Why Central Banks Should Consider Holding Digital Currency
Millions of people around the world trust and trade digital currencies, despite them only coming into existence a decade ago.
Over the past decade, digital currencies became a $600 billion industry, and are not controlled by any governing body or central bank. Digital currencies now have the potential to become the most influential group of assets, more powerful than the US dollar.
Due to this impressive growth, every central bank in the world needs to be aware of the disruptive changes ignited by digital currencies and recognize their asset class potential. Rather than shun them, central banks should consider adding digital currencies to reserves as the value of digital currencies grows overtime.
The role of the Central Bank
A central bank’s purpose is to stabilize a nation’s currency by managing its money supply.
Every central bank holds gold and foreign currency to pay off international debt and influence their domestic exchange rate. Influencing domestic exchange rates allow countries to manipulate exports and imports and therefore impact trade and economic growth.
The financial stability from storing foreign reserves and hoarding gold also provides the government flexibility and resilience in the event of external financial shocks.
If a central bank is the lender of last resort, it should look to digital currencies as an additional asset to add to their foreign reserves. Digital currencies allow for instantaneous transactions and borderless transfer of ownership, making them a viable potential option.
Stability of the money supply
Fiat currencies are similar to digital currencies because their value derives from a collective trust and shared acceptance of value.
Digital currencies, however, have no government backing. They instead have intrinsic rarity with some of the earlier generation coins like bitcoin, containing a fixed supply.
In terms of bitcoin and government, November 2017 presented a big turning point for digital currencies. Bitcoin hit a unique milestone where its market cap exceeded the value of all reserve assets, called special drawing rights (SDRs), created and allocated to members in the International Monetary Fund (IMF).
When bitcoin surpassed the $291 billion mark, Christine Lagarde, IMF’s managing director, warned central Banks about the massive disruptions that will take place.
The stability of any nation and its money supply is therefore at risk with the emergence of digital currencies. Central Banks are taking risks if they’re not watching and analyzing the emerging financial products. Especially those currently shaking up the financial services and global payments system.
While the US Federal Reserve launched an investigation into digital currencies, they haven’t formally regulated any. China, on the other hand, has banned all digital currencies. They also set up a team to investigate creating their own digital currency.
With over 200 digital currencies on the market, reaching a combined market capitalization of $600 billion, the money supply is ballooning. This, however, does not imply a fiat inflation. Instead, the fixed supply of digital currencies could mean deflation over time.
Digital currencies are however, digitally correlated and subject to group and social engineering. There is currently no regulatory regime or risk transfer mechanism to prevent or punish cyber attacks. While there some disadvantages to digital currencies, including a small amount may be a wise long-term decision.
All that said, increased mainstream adoption such as Bloomberg adding digital currencies to their terminals signals a new shift. Other currencies have begun to hit their own global milestones, including Ethereum breaking one million transactions in a 24 hour period. Bitcoin even created a few billionaires, the Winklevoss twins among them. These shifts could be a signal that digital currencies are ready for the mainstream.
Although digital currencies are volatile and subject to cyber attacks, they’ve become a valuable asset over the past ten years. Cyber attacks also often make digital currencies stronger. As such, central banks need to reconsider how digital currencies affect money supply and stability domestically and abroad.
Image credit: Wikimedia Commons
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