Infrastructure related to financial markets and payments has seen considerable activity recently, mainly due to the proliferation of stablecoins and cryptocurrencies, distributed ledger technology, and potential digital currency issued by central banks. Some fascinating advancements have already taken place within this field.
As such, this paper aims to outline various kinds of digital assets, their differences, potential roles for them in the future, and policy implications associated with them today. Hedge funds and households alike appear to think cryptocurrencies hold great promise as an investment vehicle; cryptocurrency-based versions of traditional asset classes such as exchange-traded funds, futures contracts, or even micro futures contracts have also been introduced across different jurisdictions to make smaller investments more accessible; additionally, renowned financial institutions provide access to crypto assets for clients.
Cryptocurrencies, stablecoins and CBDCs
Three primary categories can help organize digital assets or payment instruments that have come to market recently.
Cryptocurrencies
Cryptocurrencies encompass an expansive collection of privately issued digital assets known as cryptocurrencies. Not valued against any sovereign issuer, cryptocurrencies have their own "currency" unit instead. Instead of depending on a single entity to run them, cryptocurrencies use cryptography to record ownership and transaction histories in a distributed digital ledger that syncs across several "nodes" or computers.
While there are thousands of different decentralized cryptocurrency protocols out there - Bitcoin being perhaps the best known - users entrust software protocol governing these currencies, which do not possess intrinsic values themselves nor does any issuer support them directly - cryptocurrency is no different in terms of value than anything issued from traditional assets issued from central governments or support from issuers.
Though all cryptocurrency might imply money, most agree it does not meet all the essential characteristics that define currency - this is why some prefer "crypto-assets." According to many observers, they're rarely accepted or used as payment and their prices fluctuate significantly - all factors which render cryptocurrencies poor stores of value.
Stablecoins
Stablecoins, another new digital asset class, were specifically created to reduce price volatility relative to commonly held units of account (like US dollars ) or stores of value ( such as gold). As part of their effort to emulate money's function in exchange medium or store of value transactions, stablecoin promoters attempt to ensure assets supporting coins stay circulating so the value remains constant; yet legitimacy for such arrangements varied considerably, especially Tether, the largest stablecoin by market capitalization; which recently received an unprecedented US$41 Million fine from US Commodity Futures Trading Commission due making false claims regarding being fully-backed assets by Tether's promoters.
Within this group, it may be helpful to distinguish between three possible broad types of stablecoins:
Most stable coins currently in circulation - including Tether, USD Coin, and Binance USD - fall under this first group. Stablecoins act as intermediary links between cryptocurrency trading and fiat money claims for individuals looking for fiat currency alternatives without leaving the distributed-ledger technology (DLT) ecosystem; additionally, they serve as payment or settlement of transactions involving crypto or tokenized asset trading transactions and can even be released onto open blockchains as store of value options for traders looking for fiat claims without leaving DLT ecosystem.
Some central investment banks are currently proposing stablecoins that fall into the second category: These coins may be intended for more generalized applications within corporate or financial sector operations, including cross-border payments and Treasury operations; their assets might even include central bank deposits.
Thirdly, Diem would be ideal for retail use; Facebook led its development. Merchants or households using Diem coins as regular transfers or payments might find the system similar to an "e-money" or stored-value facility (SVF). However, users likely would care less about its specific ledger technology.
Central Bank Digital Currency
Central bank digital currency, commonly called CBDC, could serve as a claim or liability of central banks and function similarly to an easily accessible cash substitute through phone wallets and smart cards. Wholesale CBDC would only be accessible to smaller groups like settlement accounts at central banks.
CBDC accounts would use sovereign currency as their unit of account - also commonly referred to as fiat currency - just like cash and settlement account balances. Convertibility into other currencies would occur on equal terms with no loss in purchasing power resulting from such conversion. Furthermore, legal tender status might even be granted.
Even though central banks would issue CBDCs, private-sector organizations typically take charge of customer relations when disseminating these to users. While DLT may play an essential part in CBDC implementations (and will reportedly do so for China's planned CBDC), alternative databases (such as MySQL ) could also be employed - something expected by researchers for the success of implementation of such schemes.
Distinguishing Between The New Digital Assets
Digital assets fall into three general categories: cryptocurrencies, stablecoins, and CBDCs. One particular subcategory stands out as being particularly significant. This category includes cryptocurrency.
Denomination and backing: Stablecoins, typically priced in fiat currencies and secured with properties meant to guarantee redeemability at par, to CBDCs that use denominations like fiat money or precious metals and offer complete exchangeability into other forms of money from one end of a spectrum; on the other end lie cryptocurrencies, with their unit without reference to any fiat currency and with no tangible asset backing and therefore any value they might possess is determined solely by what others pay for them.
Governance and technology: While cryptocurrencies usually rely on some consensus-driven process to modify pre existing software protocols for system governance purposes, CBDCs and stablecoins typically enlist centralized (permissioned) governance arrangements and may use different verification processes than their cryptocurrency counterparts: more reliable entities may verify transactions for CBDCs/stablecoins. In contrast, competing entities compete to do the same via "proof of work" mining competitions for verification services in cryptocurrency coins.
Bitcoin remains the most prominent cryptocurrency, with an approximate market valuation of US$1.1 trillion. However, its market capitalization continues to decrease due to stablecoins tied to US dollars and rising interest in tokens connected to blockchains employing "smart contracts," which provide greater functionality than Bitcoin. Regardless, its proportionate share has decreased substantially as stablecoins grow increasingly popular and tokens connected with smart contracts develop their presence among market capitalization figures.
Smart contracts on DLT platforms are self-executing computer programs that automatically perform various tasks for parties using them, like "if, then" clauses enabling parties to enter agreements without needing third-party intermediary trust or mutual commitment between themselves; smart contracts enable new applications ranging from non-fungible tokens (NFTs), decentralized autonomous organizations (DAOs) and decentralized finance (DeFi). Our time constraints only permit us to cover some of them.
Read More: Beyond Bitcoin: Navigating Diverse Digital Tokens and Uses
The Future For Digital Assets?
Prediction is always challenging, especially regarding the future. Niels Bohr, Yogi Berra, and others are widely credited with coining this axiom.
DLT will find applications in the near future, mainly where multiple ledger instances provide significant resilience advantages over having only a centralized ledger instance in operation. There could also be instances in which multiple parties involved with ineffective legacy business processes could all write to one distributed ledger to complete tasks more efficiently and write on this ledger at once - something smart contracts or DeFi can make possible without needing specific tokens for tasks being automated by these ledgers or by themselves in general.
Current cryptocurrencies rely on proof-of-work consensus and public blockchains for transaction verification purposes, so transaction verification can often be probabilistic. A general rule states that it typically takes six blocks (each lasting approximately 10 minutes) before someone receiving Bitcoin can be confident they received it after its inclusion into one; about Ethereum transactions, this period tends to be shorter but still works similarly.
As would be the case for regulated stablecoins or CBDCs, permissioned networks with trusted parties should have the capability of creating far more effective consensus mechanisms to match current delivery-versus-payment (DVP) procedures in the non-tokenized world. This should enable large organizations to feel safe when purchasing or disposing of tokenized assets.
In This Case, What Function Would Digital Cryptocurrencies Serve?
There may be scenarios in which several factors come together to seriously dampen current enthusiasm for cryptocurrency investments, leading to a shift away from speculation and an undoing of recent price increases. Potential factors could include:
- Families may become less vulnerable to being misled by trends and FOMO; instead, they could heed warnings issued by consumer protection organizations and securities regulators worldwide about investing in hazardous products with no support structure or variable value.
- Governments and legislators could become increasingly curious about cryptocurrency mining due to its immense energy consumption. Digiconomists estimate the annualized energy usage for Bitcoin systems to be comparable with that of Thailand, which is currently considered one of the 23rd most potent economies worldwide based on their most up-to-date figures. Though Ethereum will begin transitioning away from proof-of-work consensus to less energy-intensive "proof-of-stake" consensus in 2022, current estimates put its energy use comparable to that of the Philippines (35th largest economy by energy usage), while the combined energy usage of both systems approximates to that of 13th largest economy worldwide.
- More consideration should be paid to the relative anonymity provided by cryptocurrency and how its anonymity could facilitate financial crime or black markets. Tax authorities and organizations tasked with combating financial crime must pay careful attention when monitoring transactions that pass through any off-ramps connecting cryptocurrencies with conventional finance, such as exchanges for digital currencies.
Is Cryptocurrency A Good Investment?
One of the more frequently raised investor queries about cryptocurrencies is whether or not they represent an intelligent investment opportunity, given their massive market capitalization and incredible excitement associated with them, not to mention daily project launches that use this form of currency. Is investing still wise considering recent losses via scams such as Squid Game Token (SGT), TerraUSD stablecoin, and altcoin scams, or would prudent investors still invest despite the extreme volatility experienced thus far and stories of overnight millionaire crypto traders made and broken overnight?
Is Cryptocurrency A Good Investment For You?
As with investing, trading involves differentiating between investments and trading based on time horizon. Trading tends to involve shorter time horizons with frequent intraday price fluctuations, often necessitating multiple trades per day for maximum gain.
Trading vs Investing
Trading requires discipline because successful traders carefully monitor how much risk exposure they take on. Conversely, investing is more of a long-term strategy with goals set over five or more years - investors may use investing for retirement purposes, purchasing real estate investments, or saving for college tuition expenses as their investment objectives. Both approaches must adhere to disciplined plans.
Consider your risk tolerance before investing. Regarding cryptocurrency's volatility, only you can decide how much risk you can take comfortably; even minor fluctuations of value could make investing with greater volatility uncomfortable for some individuals. Cryptocurrencies pose more significant price fluctuations compared with growth stocks or high-yield bonds. They must be prepared to deal with significant price swings or potential losses that might occur as part of any portfolio investment decision.
Liquidity Constraints
Liquidity restrictions associated with cryptocurrency assets are another essential consideration. Stated, liquidity describes an asset's capacity to be bought or sold at any point without substantially altering its price; for example, if you want to purchase an expensive car like one from a rare car dealer, you won't find too many, and the seller demands an exorbitant price; making the market even less liquid as subsequent sellers could demand even higher costs from subsequent buyers than what your purchase cost you if sold before someone else bought it from your first one.
However, given ample liquidity in the marketplace, your purchase price of Japanese yen may depend on market forces alone if you want something generic, like exchanging some US dollars for Japanese yen. Plenty of JPY sellers are taking USD as payment in return for Japanese yen being purchased again at similar or similar pricing by another buyer (due to liquidity factors).
As specific cryptocurrencies are less liquid than others, investing in them requires you to be ready for potential illiquidity during the buying and selling processes. Should cryptocurrency liquidity levels ever decline below acceptable levels, selling your investments may be impossible when necessary.
Benefits Of Investing In Cryptocurrency
Thus far, we've addressed many of the critical considerations investors must be mindful of before investing in cryptocurrency assets, but there remain strong arguments, both pro and con, for investing.
New Asset Class
As cryptocurrency grows and advances--such as seen with Bitcoin and Ethereum--we witness their emergence as a new class of assets. Large, experienced fund managers such as Cathy Wood of Ark Investment Management have even created funds exclusively dedicated to Bitcoin investments and related cryptocurrencies like Litecoin.
Diversification
Institutional investors employ diversifying investments that respond differently to similar economic conditions to lower risks, with cryptocurrency investments offering tangible diversification effects against rising inflation.
Also, financial instruments that seek to take advantage of the rise of specific cryptocurrencies like Ethereum and Bitcoin futures and options contracts have emerged, as well as investment funds that specialize in handling cryptocurrency investments on behalf of their investors.
Upside Potential
One final advantage to investing in cryptocurrency is that its market remains relatively young, which could allow more developments to emerge over time and make investing even more alluring for some investors. Stablecoins backed by assets correlated to fiat currency values are among the many promising examples.
Laws regarding Initial Coin Offerings (ICO) could be implemented to alleviate investor worries about fraud. Futures trading cryptocurrencies was discussed; as the market expands, more reliable exchanges may offer futures on other cryptocurrencies; bears can then sell short with futures, thus increasing overall liquidity and improving overall liquidity levels.
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Conclusion
This brief tour should have shown you that digital assets have provided us with much to research, analyze, and implement over the past ten years - it has certainly been exciting working at the Reserve Bank during that period.
To maintain stability within our monetary, financial, and payment systems and ensure public access to safe forms of money, the Bank will prioritize payments' future in the coming years. Working closely with private industry players and global counterparts ensures we stay current with advances within this system. At the same time, collaboration must also continue between Parliamentarians and financial regulators. Hence, we have an appropriate regulatory framework for digital assets that supports their intended usages - It will be fascinating to observe changes over the next decade.
