If there’s any group that wants to drive a stake into the heart of bitcoin and other cryptocurrencies, it’s central bankers. After all, many cryptocurrency evangelists see the beauty of digital money in the fact that it is not subject to the potentially “misguided” incentives of central banks and sovereign nations.

Of course, central banks don’t see it that way. The Bank for International Settlements (BIS), the central bank for central bankers, claims that that lack of backing by a central authority is not a virtue; it’s a major weakness.

To bolster its argument, the BIS released a 24-page paper last Sunday heavily criticizing cryptocurrencies. The paper’s theme: the “decentralized technology of cryptocurrencies, however sophisticated, is a poor substitute for the solid institutional backing of money.”

While that and other statements evince the BIS’s bias, the paper contains some solid points that bitcoin experts need to address — if they want to continue to claim that cryptocurrencies such as bitcoin still hold promise as a form of money.

Trust Is An Issue

The central point of cryptocurrency, experts claim, is that it doesn’t require an institution’s or sovereign’s backing. The BIS says that’s wrong — cryptocurrencies, at least “permissioned” ones, do depend on a central authority.

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cryptocurrenciesAny cryptocurrency requires three elements: computer code specifying how participants can transact (the rules); a ledger storing the history of transactions; and a decentralized network of participants that update, store, and read the ledger of transactions following the rules of the protocol.

In the case of permissioned cryptocurrencies, which allow only trusted participants to updated the distributed ledger, those “trusted nodes” are overseen by the firm that developed the cryptocurrency.

“Thus, while cryptocurrencies based on permissioned systems differ from conventional money in terms of how transaction records are stored (decentralized versus centralized), they share with it the reliance on specific institutions as the ultimate source of trust,” the BIS says. The BIS doesn’t come straight out and say that a cryptocurrency’s “trusted participants” have much less credibility than a central bank, but the implication is there.

Permissionless currencies, of course, are a slightly different animal: they are trying to achieve a new model of trust. The ledger recording transactions can be changed by a consensus of the participants in the currency. But achieving decentralized trust is inefficient, says the BIS, and causes problems with scalability.

Inefficiencies

Blockchain-based permissionless cryptocurrencies have two groups of participants: “miners” who act as bookkeepers and “users” who want to transact in the cryptocurrency.

Each and every user needs to verify the history of transactions.

“To live up to their promise of decentralized trust, cryptocurrencies require each and every user to download and verify the history of all transactions ever made, including amount paid, payer, payee and other details,” according to the BIS.

With every transaction adding a few hundred bytes, the ledger grows substantially over time. The bitcoin blockchain, according to the BIS, is at 170 gigabytes and growing 50 gigabytes per year.

Updating the ledger also subjects transactions to system congestion, according to the BIS.

In blockchain-based cryptocurrencies, for example, in order to limit the number of transactions added to the ledger at any given point, new blocks can only be added at pre-specified intervals.

“At times transactions have remained in a queue for several hours, interrupting the payment process,” says the BIS. “This limits cryptocurrencies’ usefulness for day-to-day transactions, such as paying for a coffee or a conference fee, not to mention for wholesale payments.”

The more people use a cryptocurrency, the more cumbersome payments become, sums up the BIS. “This negates an essential property of present-day money: the more people use it, the stronger the incentive to use it.”

The Value Problem

Why do the values of bitcoin and other cryptocurrencies bounce around so much? The BIS says it’s due to the “absence of a central issuer with a mandate to guarantee the currency’s stability.”

Central banks, at least well-run ones, “stabilize the domestic value of their sovereign currency by adjusting the supply of the means of payment in line with transaction demand.” With a cryptocurrency, generating some confidence in its value requires that supply be predetermined by a protocol. “This prevents it from being supplied elastically,” says the BIS. “Therefore, any fluctuation in demand translates into changes in valuation.

In a decentralized network of cryptocurrency users, “there is no central agent with the obligation or the incentives to stabilize the value of the currency.”

The BIS makes plenty of other arguments against cryptocurrencies, including their use for illicit activity. But the report ends on a positive note, suggesting approaches for regulating cryptocurrencies and noting that central banks are closely monitoring the underlying technologies.

But don’t expect central banks to issue their own digital currencies anytime soon — “such an instrument would come with substantial financial vulnerabilities, while the benefits are less clear,” concludes the BIS.

Has the BIS killed, once and for all, the idea that bitcoin or any other cryptocurrency could become the dominant means of exchange in the U.S. or any other economy? No. After all, some of its arguments boil down to “cryptocurrencies can’t work because a central bank isn’t involved.”

But, the BIS has made a compelling case for why, at least in their current form, cryptocurrencies fall far short of a reliable medium of exchange.

Image: Thinkstock

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