The basic principle of disruption is that innovators come from the outside of a given industry and capture a market dominated by incumbents. In the world of cryptocurrencies, this all happened when the disruptors – the non-permission blockchains and their cryptocurrencies such as bitcoin (BTC), ethereum (ETH) and cardano (ADA) – rocked the boat of the central bank incumbents.
For centuries, central banks worked as monopolies in the issuance of currency in their markets. Money is a strange asset; its physical value (that of the notes and coins on which it is printed) does not necessarily deteriorate over time, but its integral value does. This comes down to risk, uncertainty and the basic principle of the time value of money, which is that money today is worth more than money tomorrow.
To make up for that loss in value, central banks created an artifact called interest rates, which compensates money holders for their loss in value. How interest rates are paid is not a mystery: the central bank prints (technically “issues”) more money to satisfy the needs of the system and to pay such interest.
Central banks’ money plays three roles: that of being unit of account, deposit of value and medium of exchange, with the most difficult to fulfill being the latter. For any asset to be a unit of account, it just needs to be countable, and almost everything — except for intangibles such as love and fear — is countable: gold, stones, but also water (in liters) and sand (in kilos). Any asset that does not deteriorate over time can be a deposit of value; that is why tomatoes and leaves cannot be used as money.
But for an asset to be a medium of exchange it must be fully accepted by all, and this is the role that central banks play. Because they are both trustworthy and stable institutions, I can trust that my Swiss francs will be converted into dollars, and these dollars into TJ Maxx t-shirts, say. Equally, I am confident that if I keep my Swiss francs under the mattress, in a year’s time (or 10) they will still be worth at least something.
For decentralised blockchains, the issue of credibility remains a challenge. Most people still see cryptocurrencies as investments and not as deposits of value, and this is why their price fluctuates so much. Credibility in the currency world is the magic key to full acceptability and today, while I can pay for some items with BTC, I still cannot pay for important things such as my mortgage or my plane tickets.
Take the canton of Zug in Switzerland, for instance. Since February 2021 it has accepted BTC to pay for cantonal taxes in a climate in which the vast majority of companies are still reluctant to pay salaries to their employees in cryptocurrencies. For cryptos to be fully accepted, we need a tipping point that turns them from a seductive currency to a perfect one. If you think about it, cryptocurrencies tick all the boxes for being perfect money: they don’t deteriorate over time, their supply is limited and they are countable. And here’s their trump card: they do not need any physical representation.
What might that tipping point be? We thought for years that events such as the adoption of crypto payments by Amazon Coin (AMZ) and the issuance of a crypto by Facebook (does anybody remember Libra?) would mark the moment when cryptocurrencies were going to be fully accepted. Why? Because if AMZ accepts BTC to pay for books, it is facilitating a crypto market because it means I know that my digital money has real value. And since AMZ is trustworthy, it could easily replace the Swiss National Bank in providing my crypto with credibility.
Instead, what has happened is that with the emergence of a new generation of blockchains, and especially with the development of Web3, the acceptance of cryptocurrencies has got underway via a different route to that which we expected: their own business models.
Today crypto is at the center of a massive transformation in financial services driven by decentralised finance, commonly known as DeFi. New non-fungible tokens (NFTs) have become available to individuals and provide a value-creating business model. Essentially, the oligopoly that BTC gave to “miners” to enjoy returns for every block they verified has been removed. Thanks to the introduction of “proof of stake” consensus algorithms, citizens have been accepting cryptocurrencies as an alternative to money.
Let me explain the process of staking briefly. In a similar way to that in which central banks periodically increase money supply to satisfy interest payments, blockchains generate an additional supply of crypto for every block that gets completed and verified. With “proof of stake” consensus algorithms, any member of a blockchain can verify transactions and get compensated for every block that is completed.
However, unlike “proof of work” which uses a competitive validation method to confirm transactions and add new blocks to the blockchain, the member who verifies proof of stake transactions wins that right depending on how many units of crypto she controls. In turn, other members can “stake” their holdings in a particular “pool” to gain verification rights and hence returns. This is called “staking returns”. By holding any crypto different to BTC and ETH – such as ADA, Solana (SOL) or ETH 2.0 – we can earn returns in the same way we could earn interest rates on bank deposits.
This is the massive disruption faced by central banks; their business model is being replicated by decentralised blockchains which, because they are more democratic, distribute “interest” more fairly.
How are central banks responding? As with any typical disruption, there are several potential options. One is to ignore the innovator and do nothing. But this is dangerous because you risk being killed (remember how dismissive flagship airlines were to their low-cost competitors?). Another option is to fight with your own product (in this case fiat money), and a third is to trash the disruptor (in this case crypto would be decried on the grounds that it is run by anarchists and demagogues).
The right response, though, is for central banks themselves to innovate. And this is why today we see a plethora of so-called Central Bank Digital Currencies (CBDCs), all trying to compete with traditional crypto on their own terrain. The Swiss National Bank and partners are pursuing “Project Helvetia”; the European Central Bank is evaluating the possibility of introducing a digital euro over the next two years, while The Bahamas and Nigeria have gone the full distance and launched their own respective digital currencies. In Antigua and Barbuda, Grenada, Saint Kitts and Nevis, Saint Lucia, Dominica and Montserrat an electronic version of the Eastern Caribbean dollar has been enabling citizens, with or without a bank account, to make mobile payments without fees since March this year. The US Federal Reserve has issued a discussion paper that examines the pros and cons of a potential CBDC, and a distribution model for Sweden’s CBDC is under discussion.
Unlike BTC, ETH and the other private digital currencies, CBDCs pose several problems. One is technical: how to ensure that commercial banks can borrow and lend CBDCs given that they can only be minted by the central bank. The other is a lack of privacy, because the central bank (and possibly the central government) could, in theory, choose to find out by whom and how every single euro or renminbi is owned at any given point in time. Whilst I don’t object to my government controlling money flows and curbing tax fraud, I’m not a big fan of them knowing that I probably spend too much money on cycling gear, Swiss chocolate and air-polluting plane tickets.
In the future, the two worlds will live together in harmony. On the one hand, CBDCs will certainly be used at the institutional level by banks and corporates. On the other, permissionless digital currencies will be used by individuals to facilitate payments and investment. In both cases, individuals will be better off.
Arturo Bris is professor of finance at IMD. Since January 2014 he is also leading the world-renowned IMD World Competitiveness Center. Prior to joining IMD, Professor Bris was the Robert B & Candice J. Haas Associate Professor of Corporate Finance at the Yale School of Management. His research and consulting activities focus on the international aspects of financial regulation, and in particular on the effects of bankruptcy, short sales, insider trading and merger laws.