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Central Bank Digital Currencies - Part 2 of the "Virtual Currencies" EP report of July 2018

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sorin.cristescu
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last yearBusy9 min read

The Crypto-financial Ecosystem

This is the second part of the analysis of a recent report authored by a German think-tank and published by the European Parliament.

Why is it important to analyze it, why should you care? Because such reports shape the understanding of political decision-makers and influence their attitude and position with respect to this new domain of blockchain and cryptocurrencies. If advisers and experts from think-tanks have an outdated, partial view, they will provide incomplete information that may lead to sub-optimal political and regulatory outcomes.

Because we have in Steemit / Busy a platform for public expression, it is ultimately in our hands to complete the views of politicians and regulators with the most up-to-date information concerning the rapid evolution of the blockchain and crypto space, what I called in the previous post the Cryptoverse.

Sun-Tzu.jpg

Volatility

The report authors correctly identify excessive volatility as one of the major factors hindering broad adoption of cryptocurrencies. They dedicate several paragraphs to analyzing its causes and trying to predict whether and how it might recede in the future.

Price volatility in cryptocurrencies is all the more upsetting for "mainstream people" (thus slowing adoption outside the circle of enthusiasts) as traditional risk management techniques from classic finance do not seem to function well when applied to bitcoin & co.:

"Standard empirical models have difficulties describing the behaviour of volatility of Bitcoin and other crypto assets.

However one positive aspect is identified, going forward, provided volatility is tamed somehow:

We could even go from the current "lender of last resort" paradigm to a "system of last resort" where cryptocurrencies work as a fall-back option in case the traditional currency system should fail, just as e.g. the US-Dollar has replaced failing currencies in some countries such as Zimbabwe and Venezuela in the past. However, as discussed above, so far there are severe limitations on Bitcoin to fill such a role with respect to scalability"

I do posit that SBD on the steem blockchain with not face the same scalability issues as Bitcoin when replacing government fiat in, say Venezuela but that assumption needs testing.

Just above there is a noteworthy related remark:

[...] cryptocurrency investments could work as a hedge for other investment risk and play a productive role in overall risk management

Indeed, it made me think of the "0.1%" strategy I've heard some Canadian asset managers were discussing (maybe even applying?). The idea is that crypto being (till now at least) completely uncorrelated with traditional asset prices, parking 0.1% of the total holdings in a basket (heavy on BTC) could play the role of "systemic hedge", in case of a global financial meltdown.

The report spells out a very powerful idea:

cryptocurrencies could discipline financial institutions and central banks, which could ultimately lead to more financial stability.

The importance of sowing this seed in the minds of (specifically) European policy makers should not be underestimated. Indeed, crypto provides, for the first time since the beginning of the Bretton Woods era, a grassroots competitor to the monopolistic, crisis- and abuse-prone financial system.

Steem the Unnamed

In Part 1 I opined that probably the biggest oversight of the report was to implicitly equate "crypto investment in ICOs" with "fiat investment in ICOs" thus spurring unwarranted and potentially harmful "protective" reflexes from regulators.

Here in Part 2 lies what might count as the best recommendation in the report, which also makes a direct reference to Steemit without naming it:

Regulation should be careful to account for diversity and evolution in a rapidly changing environment to not unnecessarily restrain wealth creation. The market of distributed ledger technologies is very diverse. Business models include not only currencies but range from "good content” gratification tokens in social media

i.e. STEEM ...

... across automated digital contracts and ways to manage intellectual property, towards pension schemes. In a rapidly changing market, where new services and tokens are offered daily, regulators must be careful to avoid unduly restricting welfare enhancing innovations.

This display of a clearly positive inclination toward the Cryptoverse on the part of the authors is paired for good measure with an indirect scolding of the German regulators in the last paragraph of this chapter:

Another example of potential overregulation is the German financial services supervisory authority (BaFin) classifying Bitcoin as a financial instrument (unit of account, to be exact) and not as a currency. Therefore, the strict Banking Act (Kreditwesengesetz) applies, effectively creating an entry hurdle which reduces cryptocurrency demand and liquidity and ultimately inhibits further mass adoption of cryptocurrencies.

Mass adoption of cryptocurrencies is thus seen as a positive development to be encouraged by their classification as currencies (rather than as financial instruments). This is a serious "leg up" for the Cryptoverse with European political decision makers.

Central Bank Digital Currencies

The 6th chapter is probably the most daring - and therefore controversial - of the report. It basically supports the thesis of the Vollgeld ("Monnaie Pleine") proponents, most active in Switzerland (such as @orlandumike here on Steemit).

What they have said for a long time: that the rent-seeking behavior and risks imposed by commercial banks are not an acceptable compromise anymore in exchange for broader access to credit. That the fractional banking system should be overhauled, people should be allowed to have an account directly with the Central Bank and the commercial banks should work harder to find other sources of funding rather than exploiting cheap deposits from ordinary citizens.

The report boldly ventures into exploring this possibility using Central Bank-issued cryptocurrencies as a practical implementation vehicle and conclude that, but for the disruption it will cause to the present-day financial system, it could work!

If a CBDC were introduced and rose to prevalence, the present fractional reserve system could evolve into a full reserve system, or at least leave considerably less room for commercial banks to create money out of thin air and to use sight deposits as a source of funding.

While I agree that currently commercial banks enjoy too much power and abuse it at regular intervals, I have three qualms with such a development.

First, the authors fail to convincingly account for commercial banks' role in providing fine-grained risk management. Extending credit to individuals and business relies on a poorly scalable activity, credit-risk assessment, for which commercial banks employ lots of people and systems. Credit risk management could become a lot more efficient and a lot less "people intensive" thanks to blockchain technologies as well, but this won't happen tomorrow. Closely managing the transition to avoid commercial banks collapsing and starving the society of credit before alternatives are able to take over will be a challenge

Second, concentrating the power enjoyed today by commercial banks in the Central Bank (run by difficult to incentivize civil servants), on top of the huge power Central Banks already enjoy, does not appear as entirely without risks either (even if the risks would be different).

Third, advancing such an aggressive hypothesis in a serious report at this point in time, when the opponent has the strength of the current financial system, is in my opinion a tactical mistake Sun Tzu would have disapproved of.

This rather surprising chapter ends with what can be seen as vindicating the original vision of Satoshi Nakamoto:

As the fractional reserve character of the current banking system can be a major source of instability, such a disruptive change due to the introduction of a CBDC is not necessarily a bad development, but instead could finally pave the way for a more stable financial system.

Conclusion

Overall, this is a very good report, thoroughly researched and providing several very useful insights and recommendations to political decision makers. By design, it has the shortcoming of heavily stressing the financial and monetary aspects of the emerging blockchain world and not providing a balanced view of the many other aspects of society which blockchain technology can improve, e.g. "sovereign identity" and its use in education, or the legal system through blockchain-recorded evidence. But this partial view has explicitly been requested by the EP.

My main issue with it is in its strategic choice of using the CDBC as the intellectual spearhead of the report (thus indirectly steering the discussion in this direction). This risks stirring trouble by alerting the powerful lobby of the financial industry and leading to an even greater hostility of banks toward cryptocurrencies. When one is weak, it doesn't look wise to pick a fight with a stronger adversary ...

I am convinced the most important feature of cryptocurrencies is their potential of decreasing transaction friction thus increasing overall economic and social activity, and with it citizens' prosperity and welfare.

I would have preferred the report emphasizes this aspect. Increasing financial stability through a CDBC might be interesting but it pales when compared with the possibility of unleashing a sea of new value-adding (both "economic" and "social" value) activities (in effect: new jobs) that are currently uneconomical, constrained by the monolithic and monopolistic nature of fiat money.


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If you read this post first, here is the "Part 1":

Other posts on blockchain technology that you might enjoy:

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