This is the second part to Mark McKenzie’s article, originally published on 3 May 2019.
The Quest for Speed
The BIS Quarterly Review, March 2017 noted that speed of retail payments is now immediate in some countries thanks to improvements in information and communication technologies, including the ubiquity of smartphones and the internet. Fast payments provide retail funds transfer “in which the transmission of the payment message and the availability of ‘final’ funds to the payee occur in real-time or near real-time on as near to a 24/7 basis”. Further, this feature focuses on open systems, where end users can use any number of intermediaries, such as payment service providers (PSPs) and banks, to access the payment system. The EU’s Second Payment Services Directive (PSD2) is a good example of public policy that is driving changes in payments in Europe. PSD2 requires banks to open up their systems to third-party payment services providers (TPPs) for account information, payment initiation and confirmation of funds via open application program interfaces (APIs).
Against this background Auer’s paper on the economic finality of bitcoin transaction is important as it implicitly points back to centralisation and institutional backing. He found that the Bitcoin protocol has severe limitations, and this has implications for the road ahead and the outlook for Bitcoin and related cryptocurrencies. The analysis in the BIS Working Paper shows that Bitcoin’s liquidity will fall substantially in the years to come in the absence of relevant technological advances. One needs to keep in mind that, together with self-calibrating difficulty, proof-of-work becomes a deeply economic concept that ultimately proves that a certain amount of real resources has been used for computations. This amount is insensitive to general technological progress by its very design. And with block rewards – which, at present, represent the vast majority of miners’ income and thus underpin the security of payments – being gradually phased out, the security of payments is also set to deteriorate.
While Auer argued that second-layer solutions such a “Lightning Network” can improve the economics of payment security he noted some concerns. The Lightning Network essentially aim to add liquid methods of exchange on top of the Bitcoin blockchain. It opens up some new options for cryptocurrencies by theoretically allowing bilateral transactions to be final before a block is added to the blockchain. Given that the transactions occur in separate bilateral contracts this might reduce the cost of decentralised exchange, and consequently, do not directly require proof-of-work security. It is unclear, however, whether second-layer solutions can themselves scale. There are concerns relating to the technical complexity requirements to deter potential attacks on this specific architecture and whether all participants need to be online all the time for payments to be a routable. In addition, there is concern relating to economic network theory on the trade-off between efficiency and centralisation. If the Lightning Network remains truly distributed, it would require substantial pre-funding.
Institutionalization and Central Banks
The tried, trusted and resilient way to provide confidence in money in modern times is the independent central bank. This means agreed goals: clear monetary policy and financial stability objectives; operational, instrument and administrative independence; and democratic accountability, so as to ensure broad-based political support and legitimacy. Independent central banks have largely achieved the goal of safeguarding society’s economic and political interest in a stable currency. With this setup, money can be accurately defined as an “indispensable social convention backed by an accountable institution within the state that enjoys public trust”.
As part of fulfilling their mandate to maintain a stable unit of account and means of payment, central banks take an active role in supervising, overseeing and in some cases providing the payments infrastructure for their currency. The central bank’s role includes ensuring that the payment system operates smoothly and seeing to it that the supply of reserves responds appropriately to shifting demand, including at intraday frequency, i.e., ensuring an elastic money supply. Thanks to the active involvement of central banks, today’s diverse payment systems have achieved safety, cost-effectiveness, scalability and trust that a payment, once made, is final.
Payment systems are safe and cost-effective, handling high volumes and accommodating rapid growth with hardly any abuse and at low costs. An important contributor to safety and cost-effectiveness is scalability. In today’s sophisticated economies, the volume of payments is huge, equal to many multiples of GDP. Despite these large volumes, expanding use of the instrument does not lead to a proportional increase in costs. This is important, since an essential feature of any successful money and payment system is how widely used it is by both buyers and sellers: the more others connect to a particular payment system, the greater one’s own incentive to use it.
Users not only need to have trust in money itself, they also need to trust that a payment will take place promptly and smoothly. A desirable operational attribute is thus certainty of payment (“finality”) and the related ability to contest transactions that may have been incorrectly executed. Finality requires that the system be largely free of fraud and operational risks, at the level of both individual transactions and the system as a whole. Strong oversight and central bank accountability both help to support finality and hence trust. While most modern-day transactions occur through means ultimately supported by central banks, over time a wide range of public and private payment means has emerged.
In the aftermath of the 2008 Great Financial Crisis (GFC) Bitcoin and its underlying technology, blockchain erupted on the scene, and almost instantly viewed as potential game-changer in banking and finance. Today there is doubt about its future. There are media reports of mining operations either closing because it is uneconomical for them or laying off workers to compensate for financial losses due to the bearish market. The narrative is similar when it comes to crypto exchanges closing and going out of business. For example, Liqui, Ukrainian exchange recently announced that it would close down its operations stating that it was unable to provide liquidity to its customers, and therefore had no economic reason to continue its services. Imminent regulation may be playing a huge role in the current state of affairs in the nascent crypto space. Increased scrutiny may have a led to the failure of many ICO projects that were fuel or life-blood for the small crypto exchanges.
The bearish market and imminent regulation may be contributing to the fading of the allure of Bitcoin and other cryptocurrencies, and consequently we may be seeing a separation the men from the boys. Without a doubt Bitcoin has had a long history of infamy and volatility, and its survivability is a bit of marvel.
A decade after Satoshi Nakamoto’s white paper we are now seeing more and more academic and research papers relating to Bitcoin that are quite critical, terse and incisive. Auer in his analysis noted that fiat money is likely to remain a social construct rather than a purely technological one. For a start, the efficiency of decentralised exchange via proof-of-work exclusively is much lower than would appear at first start. In addition, alternative technologies such as Capser protocol for Ethereum’s proof-of-stake still need to demonstrate that they can function with institutional backing.
Auer is not alone. Claudio Borio, Head of the BIS Monetary and Economic Department, also noted that the present system with central banks and a regulatory/supervisory apparatus at its core is far from perfect. Yet, cryptocurrencies, with their promise of fully decentralised trust, is not a panacea for the ills of the present system. We will still need strong and independent regulatory and supervisory apparatus to safeguard financial stability. More importantly, in the event of financial crisis, we will need an authority capable of providing emergency liquidity assistance, and such authority should be capable of taking on enormous risk and possess implausible immunity to conflicts of interest.
Bitcoin and other cryptocurrencies are facing a formidable uphill battle.
Auer, Raphael “Beyond the doomsday economics of “proof-of-work” in cryptocurrencies” Bank for International Settlements (BIS) Working Papers No 765, January 2019. https://www.bis.org/publ/work765.pdf.
Casey, Michael, Jonah Crane, Gary Gensler, Simon Johnson and Neha Narula “The Impact of Blockchain Technology on Finance: A Catalyst for Change”, International Centre for Monetary and Banking Studies (ICMB), July 2018. https://voxeu.org/content/impact-blockchain-technology-finance-catalyst-change.
Bech, Morten, Yuuki Shimizu and Paul Wong “The quest for speed in payments”, BIS Quarterly Review, March 2017. https://www.bis.org/publ/qtrpdf/r_qt1703g.pdf.
BIS Annual Economic Report 2018 “V. Cryptocurrencies: looking beyond the hype”. https://www.bis.org/publ/arpdf/ar2018e5.pdf.
Borio, Claudio “On money, debt, trust and central banking” Keynote speech delivered at the 36th Annual Monetary Conference, Cato Institute, Washington DC, 15 November 2018. https://www.bis.org/speeches/sp181115.pdf.
Shin, Hyun Song “Cryptocurrencies and the economics of money” Speech delivered BIS Annual General Meeting, Basel, 24 June 2018. https://www.bis.org/speeches/sp180624b.pdf.
Mark McKenzie is a Senior Financial Sector Specialist in the Financial Stability and Supervision & Payment and Settlement Systems pillar at the SEACEN Centre.