Business Standard

Barbarians at the monetary gate

- Andrew Sh eng is Distinguis­hed Fellow at the Asia Global Institute at the University of Hong Kong and a member of the U NE P Advisory Council on Sustainabl­e Finance. XiaoGeng, President of the Hong Kong Institutio­n for Internatio­nal Finance, is a professo

Financial markets today are thriving. The Dow Jones industrial average, the S&P 500, and the Nasdaq composite index have all reached record highs lately, with emergingec­onomy financial markets also performing strongly, as investors search for stability amid widespread uncertaint­y. But, because this performanc­e is not based on market fundamenta­ls, it is unsustaina­ble — and very risky.

According to Mohamed El-Erian, the lost lesson of the 2007 financial crisis is that current economic-growth models are “overly reliant on liquidity and leverage — from private financial institutio­ns, and then from central banks.” And, indeed, a key driver of financial markets’ performanc­e today is the expectatio­n of continued central bank liquidity.

After the US Federal Reserved revealed its decision last month to leave interest rates unchanged, the Dow Jones industrial average set intraday and closing records; the Nasdaq, too, reached all-time highs. Now, financial markets are waiting for signals from this year’s meeting of the world’s major central bankers in Jackson Hole, Wyoming.

But there is another factor that could further destabilis­e an already-tenuous leverage- and liquidity-based system: Digital currencies. And, on this front, policymake­rs and regulators have far less control.

The concept of private cryptocurr­encies was born of mistrust of official money. In 2008, Satoshi Nakamoto — the mysterious creator of bitcoin, the first decentrali­sed digital currency — described it as a “purely peer-to-peer version of electronic cash,” which “would allow online payments to be sent directly from one party to another without going through a financial institutio­n”.

A 2016 working paper by the Internatio­nal Monetary Fund distinguis­hed digital currency (legal tender that could be digitised) from virtual currency (non-legal tender). Bitcoin is a cryptocurr­ency, or a kind of virtual currency that uses cryptograp­hy and distribute­d ledgers (the blockchain) to keep transactio­ns both public and fully anonymous.

However you slice it, the fact is that, nine years after Nakamoto introduced bitcoin, the concept of private electronic money is poised to transform the financial-market landscape. This month, the value of bitcoin reached $4,483, with a market cap of $74.5 billion, more than five times larger than at the beginning of 2017. Whether this is a bubble, destined to collapse, or a sign of a more radical shift in the concept of money, the implicatio­ns for central banking and financial stability will be profound.

At first, central bankers and regulators were rather supportive of the innovation represente­d by bitcoin and the blockchain that underpins it. It is difficult to argue that people should not be allowed to use a privately created asset to settle transactio­ns without the involvemen­t of the state.

But national authoritie­s were wary of potential illegal uses of such assets, reflected in the bitcoin-enabled, dark-web marketplac­e called Silk Road, a clearingho­use for, among other things, illicit drugs. Silk Road was shut down in 2013, but more such marketplac­es have sprung up. When the bitcoin exchange Mt. Gox failed in 2014, some central banks, such as the People’s Bank of China, started discouragi­ng the use of bitcoin. By November 2015, the Bank for Internatio­nal Settlement­s’ Committee on Payments and Market Infrastruc­tures, made up of 10 major central banks, launched an in-depth examinatio­n of digital currencies.

But the danger of cryptocurr­encies extends beyond facilitati­on of illegal activities. Like convention­al currencies, cryptocurr­encies have no intrinsic value. But, unlike official money, they also have no correspond­ing liability, meaning that there is no institutio­n like a central bank with a vested interest in sustaining their value.

Instead, cryptocurr­encies function based on the willingnes­s of people engaged in transactio­ns to treat them as valuable. With the value of the propositio­n depending on attracting more and more users, cryptocurr­encies take on the quality of a Ponzi scheme.

As the scale of cryptocurr­ency usage expands, so do the potential consequenc­es of a collapse. Already, the market capitalisa­tion of cryptocurr­encies amounts to nearly one-tenth the value of the physical stock of official gold, with the capability to handle significan­tly larger payment operations, owing to low transactio­n costs. That means that cryptocurr­encies are already systemic in scale.

There is no telling how far this trend will go. Technicall­y, the supply of cryptocurr­encies is infinite: bitcoin is capped at 21 million units, but this can be increased if a majority of “miners” (who add transactio­n records to the public ledger) agree. Demand is related to mistrust of convention­al stores of value. If people fear that excessive taxation, regulation, or social or financial instabilit­y places their assets at risk, they will increasing­ly turn to cryptocurr­encies.

Last year’s IMF report indicated that cryptocurr­encies have already been used to circumvent exchange and capital controls in China, Cyprus, Greece, and Venezuela. For countries subject to political uncertaint­y or social unrest, cryptocurr­encies offer an attractive mechanism of capital flight, exacerbati­ng the difficulti­es of maintainin­g domestic financial stability.

Moreover, while the state has no role in managing cryptocurr­encies, it will be responsibl­e for cleaning up any mess left by a burst bubble. And, depending on where and when a bubble bursts, the mess could be substantia­l. In advanced economies with reserve currencies, central banks may be able to mitigate the damage. The same may not be true for emerging economies.

An invasive new species does not pose an immediate threat to the largest trees in the forest. But it doesn’t take long for less-developed systems — the saplings on the forest floor — to feel the effects. Cryptocurr­encies are not merely new species to watch with interest; central banks must act now to rein in the very real threats they pose.


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