Crypto could undermine interest rates. Here’s how.

“My concern is everyone’s in on the way up, just be very careful when things slow down and go the other way,” he said.

Less influence

More than $US2 trillion ($2.7 trillion) has flooded into cryptocurrencies globally – more than Australia’s annual economic output.

If a significant weight of money shifts into private digital currencies such as bitcoin, ethereum, binance and tether, the interest rate policies of central banks will have less influence over the economy and financial system.

Finance traditionalists see cryptocurrency as a speculative frenzy and Ponzi scheme for naive Millennials.

Central banks use the traditional banking system to shape the value of the domestic currency and to influence people’s spending, saving and investment decisions.

Decentralised finance (DeFi) can weaken this channel.

Cryptocurrencies are not denominated in the currency of any sovereign issuer.

Ownership records and transactions are stored in a digital ledger that is not controlled by a central party such as a bank.

The Reserve Bank of Australia has acknowledged the potential implications for central banks from the rise of cryptocurrencies.

“Widespread substitution away from the domestic currency could threaten a country’s monetary sovereignty and reduce the ability of the central bank to influence domestic monetary conditions (including via changes to the structure of interest rates and the exchange rate) and to act as the lender of last resort if required,” the RBA’s head of payments, Tony Richards, noted in a September 2020 research paper.

The potential erosion of monetary sovereignty explains why more than 50 central banks, including the RBA, are exploring introducing their own digital currencies.

Private digital token sceptics

In theory, the introduction of central bank digital currencies (CBDCs) as alternatives to cryptocurrencies may slow the shift to private digital tokens.

The RBA is examining the merits of creating a wholesale-only digital version of the Australian dollar to facilitate the movement of assets on blockchain.

A wholesale CBDC would be limited to major institutions such as commercial banks with deposit accounts at the RBA.

The RBA has rejected introducing a retail central bank currency for mums and dads.

A retail CBDC could destabilise the private banking sector. During a financial crisis, depositors may be tempted to yank their money from commercial banks and park the funds at the government-backed central bank.

A “bank run” would be disastrous because deposits fund about 60 per cent of commercial bank loans in Australia.

Hence, it is perhaps not surprising that traditional bankers like NAB’s McEwan and economists are sceptical of private digital tokens.

Finance traditionalists see cryptocurrency as a speculative frenzy and Ponzi scheme for naive Millennials, even if the underlying blockchain technology infrastructure has a real future in finance and beyond.

Digital currencies are a risky store of value, can’t be readily used as a medium of exchange and are difficult to quickly convert to real currency. Commonwealth Bank’s foray could make it easier.

Cryptocurrencies are vulnerable to exploitation by financial criminals for money laundering and ransomware. A lot of energy is used by supercomputers to “mine” cryptocurrencies, contributing to greenhouse gas emissions.

The RBA’s scepticism is evident in its submission to the Senate’s Inquiry into Australia as a Technology and Financial Centre.

“Cryptocurrencies have no intrinsic value, are typically not issued by any single entity and effectively rely on users’ complete trust in the software protocol that controls the system,” its July 2021 submission noted.

“While the term ‘cryptocurrency’ may suggest that they are a form of money, the consensus is that existing cryptocurrencies do not provide the key attributes of money.”

“As the bank and many others have previously noted, they are rarely used or accepted as a means of payment, they are not used as a unit of account, and their prices can be very volatile and so they are a poor store of value.”

Digital yuan

The irony is that the unconventional monetary policies of central banks, such as money printing and talk of possible negative interest rates, as well as the ballooning debts of governments, have boosted the appeal of DeFi.

A cohort of people is losing confidence in government institutions exerting control over their finances.

Moreover, China’s quest to create a CBDC is raising the eyebrows of the economic and national security officials in Canberra.

The People’s Bank of China is at an advanced stage of testing possible issuance of a retail CBDC or “digital yuan”.

If China’s proposed CBDC succeeds, Chinese authorities would be more easily able to monitor who is spending, how much and on what items.

For state-controlled China that could allow its financial authorities to better monitor real-time economic activity and inform policy decisions.

But it would boost the spying powers of Chinese intelligence organisations.

Australians travelling to China may need to use a digital yuan.

The Communist Party may nudge Chinese tourists and students in Australia to use it via their digital wallets.

China may even require Australian exporters to conduct transactions in its digital currency.

A digital yuan would aid China’s long-term ambitions to displace the US dollar as the world’s reserve currency.

Controlling the world’s reserve currency since the end of World War II has allowed the US to borrow more easily and cheaply, and to impose painful financial sanctions on foreign adversaries such as China and Russia.

The US dollar reserves held by central banks has fallen to 59 per cent, from 71 per cent in 1999, according to the International Monetary Fund.

The dominance of the US dollar is not under immediate threat.

But the rise of digital money poses big uncertainties for global finance.