Within an era of increased bailouts of major financial institutions and high-inflationary economic environments globally, scepticism has developed on the monopoly position of central banks within fiat currency (or traditional currency) issuance. Within the modern monetary system, commercial banks are the primary source of liquidity, with central banks providing marginal sources of liquidity in comparison. This results in large distributional issues, with liquidity flows being intermittent and unevenly dispersed across different economic sectors. The sustainability of these flows is necessitated by a banking system characterised by a continuous demand for liquidity to meet financial obligations and maintain economic stability. Detractors claim that the absence of diversity within monetary policy instruments leads to a lack of adaptability and responsiveness in delivering economic stability within this complex financial system.
What is Blockchain Technology?
Blockchain technology can be used to provide a decentralised liquidity system that provides alternative sources of liquidity through innovative technology, with a larger variety of monetary instruments available and the potential for greater transactional efficiency. The largest and most famous application is Bitcoin, created in 2008, established as a pseudonymous peer-to-peer network with no established central authority to facilitate decentralised transactions across the internet. These blockchain systems can employ their own iterations of “monetary policy” (Singh, 2023), as typically described in their white papers, with transparency disclosures made on token supply (or liquidity) alongside alternative mechanisms such as proof-of-stake systems that ensure the continued stability of the market and token supply.
Could cryptocurrency replace traditional currency?
A key motivator for the use of cryptocurrency is its decentralised nature. The utilisation of standardised central bank monetary policy tools, such as currency issuance and the control of interest rates, generates large volatility within liquidity markets due to changes in market sentiment forcing banks to undertake strict risk strategies to mitigate against uncertainty. With the use of blockchain tokenised liquidity, the transparency of supply mechanisms and the absence of an intervening central body could potentially remove this source of uncertainty entirely. For example, Cardano (ADA) utilises a democratic governing system (Cardano, 2023) in which every token-holder holds a stake in the network and is incentivised to vote on policy proposals thus allowing for greater certainty on future supply trajectory within the network.
Another motivator for the use of blockchain technology within the monetary system is the greater transactional efficiency and security. The use of cryptographic technology ensures that unauthorised parties are almost completely unable to alter transaction data or gain access to user funds. In addition, the efficiency of modern network consensus mechanisms allows for extremely rapid yet cheap transfer of funds internationally. For example, the Ripple (XRP) blockchain typically performs international transactions in less than eight seconds (XRPLedger, 2023), with transactions costing 0.0001 XRP tokens which translates to a small fraction of a penny within current market conditions (Schmidt, 2023).
What limitations could cryptocurrency face in replacing traditional currency?
The implementation of blockchain technology within the modern monetary system could face several potential limitations. One significant issue is the environmental impact of maintaining and operating such computationally intensive networks. Several papers have highlighted this issue, with Stoll (2022) suggesting that Bitcoin mining alone represents 0.19% of global emissions despite Bitcoin not yet being fully implemented and utilised within the global monetary system.
In addition, cryptocurrencies operate within a pseudonymous environment that is incredibly challenging to regulate. This has allowed cryptocurrency to be a harbour of illegal activity, such as money laundering, fraud and tax evasion. For example, Foley (2019) suggests that $76bn of illegal activity per year involves Bitcoin, covering approximately 46% of total Bitcoin transactions. Regulators are therefore forced to find a difficult middle ground in which they mitigate against the risk of illegal activity while still endorsing its applications due to the large financial innovation externalities they can potentially generate. Central Banks, for example, have begun the development of central-bank digital currencies (CBDCs) that take advantage of greater transactional efficiency within transactions while still maintaining a strong degree of regulatory control (Bank of England, 2023). However, the highly centralised nature of these tokens means they simply do not achieve the decentralisation benefits and privacy of traditional cryptocurrency.
Cryptocurrency, driven by blockchain technology, therefore holds great promise as a transformative force in the modern monetary system. However, clear obstacles exist in integrating cryptocurrency as a prominent source of liquidity within the financial system. With rapid innovation occurring within this space, it will be interesting to see what blockchain researchers can develop around mitigating risks and challenges in the journey toward potentially widespread adoption of cryptocurrency.
Article by Darren Kantharaj
Edited by Lara Gigov (Editor-in-Chief)
Bibliography
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Foley, S. (2019) 'Sex, Drugs, and Bitcoin: How Much Illegal Activity Is Financed through Cryptocurrencies?.' The Review of Financial Studies, Volume 32, Issue 5, May 2019, pp. 1798–1853.
Schmidt, J. (2023) What is Ripple (XRP)?. [Online] Available at: https://www.forbes.com/uk/advisor/investing/cryptocurrency/ripple-xrp/#:~:text=The%20cost%20to%20complete%20a,a%20penny%20at%20current%20rates. [Accessed 23/11/23]
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XRPLedger, 2023. XRP Transaction Costs. [Online] Available at: https://xrpl.org/transaction-cost.html [Accessed 24/11/23]
