One of the main purposes of introducing cryptocurrency was to deal with the imperfections from existing monetary systems that are based on fiat money. As most of us already know (and have probably experienced), inflation is the result of monetary policy — the losses we incur because of it can only be covered by depositing money into banks for interest. Outperforming the system and receiving returns is only possible if you’re involved in trading or own real estate at the very least. However, the current monetary paradigm could be changed through the introduction of a digital monetary system. Let’s find out how!
What is a digital monetary system?
A monetary system itself simply describes the rules of how a government provides money to the society. This system can be defined as a set of policies, frameworks, and institutions that a government uses to create money in the economy. The main participants of our modern monetary systems include the national treasury, the central bank, the mint, and commercial banks.
There are three traditional types of monetary systems: commodities, commodity-backed assets, and fiat currency.
- In the first type of monetary system, precious metals or other commodities with intrinsic value are exchanged physically as currency. The obvious example is gold and silver coins that have been widely used throughout history.
- In the commodity-backed monetary system, money is backed by a commodity (drawing its value from it) and there is no need to handle transactions physically using these commodities. Another asset with no actual physical value takes this role, for example, paper notes. The Gold Standard is the most famous example of this system.
- Finally, the most widespread monetary system nowadays is based on fiat money — the government guarantees the value of the currency. Under this system, people use notes or bank balances as a medium of exchange and store of value.
All monetary systems listed above have their own drawbacks. For instance, commodities are not as divisible as traditional paper money, which makes them inconvenient to be used for purchases. Commodities suffer from the bandwagon effect — their price may change with the whims of the general population.
For asset-backed money, the problem is described by Gresham’s Law of Money: “If there are two forms of commodity money in circulation, which are accepted by law as having similar face value, the more valuable commodity will gradually disappear from circulation.” So, people are unlikely to spend commodities, choosing to use fiat currency for regular transactions. In addition, commodities and other assets usually lack yield and cost money to hold securely. For this reason, they lose to banking deposits offering interest rates.
On the other hand, fiat money is not an ideal store of value. The risk arises the moment you deposit funds with a bank. Most bank deposits globally lose money in real terms, as the interest rates paid on them are lower than the rate of inflation caused by central banks printing and devaluing money. Furthermore, printing money is expensive — in the US, the print order in the budget for 2017 was $6.6 billion, and the currency budget was $726.6 million (this includes transportation and other related costs).
Digital monetary system
From the limitations of traditional monetary systems, the idea of a digital one has risen. In such a system, digital currency becomes the basis — it is used as a store of value, a medium of exchange, and unit of account, just like fiat currency. Such a solution could provide better financial stability and solve the problem of inflation and negative yields for consumers.
There are different visions of digital monetary systems, and the ideal one excludes central banks from the process. As Donovan Berry, who is studying economics at UC Berkeley, says: “There is definitely an aesthetic attractiveness to a ‘pure’ monetary system; a self-regulating, libertarian institution with a currency backed by something real, something tangible and natural, unable to be debased by reckless, greedy actors (like central banks)”. At the same time, Donovan continues, “without some centralized body possessing the power to regulate currency flows, there would be no obvious way to institute capital controls. Such a complete opening up of national capital accounts could exacerbate and even give rise to financial crises, especially in developing and emerging markets.”
So, what are the ways to integrate a digital monetary system with the current technologies and enjoy its advantages?
The possible ways of implementing a digital monetary system
Central bank: digital money with no decentralization
One of the ways to introduce digital currency into the monetary system was offered by PositiveMoney, a non-profit organization based in London and Brussels that campaigns for various monetary reforms. The bank would decide how much cash to issue by letting the public determine how to split their holdings of money between bank deposits and digital currency. Alternatively, the bank could use digital currency as a monetary policy tool to stimulate aggregate demand and influence the economy by making small and occasional airdrops of newly created digital cash to every citizen.
Such a system would widen the range of options for monetary policy, increase safety by allowing anyone to settle directly with central bank money, and improve financial inclusion. However, its implementation requires significant changes to the whole process, it doesn’t solve the problem of inflation and yield absence, and it has a fair number of other limitations.
Central bank: a decentralized digital system
Creating a decentralized payment system that the central bank will fully control is another option. The implementation of such a system is already being discussed by several countries due to the fact that cash is becoming less popular — e.g. in Sweden, only 15–20% of retail payments were conducted in cash (market share in total number of transactions), while in 2010 the total market share reached 60%.
In this model, the central bank would control the issue of cryptocurrency and guarantee a fixed exchange rate between digital and fiat currencies. Participants would be able to conduct payments directly between each other without the engagement of third parties (such as clearing houses, settlement institutions, etc.) — so all intermediaries would be eliminated.
Morgan Stanley strategist Sheena Shah believes that a fully digital monetary system might enable central banks to push rates deeper into the negative territory. “Now, the only way negative rates can spread throughout an economy is if all deposits are held in the banking system. However, digital currencies may enable negative rates on all of the money that’s in circulation throughout the entire economy.”
Fully decentralized digital monetary system
In the book “The Denationalization of Money” issued in 1976, Nobel Laureate Friedrich August von Hayek proposed the establishment of competitively issued private money as a replacement for the monopolistic power held by the central banks. Two years later, he published a revised version of the book and described a monetary system where markets and citizens would converge on one or a limited number of monetary standards.
Cryptocurrencies share a lot in common with Hayek’s vision of a decentralized monetary system. Cryptos are issued through a private, decentralized mechanism that is somehow comparable to old-fashioned gold mining; they are scarce, there is a finite number of them that is artificially defined (21 million for Bitcoin). Not surprisingly, digital currencies have often been compared to gold, and the monetary system they form as the “Digital Gold Standard.”
However, crypto volatility makes it a non-viable store of value and unsuitable for use as currency, as stability is one of the main requirements for money in this monetary system. There are several possible ways to solve this problem:
- Cryptocurrencies backed with commodities (which are stable and definable stores of value for use in commercial and private transactions and investment).
- The two-token model with stabilized exchange tokens and the reserve tokens.
- Incentives built into the blockchain to encourage market interactions that tend to stabilize crypto prices.
Blockchain-based digital monetary systems
Digital monetary systems can be achieved by leveraging blockchain technology in order to provide truly decentralized solutions to the public.
- In such a system, currencies are backed 1:1 with allocated physical assets.
- A perpetually recurring yield is generated from economic activity, not from debt-based interest.
As an example, Kinesis, a yield-bearing digital currency based on physical gold and silver, is achieving this by:
- Full direct title to the bullion used for the 1:1 basing of KAU and KAG coins being allocated to the owner of the respective coin.
- Providing definable value via Net Present Value calculations for use in commercial, institutional, and retail investments.
The Kinesis system can be overlaid on top of anything that can be standardized, traded, and stored as value. It has been developed in partnership with the Allocated Bullion Exchange, the world’s leading electronic institutional exchange for allocated, physical precious metals and they have already partnered with several market participants to expand its system. Among which we can mention the Jakarta Futures Exchange, which is planning to develop a regulated blockchain exchange based on Kinesis technology and MBAex, offering audited, liquid, and secure stablecoins to its traders thanks to the Kinesis monetary system.
Modern monetary systems are undoubtedly far from perfect. Monetary policies used by central banks lead to inflation (and sometimes even hyperinflation), which doesn’t allow citizens to enjoy returns on their funds. Alternatively, depositing money into banks is the only way to cover losses. A digital monetary system of some kind, however, may be the answer to this very problem.
Debates currently continue as to whether or not the digital monetary system will be able to exist without the control of a centralized entity. Some experts believe that digital currency could challenge the banking system and exacerbate a financial crisis. Through the introduction of digital currency, central banks would be sacrificing the ability to conduct monetary policy, while others disagree and argue that digital currency would allow for the creation of a safer environment for a larger variety of monetary policies.
At the same time, independent solutions continue to evolve and integrate with the current market participants, such as exchanges. These private, blockchain-based monetary systems with digital currencies in circulation could provide a secure, stable, and efficient way to store and exchange money, enjoying a recurring yield generated from economic activity of participants. The only question that remains is if they will be able to replace the traditional monetary practices — as both government and people have a tendency to be reluctant to change.