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Cryptocurrency is a poor substitute for fiat money, claims the Bank of International Settlements in a chapter of its annual report, released on June 17. In a solid and neatly formatted document laden with footnotes and graphs, the BIS’ experts present a particular historical view on money that they use as a vantage point in establishing the alleged superiority of stalwart centralized institutional arrangements over the chaos of permissionless distributed ledgers. How robust is their argument?
The sender is the message
Before delving into the substance of the claim, a brief review of where it comes from is instrumental. The Bank of International Settlements is an institution owned by the world’s 60-largest central banks that together command 95 percent of global GDP. The Bank’s mission lies in promoting cooperation between central banks, for the sake of global monetary and financial stability. Some particular areas of the BIS’ jurisdiction include setting the standards of capital adequacy as well as ensuring liquidity and transparency of central banks’ reserves. In addition to the cooperation and supervision functions, the BIS serves as the ‘bank for central banks,’ by operating as a counterparty in their financial transactions, for example.
In short, this institution — which tends to be less in the public eye than other global giants of similar standing, such as the World Bank or the International Monetary Fund — is clearly one of the pillars of the incumbent global financial system. Furthermore, its focus on financial stability arguably puts the BIS in the position of being the main guardian of the global status quo. Keeping this in mind provides a framework to approach the Bank’s broad vision of any potentially disrupting financial technology.
A primer on the history of money
A historical sketch that the BIS analysts use as a segway into their cryptocurrency argument paints a picture where multiple forms of moneys emerged and faded throughout the centuries. Some of them were ‘decentralized,’ like privately issued, competitively issued, or monopolistically controlled (by a sovereign) forms of currency. This strikes a crypto-savvy reader as a somewhat stretched use of the sacred term; at the very least, it is clear that in the context of the BIS’ report, the meaning of ‘decentralized’ is vastly different from what the blockchain community is used to.
On a positive note, the text reveals a conceptual departure from the antiquated notion of asset-backed money, which manifests itself in the criticism of one of its ‘decentralized’ forms — money issued by private banks: “Bank-issued money is only as good as the assets that back it.” It is trust and social convention that emerge as indispensable elements of the system of monetary exchange. However, the authors make it clear pretty early that the best kind of trust, in their opinion, is the centralized, institutional trust. Unsurprisingly, the BIS thus considers independent formal central banks as the pinnacle of the evolution of trust-enabling arrangements:
The tried, trusted and resilient way to provide confidence in money in modern times is the independent central bank.
The following section of the chapter, entitled ‘The current monetary and payment system,’ describes a global monetary arrangement that is safe, cost-effective, scalable and capable of ensuring certainty — or ‘finality’ — of payment. The ground is now set for discussing the ‘elusive promise’ of cryptocurrencies.
How much is trust worth?
The BIS opens its argument with drawing a distinction between cryptocurrencies based on permissioned ledgers and their permissionless counterparts, noting that the former shares the reliance on specific institutions as the source of trust with conventional money. The main batch of critical arrows then goes entirely at permissionless systems. Further still, the critique that follows addresses exclusively cryptocurrencies that rely on Proof-of-Work consensus algorithms — without much regard to the fact that systems that use, say, Proof-of-Stake might also be designed as permissionless.
Such a lack of regard to some basic technicalities of the cryptocurrency business sticks out several times elsewhere in the text. It ultimately creates the impression that, when talking about crypto in general, the authors refer to Bitcoin and Bitcoin alone, remaining oblivious to the raging pace at which new coins, platforms and solutions are surfacing. Therefore, the authors’ claim that the major efficiency problem that cryptocurrencies pose is the cost of generating consensus fails to account for a whole class of remedies that could potentially reduce such costs in the near future. This claim could also use some comparative angle, considering that the preceding ode to centralized, trust-generating institutions doesn’t say anything about the cost of maintaining trust via the global system of central banks.
Three shortcomings
In the BIS economists’ opinion, the gravest obstacles in cryptocurrencies’ way to becoming a dominant form of money are those related to their ability to foster positive network externalities and, therefore, facilitate economic activity. Those flaws are the capacity to scale, stability of valuation, and ability to ensure the ‘finality’ of payments.
It is hard to argue with the first one. Scalability has long been a stumbling block for all truly decentralized monetary systems, and the most promising ways around this problem include tradeoffs with varying degrees and forms of centralization added to the design (think EOS). Even though there is no definitive answer to this in sight right now, serious solutions in the making, such as the Lightning Network and Ethereum’s Casper protocol, deserve at least a mention in this context. Both offer at least a credible promise for robust fixes to the authors’ concerns, such as surging electricity consumption and transaction throughput. Without this caveat, the discussion resembles a critique of Bitcoin 1.0.
The second issue that the authors of the chapter raise — that of extreme instability of value caused by inelastic supply — is also legitimate in itself. Nobody wants their main instrument of everyday transactions to be casually depreciating 20 percent overnight. However, the suggested root cause of this problem, namely the ‘absence of a central issuer with a mandate to guarantee the currency’s stability’ seems arguable. The report completely ignores the growing realm of stable coins, where high-quality fintech talent is working on decentralized solutions to cryptocurrency volatility and even supply inelasticity. For example, non-collateralized stable coins use an approach where smart contracts perform the same function as central banks, in that they regulate the supply of money contingent upon the market’s supply and demand. Out of all stable coins, however, only Dai — not the most obvious choice — enjoys a brief mention in the chapter.
Lastly, the ‘finality of transactions’ argument does not look all too convincing. The authors call the hypothetical lack of immediate certainty about whether the transaction is complete ‘the fragile foundation of the trust in cryptocurrency.’ The criticism pertains to the transactions that make it to the shorter chain, which ultimately gets overwhelmed by a longer one, prompting the BIS analysts to call the finality of payments in each chain ‘probabilistic.’ Even though there are no reliable statistics on the share of transactions that get reverted for being recorded on orphan chains, the fact that this consideration is absent from the crypto community’s discourse suggests that it is marginal, as likely is the number of failed transactions.
All in all, the BIS report presents exactly the kind of criticism of crypto that one could expect from a conglomerate of central banks. It advances a picture of the world that has no place for an alternative to the status quo that they are meant to buttress. In discussing the reasons why decentralized cryptocurrencies are not suited for the role of the primary means of economic exchange, the authors only speak to the established shortcomings of Bitcoin. At the same time, they completely leave out numerous alternative solutions that proved serious enough to deserve an earnest consideration. The reason behind this case selection might be a preference for only those systems that are already up and running. Yet this also could be an instance of wishful thinking by those who only accept their own version of the global economy.