By Dr. Chiragra Chakrabarty, CEO, KATIC CONSULTING LTD
From the Bahamas to Britain, central banks are jumping on the bandwagon to issue digital cash in a bid to fend off emerging threats to traditional money and to make payment systems smoother.
Earlier this year, Tesla’s CEO Elon Musk announced he was buying more than US$1 billion in Bitcoin for his automaker’s balance sheet. Several payments firms announced they were upgrading their capabilities for more transactions in crypto, and major Wall Street banks began working on crypto trading teams for their clients.
Worried by the spread of cryptocurrencies, central banks are researching and experimenting with digital currencies.
Why the world needs an alternative to cryptocurrencies
Volatile prices
Extreme volatility often has a negative connotation because many investors associate volatility with market chaos, uncertainty, and loss. When markets swing between extreme highs and lows, investors and traders may place more bets predicting continued swings, which in turn causes more price volatility. The volatility index (VIX), also known as Wall Street’s “fear gauge”, at the Cboe Options Exchange defines healthy volatility as a value between 12 (which is considered low) and 20 (which is considered high). If a stock market’s volatility, as calculated by movements of its index, falls above this range, then it is said to be a case of extreme volatility.
Most observers of cryptocurrency markets will agree that crypto volatility is in a different league altogether. While there are no indices to measure crypto price volatility, you just need to glance through historical price charts. In 2016, the price of Bitcoin rose by 125% and in 2017 the price rose again, this time by more than 2,000%. Following the 2017 peak that saw it hit new all-time highs, Bitcoin’s price receded once more. In 2021, Bitcoin continued to set new all-time highs, more than tripling the peak price it achieved during the 2017 bull run.
Volatility is also the price that Bitcoin investors pay for its limited supply. The supply of Bitcoin is perfectly inelastic. Moreover, Bitcoin’s value is also derived from its decentralised network. There is no central authority which has the power to intervene in the Bitcoin market. No authorities can step in to support or prop up markets and artificially subdue volatility.
High carbon footprint
Compounding the issue of volatile prices is Bitcoin’s adverse environmental impact. Bitcoin’s ‘mining’ process, which determines its finite supply of 21 million Bitcoins by 2040, comes at a significant environmental cost in terms of massive electricity consumption. The Cambridge Centre for Alternative Finance estimated that the Bitcoin mining industry burned through about 143 terawatt-hours of electricity a year as of May 2021, or 0.6% of the world’s total energy consumption. Under the global initiatives for climate change control, Bitcoin mining faces an imminent risk of a global regulatory crackdown.
This risk is especially prominent in China, where coal is the main source of energy. The Chinese government is starting to rein in Bitcoin mining as it implements climate targets. Even renewable energy-rich provinces do not want to accept Bitcoin mining projects. Already in 2013, the People’s Bank of China (PBoC) banned banks and retailers from dealing in Bitcoin. In 2017, it shut down all domestic exchanges and banned initial coin offerings (ICOs) that created Bitcoins to fund new ventures.
From a climate-control perspective, the regulatory risk now seen in China is likely to emerge in other countries as well. So, it seems that Bitcoin/crypto mining will have nowhere to go in the longer term.
How CBDCs counter the negative effects of cryptocurrencies
With Bitcoin mining being subjected to enhanced scrutiny because of its negative environmental implications, the short-term impact on supply could squeeze Bitcoin’s price higher, thus, inflating and prolonging the bubble. The fixed supply of Bitcoin (and other cryptocurrencies) is the big potential ‘economic apocalypse’ that central banks want to avoid.
If you fix nominal variables (cryptocurrency, in our case), real output has to adjust violently to absorb any economic shocks. In the case of an economic recession, when Bitcoin supply cannot expand, economic output would go into free fall. It was this problem of rigid money supply that led to the demise of the Gold Standard and the Bretton Woods system. Similar to Bitcoin, both these systems deprived governments of the ability to counteract large negative economic shocks, financial crises and asset price deflation.
With the above issues inherent in private cryptocurrencies, a growing trend is for global central banks to develop and offer CBDCs for both economic and political reasons. They want to protect their monetary systems and currencies to safeguard the sovereignty of economic management.
For instance, to take the case of China, despite the ban, millions of Chinese customers still trade in Bitcoin through overseas exchanges, or through local brokers arranging peer-to-peer trades without an exchange. This has prompted the PBoC to start exploring the issuance of an official digital currency, the DCEP. Thus, China’s stance is clearly anti-Bitcoin, with the PBoC aiming at replacing cash with a centrally controlled e-CNY that will give it ‘controllable anonymity’. This is a direct attack on crypto’s untraceable anonymity.
Recent developments in the Bitcoin market
The recent reduction in the prices of Bitcoin and other cryptocurrencies – a reversal from the dramatic rise that started in the second half of last year – was due to the negative news related to Mr. Elon Musk not accepting Bitcoin as payment, citing environmental concerns, and the new round of regulations by the Chinese government.
Part of the reason for Bitcoin’s weakness seems to be at least a temporary reversal in the theory of broader acceptance for cryptocurrency. A new report from JPMorgan said that, based on futures contracts, institutional investors appeared to be moving away from Bitcoin and back to gold. Bitcoin is often touted as a potential replacement for the traditional metal as a store of value.
Bitcoin and related assets have also come under increased scrutiny from regulators around the world as they have grown into a bigger part of the financial markets. The regulatory obstructions may drive fund managers away from this asset, which may push down the price further.
On the positive side, Bitcoin trading is no longer dominated by retail buyers. Professional money managers and corporate America have flooded the market over the last year, and they’re just getting started. As more institutional investors adopt Bitcoin, it lends newfound legitimacy to the cryptocurrency, helping to alleviate its reputational risk and also creating more stability overall.
What does the future hold for digital currencies?
With more and more central banks going the CBDC route, even as Bitcoins go increasingly mainstream, I can envisage two scenarios that may prevail, which are as follows:
Scenario 1: Collaboration between central banks and private crypto providers
One potential scenario I can visualise is that Bitcoin or other cryptocurrencies can come out with mining technology which is environment friendly.
This would open the doors for private crypto providers to join hands with central banks to roll out CBDCs. Since certain central banks might require the technology support and technical platforms to launch CBDCs, such assistance could be best provided by private crypto providers which have the relevant expertise.
Scenario 2: Cryptocurrencies could be marginalised by the rise of CBDCs
Another potential scenario is that there remain only a few jurisdictions in the world where private cryptocurrencies are allowed to be traded. The reason for this would be due the push back by various central banks across countries. Due to this, cryptocurrencies may not be able to trade in such jurisdictions.
With big central banks barring investors from on-shore trading, they will be forced to move to off-shore jurisdictions where cryptocurrencies can be legally traded. However, if this happens, then private cryptocurrencies will be just an alternative asset and not a mode of payment.
How to navigate the world of digital money
For the way forward, I believe investor/traders should exercise extreme caution in dealing with Bitcoin, as it is a very volatile and risky asset. Once cryptocurrency/digital currency is issued by central banks, then it will be a much safer asset to invest in and use as a mode of payment.
Keeping this in in mind, I am very happy that the Bank of Mauritius is working on a CBDC, which can be expected to be a great source of support for the Mauritian economy, especially in a post-pandemic context where digital payments are becoming the new normal.
