By James A. Fok
The rapid growth of cryptocurrencies in recent years has been viewed by many as a speculative bubble. However, it also reflects growing scepticism in fiat currencies and fears that prevailing monetary policies are debasing their value. While few today can imagine cryptocurrencies challenging the global dominance of the dollar, with its backing of the full faith and credit of the US Government, private currencies issued by commercial banks, railroad companies and even religious institutions had been widespread in the US until the 1860s. It was the National Bank Acts of that decade that imposed government supervision over the banking sector and helped establish a national currency. Ultimately, anything can serve as a currency – from cowrie shells or lumps of metal to bits of data on computer servers – so long as people believe in it. Where faith in a state-issued currency is undermined, the private sector will inevitably innovate to create substitutes.
The Rise of Decentralised Money
Invented as the Global Financial Crisis was roiling markets in 2008 by a so-far-unidentified individual or group of people using the name Satoshi Nakamoto, the cryptocurrency Bitcoin began use in 2009. Bitcoin operates as a decentralised digital currency on a peer-to-peer network, with no single administrator or central bank. Transactions are verified cryptographically through ‘nodes’ on the network and recorded on a public distributed ledger called a ‘blockchain’. The anonymised nature of Bitcoin transactions and the impracticability for any individual or group to cancel or amend a transaction that has taken place renders it difficult – if not impossible – for any government to control or manipulate the currency. Further, the total number of Bitcoins that can be issued is capped at 21 million, ensuring their value cannot be diluted by expanding their supply beyond that cap.
Hidden in the jumble of code of the first 50 Bitcoins, known as the ‘genesis block’, was the text: ‘The Times 03/Jan/2009 Chancellor on the brink of second bailout for banks’. This referred to articles in The Times of London about the breakdown of the banking system amidst the Global Financial Crisis and has been interpreted as a ‘battle cry’ against the fiat money system. Astonishingly, this movement caught on and spawned a market that has since topped $2.5 trillion in size. The first known commercial transaction took place in 2010, when 10,000 Bitcoins were used to purchase two Papa John’s pizzas. Since then, the value of the cryptocurrency (as expressed by its conversion rate into US dollars) has seen meteoric rises and falls, surpassing $69,000 per Bitcoin in November 2021.
The surge in interest in Bitcoin has spawned the creation of a raft of other cryptocurrencies. As of February 2022, there were more than 12,000 cryptocurrencies in existence, and a large number of cryptocurrency exchanges have been launched to facilitate trading in them. In December 2017, both the CBOE and the CME launched trading in Bitcoin futures, further endorsing Bitcoin’s status as part of the mainstream financial system. When the cryptocurrency exchange Coinbase listed on Nasdaq in April 2021, its market value briefly topped $100 billion, making it the largest exchange in the world by market capitalisation. In June 2021, El Salvador even passed legislation to make Bitcoin legal tender.
Nevertheless, Bitcoin is beset by challenges that make it unlikely to pose any serious challenge to the dollar.
First, the lengthy processing time required to complete a Bitcoin transaction renders it impractical as a currency for everyday payments. The Bitcoin network has a capacity of just 7 transactions per second (TPS). By comparison, Visa’s network handles around 1,700 TPS and the payments company claims to be able to handle up to 24,000 TPS.
Second, its high level of price volatility makes Bitcoin an unreliable store of value. Having surpassed $60,000 for the first time in April 2021, its price had more than halved just three months later before touching a new high and then falling again.
Third, a large amount of electricity is required to create (or ‘mine’) new Bitcoins, making it both costly and environmentally unfriendly. The Bitcoin network’s annualised electricity consumption of 130 TWh exceeds that of even some advanced countries, including the Netherlands and Norway.
Fourth, its role in facilitating illicit transactions undermines state authority and, for this reason, governments are likely to intervene to limit Bitcoin’s use.
However, it is one of Bitcoin’s greatest attractions that is likely to prove its fatal flaw in achieving universal adoption. The absolute limit on supply to 21 million Bitcoins means that the supply of the currency cannot increase to keep pace with economic expansion – a key defect of the now-defunct gold standard.
Bitcoin’s shortcomings do not necessarily rule out other cryptocurrencies from posing a serious challenge to the dollar though. This is a relatively nascent technology and there will likely be further innovations and design improvements over time. Notably, Ethereum, the second most popular cryptocurrency by market value, already features significant modifications compared with Bitcoin to improve its attractiveness as a currency. By employing a different cryptographic protocol, Ethereum is set to become far more energy efficient than Bitcoin. Through a technology called ‘sharding’, whereby the blockchain is split up into multiple parts to process transactions, and ‘Layer Two’ solutions that work via ‘side chains’ off the main Ethereum blockchain, Ethereum’s transaction capacity could eventually be increased to around 100,000 TPS. Crucially, Ethereum is also designed to allow it to be inflationary. In time, other more credible challengers are likely to emerge. This has started to make governments and central banks nervous.
In June 2019, a Facebook-led consortium, including some of the biggest names in payments technologies, announced plans to launch a new digital currency called Libra. Libra was designed as a ‘stablecoin’ – meaning that it was to be fully asset-backed, rather than fiat-based as Bitcoin and Ethereum are. The assets backing Libra were to be a basket of national currencies. Given Facebook’s billions of users, Libra had the potential to achieve widespread international uptake and, therefore, posed a considerable threat to national currencies and governments’ monetary sovereignty. After both US and European regulators expressed serious concerns, a number of the consortium members, including both MasterCard and Visa, backed out. Eventually, Facebook announced significantly scaled-back digital currency plans in late 2020 under the brand ‘Diem,’ before ultimately abandoning the project altogether.
Facebook’s Libra proposal catalysed central banks around the world to begin taking digital currencies far more seriously, and to launch a series of efforts of their own. By January 2021, 86 percent of central banks were actively investigating the possibility of launching central bank digital currencies (CBDCs), 60 percent were already conducting experiments or proofs-of-concept on them, and 14 percent had moved onto development and pilot arrangements.
National currencies have significant advantages over private ones. Not only do they enjoy the backing of accountable public institutions, but governments’ power to require payment of taxes in the national currency creates substantial natural demand that private currencies cannot easily replicate. The advent of CBDCs could bring about a wide range of public benefits, including lowering the cost of payments across the economy; improved ability to monitor inflation and transmit monetary policy; and greater ability to combat tax evasion, money laundering and other financial crime. Nevertheless, there are also significant challenges associated with them.
The key risks associated are: (i) they could give governments unprecedented levels of insight into individual citizens’ private transactions, which gives rise to civil liberty concerns; (ii) they could disintermediate commercial banks, undermining the market’s ability to price and create credit; and (iii) the use of CBDCs across borders could exacerbate the risk of national currencies being displaced.
The renminbi has long been viewed as an emerging rival to the dollar due to the scale and rapid growth of China’s economy and international trade. China is also among the front runners in the development of CBDCs. In a step towards promoting greater international adoption of the renminbi, in 2019 the PBOC launched the digital renminbi (e-CNY), the first digital currency to be issued by a major economy. Use of e-CNY to invoice and settle payments in Chinese international trade could substantially reduce transaction costs by disintermediating banks and other financial intermediaries, thereby encouraging adoption. This could reduce the dollar’s role in international trade settlement. However, a more profound impact of the transition to digital currencies could be a shift in the balance of power in the global financial system.
The Path Ahead
Digital currencies have the potential to radically transform the global monetary system and pose the greatest threat to the dollar’s global dominance in at least a generation. The new technology could well challenge the incumbency of key pillars of the plumbing of international finance. For example, digital currencies might operate on new messaging protocols, and messaging and settlement could be carried out as a single process. This could displace the SWIFT messaging network, undermining America’s ability to impose financial sanctions. Further, new international financial infrastructures that emerge around digital currencies could transfer significant influence over the financial system to the parties that control them. It was surprising, therefore, that in a June 2021 speech Federal Reserve Governor Randal Quarles appeared to caution against the US rushing to develop its own CBDC, due to the risk that this might pose to the dollar. Perhaps recognising the folly of burying its head in the sand, the US is now playing catch-up, with President Biden recently issuing an executive order to develop a regulatory framework for digital assets.
In the global marketplace for commerce and investment, it will ultimately be futile to try and hide from the forces of technological creative destruction. The race to define the future of money could well determine the leadership of the institutions governing a wide range of global rules and conventions over the coming decades. It also presents an interesting test of the effectiveness China’s responsive one-party governance model versus America’s ‘free market’ democracy. China’s present lead in CBDCs is no guarantee of ultimate success.
But perhaps the issue is not which major power takes the lead. Given the smooth functioning of the global monetary system is of vital importance to everyone, the real issue is how America and China can collaborate, rather than compete, in designing the future pillars of the international financial system.
About the Author
James A. Fok, author of Financial Cold War, is a veteran financial and strategic advisor to corporations and governments, who served as a senior executive at Hong Kong Exchanges and Clearing during a decade of rapid internationalization in China’s capital markets. Among other roles, he is a member of the Advisory Board of the digital custodian Hex Trust. Financial Cold War: A View of Sino-U.S. Relations from the Financial Markets is published by Wiley. For more information, visit: jamesafok.com.