The evolution of the payment system

Can fiat money be replaced by digital currencies? Professor Rabee Tourky, the Director of the Research School of Economics at Australian National University, has predicted that cryptocurrencies, such as Bitcoin, will replace fiat money within a decade. Furthermore, the current monetary system has been heavily criticised by the Austrian School, which disapproves the central banks’ monopolistic supply of money, where third parties are essential to debit and credit transactions. As a result, entrepreneurs are wondering if Bitcoin is a valid alternative to fiat money. Many business leaders and technologists believe it has the potential to transform developing economies, lower transaction costs, and reshape the financial system. In fact, digital currencies aim to establish a more efficient medium of exchange, removing dependencies on governments and banks. However, because of its high volatility and lack or regulation, it is reasonable to believe that they will enjoy only a brief and fleeting moment of success.

Supporters of cryptocurrencies claim that they can drastically reduce transaction costs; digital currency represents a cheaper, quicker and safer way of sending money. Today, transactions are unreasonably slow and expensive because they need to be authorized and approved within the private card network. Contrarily, the blockchain protocol would allow anyone who has a mobile phone or other connected devices to send and receive Bitcoins almost free of charge. In fact, Adam Shapiro, director at Promontory Financial Group, noticed that sending $1,000 USD requires a cost of $80 USD via bank wire and, $50 USD via credit card, while using digital currencies, the same transaction would cost only $15 USD. Moreover, the transaction would happen instantly. Consequently, businesses and organizations would have more cash available for financing their activities and operations, without relying on bank loans. Eventually, a faster and cheaper way of exchanging money would benefit the economy as a whole, make operations more efficient, and increase living standards.

However, no accounting principle for cryptocurrencies exists, and the absence of such regulations would increase firms’ expenses. In fact, Bitcoins cannot be considered as cash because they do not have an issuer and most companies do not accept them as medium of exchange. As a matter of fact, governments in Korea, Finland, Germany, and Norway claimed that Bitcoins are neither currency, nor electronic payment. Additionally, cryptocurrencies do not fit the definition of cash equivalents: they cannot be deposited into a bank account or withdrawn at ATMs. A highly liquid asset does not have such limited access. Finally, according to the Internal Revenue Service, digital money would fall under the definition of investment, like stocks and bonds. Yet, owning Bitcoins as an investment would compel the “investor” to book each transaction at their effective value when received. As a consequence, any transaction would represent a taxable event, especially when the digital currency increases in value. This would definitely prevent Bitcoins from replacing fiat money.

Although no accounting principle that regulate cryptocurrencies exists, the blockchain protocol is cryptographically more secure than fiat money and cannot be manipulated by any person, organization, or government. Therefore, the use of such technology would benefit the economy as a whole. Using virtual currency, vendors cannot charge hidden fees without being noticed, because every transaction is publicly available. Furthermore, due to the fact that these transactions are secure, and do not carry any personal information, it becomes easier to do business where fraud and crime rates are high. Finally, the adoption of cryptocurrencies would create new business opportunities and promote the expansion of international trade, thus, benefit both consumers and organizations.

Nonetheless, virtual currencies project another serious drawback for consumers: their value can fluctuate widely. Fiat money is regulated by governments and controlled by central banks through monetary policies, which guarantee price stability. Contrarily, the purchasing power of unregulated currencies can drastically increase or decrease on the spur of the moment. Additionally, during a recession or a period of deflation, a monetary policy could not take place because it is not possible to adjust Bitcoin supply. For this reason, its price is highly volatile and unstable, which makes the behaviour of digital currencies comparable to the one of stocks: their price is highly responsive to how people perceive them. For instance, over the past three years, Bitcoin’s volatility has ranged from 50 percent to 400 percent with an average of 120 percent, while the volatility of G10 fiat currencies has ranged from 7 percent to 16 percent with an average volatility of 8 percent. In conclusion, volatility is not a desirable trait for a currency, and therefore, cryptocurrencies cannot represent a suitable medium of exchange for economic transactions.

Taking everything into account, the blockchain technology offers valuable advantages, as it allows anyone to monitor and verify transactions without the role of an institution or a trusted third party. It provides a borderless, faster and cheaper infrastructure than banks. However, fiat money is the only currency recognized as legal tender, it is used to pay taxes to the government, and its supply and value is regulated by the central bank, which significantly reduce price volatility. Ultimately, cryptocurrencies cannot replace fiat money. Nonetheless, a potential weakness of this perspective relies in the erroneous representation of the conflict between fiat money and cryptocurrency. In fact, they could coexist in a condition of mutual optimization, which does not imply the replacement of one by the other. Specifically, digital currency protocols could be assimilated to build a safer, cheaper and more efficient hybrid economy, where transactions are optimized without replacing state money. The central bank could provide a decentralized, stable and familiar unit of account by issuing a virtual currency backed by fiat money, and maintaining a one-to-one reserve ratio between them. Consequently, the cryptocurrency price would be permanently equal to the fiat price, and the central bank would still be able to implement a monetary policy by creating and destroying money. Instead of relying on market forces, a one-to-one reserve ratio would prevent both volatility and accountability risks. To conclude, cryptocurrencies are not likely to replace fiat money in the short run, but they will certainly make a significant impact on the evolution of payment systems. As Bill Gates affirmed, “we always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten”.