finally, cryptocurrencies can be divided into small portions, a fact that makes them perfect for micropayments.
Resistance to Inflation
The fact that Bitcoin has a limit of 21 million coins raises concerns about deflation. This limited number makes the coins resistant to inflation. However, Dong He explains that digital coins lack some mandatory regulations, including “Protection against the risk of structural deflation, the ability to respond flexibly to temporary shocks to money demand and thus smooth the business cycle, and the capacity to function as a lender of last resort.”
Once all Bitcoins are in use, people will likely try to store them since there is nothing that has a greater value to trade. Thus, spending will decrease, leading to low market productivity.
Shift in Payment System
With the rise of ledger technologies and digital assets, the payment system may be shifted “from an account-based payment system to one that is value or token based.”
Dong He explains that “an account-based system” requires a third party and records the transfer of transactions, just like a bank. However, a “value or token based” system requires the transfer of a “payment object” such as a paper currency or a commodity. When the value of the payment is verified, the transaction can be completed.
Bitcoins are considered “commodity money” whereas central banks’ money is considered “credit money.”
It can be stated that the shift of the payment system depicts the future of finance, and central banks must take further steps to stay competitive with digital assets unless their goal is to decrease the demand of their money.
Short-Term Interest Rates and the Monetary Policy
According to the report, economy’s monetary policy is mainly controlled by the central bank, including “setting short-term interest rates in the interbank market for reserves (or clearing balances they keep with the central bank).”
However, the rise of digital assets would make central banks unable to control these interest rates, thus unable to implement their monetary policy.
If fewer individuals trade with fiat, it is conceivable that central banks’ money will not characterize the units of accounts for most financial activities. Thus, according to the report, “if those units of account are instead provided by crypto assets — then the central bank’s monetary policy becomes irrelevant.”