(Francesco Mondello, CC BY-NC-SA)
The report of the Bank for International Settlements (BIS) on cryptocurrencies, which constitutes a part of the bank’s annual report, examines the impact of the new crypto-assets on the financial system, as well as the economic constraints related to the decentralized creation of trust as part of the distributed ledger and blockchain technologies, which are the foundation of all cryptocurrencies.
According to the BIS, the objective of cryptocurrencies is to replace the functions of public trust financial institutions — such as central and commercial banks — through the use of the blockchain and distributed ledger technology. The report indicates, however, that the replacement of traditional forms of money by cryptocurrencies is not possible.
The authors of the report note that the main problem associated with cryptocurrencies is their high degree of decentralization. Consequently, the creation of the required level of trust in this system is ineffective, unstable, and leads to great losses of computing power.
In the case of cryptocurrencies, in order for trust to be maintained, all network participants would need to download and verify the history of all transactions that have ever been performed, including the amount paid, the payer, the payee and other details, which requires enormous computing power, is inefficient, and causes huge energy consumption. At the same time, trust in cryptocurrencies could evaporate at any time due to the lack of a central issuer that guarantees the stability of the currency. A cryptocurrency can simply stop functioning, resulting in the complete loss of its value.
Central banks stabilize the value of their national currencies by adjusting the supply of the means of payment in accordance with the demand for transactions. Meanwhile, due to the method in which cryptocurrencies are created, they cannot flexibly respond to changes in demand, as the supply of the cryptocurrency needs to be predetermined by its protocol. This means that any fluctuations in demand result in changes in the valuation of the cryptocurrencies.
As a result, according to the BIS, the decentralized technology which provides the basis for cryptocurrencies cannot become a substitute for the solutions currently applied in the field of issuing money. It may be applicable in other areas, however, such as the simplification of administrative processes in the settlement of financial transactions or low-value cross-border payment services (which are important for countries with a large share of their workforce living abroad). The bank emphasizes, however, that this issue requires further research.
The BIS also addressed the idea that central banks could issue their own digital currencies (central bank digital currencies, CBDC) — the report indicates, that the tests carried out so far do not clearly indicate the necessity of issuing such means of payment in the short term.
The BIS also recalls that regulatory bodies have an important role to play in this area. The authorities have to ensure the integrity of the markets and payment systems, the protection of the consumers and the investors, and overall financial stability. Another important challenge is to combat the illicit use of new technologies and crypto-assets while maintaining incentives and promoting innovation.
Like the members of the G20 and many central banks, the BIS recognizes the need to strengthen or create new regulations relating to the monitoring of activities associated with crypto-assets.
Due to the fact that cryptocurrencies function in a transnational digital reality, largely in isolation from existing institutional environments or other infrastructure, and can only be regulated indirectly, the BIS calls for regulatory authorities to be given enhanced regulatory capacities and for the scope of regulation to be adjusted, taking into account the new types of risks associated with crypto-assets and their cross-border nature.
The full BIS report can be found here