Central Banks Face 3 New Dilemmas in the Era of Bitcoin and Digital Currencies

This is a guest post by Sunil Aggarwal. He runs
an online learning solutions company, Theory Frames, and has
taught about Bitcoin and blockchain at the National Academy
of Legal Studies and Research

 in Hyderabad, India.

The global monetary system has reached a unique point in its
history. The money that defines it is undergoing a serious

At one time, there were nearly 200 national currencies, with
the current figure just above 180. For a national currency to
become global money, it has to undergo conversion to other
currencies at the prevailing exchange rate. And outside its
national borders, it is subject to the laws of supply and demand.
A Bangladeshi taka would rarely be demanded on the global market
as compared to the U.S. dollar. So for the global population,
labor output is not measured in reference to any actual universal
money, but by the power centers of different political

This notion of fiat money has dominated the entire 20th
century and continued to do so in the first decade of 21st
century, until the emergence of Bitcoin. There was no political
subjectivity involved in Bitcoin; it was based on the
mathematical design of issuing currency as well as settling
payment transactions through a continuously updating chain of
distributed ledgers called the blockchain.

Bitcoin successfully solves the issue of double-spend that is
a typical problem of digital money. It was quickly accepted by
people because it was money, a payment rail and a messaging
system all-in-one. It ensured both privacy as well as the
security of a unique digital signature to every user without
depending upon any intermediary.

In less than eight years since its emergence, Bitcoin has
grown to nearly 10 million user wallets, a daily transaction
range of more than 200,000 and a market cap of more than $6
billion and rising.

It’s not just Bitcoin; this math-driven logic of currency has
been improved by many others, and there are now more than 600
Bitcoin-like currencies. Four of these have market caps of $100
million, 10 have market caps of over $10 million, more than 50
have over $1 million and more than 150 have over $100,000.

Not only is this market cap of new currencies rising, but
their daily transaction graph is increasing. It is expected that
by 2020, there will be more than a billion cryptocurrency
transactions per day as smartphone sales show a volume of 4
million units per day.

A world where everybody can send free email or SMS to every
other human being on earth would also expect a currency that
follows similar ease of transfer. That is where a politically
fragmented notion of money faces a serious challenge of

But to go from a cash-based issuance system to a global
seamless payment system requires a big political jump. It would
require nations to raise their “interaction capacity” to the
equivalent level of the permissionless regime of Bitcoin and many
other cryptocurrencies. That is what is confusing central banks
and presenting them with three big dilemmas, the answers to which
will determine their futures.

The First Dilemma: Equaling the Reliability of

All central banks have issued a large amount of cash to their
populations. For example, Reserve Bank of India has created a
monetary base of more than 15 trillion rupees to date. This cash
component makes up nearly 12 percent of the total money supply at

People trust this cash because this is the best notion of a
bearer asset they have at present. Currencies working within
borders are fungible as well as anonymous, and they are backed by
statutory guarantee.

Some currencies are acceptable abroad, too. In such a case,
the problem is how to recover this huge amount of cash and to
replace it with a digital vault of cash. It would mean the
creation of an equally reliable digital infrastructure of
currency issuance and payment infrastructure. It would require
that not only every citizen have a smartphone or a mobile digital
device, but that he or she should also be in a position of using
it with efficiency.

In a country with more than 1.2 billion people, this is a huge
challenge. It would require that country to have a highly
authentic register of citizens’ digital identities. And not just
that – the issues of privacy need to be sorted out before people
can be convinced to shift to a digital payment

Even a small country such as Sweden that has nearly replaced
cash with a digital payment system doesn’t expect to do away with
cash completely before 2025. Eliminating higher denomination
currency notes has proved to be a very difficult task for central
banks. The currency printing and distribution cost alone for RBI
has been the equivalent of more than $5 billion for the years

If you add bank branches’ management costs, the overall
inefficiency of the system brings with it a huge burden of
maintaining the legacy structure of cash. The desire to go
cashless has good intentions, but having citizens accept it as
easily as they have accepted Facebook is a dream that may not
become reality for most countries.

The Second Dilemma: Non-workable Structures

The second fundamental issue is the existing structure of
deposit and credit systems.

This model works with a central bank-commercial bank binary
system. The central bank issues money, but a commercial bank
extends it to the population through its branches and ATM

A common bank does not interact with a central bank at all. A
bank branch is the only connecting link between a customer and a
central bank. A central bank is like the operating system, and a
branch-led commercial bank network is the hardware.

These two constitute the banking system, but there is a
serious problem with this hardware. It was built during the time
when a central bank could not reach a customer directly. So the
lending, as well as the deposit function, was leased to a bank

But this branch-driven system has aggregated a lot of hubris.
It stretches the system through survival pangs as well as debt
overhang. In the last four monetary policy steps, RBI has
decreased the bank repo rate by 125 basis points, but the banks
have transferred only 60 basis points to the end-user who needs

In India, the result is a sustained phase of stagnation in the
economy. Within this binary, a central bank is proving to be only
half-effective because it has to carry its bedfellow, commercial

The situation is even worse than that. Continuing with the
example of India, public sector banks have a huge overload of
non-performing as well as stressed assets. The market value of
these banks is much less than their liabilities. The problem is
aggravated by the rise in the number of willful defaulters.

This poses a serious statutory risk to the monetary system,
too. RBI has tried to bypass this issue by designing a new
category of payment-only banks. It has given licenses to 11 new
entities, half of which are telecom and payment app players.
These banks may sort out the deposit and payment aspect, but the
credit aspect remains unsolved.

The Third Dilemma: When to Issue

The Chinese central bank governor has announced plans to issue
that bank’s own digital currency, but no time frame and monetary
design have been announced. Will it be a permissionless currency
focusing on the privacy of the users, or will it be permissioned
currency centered on the social order and security of the

Will it ensure complete convertibility to other
cryptocurrencies or will there be controls on that? Will it
pursue a proof-of-work model or will it pursue proof-of-stake
model or a hybrid of the two? What kind of dilution of monetary
sovereignty will it tolerate because of the Triffin dilemma, in
which short-term domestic objectives conflict with long-term
international plans?

Will it establish a single payment terminal for all the
citizens and bypass the separate bank terminals? Will it allow
direct issuance of money through direct download of digital
wallets or will it partner with banks? Will it be issued only to
taxpayers? Will it be rationed through monthly or weekly

Even if these issues are resolved, the big challenge is when
this digital currency would be issued.  Will it wait for
universal adoption of smartphones? Will it make free Internet
availability a mandatory feature of its state system?

All these questions are not only important for China, but are
critical for every central bank. This is a step that would
require a historical jump on the part of political elites. It is
easier said than done. The realm of math-driven currencies is a
totally new ballgame, and political design may not work well
within the straightjacket of such a new paradigm.

One experiment now in the works is the Sistema de Dinero
Electrónico (electronic money system) of Ecuador that replaced
physical cash with digital money as of January 2015. But this is
neither a new digital currency nor the digital equivalent of a
cash-like bearer asset. All money is with the central database of
government. So it is a domain of pull-payment and not
push-payment like that of Bitcoin. Privacy concerns related to
digital identity have been raised, but the Ecuadorian government
has so far ignored them. It has banned the use of Bitcoin and
other cryptocurrencies as well.

In a population of 16 million where 40 percent of all people
are unbanked, the Ecuadorian shift is going to take a long time
for full implementation, particularly among the older and
illiterate. It is like an official version of M-Pesa that
succeeded in Kenya and some other parts of Africa. But even after
one year, the Ecuadorian system is yet to become a popular
choice. Not even 10 percent of the population has adopted it.
Ecuador has a turbulent monetary history and it lives now with
the U.S. dollar as the national currency.

This attempt at digital cash is aimed only at protecting
against a future de-dollarization of its economy, and realizing
savings on the printing cost of paper money. It not only kills
the monetary autonomy of the individual, it gives a government
absolute power in matters of taxation, inflation and interest
rates. Any other central bank that tries to repeat this
experiment in a politically active and diverse country will have
to take into account of all these factors in order to avoid any

What happens next is only guesswork, but the historical shift
is knocking at the door. We have entered a world where both
peer-to-peer communication as well as transfer of value would
ensure a better distribution of human output. Whatever network
achieves this will gain political acceptability. Who will do it –
nations, global technology giants or some invisible agencies – is
not yet clear, but something is going to happen.




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