Cryptos and a CBDC are not the same thing

The central bank should note that a central bank digital currency can only be a fiat currency and not a cryptocurrency.

The central bank should note that a central bank digital currency can only be a fiat currency and not a cryptocurrency.

The use of cryptocurrencies will be discouraged through tax and capital gains provisions. This was the message of the Minister of Finance during the discussion of the Budget in Parliament. Will this reduce the growing use of crypto in India? Russian kleptocrats have been using crypto to escape sanctions. Ukraine has been a hub for cryptocurrency trading due to its lax rules and is using it to raise funds for its war with Russia.

The governor of the Reserve Bank of India, in February, highlighted two things. First, “private cryptocurrencies are a huge threat to our financial and macroeconomic stability.” Second, “these cryptocurrencies do not have any underlying (asset)… not even a tulip.” Shortly after, a deputy governor of the RBI called cryptocurrencies worse than a Ponzi scheme and argued against “legitimizing” them. However, the RBI announced that it will float a Central Bank Digital Currency (CBDC). How do we understand all this? The Supreme Court of India has also asked the Government whether cryptocurrencies are legal or not.

The governor who calls cryptos as cryptocurrencies has unintentionally identified them as a currency. Clearly, the RBI’s statements indicate a growing concern as the proliferation of crypto threatens the RBI’s place in the economy’s financial system. This threat arises from the decentralized nature of cryptos based on blockchain technology that cannot be regulated by central banks and that allows entrepreneurial private entities (such as Satoshi Nakamoto, who started Bitcoins in 2009) to float cryptos that can function as assets and money. .

Cryptocurrencies operating through the network can only be banned if all nations come together. Even then, tax havens may allow cryptocurrencies to work, defying the global agreement. They have been facilitating capital flight and illegality despite pressure from powerful nations. The genie is out of the bottle. The total valuation of cryptocurrencies recently surpassed $2 trillion, more than the value of gold worldwide.

crypto as currency

A CBDC will not solve the RBI problem as it can only be a fiat currency and not a crypto. However, cryptocurrencies can function like money. This difference needs to be understood.

A coin is a token used in market transactions. Historically, commodities (such as copper coins) have been used as tokens, as they are valuable. But paper money is useless until the government declares it to be fiat currency. Only then does everyone accept it at the value printed on it.

So paper money derives its value from state backing. Cryptos are a string of numbers in a computer program and are even more useless. And there is no state support. So how do they become acceptable as tokens for exchange? Their acceptability to the wealthy allows them to act like money. Paintings with little use value have high appraisals because the rich accept it. It is similar for cryptos.

Bitcoin, the most prominent crypto, has been designed to become expensive. Their total number is limited to 21 million and it progressively requires more and more computing power and energy to produce (which is called mining, like gold). As the cost of producing bitcoin increases, its price also increases. This has led to speculative investments driving up the price and attracting more investors. Therefore, since 2009, despite the great fluctuation in prices, they have generated high returns, which makes speculation successful.

Unlike tulipomania

The RBI Governor’s statement that cryptocurrencies have no underlying asset, not even a tulip, refers to the time when tulip prices rose sharply before collapsing. But tulips cannot be used as tokens, while cryptocurrencies can be used over the Internet. Also, the supply of tulips can expand rapidly as their price increases, while the number of Bitcoins is limited.

Then the cryptocurrencies acquire value and transactions can be carried out through the network. This allows them to function as money. It is true that bitcoins are difficult to use, but there are other simpler cryptocurrencies available.

The different degrees of difficulty underlying cryptocurrencies relate to the “double spending” problem. Fiat currency has the property that, once spent, it cannot be spent again except by counterfeiting, because it is no longer with the spender. But, the software on a computer can be used repeatedly.

Blockchain and encryption have solved the problem by designing protocols like ‘proof of work’ and ‘proof of stake’. They allow the use of cryptos for transactions. While the first protocol is difficult, the second is simpler but prone to hacking and fraud. Today, there are thousands of different types of cryptocurrencies; Bitcoin as Cryptos, Alt Coins and Stablecoins.

CBDC, unlike crypto

Blockchain enables decentralization. That is, everyone on the crypto platform has something to say. But, the central banks would not want that. Furthermore, they would want a fiat currency to be issued and controlled exclusively by them. But, in theory, everyone can ‘mine’ and create crypto. Therefore, for the CBDC to have central control, it seems impossible to solve the “double spending” problem and be a cryptocurrency (not just a digital version of currency).

A centralized CBDC will require the RBI to validate each transaction, something it does not currently do. Once a note is issued, the RBI does not track its use in transactions. Keeping track of it will be terribly complex, which could render a crypto like CBDC unusable unless new secure protocols are devised. Not surprisingly, Kristalina Georgieva, Managing Director of the International Monetary Fund, said earlier this year: “In total, around 100 countries are exploring CBDCs at one level or another. Some research, some testing, and some already distributing CBDC to the public… Unsurprisingly, the IMF is deeply involved in this issue, including providing technical assistance to many members.”

Therefore, CBDCs today cannot be a substitute for cryptocurrencies that will soon start to be used as money. This will affect the functioning of central banks and commercial banks. Furthermore, a cryptocurrency ban requires global coordination, which seems unlikely. Ms. Georgieva has said: “The history of money is entering a new chapter”. The RBI needs to heed this caution and not be defensive.

Arun Kumar is Malcolm Adiseshiah Professor, Institute of Social Sciences and author of ‘Indian Economy’s Greatest Crisis: Impact of the Coronavirus and the Road Ahead’, 2020