ECB: Digital currencies unstable

unstable” whilst remaining upbeat about the potentially transformative benefits they may offer in payments.

The ECB study builds off an earlier study published in 2012, offering both a general overview of digital currencies as well as follow-up analysis on the potential benefits and risk of using so-called virtual currency schemes (VCS).

The central bank, which oversees national-level central banks in the eurozone, suggested in the report that digital currencies could impact the ECB’s ability to function. However, it stopped short of calling digital currencies a threat to its operations because of its lack of widespread adoption among consumers and businesses.

The report’s authors note:

“Although VCS units are not denominated in euro, they do have the potential to have an impact on monetary policy and price stability, financial stability and the smooth operation of payment systems in the euro area.”

The viewpoint echoes a report released last year by the Bank of England, which in September acknowledged that, if widely adopted, bitcoin could “severely impair” its ability to govern the UK monetary system. The Bank of England said in a study published last month that the technology could fundamentally change the way that central banks function.

Virtual Currency Schemes – A Further Analysis

Cross-border payments disruption

The ECB outlined a number of areas in which digital currency development could broadly impact the traditional payments space, noting that defects in the remittance ecosystem could provide an opportunity for the technology to flourish in the long term.

The report’s authors state that digital currencies like bitcoin, given their cost structures, make the technology a potentially attractive option for both domestic and international remittances. While acknowledging the technological resources required to build such a network, the ECB notes:

“…there is major room for improvement, especially in [the remittance] field, and hence a VCS could have the potential to offer a better service than traditional providers (banks, money remitters and informal remittance systems).”

The ECB goes on to say that a significant barrier to broader adoption for remittance is the lack of centralized protections for those who opt to use digital currencies.

ECB highlights risk of ‘scamcoins’

As well as including refrains of central bank warnings about digital currencies, such as a perceived lack of transparency and market volatility, the ECB also touched on the growth of altcoins.

The report suggested that altcoins may one day serve as future payment networks that, in the eyes of the ECB, could compete with bitcoin given the differences in design, distribution and implementation.

At the same time, the report highlighted how altcoins pose added risks for investors because of the nebulous nature of some projects, noting:

“It is too early to tell what the future of these altcoins will be. A great many of them could be nothing more than “scamcoins”, ie VCSs that are created with the main objective of swindling naive buyers, either as consumers and payers or as investors.”

Specific risks named in the report include a lack of specific information about an altcoin network’s management, premining and market illiquidity.

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Early currencies were actual coins made of precious metals, which people trusted to have an intrinsic

Can we trust Cryptocurrencies?

value that they could use to obtain goods or services. Today, most countries use fiat currencies which have no intrinsic value and are not tied to any physical value such as precious metals. Instead, fiat currencies are backed by government guarantee – entirely lacking in physicality and intrinsic value, fiat currency demands ultimate trust.

The identity of those involved in a transaction (and the ability to verify such identity) is invariably a key component of this trust equation. In order for the fiat currency system to function, the currency issuer and each of the key players in a payment chain must be trustworthy to ensure that the currency is not counterfeit and that the currency will not be stolen before reaching its final destination.

But in the deliberately anonymous world of cryptocurrencies, where value is established by algorithms and verified by the electronic transfer of data, how can trust be established without proof of identity? In light of the widely reported vulnerability of e-wallets, can we ever truly establish the same trust in cryptocurrencies that we have in our own fiat ones today?

The answer perhaps lies in an appreciation that the trust deficit will only be met once there is sufficient confidence in the technology which underpins the currency and the key market players in cryptocurrency transactions are held to a high level of accountability. In fiat transactions today, “money” must pass through many hands before reaching its final destination. When you pay for your shopping with a credit card, your personal details are collected by the shop, transmitted to their acquiring bank that then transmits your details again to your card issuing bank. After initial approval, these details are transmitted along this chain once more before the funds are actually released.

This chain demonstrates a number of potential points for a security breach. Despite this, society generally trusts in the system because the banks and payment processors are regulated and we can feel secure in knowing that the parties involved are required to enforce a high level of security. Even if a breach occurs, we know that the parties involved will be held accountable and trust that we as participants will have the opportunity for redress.

Cryptocurrencies, on the other hand, are entirely decentralised and value passes directly from payer to payee. Quite clearly, there are far fewer potential points for a security breach along the Bitcoin payment chain that solely consists of a payer and a payee. There has also never been a recognised security breach or defrauding of the actual Bitcoin ledger, known as the Blockchain, to date. The Blockchain is considered to be extremely secure as it publically records every transaction that is ever made.

For a system that seems to be so secure in its technology to be plagued with instances of hacking and fraud (most recently the hack of the popular Chinese Bitcoin exchange Bter), the real trust issue lies with the gatekeepers between cryptocurrencies and their traditional fiat relations.

Cryptocurrency-related businesses that act as interfaces with fiat currencies, such as exchanges and payment processors, are largely unregulated by any regulator worldwide. They have also been the generators of the largest reported hacks to date, causing widespread mistrust in the system and extreme volatility in cryptocurrency pricing. However, this mistrust stems from the lack of accountability of the cryptocurrency-related businesses that are able to operate without any required disclosure of identity or location.

To condemn cryptocurrencies as a whole based on the poor security of a few rogue market players would be tantamount to condemning a fiat currency because of a few bank thefts. If currency is stolen from a bank, its security is increased. Consequently, when a cryptocurrency exchange is compromised, it should follow that the solution should be increasing the security of exchanges. However, unless and until the loss falls on the exchange, there is no incentive on the exchange to change its behaviour.

Indeed, it is only when the behavioural and organisational standards are enforced by industry or national regulators that the collective conduct and security of the cryptocurrency industry will be elevated. When responsible conduct of participants is required, confidence in the market will follow. It is therefore in the best interests of most cryptocurrency-related businesses to support the push for regulation and instil trust in the wider currency platform.

It is only by learning how to play this trust game effectively that cryptocurrencies have any real shot at viability: if consumers feel able to trust in the industry that has thus far been plagued by hacks and security breaches, cryptocurrencies could even revolutionise the way we live.

It should therefore be a truth universally acknowledged that a cryptocurrency exchange in possession of fortunes, must be in want of good regulation.

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