Are Bitcoin and other digital currencies the future of money?

What is Bitcoin?

Bitcoin is a decentralised virtual currency or ‘cryptocurrency’: in the words of its anonymous founder, ‘a purely peer-to-peer version of electronic cash that allows online payments to be sent directly from one party to another without going through a financial institution.’ When you own Bitcoin, you own the ‘key’ (or password) to an ‘address’ (or account) that contains the virtual currency. Bitcoin can be sent from one address to another by generating a transaction, which is then recorded on an immutable public ‘block’. These blocks are then chained together, creating a ‘blockchain’ – a publicly available record of all historical Bitcoin transactions.

What are the advantages of Bitcoin over existing currencies?

According to its supporters, Bitcoin has two advantages over existing currencies. The first is that its supply is limited to 21 million, making it impossible for a central authority to issue it in quantities that would devalue it. This means it is much less vulnerable to hyperinflation crises, such as those seen in Weimar Germany, Zimbabwe or Venezuela. But a limited supply can also be a weakness, as it makes it impossible to control deflation – a phenomenon that can also lead to very severe economic consequences.

The second claimed advantage of Bitcoin is that all transactions are permanent and immutable. When money is held in a bank account, that bank could theoretically expropriate the money from its user and claim that it never existed. With Bitcoin, this is impossible, because the database on which transactions are recorded cannot be edited by any central authority.

What are the disadvantages of Bitcoin compared with existing currencies?

In economic theory, money is said to have several primary functions. How well does Bitcoin fulfil these roles?

As discussed, Bitcoin is an excellent medium of exchange for transactions that require anonymity. But using it for other transactions is often prohibitively expensive. The average Bitcoin transaction fee during 2020 has ranged from 28 cents on 2 January to $13.41 on 31 October.

The usefulness of Bitcoin as a store of value is limited by its volatility. In the year to 9 December 2020, the US dollar value of Bitcoin changed by an average of 2.22% per day. The price of Bitcoin has risen considerably in that time and advocates often argue that the cryptocurrency is a good store of value because its price will continue to rise over time.

The future price is inherently unpredictable, but even if optimists are correct that its price will rise, this is only an argument that Bitcoin is a good speculative investment – not that it is a useful form of money. Countries typically aim to have a stable currency rather than an appreciating but highly volatile currency, because the former is much more conducive to a healthy economy. This volatility also limits the effectiveness of Bitcoin as a unit of account: denoting the value of an asset in Bitcoin makes little sense when the real value of Bitcoin changes by an average of 2.22% per day.

These problems with Bitcoin resulted in several attempts to create new digital currencies that solve these volatility problem – some of which have come to be known as ‘stablecoins’.

What are stablecoins?

A stablecoin is a cryptocurrency that has its market value pegged to another asset or basket of assets. If traditional cryptocurrencies could be said to have a floating exchange rate, in that their price is allowed to fluctuate, stablecoins have a fixed exchange rate, in that their price is held constant by the guarantee of a central authority.

The most widely used stablecoin is Tether, which is purportedly pegged to the US dollar at a 1:1 ratio by the Tether Corporation. While the corporation’s original ‘white paper’ stated that Tethers would be fully backed by US dollars, this is no longer the case. But Tether still trades at very close to $1 on secondary markets.

Partly in response to the perceived threat posed by private currencies, central banks around the world have begun to research ways in which these technologies could be used to create state-controlled digital currencies.

What are central bank digital currencies?

A central bank digital currency (or CBDC) is a form of electronic money issued by a central bank. Existing national currencies can be traded electronically, so what is the benefit of a CBDC? This varies from one proposal to the next: it might be to allow the public to access central bank lending or to facilitate a move to a smoother payments system. A more sinister possibility is that a CBDC could allow an authoritarian government to record all transactions on a blockchain for the purposes of law enforcement.