The Blockchain Revolution: Decoding Digital Currencies

After completing this reading, you should be able to:

• Explain how a blockchain-based cryptocurrency system works and compare cryptocurrencies to conventional money and payment systems.
• Describe elements of a decentralized finance structure, including smart contracts, tokenized assets, decentralized autonomous organizations, and decentralized exchanges.
• Define stablecoins and assess their advantages and disadvantages, including their potential contribution to systemic risk and regulatory considerations.
• Explain the advantages, disadvantages, and potential applications of a central bank digital currency.

How a Blockchain-based Cryptocurrency System Works

Money, Digital Money, and Payments

Money is a form of social credit because it allows people to exchange goods and services within a community. In smaller communities, people’s actions can easily be tracked and recorded, allowing for a communal ledger of individual consumption and production decisions. In larger communities, where people mostly don’t know one another, this system doesn’t work, so money is used as a medium of exchange. Money can be in physical form, like cash, or digital form, like electronic bank transfers. Physical cash transactions are direct between parties, while digital payments require a trusted intermediary to process the transfer.

Cryptocurrencies, Blockchain, and the Double-spend Problem of Digital Money

Cryptocurrencies are digital information transfer mechanisms that can be used as a form of money and payment system. Unlike conventional money systems, cryptocurrencies are not controlled by a single entity, but by a group of volunteers called miners. Miners are responsible for keeping track of all cryptocurrency transactions. Miners keep their records in a digital ledger known as the blockchain. The protocols that govern the blockchain are embedded in computer code, and cryptocurrency users must trust that the rules for using them are fair and won’t be changed without a good reason. However, managing this digital ledger is not easy. There is a risk that someone could duplicate the digital money and spend it multiple times, causing what is known as the “double-spend problem” in the monetary system.

Creating multiple copies of a digital file is easy, allowing the same digital file to be spent twice. This makes the double-spend problem a challenge in digital money systems. Each society member would have their own personal money printing press, which is unlikely to work successfully if they could generate personal copies of digital money files. Despite not being immune to the double-spend problem, physical currency can be designed to make counterfeiting sufficiently expensive. The traditional approach to solving the double-spend problem with digital money is to provide a reliable third party, such as a bank, to aid in mediating the movement of value between accounts in a ledger.  Bitcoin was the first money and payment system to solve the double-spend problem for digital money without the help of a trusted third party, and below is an explanation of how they managed to do that:

The Digital Village: Communal Record-keeping

Cryptocurrencies transaction record keeping can be likened to small communities whose members know one another. Each member in these communities has a history of behavior known to others. This history is a virtual database that is shared among members. The maintenance of this database is a shared responsibility, not solely the responsibility of one person. The community records members’ contributions here. Each member’s record is a reputation history based on what individuals have contributed to the community. In this sense, the credit they receive from the community can be considered a form of money. Even though it is possible for individuals to fabricate their history for personal gain, open and shared ledgers are difficult to alter without communal consensus. This is the fundamental concept behind decentralized finance (DeFi).

Governance via Computer Code

All social interaction is subject to rules that govern behavior. Behavior in small communities is governed largely by unwritten rules or social norms. In larger communities, rules often take the form of explicit laws and regulations. In financial markets, the rules governing behavior and transactions are important for maintaining the stability and integrity of the system. In the case of the United States, the Federal Reserve plays a central role in this system. The Federal Reserve Act of 1913, as well as other laws and regulations, govern all the actions the Federal Reserve takes. These rules can change over time as political support for certain changes emerges. Similarly, in the case of cryptocurrencies, the rules and protocols that govern the monetary policy and payment processing are built into the code and are difficult to change. Some individuals see this as an advantage since it provides a clear and unchanging framework for the system.

How Blockchain Technology Works

While data itself is the centerpiece of operations for any database management system, cryptocurrencies use a database known as the blockchain. A blockchain is like a ledger of money accounts with unique addresses. These money accounts work like post boxes such that anyone visiting the post offices is permitted to see the money balance in each account, but you need the correct password to access the money. These passwords are generated automatically upon account opening and are only known to the account user. The names of these accounts are pseudonymous. Cryptocurrencies are considered “digital bearer instruments” because possession of the private password determines their ownership and control. Note that cryptocurrencies are often referred to as “digital cash” thanks to their similarity to physical cash.

Cryptocurrency transactions are similar to using physical cash since neither permission nor personal information is required. By downloading a cryptocurrency wallet, anyone with internet access can communicate with the system’s miners and generate a public address and private key for their account. This will create a similar front-end experience to online banking for managing money balances and initiating payment requests. However, if the private key is lost or stolen, there is no way to recover the funds.

While cryptocurrencies have gained popularity because of their provocative and glamorous appearance, the real innovation lies in the way in which their databases operate. Each money account is managed in accordance with a set of computer code rules that regulate access to the database. Additionally, protocols govern how account managers are rewarded for updating the database. Proof-of-Work (PoW) and Proof-of-State (PoS) are two common protocols used in this process. It is worth noting that some form of gatekeeping is required to prevent the addition of unwanted data to the database. The primary economic question is whether these protocols can process payments and manage money accounts more efficiently, cheaply, and securely than existing centralized finance systems.

Native Token

To record money balances, cryptocurrency uses a monetary unit known as native tokens. These tokens are similar to foreign currencies. However, computer algorithms, not a country’s policymakers, determine their value. The potential for capital gains from appreciating the value of the native token relative to the U.S. dollar often drives the excitement around cryptocurrencies. However, the fundamentals of a cryptocurrency that would generate continued capital gains for investors beyond the initial adoption phase are unknown. Furthermore, while the supply of a specific cryptocurrency, such as Bitcoin, may be limited, the supply of close substitutes may be unlimited. The total market capitalization of cryptocurrencies will likely continue to grow. Still, this growth may be attributed more to the creation of new cryptocurrencies than to a rise in the price per unit of any given cryptocurrency, such as Bitcoin.

Cryptocurrency Application

Cryptocurrencies, like Bitcoin, have primarily been used as a store of value rather than a medium of exchange due to their volatility. However, their potential use as a vehicle currency for international remittances and their decentralized nature, which operates independently of any government or concentration of power, makes them attractive to some individuals and organizations. Furthermore, anyone can access Bitcoin payments freely and without permission, provided they have an internet connection. However, it also makes it easier for illegal activities and money laundering to occur. El Salvador’s recent adoption of Bitcoin as a legal tender has aroused interest as a case study of how a cryptocurrency can perform as a domestic payment system.

Using blockchain technology, Bitcoin operates as a decentralized autonomous organization (DAO) utilizing open-source computer code on a large network of computers. Moreover, it has no physical location, is not required to be registered as a business, and lacks a CEO and traditional employees. Since it has a fixed supply of 21 million BTC and allows anyone to participate, it’s an ideal platform for fast, low-cost, high-value transactions.

Policy Considerations of Cryptocurrency

Central banks view cryptocurrencies the same way they do (view) foreign currencies, which governments may consider a threat. Controlling cryptocurrencies would be difficult due to their nature of being easily accessible and not requiring permission. Cryptocurrencies may also constrain domestic monetary and fiscal policies by limiting the amount of seigniorage available to fund government expenses. Furthermore, while issuing debt denominated in foreign currency, such as the U.S. dollar, may be less expensive, it may cause problems if the domestic currency depreciates, making it difficult for debtors to repay and potentially causing a financial crisis. If debt instruments are denominated in cryptocurrency, there is no way to negotiate with the cryptocurrency’s decentralized organization (DAO). As a result, domestic regulators may be more strict in regulating the issuance of cryptocurrency-denominated debt if it poses a significant risk to the system.

Elements of a Decentralized Finance Structure

Decentralized finance, or DeFi, refers to financial activities conducted on blockchains. Unlike traditional finance, which relies on intermediaries and centralized institutions, DeFi uses smart contracts to enable transactions between parties without the need for intermediaries, which can significantly reduce costs and give parties more control over the terms of agreements. However, intermediaries continue to play an important role in areas such as verification and enforcement, and they may not disappear entirely. This section describes the concepts of DeFi and its implications.

Smart Contracts

A smart contract is a computer program that performs a set of predefined actions agreed upon by the parties. Nick Szabo first introduced it in the 1990s as a crude example of a vending machine. Smart contracts enable secure financial transactions without the use of third parties and can be used for purposes other than traditional financial transactions. Ethereum is a blockchain platform that supports smart contracts, which in this case, are a type of account with their own balance that can interact with the network. Like cryptocurrencies, smart contracts allow for secure and transparent transactions between untrusted parties without intermediaries. Consider a collateralized loan as an example. In traditional finance, such a transaction would involve many parties, including the lender, the borrower, a broker, financial intermediaries, appraisers, loan servicers, asset custodians, and others.

On the other hand, a smart contract is a computer program that details an agreement and stores it on the blockchain. It contains information about the loan and the actions that will be taken based on compliance. The blockchain ensures the contract’s successful execution, removing the need for any additional parties other than the borrower and lender.

Asset Tokenization

Asset tokenization involves the conversion of physical assets into digital tokens that can be used on a blockchain. This allows assets such as real estate to be used as collateral in smart contracts. However, enforcing blockchain property rights for assets that exist in physical form remains a challenge for DeFi. Tokens also have non-financial uses, such as granting voting rights to organizations and creating unique digital artistic images through nonfungible tokens (NFTs), which serve as a certificate of authenticity. The key advantage of NFTs is that they use the security of the blockchain to ensure authenticity and security, rather than relying on signatures that can be forged.

Decentralized Autonomous Organizations

Smart contracts have the potential to fundamentally alter the way institutions are organized and managed. This applies to investment funds, corporations, as well as public goods and services. One such application is the decentralized autonomous organization (DAO), which is an organization represented by computer code and governed by smart contracts on a blockchain. A popular example is MakerDAO, which issues the stablecoin Dai and is governed by its stakeholders, who use tokens to make decisions about protocol changes. Governance refers to the rules that balance the interests of different stakeholders in an institution. In traditional corporations, the board of directors plays a critical role in corporate governance, addressing issues such as agency problems where managers do not act in the best interest of shareholders. DAOs offer an alternative governance model by encoding rules in a smart contract, replacing the traditional top-down structure with a decentralized consensus-based model. Examples include Uniswap, a decentralized exchange, and Aave, a borrowing and lending platform. These started out with development teams in charge of operations and decisions. Eventually, they distributed governance to the wider community through the issuance of tokens, allowing holders to submit proposals and vote on them.

Centralized and Decentralized Exchanges

Nowadays, crypto-assets are mostly traded through a centralized exchange (CEX), whose operation is similar to a traditional bank or a broker. A client opens an account by providing personal information and then depositing funds. The client can then trade crypto assets at prices listed in the exchange. The client’s assets are in the custody of the exchange; hence the client does not own these assets. As such, all client transactions are recorded on the database of the exchange rather than on a blockchain.

On the other hand, decentralized exchanges (DEX) use smart contracts for peer-to-peer trading without intermediaries, allowing traders to keep custody of their funds and interact directly with smart contracts on a blockchain. Order books, which list buy and sell orders for a given asset as well as their offer and bid prices, can be used to implement DEX. CEXs operate like DEXs. However, with DEXs, smart contracts handle the list and transactions. When all transactions are handled on a blockchain, the order book is referred to as “on-chain.” Otherwise, it is referred to as “off-chain.” One particular issue of concern with order books is their potential to slow execution and lack of liquidity. DEX aggregators and automated market makers (AMM) can solve the liquidity problem, making trades faster and cheaper. AMMs are currently the most popular form of DEXs since they offer the best solution to liquidity problems.

Stablecoins

As discussed previously, cryptocurrencies are highly unsuitable as payment instruments due to their extreme exchange rate volatility. A stablecoin is a cryptocurrency whose value is linked to an external asset, such as the U.S. dollar, to make it more useful as a payment method. To accomplish this, the stablecoin must persuade its owners that it can be exchanged for U.S. dollars at par or at a fixed exchange rate. The aim of this design is to increase the use of stablecoin by making it more appealing as a payment option. One significant advantage of using stablecoin instead of a traditional bank account is that it allows for lower-cost USD payments due to its use of blockchain technology for more efficient account management and payment processing services, which can be passed on to customers in the form of lower fees. It can also be viewed as a method of avoiding certain costs by transferring the transaction outside the regulated environment.

Financial Stability Concerns

Stablecoins based on the U.S. dollar are similar to money market funds in that the price of their liabilities is tied to the U.S. dollar. They are also closely related to banks that do not provide deposit insurance. As pointed out in the 2007-09 financial crisis, even money market funds are vulnerable to runs if their assets are of poor quality. Similarly, unless fully backed by U.S. dollar reserves or bills, U.S. dollar-based stablecoins may experience a bank run. This can happen if a stablecoin is unable to sell its assets at reasonable prices or raise the funds required to meet its redemption promises. This poses a risk not only to stablecoin holders but also to the financial system as a whole.

Regulators are also concerned about the possibility of systemic risk if a stablecoin run leads to a fire sale of commercial paper, as well as negative economic consequences for firms that rely on this market. Regulators face challenges when dealing with stablecoins that are “too big to fail” and can rely on central bank support. Nonetheless, the use of smart contracts to design more resilient financial structures may make stablecoins “run-proof.”

Regulatory Concerns

As the world of stablecoins evolves, regulators face concerns similar to those faced by the traditional banking industry. Banks create money by issuing deposit liabilities with a fixed exchange rate against U.S. dollars, as well as credits held in Federal Reserve accounts. They use low-earning liabilities to purchase high-earning assets. Commercial banks are referred to as fractional reserve banks because they typically hold only a small percentage of their assets as reserves. The implementation of federal deposit insurance has largely eliminated retail bank runs. The Federal Reserve also provides emergency lending to banks, but regulatory restrictions accompany these benefits on bank balance sheets and business operations.

Some stablecoin issuers attempt to replicate the business models of banks or top institutional money market funds, which can be a profitable venture. However, this approach carries significant risks that could lead to instability. Other stablecoin issuers, on the other hand, focus on providing payment services by holding only risk-free assets such as U.S. Treasury securities. These stablecoins are similar to government money market funds. Stablecoins may adhere to government regulations, hold only risk-free assets, and generate profits via transaction fees or net interest margins. The goal is to keep stablecoin users’ capital requirements low.

Advantages, Disadvantages, and Potential Applications of a Central Bank Digital Currency

According to The Board of Governors of the Federal Reserve System (BOG), in its recent publication “Money and Payments: The U.S. Dollar in the Age of Digital Transformation,” a central bank digital currency (CBDC) is a “digital liability of the Federal Reserve that is widely available to the general public.” In other words, this is saying that anyone can open a bank account at the central bank.  

Currently, only depository financial institutions and a limited number of agencies, including the federal government, are allowed to have accounts at the Federal Reserve, known as reserve accounts. These accounts hold bank reserves, and the account held by the federal government is referred to as the Treasury General Account. Although a form of CBDC already exists at a wholesale level for a select group of agencies, the question of whether to expand access to it and how to do so remains. The public already has access to digital currency in the form of digital deposit liabilities issued by banks and physical currency, i.e., cash, which is considered a central bank liability. However, bank deposits are not legally considered central bank or government liabilities, whereas CBDC would be considered legal tender.

Federal Deposit Insurance

Bank accounts in the United States are today insured by the Federal Deposit Insurance Corporation up to $250,000. It can be argued that retail bank deposits are a de facto government liability. Furthermore, given the Federal Reserve’s role as lender of last resort, large-value bank deposits can be argued to be a de facto government liability. This means that the legal status of a CBDC in comparison to bank money may not be as important in terms of money account security.

Counterparty Risk Concerns

When it comes to money and payments, security isn’t the only thing to think about. There is also the issue of counterparty risk, which can impact access to funds. Even if your money is insured in a bank account, accessing it may be delayed if the bank is experiencing financial difficulties. This is one of the reasons corporate cash managers frequently use the repo market, where deposits are secured by Treasury securities that can easily be sold if the deposited cash is not returned on time. A CBDC with no account size limits would provide fully insured money accounts for corporations with no counterparty risk. If properly implemented, this could potentially help streamline certain aspects of the money market.

Potential for Efficiency Gains

It’s a difficult issue to address when it comes to improving the overall efficiency of CBDC’s payment system. In light of the current state of the U.S. payment system, which lags behind developments in other countries, some argue that a properly designed CBDC could be a game changer. However, it is important to note that the United States’ payment system is rapidly evolving, with platforms for real-time payment services, such as the Federal Reserve’s FedNow and the Clearing House, emerging. It’s also important to note that there is no “ideal” way to organize a payment system. A payment system’s primary function is to process payment requests and transfer funds between accounts. While the concept is simple, actual implementation and operation can be quite difficult.

In order to prevent fraud and ensure efficient messaging systems, any system would require strong security measures. The potential of CBDC has divided opinion, with some strongly in favor and others less so. Theoretically, a private, public, or private-public partnership could all be viable options. The Federal Reserve is primarily concerned with wholesale payments, whereas the private sector typically serves the retail sector. A CBDC could be designed to respect this division of labor by allowing free entry into the business of “narrow banking” or by providing direct access to CBDC and delegating retail-level processing to private firms.

Question

Consider the fictional cryptocurrency, Plutocoin, a prominent blockchain-based system that uses a unique blend of proof-of-work (PoW) and proof-of-stake (PoS) protocols. Joe, a software engineer, is debating whether to use Plutocoin as his primary means of transaction instead of conventional money and payment systems. 
Which of the following would be the most accurate statement for Joe to make?

A. Plutocoin, being a cryptocurrency, does not provide the same security as conventional banking systems.

B. Plutocoin transactions require the disclosure of personal information, similar to conventional banking systems.

C. Plutocoin transactions are based on digital bearer instruments, making it akin to digital cash.

D. Plutocoin transactions are only accessible to a certain group of people, unlike conventional banking systems.

Solution

The correct answer is C.

Cryptocurrencies like Plutocoin are indeed akin to digital cash. They are digital bearer instruments, where ownership control is defined by possession of a private key. Just as physical cash doesn’t need permission to acquire and spend, cryptocurrencies can be similarly managed. This is unique to cryptocurrencies compared to conventional banking systems.

A is incorrect because Plutocoin, as a cryptocurrency, actually offers a high degree of security, often more than conventional banking systems. This is due to the blockchain technology and private key mechanisms that secure each account.

B is incorrect because one of the main features of cryptocurrencies like Plutocoin is the ability to transact without having to disclose any personal information, unlike conventional banking systems where personal information is usually required.

D is incorrect because, contrary to the statement, cryptocurrencies like Plutocoin can be accessed by anyone with internet access and does not require any permissions or qualifications to acquire or spend, unlike some conventional banking systems that may have restrictions on who can open an account.