Why are Central Banks suddenly interested in crypto?

5 November, 2019

A year ago you couldn't get the heads of the world's central banks to think about cryptocurrency let alone make any public comments about it. All of a sudden, every bank regulator and his brother has something to say. This is no accident. There are very good reasons that explain why central banks are suddenly 'woke' to the reality that cryptocurrency and digital payment systems are here to stay and growing stronger.

To get an idea of where we are going, consider remarks made by Riksbank Governor Stefan Ingves just a few weeks ago. Riksbank is Sweden's central bank, for the record.

Speaking on Squawk Box Europe, Ingves called Facebook's announcement of the Libra project an "incredibly important catalytic event" for the world's central banks. He went on to explain how money has evolved over time. He explained that the Swedish krona is "convenient to use for Swedish citizens", but that Riksbank would soon "be out of business" if it started issuing copper coins not used since the mid-17th century.

If you understand what Ingves meant by his comments, you understand why central banks are suddenly interested in cryptocurrency. Reality has forced them to recognize the fact that money changes. More importantly, the form money takes also changes.

From bartering to coins

The history of money is a fascinating topic to study. Without getting into details, money has existed for millennia. But in ancient times, money was the domain of political leaders and wealthy landowners who used it to maintain a subservient workforce. Transactions between average people took place through bartering.

Let's say you were a farmer with a couple of dairy cows. You might provide milk and butter to the baker in exchange for bread. You would have similar arrangements with the butcher and cobbler. Bartering was a system that worked very well for a very long time. It is still practiced in some cultures today.

Eventually though, bartering gave way to official government currency. Coins were minted from whatever metals were available at the time. Some were made of wood. Currency evolved to a paper exchange following the advent of the printing press.

Modern money is electronic and digital

Modern money exists in the form of minted coins and printed bills. Yet we use less of it. Why? Because so much of our monetary system has been made electronic and digital. Even without cryptocurrency, it is no longer necessary to carry cash in most parts of the developed world. All you need is a plastic card or a mobile pay system on your smartphone.

Believe it or not, banks do not transfer large amounts of cash between themselves. If you have a UK resident buying merchandise from the U.S. with a debit card, his bank would not package up cash and ship it overseas to the merchant's bank for deposit. Rather, the money would be sent electronically. No cash actually trades hands.

The same thing is true when you use your credit card or mobile phone to pay for goods in person. Money is transferred from your account to the merchant's account electronically. Now can you see why Ingves calls news of Libra 'catalytical'?

It is looking more likely every day that Libra will never actually launch. And yet just the idea has caused quite a stir in the world's financial systems. Libra has acted as a catalyst for change. It has forced central banks and their government enablers to sit up and pay attention. It has forced them to rethink the future of money.

Money is a product

Ingves said something else in his remarks that is quite telling: he referred to money as a 'product'. He is right. Money is a consumer product created from nothing. In its creation, money has inherent value as a means of facilitating financial transactions between parties. But here's the thing: it's not a necessary product.

The world would continue to function if all fiat were done away with and everyone was forced to return to bartering. Yes, business and economics would both be much more complicated. But bartering would work the way it has worked for millennia. This is the problem central banks suddenly realize they face.

If money is an unnecessary product that could be lived without, central banks have to give people reasons to continue using it. If an upstart product comes along that threatens to disrupt their product, they have a real problem on their hands. Such is the case with cryptocurrency.

Central banks suddenly realize that the convenience, security, and decentralization of cryptocurrency is superior to anything fiat has to offer. About the only thing they have going for them is the fact that the computer networks that handle worldwide settlements can process transactions magnitudes of order faster than the fastest blockchain. But that technological advantage is not going to last forever.

There is going to come a point at which traditional financial systems no longer have any advantages over blockchain. Until that time comes, Bitcoin and its competitors still have plenty going for them. There are very valid reasons to choose cryptocurrency payments over fiat, reasons that are beyond central bank control.

They have to compete

Just think about all the positives of cryptocurrency payments. Let us say you are an online gambler who normally funds your game-play with Bitcoin. You enjoy the benefits of secure transactions, nearly instantaneous payments, and economic parity. You also know that your casino deposits are 100% private. No one knows you are gambling with BTC unless you let the secret slip.

Banks cannot compete with that. Make that same deposit with your credit card and you instantly create a digital paper trail that is easily followed. You are less secure in the sense that you have to provide credit card information to either the casino or the payment processor.

It is these sorts of things that are causing people like Stefan Ingves to implore government leaders and central bank officials to take a second look at cryptocurrency. Ingves himself is very much in favor of a government-backed digital currency in Sweden. He believes it is only a matter of time before the e-krona is a reality.

Ingves' enlightenment is a good thing. But he is not alone. Central bank authorities in China, the UK, the U.S., Germany, and many other countries have come to understand that money is eventually going to be digital one way or the other. The smart ones among them want to get out ahead of the shift so that when it finally happens, they are positioned to be leaders rather than followers.

This explains the sudden interest in stablecoins. From the government perspective, a stablecoin represents a way to complement minted coins and paper bills with a digital alternative. That complementary relationship will eventually come to an end when government leaders realize the superiority of digital tokens for day-to-day transactions.

A private system that could work

There is one final comment Ingves made that is germane to this discussion. He reminded the audience that most private sector monetary systems that have been implemented over the centuries eventually failed. He makes a good point, but he fails to realize one of the fundamental differences between cryptocurrency and all those previous attempts.

Fiat has thrived for so long because it is the most convenient way to pay for things. Handing someone a stack of paper bills is a lot more convenient than bartering service for service. And of course, cross-border bartering is all but impossible. The fact that we have managed to tie fiat to a now largely electronic banking system makes it even easier to use.

Private sector alternatives from past years did not succeed because they weren't as convenient. Not only that, they were not universal either. That meant that consumers had to work with multiple monetary systems depending on whom they were buying products and services from. Cryptocurrency overcomes all those systemic weaknesses.

Once a person owns cryptocurrency, it is as convenient to use as a credit or debit card. Transactions are just as seamless. Cross-border transactions occur just as quickly. Where convenience breaks down at this point is adoption. Not enough businesses have adopted the cryptocurrency model to make it a practical replacement for fiat.

In the end, that may prove to be the eventual downfall of Bitcoin et al. It is quite possible that worldwide adoption will never be achieved and, subsequently, fiat will continue to reign supreme - even if in a digital form. On the other hand, cryptocurrency is a private sector system that can succeed if the adoption problem can be overcome.

This is something that central banks finally understand. And now that they understand it, they realize they have to find a way to compete with cryptocurrency so as to persuade large corporations and small merchants to stay away from crypto.

And so the race begins. Will central banks preempt worldwide adoption of cryptocurrency by issuing their own digital fiats in the next 12 to 18 months? Or will Bitcoin and its competitors get out front with new technologies and upgrades that bring large numbers of businesses on board? We shall see.