Blockchain, Banks, and Governments

The prices of cryptocurrencies across the board have recently taken a large dip and no one knows in which direction they will go in the future. The falls in prices largely had to do with bad news and hence a more pessimistic outlook on how governments across the world want to regulate cryptocurrencies.

Is this because governments believe that cryptocurrencies are overall welfare-decreasing? Do they see a need to protect their citizens from fraud, or to prevent the emergence of dark markets? Or do they mainly see their monetary monopoly threatened and want to prevent alternatives?

Cryptocurrencies are tokens, given out by private entities. Primarily, they are tokens with which you can pay other people that are willing to accept them. The fundamental value of any cryptocurrency relies hence only on the trust of other agents in a system. It is an unbacked asset—a bubble. Their original intention was to reward the miners that confirm transactions on the blockchain protocol. In a nutshell, the mechanism works as follows: Every agent in a network keeps track of the money (property rights…) that every agent has on that network. The agents are anonymized, so that no bank balance can be linked to a known individual. When money, an asset, or any certificate is transferred from one agent to another, everyone in the network writes the transaction down. A “block” consists of a fixed number of transactions. When a block is full, it is encrypted with a prime-factor passcode. Now to validate the block, each miner in the network tries to find the prime factors. The first miner to find the two prime factors of the passcode is rewarded with a crypto-coin.

So what effects do these coins have? Firstly, the blockchain or similar protocols greatly reduce the need for intermediaries in the economy. When everyone in the network keeps track of the transactions, the original—not just a copy—of any document can be sent electronically. On a trusted blockchain network, money, contracts that certify ownership rights, and other official documents could be sent from one person to the next instantly—they would not need months to arrive and could be transmitted across the globe. Students would not have to wait months for their university degrees, or ask their friends to pick them up if they moved abroad in the meantime. Money transfers to friends in other countries could be done without paying a fee to Western Union. Even though bitcoin requires fees for transactions, to reward the miners, the most developed blockchain-like protocols can operate completely without miners and hence without any transaction fees.

In fact, banks are the largest and most commonly used intermediaries whose business models are threatened by these protocols. Nowadays, banks take the following roles as intermediaries:

They pool resources from savers and lend them out to firms; they specialize in gathering information on their borrowers, and select only the projects they deem profitable. The combination of these two roles reduces the risks faced by savers compared to the case where savers lend directly to entrepreneurs. Blockchain protocols reduce the role of banks to the second point: analysing which projects deserve to be financed and which borrowers are creditworthy.

Other services that banks offer nowadays (which are economically unnecessary) are financial services: the selling of stocks, bonds, options, and other derivatives. Take as an example the New York Stock Exchange: as an individual, it is impossible to purchase any product sold there. Instead you have to call your bank and ask them to buy it for you at a small surcharge.

With blockchain protocols, you cannot only buy products that are bought and sold on stock exchanges without any intermediary, but you can also create your own financial products and trade them securely. The blockchain-based firm “Augur” is a company that facilitates these services: on their website one can create an option or derivative, a “bet” on the evolution of a financial product. Then one can buy or sell “bets” to people who believe that the opposite will happen. You are rewarded both when you win your bet, as well as whenever other market participants buy the bets that you created. In other words, any market participant can pocket the mark-up that banks nowadays charge for the creation of options and derivatives.

Cutting out the middle man in such transactions could greatly enhance efficiency in the financial sector and lead to welfare gains. But it also offers vast new possibilities to savers who live in countries with imperfectly functioning banking systems. When they can securely buy options on any financial product in the world, they are incentivized to save more. This could increase capital stocks and growth.

Moreover, cryptocurrencies are the only assets which can be held at zero cost and zero interest. Cash of a publicly-backed currency was long thought to be such an asset—however this view has been challenged recently when central banks managed push interest rates below zero. The reason is simple: it is not possible to hold large amounts of cash without having to invest into secure means of storing it. These are usually voluminous, heavy, and impractical. Large amounts of a cryptocurrency however, can be stored easily and safely on the blockchain network. The only cost is to remember or safely store a password “key” of your wallet.

Possessions on a blockchain network can, in theory, not be stolen at all, as every agent in the network keeps track of everyone else’s balances (unless someone manages to take over the entire network).

This means that the zero-lower-bound on interest will be truly unbreakable in a world of stable cryptocurrencies. Stable cryptocurrencies would thus discipline central banks not to lower interest rates below zero. This goes to the benefit of savers who, in the aftermath of the financial crisis were struggling to find any safe asset that yields positive return.
So far, cryptocurrencies are far too volatile to be this kind of asset. There are multiple reasons for this: the first one is that there are currently very little means for securitization. Platforms such as Augur are still far from their breakthrough into mainstream financial markets. Secondly, the crypto-currency world needs to overcome the regulatory hurdles. Only with the certainty that cryptocurrencies will not be banned by governments can they succeed. Governments have responded very differently so far: while Japan has embraced the competition of cryptocurrencies amongst each other, South Korea has decided to ban them altogether. Yet other countries are developing their own methods to capture the benefits of cryptocurrencies but maintain a degree of control over the economy. Which adaptation works best remains to be seen.

By Friedrich Lücke

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