Crypto currencies and conventional currencies will both evolve

Business Standard, 22 February 2021

Crypto-currencies are coming together as alternative forms of money, as ways to get transactions done, representing a different set of tradeoffs compared with the traditional forms of money or gold. Today's crypto-currencies have flaws, but they are an early stage release, and the scientists will make them better in time. The makers of traditional money should look at the feature set of crypto currencies and consider improving their offerings. These developments have implications for individuals, firms and governments.

The consideration of a transaction can be transmitted in many different ways. The world has seen gold, currencies backed by gold and currencies backed by nothing. Into this mix, we now have crypto currencies, the attempt at establishing cold mathematics and algorithms through which currencies can work without the involvement of a state.

Today's crypto currencies have numerous flaws. As an example, bitcoin wastes a lot of electricity. However, with a market capitalisation of $1 trillion, there is ample incentive for scientific innovation which will overcome these problems. It is likely that in some years, there will be many improvements in the algorithms. We should zoom out of the immediate situation and think at a more strategic level, about the forces which will shape this story.

While some states are a little irritated about these developments, more competition is generally helpful. It is useful to take two steps back and think of the difficulties of state-backed currency, which have created the market opportunity for crypto currency. Crypto currency might never have been invented, if conventional money had not had certain difficulties. Each of these elements can be a part of the competitive response by state-backed currencies.

Loss of value
When wealth is stored in cash, inflation induces a loss of value. Inflation comes in two kinds, anticipated and unanticipated. Crypto currencies have established algorithmic foundations which promise that in steady state there will be price stability; they do not depend on the frailty of human institutions. Conventional money has long been working on this problem. From the late 1980s onwards, central banks worldwide have introduced inflation targeting, and evolved monetary policy committee structures which disperse power. Right now, inflation does not seem like a serious problem worldwide, so this is not an important competitive advantage for crypto currencies. But at a future date, if some central banks falter on their commitment to low and stable inflation, this would influence market share.
A good currency enjoys the network effect of acceptance. Obscure crypto currencies are almost universally not accepted in transactions. Bitcoin and the INR have limited acceptance, and the USD has high acceptance.
States have built mass surveillance systems through which all electronic transactions conducted with conventional money are logged. Humans desire greater privacy. Right now, cash and gold has the most privacy. There is potential for reduced state legibility on both sides. Crypto currencies will develop frameworks for increased privacy, and constitutional checks against mass surveillance systems could generate reduced intrusions into uses of conventional money.
Credit risk and technology barriers
With conventional money, eliminating credit risk in transactions requires access to a current account with the central bank. When this is restricted, users suffer the credit risk and fees of banks. In India, private persons are forced into central planning schemes such as NPCI and UPI. Crypto currencies are free of these problems. Conventional money could respond to this competitive pressure by opening up access to current accounts with the central bank.
Capital controls
In some countries, holding conventional money introduces difficulties with capital controls. Crypto currencies are like gold, in that it becomes possible to avoid the limitations imposed by capital controls. Conventional money can become more attractive by scaling back capital controls.

The landscape is a competitive environment where crypto currencies are an alternative to conventional money. On one hand, crypto currencies have work to do on fixing their foundations and getting better at becoming a useful frictionless money. In parallel, conventional money will not sit still. States will respond to the $1 trillion milestone by reducing the fear of loss of value through better inflation targeting, scaling back the mass surveillance system on financial transactions, emphasising their edge in transacting through cash, opening up access to current accounts at the central bank and scaling back capital controls.

At the start of aviation, every country had an airline. Over the years, only some airlines survived, and the bulk of activity shifted to the 25 main airlines of the world. In similar fashion, over a decade, perhaps the market for currencies will coalesce into 25 choices. The countries which have greater capacity for intellectual analysis, and the ability to translate diagnosed problems into commensurate monetary/financial reform, will end up with currencies that remain important. The ministries of finance of these countries will be rewarded with seigniorage revenues.

Crypto currencies have induced bellicose responses from many in the Indian state. This genie will not, however, go back into the bottle. It is useful to recall that the Indian state tried to ban imports of gold, and after decades of trying to clamp down on smuggling, had to accept free purchases of gold by households, a cash-like status for gold in transactions and de facto capital account convertibility in the form of free imports of gold.

Many in India are coming closer to the tipping point where it will become important to keep track of what is going on in the crypto currency space and think about how it could impact on their activities. For individuals and firms, crypto currency will open up new concepts in transactions and holding liquid balances. For financial firms, crypto currency will become more important as users will demand associated financial services. For the Indian IT industry, there will be export-oriented IT services work which will require familiarity with contemporary tools and concepts. For an analogy, if mobile phones were banned in India, Indian engineers would find it more difficult to build software for mobile phones for the global market. Finally, there are possibilities for Indian scientists and firms to innovate on a global scale, i.e. for crypto-currency related innovation to take place in India.

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