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PRACTICAL-10
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TITLE: Case Study on Cryptocurrency

THEORY:

Introduction
A cryptocurrency is a digital currency created and controlled by advanced
encryption methods known as cryptography. With Bitcoin's creation in 2009,
cryptocurrency leaped from being an academic idea to reality. From $83 billion in June
2017 to approximately $300 billion by June 2018, all cryptocurrencies' total market
capitalization rose within one year (Coinmarketcap, 2018). One of the primary reasons’
cryptocurrencies got a lot of media attention was this massive increase in market
capitalization. So, will these alternative currencies eventually replace conventional
currencies and one day become as pervasive as dollars and euros? Or are cryptocurrencies a
fad that will flame out for a long time to come?

Background of the Study

Blockchain

A blockchain is a chain of information blocks that register transactions; there is a

strict set of rules that govern how to verify the blocks' validity and ensure that the blocks
are not altered or disappear (Zhao, Fan, & Yan, 2016). A centralized transaction ledger
(hereafter referred to as the ledger) is used by centralized financial institutions such as
banks, where all transactions of a particular bank are recorded. Each bank typically has its
ledger, and it has to be recorded in both ledgers when a transaction is made from one bank
to another. With one significant difference, a blockchain is the same, and it is stored
decentralized. This implies that the same ledger is used by many participants in a network,
people, or institutions, and every participant has the opportunity to host the blockchain
ledger

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Cryptocurrency

Cryptocurrencies are digital solutions to traditional paper money issued by the

government. Cryptography is used to ensure that transactions are secure, prevent users from
spending more than once on the same balance, and regulate the provision of circulating
digital notes. Some cryptocurrencies are decentralized, enabling, and making it difficult for
governments to handle quasi-anonymous transactions. Also, cryptocurrencies' electronic
nature means that they are relatively simple to use across international borders (Luther,
2016). In 2008, a white paper appeared on the Internet with the title Bitcoin: A Peer-to-Peer
Electronic Cash System by a computer programmer using the pseudonym Satoshi Nakamoto
(Nakamoto, 2008).

A whitepaper is a document containing all the information about a solution, product,

or service necessary. Its primary purpose is to promote this 24/7 solution. The ledger will
update itself automatically to the newest version when connected, including all transactions
that have ever occurred on the network. Because of this blockchain ledger, it is possible to
replace trusted third parties that process, validate, protect, and preserve electronic
transactions with blockchain ledgers (Dinu, 2014). And it can be seen as a marketing and
sales document used before the point of sale (Investopedia, 2018). Since then, Bitcoin's
popularity has steadily grown, and its underlying technology has found numerous areas of
applications beyond finance in the blockchain. Cryptocurrencies are generated by individuals,
groups, or entities and not by governments such as Fiat (US-Dollar, Euro, CHF).

Areas of Consideration
When the Internet came of age twenty years ago, a group of prominent economists
and central bankers wondered if advances in information technology would make central
banks obsolete (King, 1999). The rise of cryptocurrencies has rekindled the debate, although
those predictions have not yet come to pass. Such assets may one day serve as alternative
means of payment and, possibly, account units that would reduce demand for fiat currencies
or money from central banks. It is time to re-examine the question: will monetary policy
remain efficient in a world without money from central banks (Woodford, 2000)

Addressing deficiencies

Cryptocurrencies are too volatile and too risky for the time being to pose much of a
threat to fiat currencies. Moreover, they do not enjoy the same degree of confidence that
citizens have in fiat currencies: they have suffered from notorious fraud cases, security
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breaches, and operational failures. They have been linked to illegal activities. But some of
these deficiencies may be addressed by continued technological innovation. Central banks
need to continue implementing effective monetary policies to fend off potential competitive
pressure from cryptocurrencies. They can also learn from the characteristics of
cryptocurrencies and the underlying technology and make the digital age more attractive to
fiat currencies.

Deflation risk

In principle, specific cryptocurrencies, such as Bitcoin, have limited inflation risk

because supply is limited. However, three critical functions that are expected to be fulfilled
by stable monetary regimes are lacking: protection against the risk of structural deflation, the
ability to react flexibly to temporary shocks to the demand for money and thus to smooth the
business cycle, and the ability to act as a lender of last resort.

Payment shift

More generally, the increase in cryptocurrencies and broader adoption of distributed

ledger technologies can lead to a shift from an account-based payment system to a value-
based or token-based payment system (He and others 2017). In account-based systems, an
intermediary's transfer of claims is recorded, such as a bank, in an account. Value- or token-
based systems, on the other hand, involve the transfer of a payment item, such as a
commodity or paper currency. If it is possible to verify the value or authenticity of the
payment object, the transaction may proceed irrespective of the intermediary or
counterparty's trust.

Such a shift could also bring about a change in how money is generated in the digital age: we
can move full circle back to where we were in the Renaissance, from credit money to
commodity money! Money was mainly based on credit relationships in the 20th century:
central bank money, or base money, is a credit relationship between the central bank and
citizens (in the case of cash) and between the central bank and commercial banks (in the case
of reserves). A credit relationship between the bank and its customers represents commercial
bank money (demand deposits). In contrast, cryptocurrencies are not based on any credit
relationship, are not liabilities of any entity, and in nature are more like commodity money.
Pros

• Lower transaction costs

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o It could lead to a reduction in the cost of retail transactions and institutional

payments.

• Economic growth and digital innovation

o In addition to increasing economic activity, becoming a favorable digital

currency jurisdiction and creating an attractive crypto ecosystem could
generate spillover effects in other technology sectors.
• Financial inclusion

o It could improve the access of unbanked households to digital payments.

Because some customers do not have a bank account, a prerequisite for using
existing digital payment tools, a CBDC could access these tools at minimal or
zero cost (Gnan and Masciandaro, 2018).
• Trailblazer position

o A country could position itself as a pioneer in defining monetary policy for

CBDCs and setting applicable standards for years to come if it acts quickly on
a CBDC.
• Cheap, safe value storage

o A CBDC is potentially cheaper than cash because it avoids the cost of

production and storage, transport, disposal, etc. Likewise, distribution is safer
and could minimize fraud in the payment ecosystem (Gnan and Masciandaro,
2018).
• Technology efficiency

o The lack of reliance on intermediaries such as banks and the CBDC could
improve settlement speed and allow real-time payments (Wadsworth, 2018).

o It could increase competition in payment systems and require innovation from

private actors; simultaneously, it could lead to increased competition between
banks to attract bank deposits on assets that could otherwise migrate to CBDC.
• Monetary policy transmission

o If it was interest-bearing, which would allow for more direct control of the
money supply, the CBDC could be used as an explicit monetary policy tool
(Wadsworth, 2018).
• Liquidity

o It enables central banks to provide short-term liquidity assistance, including on

bank holidays, which effectively reduces the risk of systemically triggering
chain reactions by individual institutions.
• Increased privacy

o A conventional digital currency could provide more anonymity than current

commercial bank card payments.

Cons
• Cryptocurrencies that have no connection to a conventional currency have a high

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price volatility level and are therefore subject to speculation (Maechler, 2018).

• Increased risk of system-wide bank runs

o Such bank runs in financial crises are potentially much faster and independent
of geographical proximity and time, as a risk to financial stability
(Olsen,2018).
• Competition for commercial banks

o The introduction of a near replacement for bank deposits could encourage

banks to increase deposit rates and lead to a shift from deposit financing to
wholesale financing (Olsen, 2018).
• Geographic limitations

o CBDCs are only accepted in the country where they were issued (Wadsworth,
2018).

Conclusion
In conclusion, central banks should continue to strive to make better and more stable
account units for fiat currencies. Monetary policymaking can also benefit from technology:

through the use of big data, artificial intelligence, and machine learning, central banks will
likely be able to improve their economic forecasts.

Next, to avoid regulatory arbitrage, government authorities should regulate the use of
cryptocurrencies, and any unfair competitive advantage cryptocurrencies can derive from
lighter regulation. This means the rigorous application of measures to prevent money
laundering and terrorist financing, strengthening consumer protection, and the effective
taxation of cryptographic transactions.

Then, for use as a settlement vehicle, central banks should continue making their
money attractive. For instance, by issuing digital tokens of their own to supplement physical
cash and bank reserves, they could make central bank money user-friendly in the digital
world. Such central bank digital currencies could be exchanged in a decentralized way, peer
to peer, much like cryptocurrencies are.

Recommendation
The digital currency of central banks could help counter the monopoly power
conferred on private payment networks by strong network externalities. It could help reduce
the cost of transactions for individuals and small businesses with little or expensive access to
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banking services and make long-distance transactions possible. A digital currency, unlike
cash, would not be limited in its number of denominations.

The interest-bearing digital currency of the central bank would help, from a monetary
policy perspective, transmit the policy interest rate to the rest of the economy as demand for
reserves decreases. Using these currencies would also help central banks to continue to earn
revenue from the issuance of currencies, enabling them to continue financing their operations
and distributing profits to governments. Seigniorage is the primary income source for central
banks in many emerging markets and developing economies and an essential safeguard for
their independence.

Of course, there are decisions and policy trade-offs that would require careful
consideration when it comes to designing the digital currency of the central bank, including
how to avoid any additional risk of bank runs caused by digital cash convenience. More
broadly, depending on circumstances, such as the degree of financial and technological
development, views on the balance of benefits and risks are likely to differ from country to
country.

For central banks in the digital age, there are both challenges and opportunities. In the
digital, sharing, and decentralized service economy, central banks must maintain the public's
trust in fiat currencies and remain in the game. By providing more stable account units than
cryptocurrencies and making central bank money attractive as a medium of exchange in the
digital economy, they can remain relevant.

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