A little more than a decade has passed since a select group of cryptography experts received emails from an unknown Satoshi Nakamoto announcing the launch of the innovative Bitcoin monetary system. Since then, cryptographic algorithm developers have offered many digital alternatives to existing payment systems. Consumers and investors have tested different versions of digital currencies, and governments and central banks have developed approaches to regulating the crypto market with more or less enthusiasm. However, the debate about the essential nature of cryptocurrencies continues unabated. What is it – money, a financial instrument or an operating system? Do cryptocurrencies have value? What risks do cryptocurrency users bear? Is it possible to create a global cybernetic financial system on their basis, completely replacing modern mechanisms of money creation and financial intermediation? Preliminary answers to these questions can be obtained by examining the advantages and disadvantages of this digital phenomenon. First, however, it is necessary to make a brief excursion into the history of money.
Revolution or evolution
The development of money is directly related to the application of new technologies and innovation. The leading role in this process has been played by enterprising Brits. For centuries one of the key problems of money circulation was the deterioration of coins, when their gold or silver content was constantly decreasing as a result of the trimming of the edges. This defect was remedied by Isaac Newton, who headed England’s mint in the late 17th century. During the Great Recoining, Newton ordered that all flawed and counterfeit coins be removed from circulation and replaced by new ones that were machine-made with a round ribbed rim, making them more difficult to further deface. Over time, increased foreign demand for high quality English silver coinage led to a shortage in the domestic market and necessitated a transition to paper money.
The flooding of the British economy with paper money became possible after the centralization of monetary circulation. Created in 1694, the Bank of England not only received the right to print paper money, but also secured the government’s obligation to cover the entire issue by issuing public debt. Its holders were thus assured a guaranteed income in the form of interest payments. A similar centralized model of money circulation was reproduced in the United States after the establishment of the Federal Reserve System in 1913. The Federal Reserve System (Fed) was established in 1913. Despite the fact that today the size of U.S. government debt has surpassed the $23 trillion mark, the economy of fiat money has very influential supporters, given that, along with the Fed, U.S. private investors and central banks in other countries are the owners of U.S. debt. In 2019, for example, the U.S. government’s net interest payments on government debt totaled about $390 billion, twice the capitalization of all cryptocurrencies in circulation.
Nevertheless, before paper money gained worldwide recognition, it was anathematized twice. The first time was in China back in the 14th century, when the inflation of paper money led to a ban on its subsequent issuance. Paper money suffered another fiasco in 1720 in the Scottish financier John Law’s failed experiment on the French financial system, which delayed its mass circulation in continental Europe for more than a century.
The transition from paper money to electronic money also began in London, where the world’s first ATM was installed on June 27, 1967. The prototype of the first debit cards appeared even earlier – in 1914, when the American telegraph company Western Union introduced a card for interest-free payments. True, at that time the card was made of metal sheet, not plastic as it is today.
Despite of modern wide spread of e-money, cash payments are still popular not only in developing, but also in highly-developed economies. In the modern world as a whole, the share of cash in transactions reaches 85%. For example, the share of cash payments in the total value of transactions in Austria, Germany and the U.S. is 65%, 53% and 30%, respectively. At the same time, only Norway and Sweden are experimenting with a complete renunciation of cash, where its share in the monetary supply was reduced to a symbolic 2.5%. Even after the advent of mobile payment platforms such as Apple Pay and Venmo in the U.S., cash in circulation has consistently increased, reaching $1.7 trillion in 2019.
Money or Technology
In addition to inertial barriers of political and technical nature, the mass spread of cryptocurrencies at the present stage is hindered by difficulties arising from their recognition as money. Any monetary system is based on trust in the ability of money to perform three main functions – means of payment, exchange and accumulation. The most painful for society is the depreciation of money, leading to a proportional decline in the value of created values. Trust in money is therefore based on its enduring social significance. Cryptocurrencies certainly represent a new word in the monetary sphere, but not so much as a monetary surrogate as a new technology of transaction accounting, which has the universal ability to embody the properties of money, commodity, property, financial asset and payment system without fully responding to any of them.
Yuan vs. dollar – a fight in the global financial ring
To draw a distinction between money and technology, let us turn to the following example. Over the past 30 years, the average cost per gigabyte of memory on a hard drive has dropped from $100,000 to a few cents. Does this mean that trust in dollars has gone up or that information has lost its social importance? No, it doesn’t. The decrease in the cost of storing information on a hard drive is a consequence of the development of technology and does not change the essence of money as a regulator of social interaction.
The benefits of cryptocurrencies
The main advantage of cryptocurrencies lies in the ability to reduce the cost of transactions and to involve the broadest segment of the population in financial transactions. The strengths of cryptocurrencies include decentralized (distributed) management, which means that no single entity controls the network; global access, which allows any user connected to the Internet to participate in the cryptosystem; security through cryptography, which protects the integrity of funds, which together give their users virtually unlimited freedom of action.
One of the main advantages of the Bitcoin system and a number of other cryptocurrencies is the zero transaction costs and simplified order of use. This attracts small and medium-sized businesses, as well as low-income citizens for whom access to bank cards is limited, and the transfer of funds through professional operators is too expensive. The flexible open source nature of cryptocurrencies allows programmers to develop these systems virtually online. It is believed that Bitcoin or other distributed (decentralized) network companies cannot be shut down because they do not have a single issuing center (central server).
Risks of cryptosystems
Along with the obvious advantages in practice, the operation of cryptosystems is flawed and reveals a number of serious drawbacks. The first problem is related to the limited bandwidth of the payment system. Blockchain-based cryptocurrency circulation involves two main participants – miners and users. Miners serve as bookkeepers and maintain the system infrastructure by updating the transaction list. Users make and receive payments. The financial incentive for miners is the fees charged to users for queuing up transactions. In order to generate user fees, the capacity of the system must be small enough. For example, the capacity through the Visa system is 3,526 transactions per second, while through the Bitcoin system it is 3.3 transactions. Capacity constraints overload the system, especially during peak hours, and lead to higher fees. For example, in December 2017, payment processing fees rose to $57 per transaction, regardless of the destination.
The second problem is the lack of payment finality guarantees. A payment recorded in the ledger does not guarantee that it is final and irrevocable. Cryptocurrencies are held by agreement between miners. If some of them collude and decide to rewrite the transaction history, the payment could be destroyed. In particular, such a precedent was set at Japan’s largest bitcoin exchange, Mt. Gox. In February 2014, this exchange declared bankruptcy after 850 thousand bitcoin coins worth half a billion dollars went missing, which somewhat weakened users’ faith in the perfection of cryptosystems.
The third problem is the enormous cost of operating a decentralized payment system. In the course of competition, miners add more and more blocks to their ledgers until their profits approach zero. The processing power of individual miner farms that mine cryptocurrencies is equivalent to the power of millions of personal computers. The total amount of electricity used to mine bitcoins in mid-2018 was equal to that of an average country like Switzerland. Other cryptocurrencies also use quite a bit of electricity. Such amounts of energy consumption can quickly become an environmental disaster.
In addition, double-checking all transactions constantly increases the volume of the blockchain. For example, a simulation of the spread of distributed ledger technology across economies such as the United States or China shows that, even under optimistic assumptions, the size of the ledger will exceed the capacity of a typical smartphone in just a few days, exceed the memory capacity of a typical personal computer in weeks, and go beyond server storage in months. Thus, only the capacity of supercomputers will allow the verification of all incoming transactions.
The fourth problem with cryptocurrencies is their extreme volatility, due to the lack of a central issuer designed to guarantee value stability through the use of various monetary policy instruments. The most successful Central Banks stabilize the intrinsic value of their currencies by adjusting the supply of payment instruments to match the demand for them. This is in contrast to cryptocurrency, where its supply is predetermined by the payment protocol. Therefore, any fluctuation in demand leads to a change in the value of the cryptocurrency, which makes it extremely unstable. For example, when bitcoin was created in 2009, it was worth 0.3 cents. Two years later, the price of bitcoin was $2, and at the end of 2013. – $1,000. In January 2015, its price dropped to $200 and did not return to the $1,000 mark until February 2017. In July 2016, the price dropped again to $640, and by the end of 2017, it had surpassed the $19,000 mark. In December 2018, the price dropped to $3,400, jumped to $13,000 in June 2019, and dropped to $7,268 in December 2019. Bitcoin’s market capitalization dropped 2.5 times from December 2017 to December 2019, from $320.5 billion to $131.8 billion, before starting to climb again in January 2020.
The fifth problem of cryptocurrencies is their lack of well-functioning regulation and anonymity, which increases the attractiveness of this system in criminal circles, in particular for the laundering of illicit proceeds and terrorist financing, committing cyber attacks, organizing the purchase and sale of drugs (which, for example, took place on one of the most popular anonymous Internet trading platforms Silk Road, which operated in 2011-2013).
It is believed that the introduction of Libra, a global currency, could address all of these shortcomings. The white paper, the text of which can be found on the website of the management company Libra Association, argues that the new currency will increase the speed of money transfers, lead to a significant reduction in the cost of borrowing, increase the responsibility of the financial sector in creating and offering innovative products to the market. By including in Libra hundreds of millions of new users, for whom traditional banking services are not available today for various reasons, tens of millions of jobs will be created, which will change the lives of billions of people. The participation in this project of regulators and experts in different fields will lead to the creation of a sustainable, safe, reliable, cheaper, more accessible and more connected global financial system.
The creators of Libra envision backing this currency with a reserve of real assets and tying its intrinsic value to a basket of currencies and services provided by its operators. Meanwhile, banks or real sector companies are not on that list yet.
In case of launching of digital currency Libra 2.7 billion users of social network Facebook will have access to it. If every subscriber makes a $1000 payment within Facebook using blockchain technology, the network could have an annual turnover of $2.7 trillion or 11% of the U.S. federal debt. The value of Libra, as well as all of this turnover, will be tied to the dollar (or a basket of currencies including the dollar), and therefore to the U.S. economy. It should be emphasized that other cryptocurrencies and many key technologies of the digital economy are also tied to the U.S. dollar.
Thus, American companies specializing in the creation and management of social networks offer their solutions in the monetary sphere, which, on the one hand, can be regarded as elements of disintegration of the global monetary system, and on the other hand, as its transition to a qualitatively different level – a global cybernetic financial system, in which the United States will have an unconditional comparative advantage.
The anonymous and decentralized nature of participants in cryptosystems questions the existence of a two-tier banking system. Global cryptocurrency opens the door to a digital hypermarket that knows no national borders, in which today’s fee revenues of traditional payment system operators can be transformed into tomorrow’s consumption by hundreds of millions of new digital economy users. When combined with Big Data, cryptocurrencies enable high-tech elites to create a payment system independent of the state and influence the behavior of individual social groups, consumers, and voters.
A glimpse from the future
It should be emphasized that the first digital currency projects emerged back in the 1990s (David Chom’s DigiCach, Ilon Musk’s PayPal, Sholom Rosen’s “digital dollars”) and were developed with the direct participation of system institutions such as Deutsche Bank, Credit Suisse and Citibank. However, in 2001, after the dot-com crisis, all these projects were shut down. It is difficult to predict the fate of today’s cryptosystems, given that there are already more than 5,000 digital currencies in the world and their number continues to grow.
Digital currencies are just a technology for recording transactions, which does not eliminate competition in the field of national currencies – the dollar, euro, pound sterling, yen, yuan. To overcome the devastating consequences of the global financial crisis and to protect their national economies from the unregulated elements of the global market, governments of sovereign states have teamed up with bankers and financiers, which has led to increased trends of protectionism and isolationism in the world economy. Joining this alliance of cryptographers and programmers could reinforce digital nationalism and reverse the globalization of the Internet. However, as history shows, economies cannot grow without constantly reducing transaction costs and other costs. Therefore, the question of how this cost reduction will take place in the context of increasing deglobalization remains open.