Cryptocurrencies Could Get Their Own Central Bank

By Matthew Johnston | September 21, 2017 — 4:41 AM
Cryptocurrencies are in the midst of a breakout year. The price of Bitcoin has risen more than 300% year to date, while Ethereum is up more than 3,000%. Oh, and the amount of money raised by initial coin offerings (ICO) recently surpassed that raised by early-stage venture capital funding. With all this hype, the Bank for International Settlements (BIS), in a recently published paper, explores the question of what a central bank cryptocurrency (CBCC) might look like.

While there may be some advantages for central banks to add a cryptocurrency to their current monetary mix of cash and reserves, such a move also carries certain risks, and has the potential to disrupt both the private cryptocurrency market as well as the business model of commercial banks.

Reserves, Cash, and Maybe Cryptocurrency
Central banks currently issue two forms of money: reserves and cash. Reserves are electronic forms of payment restricted to those with an account at the central bank, such as certain private banks. They can be transferred between banks through the mediating action of the central bank.

Cash, on the other hand, is a physical form of payment that can be used by anyone and is exchanged directly between buyer and seller without an intermediating third party to confirm the transaction. This peer-to-peer characteristic of cash makes it anonymous, at least to third parties.

What a cryptocurrency does is combine anonymity together with the attribute of electronic payment. With these features in mind, central banks around the world are considering the implementation of two separate versions of CBCCs: a wholesale version restricted to financial institutions use only; and a universally accessible retail version.

CBCC Advantages and Risks
While the anonymity feature is more relevant to the retail version, a wholesale CBCC, by taking advantage of the distributed ledger characteristic of cryptocurrencies, has the potential to reduce settlement costs through improved efficiency in the interbank payments system. (To read more, see: Bitcoin’s Blockchain Technology Tested by 40 Banks.)

A retail CBCC that hides the personal identities behind a public address could provide both third-party and counterparty anonymity. This feature could reduce the risk of identity theft while also protecting the privacy of people’s transactions.

One caveat, however, is that third-party anonymity makes it easier to engage in criminal activity. A central bank worried about such activity could require users to provide their personal identities, allowing only a limited amount of anonymity to users. Of course, this would kind of defeat the purpose of issuing a CBCC. Central banks could just allow universal access to reserve accounts, a technically feasible possibility and something that has been contemplated before. (To read more, see: Digital Currencies Can’t Be Anonymous, Says EU Parliament.)

If central banks go for the full-anonymity option, considering the fact that a CBCC could provide people with a less volatile cryptocurrency option, privately created cryptocurrencies could face serious competition.

Potentially easier conversion between accounts at commercial banks and a CBCC could increase the risk of bank runs, as well as disrupt the model of commercial banking. Banks would have to find new ways of attracting depositors. Also, one of their key economic functions would likely be hampered: that of monitoring borrowers.