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With just over 1,500 cryptocurrencies approaching a market cap of over $451B1 as of March 1, virtual currencies continue to remain appealing to not only market participants, but also to regulators. The J.P. Morgan Global Research team explores some of the key considerations that central banks would likely encounter if they issued their own cryptocurrencies and how the Fed’s involvement with distributed ledger technologies (DLT) could look.
The economic issues raised by cryptocurrencies mainly relate to how they will interact with existing monetary regimes and the central banks that administer them.
The first question is whether cryptocurrencies can become legitimate competitors to existing national currencies.
The second question is whether central banks will co-opt distributed ledger technology to create their own central bank-issued cryptocurrencies.
Due to the anonymity of cryptocurrency transactions and the heightened volatility around technology and regulation, cryptocurrencies, in their current state, generally do not function as money under economists’ definition of money, which is: (i) a unit of account, (ii) a medium of exchange, or (iii) a store of value. The fundamental problem seems to be that the supply of cryptocurrencies is not nimbly adjusted to offset fluctuations in demand. As a result, the values of cryptocurrencies tend to fluctuate massively, frustrating any attempt to price and transact in them. Because of this, existing cryptocurrencies are unlikely to compete with established conventional currencies.
From Sweden’s Riksbank studying the issuance of a so-called “e-krona” to the Bank of Canada experimenting with a peer-to-peer system known as Project Jasper (CADcoin), it is evident that traditional banks are exploring the practicalities of issuing central bank cryptocurrencies (CBCC). Unlike existing cryptocurrencies, a potential CBCC would be issued and backed by central banks and would trade 1:1 with the traditional currency, thus having a more stable value than existing cryptocurrencies. Virtually every central bank around the world today is an institution in the service of the public. There must be a compelling policy rationale to issue CBCCs. One such rationale is to keep up with the times: payment systems are increasingly cashless, and it would seem natural that central bank-provided payment services move in that direction.
Despite the early stage of cryptocurrency adoption, the Federal Reserve System has mused the possibility of “Fedcoin” for the U.S. Below are some considerations involved in creating a CBCC.
FEDCOIN TRADING 1:1
A potential CBCC would become a third form of monetary base, alongside currency and reserves. Just as a dollar of currency trades 1:1 with a dollar of reserves, so too would a dollar of Fedcoin trade 1:1 with either of the other two dollar forms. Bank reserves arguably are a form of electronic cash, like Bitcoin; reserves still differ from Fedcoin in two respects. First, only a limited number of entities are allowed to hold reserves. Second, reserve payments are settled by a trusted third party, the Fed, rather than on a peer-to-peer basis.
ACCESSING THE
FED’S BALANCE SHEET
The Fed’s interaction with businesses and households is generally mediated through the banking sector. If issued, Fedcoin would provide businesses and individuals with direct access to this claim on the Fed’s balance sheet. This structure could potentially create a strong incentive to shift transaction deposits from the commercial banking system to Fedcoin: claims on the Fed balance are arguably even safer than FDIC-insured claims. If Fedcoin paid interest, as is currently the case with reserves, this incentive would be even stronger. If this migration from deposits to Fedcoin were to occur, the Fed effectively would be using its balance sheet to create a “narrow bank.” The vast restructure and move toward such a system would be quite disruptive to the financial sector, in our view.
THE CHALLENGE OF
ANONYMITY
Another consideration when constructing Fedcoin is whether it should share one important attribute of both Bitcoin and cash: anonymity. This is in contrast to the other principal means of payment available to individuals—bank deposits—where the government requires banks to know their clients. In theory, Fedcoin could be structured to preserve anonymity, but should it? On the one hand, privacy has come to be seen as an implicit constitutional right, and that may extend to monetary transactions. On the other hand, there are several laws intended to prevent the financial system from being used to launder money or to finance terrorism and other activities.
The Economics of Cryptocurrencies
Michael Feroli, Chief U.S. Economist at J.P. Morgan, discusses whether cryptocurrencies can become a legitimate competitor to existing national currencies.