Cryptocurrencies have seen exceptional volatility in the last few months. India’s official stance has been critical of cryptocurrencies, with the central bank viewing them as a destabilising force on monetary and financial stability, and advocating an outright ban. Finance Minister Nirmala Sitharaman has repeatedly cautioned against the use of cryptocurrencies and her recent statements reinforce this view.
A purely economic lens highlights that the long-term risks cryptocurrencies pose to the traditional monetary system could be highly overestimated. When we analyse the long-term durability of cryptos, a ban may not be the answer or even required. Cryptocurrencies have inherent limiting factors which make it unlikely that they will supersede traditional fiat-based currencies in adoption. First, cryptocurrencies mostly rest on a decentralised blockchain network that is not conducive to building stability into currency value and the system. The system as a whole also suffers from an incentive misalignment — where there could be potential rewards for misbehaviour by individuals. Finally, cryptos such as Bitcoin, Binance Coin, and Cardona have a supply limit that could lead to disinflationary risks in the future, and the plethora of currencies on the market ensures that mass-scale adoption of a single cryptocurrency will be difficult to achieve.
The recent carnage in the crypto markets — Terra, Luna and USD coin — only further illustrates the point that cryptocurrencies are too unstable and volatile to merit being seen as serious competition to central bank-issued currencies. In the wake of the financial crisis, Bitcoin was touted as an antidote to the central bank’s power to erode the dollar’s value through printing money. However, cryptos such as Bitcoin and Ethereum, with their supply limits, ensure that they are deflationary by nature, which a currency system with wide adoption cannot afford. This was one of the major drawbacks of the gold standard of the 1930s, where when the price of gold increased in comparison to bank notes, the deflationary pressures on the economy unhinged the peg.
Second, stablecoins — Binance, USD coin, EUROS, which are pegged to a currency, suffer from a similar drawback where the peg does not inherently ensure stability. Speculators betting against the value of a stablecoin can easily introduce volatility into the system. Maintaining a peg, especially in the event of a speculative attack, requires a central authority to intervene in the market to reinforce its price. During the 1997 Asian financial crisis, Central banks of Korea and Thailand with massive reserves of currency had to resort to breaking their fixed exchange systems when faith in the value of their currency fell. A point to consider is that a stablecoin currency would not be able to sustain its value in face of a similar speculative attack, and would need central bank-type intervention. If that is the case, the decentralised model offered by cryptos fails to meet its own goal of being outside the net of institutions.
A third important point to consider is that currencies and transactions that rest on blockchain face certain risks that could impact the stability of their price. In theory, the transactions that take place on blockchain-based coins need to be verified by participants (called miners) on the network. A transaction gets validated when 51% of the miners acknowledge and verify a transaction. This verification system rests on miners acting as honest agents rather than being disruptive. However, there exists a possibility that a majority of miners cooperate to act dishonestly within the system. By doing so, they will have the ability to rewrite their own transactions and indulge in double-spending on their bitcoin money. This opportunity primarily exists when the rewards from attacking and rewriting transactions are greater than the costs of attacking it. Adding new blocks (or transactions) increases the overall security of the network, but the possibility of an attack still remains. Ultimately, the risk boils down to the comparison of cost for maintenance of the blockchain and the cost of the attack.
Fourth, to function as a replacement to central bank issued money, network effects of scale need to kick in. With the proliferation of different cryptocurrencies and the ease with which one can create a cryptocurrency of their own – it is highly unlikely that they achieve mass adoption. Another downside that is less discussed is that given the immutable nature of transactions, there is no reversibility of transactions akin to a chargeback on credit or debit cards.
To conclude, cryptos are unlikely to ever achieve mass adoption as a medium of exchange and pose a threat to monetary stability. So what value do they add? The real value of cryptos lies in the underlying blockchain technology, which could have potential specific use cases. For example, blockchain can prove to be a sound ledger for inputting land records data. Further, cryptos as an asset class need to be keenly studied and understood by regulators to assess where they can make a useful contribution to the economy.
________________________________________________________
Sharmadha Srinivsan is a Senior Associate at Artha Global, a policy research, consulting and network-facilitation organisation based in Mumbai and London. Hemant Adarkar is a Senior Fellow at Artha Global and Technology Advisor to the National Bank for Financing Infrastructure and Development (NaBFID).
