Here's why cryptocurrencies are going to struggle with central banks

The future of money looks very different in the world of cryptocurrencies. There is a growing consensus among businesses, investors and countries (Venezuela in particular) that these alternative forms of online money are going to dominate payments in the next decade. There may be agreement on the potential, but quite how regulators and central banks will respond is still up in the air.

The combined market value of all cryptocurrencies in circulation reached US$170 billion by the end of August 2017, 850% higher than at the beginning of the year, according to CoinMarketCap, a leading cryptocoin prices and market capitalisation tracker website. It is no surprise that this kind of growth sparked much hand-wringing among regulators and central banks, who are still undecided whether cryptocurrencies should be classified as a commodity, an asset or a form of currency.

That might seem like an odd discussion to be having. But one of the basic functions of currency is to facilitate transactions in a timely manner. And to protect the security of the blockchain (the technology behind cryptocurrencies such as Bitcoin), the processing of Bitcoin transactions is sometimes very slow.

Due to restrictions on the limit of Bitcoin transactions which can be completed in a day, it may take a few days to complete a single transaction, rendering the cryptocurrency unable to fulfil the basic function of money at times. Private blockchains can speed up transactions but they are not popular and availability is limited.

Money worries

The call to better regulate cryptocurrency gained momentum after the International Monetary Fund (IMF) issued a staff discussion note stating that banks should consider investing in cryptocurrencies:

Rapid advances in digital technology are transforming the financial services landscape, creating opportunities and challenges for consumers, service providers and regulators alike.

Any wholesale adoption by the banking sector would clearly establish a huge market for cryptocurrencies, but the traffic isn’t moving entirely one way. Chinese regulators dealt a huge blow to the crypto market at the beginning of September when the People’s Bank of China made it illegal to raise funds through Initial Coin Offerings (ICOs).

An ICO is a fundraising tool that trades future cryptocoins in exchange for cryptocurrencies of immediate, liquid value. They have become an easy platform for digital currency geeks to raise funds quickly. In simpler terms, ICOs are a crowdfunding platform for future cryptocoins. They have already raised US$2.32 billion, according to industry website Cryptocompare.

China is getting stricter in general. It was even reported that it may ban the trading of virtual currencies on domestic exchanges entirely. If this goes ahead, it will certainly dampen the enthusiasm around the sector. But there always seems to be some better news round the corner, and more oversight may well generate the confidence that can overcome concerns.

The Russian finance ministry is pushing to regulate the use of cryptocurrencies in the country by the end of 2017, while the central bank has been working on regulation for digital currencies since the beginning of the year. Perhaps the biggest boost for cryptocurrencies came from Finland’s central bank economists, who called the infrastructure behind crypctocurrencies such as Bitcoin “revolutionary” and praised its ability to prevent manipulation.

There has also been recognition for cryptocurrencies in countries such as Australia and Japan, which are both implementing polices to legalise cryptocurrencies exchanges. Japan has made it mandatory for Bitcoin exchanges to register with regulators and undergo annual auditing by certified accountants.

Singapore’s central bank noted that the function of digital tokens went beyond simply being a virtual currency while asserting some oversight. It said that ICOs would have to be approved or recognised by the bank or recognised under Singapore’s Securities and Futures Act.

In the US, the Securities and Exchange Commission echoed that sentiment, announcing that ICOs will be regulated as securities and any unregistered offerings could be subject to criminal punishment.

Two options

This kind of growing acceptance – China aside – is an acknowledgement of the growing popularity of cryptocurrencies as a financial instrument. Looking further ahead, regulators have two options.

First, they could implement stricter regimes to ensure cryptocurrency transactions are not related to dark net activities, terrorism financing or money laundering activities. Alternatively, central banks could start issuing their own digital currency known as Central Bank issued Digital Currency (CBDC) based on the distributed ledger technology (DLT), the same blockchain technology behind the cryptocurrencies. This raises the possibility of CBDCs destroying the value proposition of existing cryptocurrencies.

The Bank of England has taken a lead in the initial discussion while its peers in Canada, Sweden and at the European Central Bank all analyse the feasibility of launching digital currencies.

The wider discussion on CBDCs is a testimony to the fact that central banks are serious about cryptocurrencies, and in a way competing with their growing popularity. In the worst case scenario for this still fledgling market, central banks could decide to make trading or possessing cryptocurrencies illegal. That would be tough to enforce as there is no single organisation or person that controls cryptocurrencies and transactions don’t go through a central clearing house. There is precedent, however. Back in 1933, the US president, Franklin Roosevelt, made holding gold bullion a crime and required all Americans to hand over their cache of gold to the Federal Reserve.

If that happens here, then the cryptocurrency market would die a natural death. It all rests now with the central bankers. China has offered a glimpse of a difficult future; crypto evangelists will hope others continue down the more accommodating path.