Will Cryptocurrency Put Central Banks Out of Business?
Will Cryptocurrency Destroy Central Banks: Cryptocurrency’s most important financial innovation is undoubtedly its decentralized and trustless blockchain technology. Using such technology, cryptocurrencies allow individuals to make monetary transactions over the Internet without the need for a trusted third party.
Before cryptocurrency, the only way to make anonymous transactions was in cash. In its early days, Bitcoin was highly attractive to criminals making online black-market transactions. By paying with Bitcoin, there was no need to carry a suspicious amount of cash in public.
Now, the wider public sees paying with crypto as a means to avoid costly fees (as in the case of remittances), to ensure payment privacy, and as a way to make digital payments without a bank account, debit, or credit card. They also see crypto as a useful hedge against inflation.
The role of central banks
Central banks control a country’s money supply and inflation rate, and are the trusted party behind “fiat” currency, or cash.
In the United States, the central bank is known as the Federal Reserve, or simply “the Fed.” The Fed backs our paper dollar – the world’s reserve currency. Most countries’ currencies have exchange rates pegged to the U.S. dollar.
After abandoning the gold standard in 1933, the U.S. dollar was no longer backed by a physical commodity like gold. Instead, it retained value simply because the government agreed that it has value. This is what is known as “fiat” (or based on faith) currency.
The Federal Reserve requires that all major banks hold a minimum of cash reserves at one of their central bank branches. As such, the banking system is essentially governed and monitored by the central bank, which oversees all lending and borrowing.
The Fed is also responsible for the trillions of dollars of U.S. debt, and is responsible for funding the recent wars in the Middle East.
The advent of Bitcoin
The first cryptocurrency, Bitcoin, was drawn up in a white paper by Satoshi Nakamato in late 2008 following the nationwide financial crash.
The crash was a result of poor decision-making and risk management from lenders – the people we trust when buying homes or taking out business loans.
Bitcoin, an automated payment system without a centralized third party, does not require trust to operate. The system is designed to be trustless – transactions are permanent and cannot be changed. The system is also protected against double-spend attacks due to its Proof-of-Work (PoW) consensus protocol, which makes it near impossible to rewrite the blockchain and change its data. In short, the security of the blockchain is due to its use of cryptography.
Without getting too technical, Bitcoin and most other cryptocurrencies rely on economic incentives to promote honest behavior.
By eliminating the need to trust fallible human parties, Bitcoin was and still is an attractive system to those who have lost faith in the centralized banking authorities responsible for the 2008 crash.
Is crypto a threat to central banks?
Central banks undoubtedly view cryptocurrencies like Bitcoin as an existential threat. Crypto eliminates the need for a central bank entirely, and also offers an alternative currency to centralized fiat currencies. While the U.S. Treasury prints dollars under the purview of the central bank, bitcoins are created through a special “mining” process. The value of a dollar can be seen as the paper itself and the cost of printing it. For Bitcoin, it is the computing power and subsequent electricity costs that contribute to the price of BTC, disregarding market prices.
So why does this matter?
The Federal Reserve can hypothetically print as much money as they want – there is no limit, making the dollar an inflationary currency. This explains why the U.S. is under a considerable amount of debt.
By comparison, Bitcoin’s protocol caps the supply of BTC at a maximum of 21 million, making it a deflationary currency.
Because of its sustainable economic model, institutional investors and economists see Bitcoin as a hedge against inflation, similar to gold or other commodities. It’s potential use as an everyday payment would further eliminate the need for printing dollars or relying on the Fed’s economic model.
The current excitement around Bitcoin has the central bank on edge, as it potentially could supplant the dollar, and the Fed has no control or oversight over BTC. The government’s main criticism of Bitcoin or other cryptos has to do with their involvement with criminal activity and fraud, but seeing as this is also possible with cash, one has to wonder what the bankers are really concerned about.
Can Bitcoin ever be a reliable currency?
At the moment, the price of Bitcoin is too volatile to be used a daily method of payment, because merchants would be taking on too much risk accepting a currency that could wildly decrease in value a short time after accepting it.
While some countries like El Salvador are promoting its use as a daily currency, they are taking a big risk. However, if experts are right and Bitcoin surpasses $100,000 soon, then Bitcoin will once again prove that it is resilient and has a bigger upside.
With increasing adoption by individuals and businesses, and barring any disastrous authoritarian regulations, Bitcoin could surely become a stable, global means of payment.
How will crypto affect the banking industry?
Cryptocurrencies come in a variety of flavors. In addition to cryptocurrencies like Bitcoin or Ethereum, there also exist “stablecoins,” which are pegged to stable fiat currencies like the U.S. dollar.
Stablecoins allow traders to transfer amounts from volatile assets like Bitcoin to a stable digital asset like USDC, which is pegged to the U.S. dollar. This is useful for reducing financial risk, and allows traders to stay in the market when volatile assets fall in price. Stablecoins are also useful for lenders and borrowers, like banks, which rely on a stable value for setting contracts and settling accounts.
Stablecoins are digital assets issued by private entities and have a 1:1 correspondence with their reserve asset. They are not to be confused with central bank digital currencies (CBDCs), which are digital forms of fiat currency issued by a central bank.
Central banks, although ambivalent towards cryptocurrency in general, have been inspired by the development of stablecoins to create CBDCs, which the crypto community is obviously wary about due to privacy concerns. Issuing CBDCs can be cheaper and faster than printing cash, which is quickly becoming obsolete.
At the moment, banks allow customers to send money from their bank accounts to crypto exchanges like Coinbase or other apps that facilitate crypto purchases. There is also news that banks are signing up with crypto custody firm NYDIG to allow their customers to buy, sell, and hold Bitcoin through their banking account.
It is unlikely that cryptocurrencies will destroy central banks. Banks will likely find ways to coexist with and profit from cryptocurrency, or will regulate cryptos and coopt blockchain technology for CBDCs.
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