It is counterintuitive to think of something cryptic as improving transparency, but several central banks around the world are considering the use of blockchain technology with the aim of making money handling simultaneously more open and secure. Central banks in England, China, Canada, Sweden, France and Italy have all explored cryptography in recent years and the prospect of minting their own digital currencies, similar to Bitcoin, in order to keep abreast of the fintech surge.
According to Dirk Niepelt, director of the Study Center Gerzensee at the University of Bern, blockchain technology has the potential to inject fresh credibility into the global financial scene. For those in need of an explainer, a blockchain is a shared digital ledger in which transactions are recorded chronologically and publicly. Think of it like a shared document: you have to have the document open to use the currency, and you can’t buy or sell without recording it in that same document.
As Niepelt explained to the World Economic Forum in 2016:“Internet-based technology has made it cheap to collect information and to network. This has empowered the sharing economy and allows fintech to seize intermediation business from banks.” The great benefit of blockchain technology, he added, is that it “undermines the ‘middle-man’ business model. It makes it harder to cheat in transactions, and so reduces the value of credibility lent by trusted intermediaries. It is less important that counterparties may not know each other.”
Craig Bass, senior software engineer at Made Tech and an expert in coding and risk assessment, agrees. “It’s not surprising that financial institutions and central banks are looking at distributed ledgers. Blockchain technology is useful for when you have networks of untrusted parties needing to communicate with each other. You can use blockchain to verify that data in a controlled way.” But Bass does point out that “blockchain technology itself does not necessarily need to be centralised or decentralised – simply distributed. If more weight is placed on verifying nodes that the central bank controls, then it can regulate the money supply more effectively.”
The legacy of the 2008 global financial crisis is residual mistrust in institutions. As fintech continues to innovate and disrupt, through mobile and challenger services, the Bank of England’s chief cashier Victoria Cleland says that the old guard are faced with a pressure to modernise or risk being left behind. She told the Financial Times: “A lot of people think central banks are very risk-averse, but we are thinking: ‘Are there opportunities to grasp innovation ourselves?’” Some forward-thinking central banks, such as the BoE and the People’s Bank of China (PBoC) have already discussed issuing their national currencies onto some sort of distributed ledger. If the central banks succeed, it would turn the story of Bitcoin on its head – an invention popularised by the offer of anonymity and independence from the status quo would end up empowering central banks and making money easier to pinpoint.
The BoE has produced several reports with its One Bank Research Agenda (2015) suggesting that the benefits of issuing a digital currency on a distributed ledger could add as much as three per cent to a country’s economic output. Following meetings with the BoE, researchers at University College London developed a prototype currency called RSCoin. Researchers Dr George Danezis and Dr Sarah Meiklejohn describe RSCoin as “a cryptocurrency framework in which central banks maintain complete control over the supply chain, but rely on a distributed set of authorities to prevent double-spending.” While monetary policy is centralised, “RSCoin still provides strong transparency and auditability guarantees. We demonstrate, both theoretically and experimentally, the benefits of a modest degree of centralisation, such as the elimination of wasteful hashing.”
Danezis and Meiklejohn argue that RSCoin would be more palatable to governments because every unit of the currency is created by the central bank, not independently created or “mined” as Bitcoin is. It would offer the centralised control of a traditional currency while providing the benefit of the transparent transaction ledger. This allows direct access to payments and value transfers while supporting privacy, and offers more scope for innovative new payment systems and other uses of digital money. Danezis and Meiklejohn also suggest that centralising monetary authority enables RSCoin to address some of the issues in scalability faced by decentralised cryptocurrencies.
In China, meanwhile, PBoC governor Zhou Xiaochuan highlighted that the country might need a cryptocurrency if it is ever to deploy negative interest rates as the population prefers to pay in cash. In March at the Bao Forum, he said: “If everyone is holding cash, negative interest rates become useless. With the popularity of digital currency, cash usage will drop.” Negative interest rates, which effectively charge banks to store money, have in recent years been implemented by Japan, Sweden, Switzerland and Denmark to boost growth and raise inflation. China, by contrast, is still increasing rates as its economy continues to boom, but policymakers appear to be preparing for leaner times. Zhou was clear in his speech that the PBoC would not rule out the use of negative rates in the case of deflation. But in that case, even with a negative rate policy, people may want to hold onto physical cash rather than spend money. A switch to digital currency, Zhou thinks, could be part of the solution to this problem.
Against the backdrop of rapid digitalisation, there is a pressure across sectors to deliver products quickly and securely. This is particularly true within finance. Bass says it is this need for speed that may power the shift towards cryptocurrency. “I suspect that private blockchain technology will be introduced behind the scenes, between banks, to help handle intra-bank transfers. Currently, these legacy clearing systems are complicated and slow. The end result for the consumer on the street includes faster payments and statements. Nowadays, real-time data is everything but banks are lagging behind, so I can understand why they might turn to blockchain to help them keep pace.”
Does transparency necessarily denote security? Bass explains that “each player in the blockchain would communicate with all the others whenever money moved within it, allowing everyone to update the ledgers they control on the computer system simultaneously. Most importantly, no one player has control over the system. Cryptographic verification is required for a transaction. There wouldn’t be any need for direct bilateral trust, as these blockchain networks provide trust via a sort of multilateral peer review. As an extra bonus, each player would keep a backup if an individual bank’s computers came under attack. It would also hypothetically allow faster transactions and would make it easier to spot bad eggs.”
While Niepelt, Bass and Danezis and Meiklejohn at UCL make an attractive case for the use of centralised cryptocurrencies, large economies move at their own speed. Saifedean Ammous, assistant professor of economics at the Lebanese American University, compares the invention of blockchain to that of the car engine, pointing out that while the internal combustion engine did eventually replace horses, people didn’t begin bolting engines onto existing horses as soon as it was invented. So, if cryptocurrencies offer to make digital transactions as simple and trustworthy as a cash transaction – and, crucially, with a similar lack of need for a trusted third party – then why, Ammous asks, would a central bank step into that role? He wrote in American Banker: “A non-Bitcoin blockchain combines the worst of both worlds – the cumbersome structure of the blockchain with the cost and security risk of third parties. It is no wonder that years after its invention, blockchain hasn’t managed to break through in a successful, commercial application other than the one for which it was specifically designed: Bitcoin.”
Kevin Dowd, co-author of Bitcoin Will Bite The Dust and professor of finance and economics at Durham University, is similarly sceptical. Bankers are drawn, he says, by the idea of fast digital money; they are less drawn by the idea of digital money that can’t be controlled and that can be used anonymously. There is also, he adds, a natural stand-off between blockchain libertarians who support open-source networks and governments or central banks who would prefer controllable databases.“There’s tension between a central bank-issued currency, which presupposes trust in the central bank, and the use of a blockchain, which only makes sense, because of its inherent costliness, if one wishes to have a decentralised currency. The better closed systems, which depend on a manager, are cheaper to operate than a decentralised system. So if one is going to trust the central bank to run the system, why would one not want it to run the cheaper system?”
The cryptocurrency debate is not one that will go away soon and it seems that the fine tunings for central banks are not quite complete. The BoE’s website admits it is undertaking “a multi-year research programme” before putting anything to market. But as Bitcoin – which is worth £2122.68 per unit at the time of writing – continues to evolve, that programme may have to hurry up.