Central Banks Are Exploring Blockchain — but for Their Own Reasons

Published at: March 8, 2020

Despite the interest shown in decentralized ledger technology by central banks, cryptocurrencies continue to be mistrusted by the traditional financial system. This has been made apparent from comments by Andrew Bailey, the upcoming governor of the Bank of England, when addressing members of the United Kingdom Parliament at a Treasury Select Committee hearing on March 4. He stated: “If you want to buy Bitcoin, be prepared to lose all your money… [Bitcoin] has no intrinsic value.”

Despite this, seemingly convoluted efforts to “appropriate” the technology like the launch of the Venezuelan Petro and talks of centralized Central Bank Digital Currencies show that the technology is still either severely misunderstood or that it is considered a threat by the current status quo. Nevertheless, there is still a genuine effort to see the technology applied in a meaningful way while cryptocurrencies continue to establish themselves in the financial sector.

CBDCs: Are they useless?

CBDCs have recently become one of the trendiest subjects in the crypto sphere. The BIS Quarterly Review, published earlier this week, shows that at least 17 governments around the world are exploring the potential uses of CBDCs. For example, earlier this year, the president of the European Central Bank, Christine Lagarde, publicly announced the active involvement in the development of a central bank digital currency in a bid to address the demand for faster and cheaper cross-border payments.

However, the aforementioned report also shows that cross-border payments are not a priority in any of the projects currently underway and that a CBDC would also not address the lack of access to transitional accounts. These two major shortcomings of emerging markets and developing economies — where cryptocurrencies have become a way to escape inflation and economic instability — are often caused by or assisted by central banks.

These efforts also seem to overlook the real value of blockchain technology, its decentralized, immutable and (optional) transparent nature. Centralized payment systems are known for being faster and more scalable than cryptocurrencies like Bitcoin (BTC) due to the way transactions are processed and registered. The BIC Report reads:

“The overhead needed to operate a consensus mechanism is the main reason why DLTs have lower transaction throughput than conventional architectures. Specifically, these limits imply that current DLT could not be used for the direct CBDC except in very small jurisdictions, given the probable volume of data throughput.”

Despite exploring different types of architectures for the creation of a CBDC, there is always some level of centralization that goes against the core values of Bitcoin and cryptocurrencies: decentralization and immutability. The report also mentions: “The central bank is, by definition, the only party issuing and redeeming CBDC.” Arwen Smit, lead blockchain strategist at MintBit, told Cointelegraph on the sidelines of the London Blockchain Week that:

“CBDC's could very well become potentially a tool for governments to assert control on crypto. It's definitely part of the reason why these central banks are looking at it. So, that can go two ways: either the government would do it purely to assert control or to make cryptos fall in line with the future monetary policy and also grant legitimacy to these new forms of private money.”

She went on to add that creating a new digital currency will allow to embed value systems and privacy considerations in this particular currency. In turn, this would mean that everyone who uses or is exposed to that currency automatically accepts those assumptions.

Moreover, while DLT is currently being studied as an option for CBDC development, a different kind of technology may be leveraged. Blockchain technology, or something closely related, may still be used, but decentralization of transaction processing and verification is not bound to happen, which means transfers would not offer the censorless and anonymous features associated with cryptocurrencies. The report states:

“Overall, one needs to weigh carefully the costs and benefits of using DLT. This technology essentially outsources to external validators the authority to adjust claims on the central bank balance sheet, which is advantageous only if one trusts this network to operate more reliably than the central bank. Ongoing assessments of DLT-based proofs-of-concept tend to be negative.”

The history between traditional finance and crypto

Although the traditional financial world has acknowledged the potential behind blockchain technology, some have quickly dismissed cryptocurrencies due to their decentralized and anonymous, or pseudonymous, nature.

Bitcoin has oftentimes been criticized by its association with criminal activity, high volatility and speculation, as well as its lack of regulatory oversight. In short, it is often seen as just another tech fad and/or bubble, and it has also been reported “dead” too many times to count — a testament of how strongly certain individuals and groups wish for Bitcoin's demise.

Regardless of what the cryptocurrency world has endured, it continues to make progress in all of the fields where it has been criticized. Lately, several financial institutions have begun to recognize the benefits of distributed ledger technologies and are looking into incorporating them in their businesses — as shown by State Street’s announcement of a partnership with Gemini for a “new digital asset pilot” and a partnership announced by IBM with several international banks to allow the issuance of stablecoins.

Institutional demand for cryptocurrencies as a hedge against economic instability has also been growing. One of the largest companies in the world, Facebook, tried to launch its own cryptocurrency, Libra, only to be shut down by regulators. IBM, Walmart, Visa and the Bank of America now possess dozens of blockchain patents but have yet to implement them in any meaningful way. Many argue about the usefulness of amassing patents of a technology that was intended to be open-source from the beginning.

For the last few years, crypto has been knocking at the door of the financial market, but the door still remains closed. A sigh of relief echoes among most financial regulators every time the Securities and Exchange Commission rejects yet another Bitcoin Exchange Traded Fund proposal. Although SEC rejections have become typical, reactions within the commission itself are starting to change. Recently, one of the SEC’s commissioners, Hester Peirce, criticized the commission for Wilshire Phoenix’s Bitcoin ETF application.

Threatening the status quo

For some people, cryptocurrencies have offered a way out and a means to hold and transact value outside of the traditional financial system. Although some nations have chosen to embrace crypto, not all countries are crypto-friendly.

Some governments have chosen to implement either restrictions or outright bans against the cryptocurrencies, including last year's crackdown of crypto exchanges by the People’s Bank of China. Regulatory oversight is, of course, not necessarily a bad thing. However, the recent crackdowns on initial coin offerings in several countries were certainly a much-needed improvement after several huge scams were uncovered.

Despite attempts to sway people from using crypto, several new technologies are being developed that threaten the status quo. One representative of the Bank of England, Jon Cunliffe, has recently stated that “the emergence of a cryptocurrency economy may weaken or eliminate bank credit issuance.” Cunliffe shared his concerns about stablecoins in specific, stating that social media platforms adopting stablecoins may lead to users taking money held with banks and placing it into stablecoin wallets.

This type of scenario was just one of the reasons why financial regulators decided to take a hard stance against Libra. It would have been a large step in adoption if Libra were launched and exposed to Facebook’s user base, potentially making cross border payments faster and cheaper while also helping with financial inclusion to millions of unbanked individuals — which is one of the main concerns expressed in the aforementioned BIS Quarterly Report.

Moreover, decentralized finance is shaping up to become a threat to all traditional financial service providers. It allows individuals to access transparent lending, borrowing and other services like decentralized stablecoins and betting markets. DeFi is showing tremendous growth, recently breaking the barrier of over $1 billion in value locked in DeFi markets. What’s more, it is also creating space for new financial services while contributing to financial inclusion and transparency.

Is the gap between traditional finance and crypto closing?

Despite the love/hate relationship, the gap between crypto and traditional finance has narrowed. Regulation seems to be catching up to the technology throughout the world, and the launch of regulated financial instruments and innovative DeFi solutions has been drawing attention from institutional investors.

Tokenization has also become a popular buzzword in finance, as corporations seek to tokenize their securities by using blockchain technology with the aim of altering clearing and settlement processes and lowering the $17–27 billion spent on trade processing annually. While most tokenized securities have been issued on private blockchains, these systems are less centralized than the current standard while still in compliance with regulation.

There are also examples of security tokens being issued on decentralized blockchains, such as the first covered bonds issued by the Societe Generale on the Ethereum blockchain. Central banks and private institutions have also been experimenting with tokens for payment and security settling. Examples include proposals like the JPM Coin by JPMorgan Chase and the Utility Settlement Coin (USC) is a proposal by Finality International.

Decentralized stablecoins are also acting as a bridge between these two worlds, providing a more recognizable entryway into crypto and allowing users to leverage the best of the technology without being exposed to volatility. Crypto is also becoming easier to use thanks to alternative banking apps that make crypto payments and transfers intuitive while providing banking services like loans and savings accounts.

Yet, crypto still has a long way to go, and it is merely a drop in the ocean when compared to the size of our current financial system. Bitcoin’s market cap is around 4.3% of the United States dollar, according to figures from the St. Louis Federal Reserve. Moreover, the crypto space is also small compared to the overall investment market.

Interview with Arwen Smit was conducted by Joseph Birch during the London Blockchain Week.