Bitcoin, and subsequent cryptocurrencies, came to the fore as a response to the financial crisis of 2008. Boasting peer-to-peer technology and a decentralized system, Bitcoin has the potential to dismantle the conventional banking system as we know it.
The banking system is the central authority, responsible for decisions that impact every country’s economic fortunes, and the thought of this being overtaken by digital currencies is something that worries a lot of people.
It’s now easy to buy cryptocurrencies around the world. You can buy Ethereum USA with just the click of a button, for example. Of course, there are a few countries that have bans on cryptocurrency. Yet, generally speaking, it is only being more widely adopted.
However, there are some drawbacks, which make it hard to make a case for there being a fully decentralized system that only consists of cryptocurrency. With that being said, continue reading to discover everything you need to know about digital currencies and whether or not they are a threat to banking systems.
The role central banks play in the economy
To understand how digital currencies impact central banks, we first need to look at the role that central banks have when it comes to the economy. Policymaking by the central bank underpins the worldwide financial system.
The mandates for central banks differ from country to country. For instance, in the United Kingdom, the Bank of England ensures the solvency and stability of the financial system. In the United States, it is the Federal Reserve that is responsible for maintaining full employment and controlling inflation.
A number of tactics are used by banks to achieve their mandates, such as monetary policy. Chiefly, however, they manipulate interest rates and money supply.
For instance, a central bank could decrease or increase the amount of money circulation within an economy. If there is more money, this means consumers spend more and the economy grows. On the flip side, if there is less money in the economy, less is spent by consumers, and a recession may occur.
The actions the central bank takes can also impact overseas investment, exports, and imports. For instance, high-interest rates can prevent investment by foreign entities in real estate while low-interest rates can promote investment.
Tasking a central agency with economic functioning has both pros and cons. Trust within the system is one of the biggest advantages. The currency that has been issued from a central bank is trusted and can be exchanged at a universal value. If every monetary transaction issues its own coins, there would be chaos, as there would be competition between currencies.
What’s bad about there being a central decision-making authority?
The issue with the structure we have mentioned is that too much responsibility and trust is placed on the decisions the central agency makes. Incorrect monetary policy measures from central banks have caused debilitating recessions in the past.
The biggest economic recession in the United State’s history, the Great Depression, happened because the economic policy was not managed correctly. The local Federal Reserve banks made a series of bad decisions.
The complexity of today’s financial infrastructure has also caused complications in terms of the roles that central banks play in today’s economy. With money taking digital forms, the velocity of its circulation through the worldwide economy has increased. Financial products and transactions have become more abstract and difficult to comprehend.
The interconnected nature of the worldwide economy means that policymaking mistakes and decisions by one central bank are transmitted across a lot of different countries. For instance, the contagion of the Great Recession barely took any time to spread to other economies from the United States, meaning there was a swoon in stock markets around the world.
The potential culpability of the central bank in terms of creating and precipitating crises resulted in the seed for the invention of Bitcoin.
Can cryptocurrency kill central banks?
When it comes to digital coins replacing central backs, both technology and economics play a role here. The inventor of Bitcoin, Satoshi Nakamoto, described the cryptocurrency as a peer-to-peer version of electronic cash that gives people the ability to send online payments directly from one party to the next, without needing to go via a financial institution.
There are three problems that digital currency solves in the context of a monetary infrastructure system that has been dominated by central banks. These are as follows:
Double-spending
The issue of double-spending is eliminated with cryptocurrency. In the case of Bitcoin, for example, each one is cryptographically secured and unique, which means it cannot be replicated or hacked. As a consequence, you cannot spend digital currency twice, nor can you counterfeit it.
Centralized infrastructure
Next, digital currencies gets rid of the requirement for a centralized infrastructure. It does this by streamlining the process for producing and distributing the currency. Anyone that has a full node is able to generate Bitcoin from their home.
An intermediary is not needed for a peer-to-peer transfer between two addresses that are on the Bitcoin blockchain. As a consequence, a network of banks that is chartered by a central authroity is not required for distributing the cryptocurrency.
Trust
Lastly, although cryptocurrency is decentralized, Ehtereum and Bitcoin are both considered trustworthy. In this scenario, trust is an algorithmic construct. On the Bitcoin network, for instance, transactions need to be approved by nodes who are spread out across the world in order to be incorporated into the ledge.
Even a single disagreement by a node can result in the transaction being deemed not eligible to be included in Bitcoin’s ledger.
So, those are the three areas covered by Bitcoin, yet there are some catches that may prevent digital currencies from ever taking over central banks.
For example, Bitcoin’s status as a medium for legal transfers is not currently known. In El Salvador, digital currency has become legal tender, yet it is still the only country that will enable cryptocurrency to be used for transactions.
However, in other parts of the world, such as China and the United States, the users and infrastructure for cryptocurrency have been cracked down on.
We also need to consider that digital currency is restricted in supply and volatile. Again, with Bitcoin, there is only goingt o be 21 million Bitcoin mined. The cap on the number of cryptocurrency in existence will mean there are severe limits in terms of how it can be used.
Furthermore, because cryptocurrency is scarce, this means it is an attractive asset in terms of speculation. The price swings between extremes, which makes digital coins challenging to use for your day-to-day transactions.
Final words on whether digital currencies are a threat for traditional banking
So there you have it: everything you need to know about digital currencies and the threat they provide when it comes to traditional banking.
While there are some advantages that digital currencies provide, there are some clear flaws that will prevent digital currencies from completing replacing traditional banks at this point.
Despite this, we will see Bitcoin used more and more regularly for payments, and the investment potential remains very high for digital currencies.
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