How Does Cryptocurrency Expansion Change the Economy?
The benefits of cryptocurrencies are discussed at every turn, but little is known yet about the related economic risks. A few years ago, discussions about the status of cryptocurrencies were limited to the question of whether to prohibit them completely or to rigidly restrict their use. Now the regulators of most countries in the world, including Russia, are more amicable and even more optimistic about the new technology. This is partly due to the futility of such bans, as Elvira Nabiullina, Governor of the Bank of Russia, has recently said.
The market of cryptocurrencies continues growing exponentially. Their number is already close to 1,000. Central Banks of various countries are working on their projects to create local cryptocurrencies. President of Kazakhstan Nursultan Nazarbaev has even proposed to create a common international cryptocurrency, which would “put an end to currency wars and speculations in the world, and help avoid distortions in trade”.
‘E-gold’
In 2016, the Bank of Canada published a study, in which the effects of the cryptocurrency development were equated to a new gold standard. What is now referred to as the cryptocurrency is, in many ways, similar to gold.
First, it is the limited "amount" of the asset and, thus, the lack of risks of its value dilution. If we take the bitcoin, for instance, it has a limit of roughly 21 million bitcoins—this is how much will be mined in the end in accordance with the current algorithms of emission, which halves every four years. The protocols for most other cryptocurrencies are generally similar.
Secondly, this is the process of mining itself. People spend a lot of resources on mining some product that has no physical value. The value is created only when the number of people using this product as a means of payment and savings reaches some tipping point.
Such similarity to gold, which seems to be an advantage at first glance, carries some risks if this asset is used as money. These risks are typical for the gold standard and are associated with the deflationary nature of an economy relying on a finite asset. If there is a product that is a measure of value, which, moreover, constantly grows in price because of its finiteness, it becomes not worthwhile for economic agents to spend it: they turn to the "miserly knight" mode, that is, switch from consumption to savings, and the economy comes to a standstill. This is the first shortcoming of the cryptocurrency related to the government's inability to control the money supply.
The second drawback is the inability to generate demand for the means of payment issued in a decentralised way, that can undermine the function of money as a means of savings. Cryptocurrency, unlike gold, implies almost zero arbitrage costs. At the time of the gold standard, countries could have different interest rates, even in the context of a tight peg of their local currencies to gold. The costs of transporting gold are high; therefore, this asset could not freely flow across borders, pursuing more favourable financial terms. E-money can, however, be transferred to any part of the world in a fraction of a second at no cost. Governments are unable to exercise independent interest rate policies with respect to cryptocurrencies. Thus, there are risks, and, even more importantly, regulators find it difficult to estimate them.
‘Coloured Coins’
Let's keep in mind that the technology of distributed databases, and cryptocurrencies based on it, is much more than a means of payment. In fact, this is cryptographic registration of property rights. For example, in the Bitcoin network there are so-called ‘coloured coins’, which are associated with property. The person, who can spend bitcoins, i.e. possesses a corresponding private key, is considered the owner of the property. At the same time, ‘coloured coins’ can be transferred and used for regular transactions. In the case of bitcoins, this idea is not implemented well, but there are other, more advanced and effective methods of fixing property rights based on the blockchain technology. Theoretically, these methods can be applied to assign the value of ordinary digitalised currency to cryptocurrency. In this case, such a currency will be a digitalised version of a common currency, at the same time benefiting from all the advantages of virtual money, such as the speed and transparency of transactions.
Potential and Risks
Bitcoin is not the only cryptocurrency. Decentralisation of its emission is not a prerequisite either. For example, the circulation of bitcoin is based on the proof-of-work protocol, when transactions in the blockchain network are protected based on the need for the requester to perform some fairly complex and time-consuming work. In this case, the emission of new money is performed by an agent with the greatest computing capacity. This ensures decentralisation. As an alternative to the proof-of-work protocol, the proof-of-stake method can be used, when transactions are protected by the need to have a certain amount of funds in an account. With this method, to confirm the next block in the transaction chain, the algorithm is more likely to select an account with a larger amount of wealth. One of the consequences of using such a principle will be a lower decentralisation of the system and the emergence of a systemic player. It could be a new megacorporation (a hypothetical ‘crypto-Google’), or a state, or even a union of states, which has created a financial and computing pool.
Cryptocurrency and blockchain technologies have a great potential. According to the Bank of England, if its own cryptocurrency is created, that could generate the GDP growth of 3% owing to lower interest rates and costs. It can be assumed that the benefits for Russia and other members of the Eurasian Union would be even greater, in view of the fact that interest rates and transaction costs are much higher in our countries. Procrastination brings no good—the theme is rapidly expanding beyond the limits of discussion, one ICO (Initial Coin Offering) following another. On the other hand, we are dealing with the ‘brave new world’ in this area and little is known about the risks that may be associated with digitalisation of the financial system.