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GNS June Q-Review: Battle Between Cryptocurrencies and CBDCs

Cryptocurrencies and CBDCs
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EDITOR NOTE: As soon as Clausewitz wrote in his 19th-century classic military treatise On War that “war is a continuation of politics by other means,” international trade economics soon began to prove itself a continuation of warfare by more “civil” means. It was a matter of outcompeting a rival via production and trade agreements. Once President Nixon took the world off the gold standard in 1971, forcing currencies to float, then currencies and the foreign exchange market started taking form as a “floating battlefield” in which nations can outcompete their rivals by using the value of currencies against a target nation (think Japan versus the US auto industry in the late 1970s and early ‘80s). Now, there are two new competitors: private cryptocurrencies and central bank digital currencies (CBDCs). Neither spell a win for the principle of monetary value. Neither gives people an advantage in securing “real” economic stability. But only one spells both a resounding victory and impending doom for central banks, government, and the people who may be forced to use it.

Cryptocurrencies have experienced a remarkable rise in numbers and popularity in recent years. At the same time, and especially after the economic shock delivered by the coronavirus, central banks have been planning to issue their own digital currencies. 

They represent two sides of the same “coin”: while cryptos are usually created and distributed freely, central bank digital currencies, or CBDCs, are centrally controlled. We thus may be on the verge of a new sort of “currency war”.

In this special issue of our Q-Review series, we analyze the changes the monetary system is likely to face in  coming years. In this report, we first summarize the history of money and then move into explaining cryptocurrencies and CBDCs. Then we summarize our analysis and present our forecasts for the world economy and financial markets.

In this blog-entry, we briefly summarize our findings.

Cryptocurrencies

Cryptocurrencies consist of decentralized digital assets that are secure and semi-anonymous i.e., all transactions are recorded in a ledger, although parties’ identities are hidden. Blockchain technology is used to ensure the integrity of the data.

Cryptocurrencies are generally not backed by any institution or organization. They have no fundamental or intrinsic value, but may have, by design, a high degree of scarcity.

The algorithm creating the cryptocurrency may also try to stabilize the value of the cryptocurrency relative to a fiat currency issued by a central bank and government. These so-called stablecoins include XRP, which acts as an intermediary between currencies of networks, and Tether, which is (supposedly) pegged 1-to-1 to the U.S. dollar. Cryptocurrencies may also be backed by assets, like real estate, or commodities, like gold or oil.

However, while the technology itself is promising and even “revolutionary”, its application alone does not add a tremendous amount of value. Nobody owns blockchain technology and anyone can make a new cryptocurrency, and many have done just that.

Central bank digital currencies

Central bank money comprises of physical cash in circulation and central bank reserves, i.e., the deposits of financial institutions at the central bank. A central bank digital currency, or CBDC, would create another layer of central bank money.

CBDCs can take two forms.

It can be a central bank issued, a retail CBDC) digital currency or a central bank-backed digital currency, or a synthetic CBDC.

A CBDC is ‘synthetic’, when it is backed by reserves at the central bank. Another name for this is a wholesale CBDC. A retail CBDC is in question, when it is widely acceptable digital form of fiat money, which can or cannot act as a legal tender.

While the CBDC can be seen to help the monetary system in many ways, for example, by increasing the availability of currency in areas with limited access to cash, it also bears massive and close to fatal risks.

Firstly, the Issuance of CBDCs would corrupt the banking system, by making the central bank a competitor of those it regulates and guards—commercial banks.

Secondly, it would expose the banking system to catastrophic runs and, in the worst case, turn the monetary system into a government-controlled dystopia.

The monetary revolution ahead

The main problem of many cryptocurrencies is that they do not fulfill the requirements of money. For example, Bitcoin’s “price” is far too volatile to serve as a currency of any nation (see the Figure). It also not backed by any collateral. So-called “managed coins”, on the other hand, raise a question: is the asset-backed cryptocurrency anything more than a medium between assets and commodities?

Cryptocurrencies and CBDCs

Figure. The price of Bitcoin in U.S. dollars. Source: GnS Economics, Yahoo Finance

CBDCs ‘attack’ the banking system from other angle: safety. The issuance of a CBDC would make the central bank a competitor of commercial banks with a deposit services that are essentially fail-proof. During a banking crisis, a run to the CBDC would be practically guaranteed.

The future is uncertain, as always, but change is coming. The ‘battle’ between cryptocurrencies and CBDCs seems almost guaranteed. We must fully acknowledge the risks we are facing, and act accordingly. Our economic future, and freedoms, depend on that.

We explain this in more detail in our report.

Original post from GNS Economics

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All articles are provided as a third party analysis and do not necessarily reflect the explicit views of GSI Exchange and should not be construed as financial advice.

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