In their present form, cryptocurrencies are unlikely to become widely used in the consumer payments system. This is the view of the Bank for International Settlements, which says cryptocurrency technology is inefficient, its decentralised structure is “fragile”, and it cannot be “scaled” like a sovereign currency.
The BIS is a co-ordinating body for the world’s central banks. In a paper issued last week, it analysed cryptocurrency’s potential for use in day-to-day transactions. It found a number of problems that would have to be overcome before digital currencies could play such a role.
“A key limitation in terms of efficiency is the enormous cost of generating decentralised trust. Individual facilities operated by miners can host computing power equivalent to that of millions of personal computers,” the BIS says.
Cryptocurrencies do not scale like sovereign moneys. To live up to their promise of decentralised trust, each and every user must download and verify the history of all transactions ever made. To keep the ledger’s size manageable cryptocurrencies have limits on the throughput of transactions.
With capacity capped, fees soar whenever transaction demand reaches the capacity limit. And transactions have at times remained in a queue for several hours, interrupting the payment process.
“This limits cryptocurrencies’ usefulness for day-to-day transactions, such as paying for a cup of coffee. The more people use a cryptocurrecy, the more cumbersome payments become,” the report says
Money is a measure of value, a store of value and a medium of exchange. To fulfil these functions money needs to have the same value in different places and keep a stable value over time. Another key issue with cryptocurrencies is their unstable value.
“Maintaining trust in the institutional arrangements through which money is supplied has been the biggest challenge. Trust has failed frequently in history,” the BIS says.
The quest for a solid institutional underpinning for trust in money has led to the emergence of today’s central banks, working with private banks. Central banks supervise and, in some cases, provide payment infrastructure. They ensure that payment systems operate smoothly, are safe, cost-effective and scalable
The volume of payments in economies is huge and a system that can expand to meet demand without an increase in cost is important for buyers and sellers. “The institutional arrangements through which money is supplied matter a great deal,” the BIS says.
“Trust in cryptocurrencies can evaporate at any time because of the fragility of the decentralised consensus through which transactions are recorded. Not only does this call into question the finality of individual payments, it also means that a cryptocurrency can simply stop functioning, resulting in the complete loss of value.”
Cryptocurrenies have three elements: a set of rules, or protocol, that specifies how participants can transact; a ledger storing the history of transactions; and a decentralised network of participants who update, store and read the ledger of transactions.
They are akin to commodity currencies in that their value derives only from the expectation that they will continue to be accepted by others, the BIS says
The distinguishing feature is digital peer-to-peer exchange. The challenge with digital peer-to-peer exchange is the so-called “double spending problem”. Any digital form of currency is easily replicable and thus can be fraudulently spent more than once.
Solving the double-spending problem requires that someone keep a record of all transactions. Prior to cryptocurrencies, the only solution was to have a centralized agent verify all transactions.
Cryptocurrencies overcame the double-spending problem via decentralized record keeping, through the distributed ledger. An up-to-date copy of the entire ledger is stored by each user. Each user can verify whether a transfer took place and that there was no attempt to double-spend. The blockchain is a type of distributed ledger.