In their analysis, entitled „Virtual Currencies“, the Kiel Institute researchers distinguish between digital currencies in general and cryptocurrencies, such as bitcoin, in particular, where transactions and authorizations are processed using cryptographic technologies and which therefore require no central, trusted counterparties for payment settlement. The researchers regard bitcoin in its current form as unsuitable for the mass market.
“With increased use, bitcoin and similar cryptocurrencies require an increasing number of energy-intensive arithmetic operations, which can mean transactions are relatively slow. Bitcoin is thus not remotely able to match the volume and speed of current international payment transactions,” said Salomon Fiedler, an expert on monetary policy at the Kiel Institute and one of the authors of the study. This could change, however, if the technical shortcomings of today’s cryptocurrencies can be overcome through ongoing development.
As things stand, the enormous volatility of cryptocurrencies also militates against using them as a means of payment. “Cryptocurrencies are not underpinned by an intrinsic value. At the moment, they are mainly being purchased for speculative purposes, with investors hoping for significant increases in value. Even minor changes in supply and demand lead to sharp price fluctuations due to low trading volumes and the small number of market players. The high volatility of cryptocurrencies also makes conventional risk management difficult,” said Fiedler.
Moreover, the development and implementation of a set of rules to govern cryptocurrencies is still a work in progress. “Defining appropriate rules is rendered more difficult by the fact that cryptocurrencies are used both as a currency and as objects of value, which gives rise to different and sometimes contradictory regulatory requirements,” commented Fiedler. “There is clear evidence that price setting on crypto-exchanges has been manipulated in the past, via fictitious orders or trading bots, for example.”
Digital central bank money: “disruptive” consequences
The authors regard a digital central bank currency, which would be legal tender and have the same status as cash, as an opportunity to boost the stability of the financial system and to help discipline commercial banks. Commercial banks would lose their privilege of being the only institutions that hold money for private households in the form of demand deposits, e.g., in current accounts or as overnight money. The authors describe the consequences of such a step as potentially “disruptive” to the existing banking system; it would provide incentives to introduce a sovereign money system, especially if this were accompanied by a relaxation of conventional deposit guarantees.
“The commercial banks’ ability to create money would be curtailed. To maintain their balance sheet totals, they would either have to offer depositors better interest rates and terms or switch to alternative forms of financing. A digital central bank currency would also give the central bank greater control over the money supply in circulation. All these factors would make the financial system more stable compared to how it is now,” said Fiedler. However, the transition carries the risk of considerable distortions in the banking system and implementation would therefore need to be gradual and cautious.
“All in all, cryptocurrencies are already able to offer individuals certain benefits, especially with regard to circumventing government control. However, technical shortcomings are preventing mainstream use as a payment method, and the regulatory environment is still evolving.”