“A form of digital gold”

Cryptocurrencies like Bitcoin have no backing and typically do not have legal tender status. They also do not pay any cash dividends like the shares of a company. To have value, they must somehow reach a state where people not only believe they are worth something, but believe others believe they are worth something. The second part of that statement is key because my willingness to offer something of value for a cryptocurrency depends on my belief that others down the road will do the same.

To have value, Cryptocurrencies must somehow reach a state where people not only believe they are worth something, but believe others believe they are worth something.

For a cryptocurrency to have a chance at succeeding it must meet certain requirements – it must have a limited supply, be secure and be easy to store and exchange. Many cryptocurrencies meet these necessary requirements, but not all have or maintain value. 

It’s hard to say. Many events came together to support the rise of Bitcoin: the great financial crisis and the resulting distrust of financial institutions, global internet penetration, and the open-source movement. However, now that cryptocurrencies are prevalent, the issue is more about rising above the fray. Today, cryptocurrencies can gain traction for obscure reasons.

Dogecoin, for example, has value because it has an appealing logo and Elon Musk tweeted that it “might be my fav cryptocurrency”. More recently a meme coin called PNUT coin was created after agents with New York's Department of Environmental Conservation euthanised a resident’s “pet” squirrel named Peanut. Anonymous crypto enthusiasts saw the opportunity to capitalise on the public backlash by creating the new coin offering. The list goes on.

The point is that absent strong preferences over functionally equivalent, privately-issued monies it is hard to predict which ones will be successful and which ones will not. Substitutability across cryptocurrencies could create a potentially high degree of price uncertainty. At the extreme, this could involve total shifts in usage from one cryptocurrency to another, causing the initial one to become valueless. It is at least conceivable that one day everyone in the world could wake up and decide they don’t like Bitcoin anymore, and it would be worth zero.

There are lots of things in place that work to prevent this, particularly the infrastructure that has been built around it, the persistent efforts to promote it, network effects, and the general difficulty associated with coordinating shifts in beliefs. But it’s still possible. For now, Bitcoin has value because people think it should. Maybe someday they will wake up and think it shouldn’t.

At least for now, they have not. If anything, people see Bitcoin more as an alternative to gold than cash. It is used more as a speculative investment or store of value, than a medium of exchange. This is not great for Bitcoin’s price stability due to the crypto multiplier effect. The crypto multiplier effect measures the dollar change in the market cap of a cryptocurrency in response to a single dollar of aggregate inflows or outflows of investors' funds. Crypto multipliers typically take values above one meaning that the market cap of a cryptocurrency changes by more than the aggregate investment flows. Cryptocurrencies with low payment usage have high theoretical crypto multipliers which causes their exchange rates to be highly volatile in practice.

There are various technological reasons for this. Bitcoin’s proof-of-work protocol limits its throughput to at most a dozen or so transactions per second, compared to, say, 100,000 transactions per second for Alipay. However, its scarcity and proven security make it viable as a store of value – a form of digital gold.

CBDC stands for central bank digital currency, which is a bit of a misnomer because we already have digital forms of central bank digital currency, namely reserves in the United States or settlement balances elsewhere. These are the accounts that commercial banks hold with the central bank. Just as individuals have accounts at commercial banks, commercial banks have accounts at the central bank, and these accounts are digital. However, the term CBDC has come to refer specifically to crypto-based central bank money, which exists on a distributed ledger technology platform similar to those used for cryptocurrencies. 

Interestingly enough, CBDCs share a key characteristic with bitcoin: both are forms of what economists call “outside” money.  Outside money is money that does not disappear when balance sheets are consolidated. In both cases, there is no backing of underlying assets and nothing they can be redeemed for. 

There are several differences, between CBDC and Bitcoin. First, Bitcoin’s money supply is fixed, whereas the central bank influences the supply of its money. Second, if issued, CBDC would have legal tender status, similar to conventional money issued by central banks, like the physical cash in your pocket. Legal tender status does not mean individuals and businesses have to accept central bank money. Rather it means central bank money must be accepted to extinguish debts.

As I mentioned earlier, the key to having a positive value is the belief that if you accept a money, someone else will accept it from you. In the case of central bank money, one big “someone else” is the government. Third, Bitcoin is accessible to everyone. Bitcoin exists on what is called a public blockchain. There are no barriers to holding and transacting Bitcoin, except for potential technological barriers associated with setting up a wallet, which are addressed by third-party enterprises providing wallet services.

Countries have varying opinions on its accessibility. If a country envisions CBDC as a digital replacement for cash, it would be broadly accessible to the general public, known as a retail CBDC. Conversely, if a country views CBDC as a substitute for existing central bank reserves, it would be held and transacted only by banks, referred to as a wholesale CBDC. There can sometimes be confusion between these two forms of CBDC. 

Public sentiment in several countries has turned somewhat negative on the concept of a retail CBDC, citing concerns over government control and privacy issues. In his recent Executive Order entitled "Strengthening American Leadership in Digital Financial Technology," President Trump prohibits “any actions to establish, issue, or promote CBDCs within the United States”.

This order defines CBDC rather broadly – the definition includes over 3 trillion US dollars of existing reserve balances that are digital liabilities of the central bank – and will likely be revised. It is possible that the order will ultimately apply only to retail CBDC, allowing the Fed to continue pursuing wholesale tokenized central bank money to improve financial market infrastructures.

A notable example is the European Union, which is moving forward with its plans for a digital euro. Christine Lagarde argues that a digital euro could reduce Europe’s reliance on external payment networks and make it more financially resilient.

Time will tell. The current proposal involves restrictions on how much people can hold (merchants can hold zero), it doesn’t pay any interest, and it does not provide the level of privacy some might prefer. There are reasons why these conditions are imposed, but if the digital euro does not dominate other forms of money from the public’s perspective, adoption by some groups may be limited.