Kate Rhodes is founder of KRC, a regulatory and political risk management consultancy. She is also a commentator, lawyer and regulatory advocate.
One of the U.K. Crypto Task Force’s key regulatory concerns relating to digital assets is their impact on financial stability. Kate Rhodes, KRC looks at the relationship between digital and government (fiat) currencies. She also discusses the issue of financial stability and volatility.
Many regulatory concerns about digital assets pivot around their financial stability and volatility. This week I would like to delve into the differences between digital assets and fiat currencies and ask the question: are fiat currencies just as volatile as digital currencies, or just as unstable?
1. What is the definition of a government currency? Are digital currencies inflationary?
Government currencies (fiat) such as the U.K. pound sterling (GBP), or the US dollar (USD), are defined as currencies because they are backed and issued by a central bank. Quantitive easing can be described as when new money is introduced into the money supply by a central bank. In the U.K, only the Bank of England (Bank) is allowed to print money.
Central banks hold a ledger of money issued and in a case like quantitative easing, the ledger is raised to provide liquidity. In the event money runs out, the central bank prints more money and ‘inflation’ tends to occur. This is why, among other reasons, a British bank called ‘Northern Rock’ failed; simplistically it had ran out of money and could not print anymore.
Unlike government currencies, digital currencies are frequently being created. A digital currency such as Bitcoin, that has a limited amount that can be issued, is not the only digital currency in existence. So whilst there is a limited amount of Bitcoin, there is no limit to the amount of other digital currencies issued. In this respect, the digital currency market is inflationary.
2. What is the difference between currency and legal tender? What is a digital certificate of value or ’stable coin’?
A GBP £5 note is legal currency and tender as it is issued by the Bank. Anecdotally, if any of you have been to Scotland, you may have received a Scottish £5 note. This note is legal ‘currency’, not legal ‘tender’, as it is issued by Lloyd’s Banking Group (LBG), a UK bank, and not the Bank. LBG’s head offices are in Scotland and LBG deposits £5 into the Bank for every Scottish £5 note they issue. For this reason, LBG’s Scottish £5 notes are described as ‘legal currency’ and not ‘legal tender.’ Their £5 deposit in the Bank effectively underwrites their £5 LBG issued Scottish bank note.
A digital certificate of value or ’stable coin’ works a little bit like this. It is a digital currency backed by an underlying asset, slightly akin to how the LBG £5 Scottish note is underwritten by the £5 deposited in the Bank. The underlying asset that backs up the stable coin can be either be fiat or another digital asset.
3. Are government currencies ever unstable or volatile?
All currencies are inherently unstable — some more than others. However, just because a major currency is backed by a government, does not mean it is stable.
During crisis periods, it would be fair to say that currencies exhibit extremely volatile states. In September 1992 on a day called ‘Black Wednesday’, the value of the GBP crashed so dramatically that John Major’s UK Conservative government was forced to withdraw the GBP from the European Exchange Rate Mechanism (EERM) after it was unable to keep the GBP above its agreed lower limit in the EERM. High interest rates had put Britain into recession as large numbers of businesses failed and the housing market crashed. It was a dark day and HM Treasury estimates the cost of Black Wednesday to the U.K. was in the region of £3.3 billion. 26 years later we still have huge amount of economic volatility with GBP due to the unknowns around Brexit: GBP is weak and markets are bearish.
However, looking at Black Wednesday, there were two crucial differences between fiat currency and digital currency. The first is that there are substantial reserves of GBP, so the Bank could intervene to support GBP in the currency markets. Most digital currencies do not have reserves to support and stabilise their value, unless they are a ‘stable’ coin, designed to minimise price volatility. Secondly, and critically, the government could set the base rate for lending. With a lender of last resort and a clearly defined bank, traditional fiat currencies have more to secure them. For the moment, most digital currencies do not have a central bank, reserves, a base lending rate or a lender of last resort. These qualities make most digital currencies, at present, less stable that fiat currencies.
Furthermore, standard currencies demonstrate greater stability over both the short and long term relative to one another, whereas digital currencies may not. For instance, if you have all your money in Bitcoin, and need to transfer it into GBP to buy a new car, the volatility means you may have to wait until it returns to sufficient level in order that you can afford to make the purchase. Meanwhile, if you had all your money in USD or EUR and needed GBP to buy a car, these currencies generally have a more consistent relationship, so you do not need to wait until the volatility gap closes.
Inconsistencies become greater with larger capital exchanges, rather than consumer-level purchases. For example, Brexit decisions in the UK raised the costs of importing materials from the EU given the unbudgeted and significant devaluation of GBP. Unintended consequences include uncertainty in the manufacturing industry, property industry and delays to multi-million pound construction projects.
4. What is the difference between a currency and a commodity? And what is the difference between security and utility tokens?
A currency is designed to facilitate commerce and has a fixed value. A commodity has an intrinsic value but rises and falls according to supply and demand, like many digital currencies.
There are substantial differences between security and utility tokens: a fundamental difference is that one behaves like a currency and once behaves like a commodity. Prima facie Bitcoin seems to be a digital currency, however a commodity has value because it has scarcity and an absolute limit on its issuance. Viewed under this regard, Bitcoin is a commodity. Certainly our friends in the US who are close to the authorities hold the view that ‘pure’ cryptocurrencies (e.g. Bitcoin) are commodities over currencies.
5. Is the role of digital currency to achieve economic sovereignty, without relying on government?
Bitcoin was born out of the 2008 financial crisis — and to disenfranchise the vested interests of central banks and governments.
Digital currencies are still subject to inflation even though they have independence from governments. With Bitcoin, there is a limit to the maximum number created so prices will inevitably inflate over time. It should be noted that most inflation is not caused by printing money: inflation is influenced by ‘the velocity of money.’
Let’s use the following example: suppose you are a hairdresser who needs a manicure, and I am a manicurist who needs a blow dry. If I buy a blow dry each week for the amount of money for which you use to buy a manicure, then that all works well. But, if rather than one manicure a week, and one blow dry a week, we start transacting each day, that same amount of money is now going around faster. To each of us, it seems like the demand for our service has risen so we raise our prices, thus we get inflation. Digital currencies are also subject to this, and this is one reason for their volatility. Arguably, it is almost worse in this setting, as ordinarily governments use interest rates (and other macro prudential tools) to help prevent this volatility, effectively stopping us trading so quickly that we end up ‘exhausted.’ Economic sovereignty is not necessarily good in this context.
Ultimately, many governments and central banks are developing their understanding and definitions for digital assets and/or digital currencies. The primary concern, quite rightly so, of the central banks is to ensure financial stability. Once digital assets and digital currencies have established themselves and achieved greater stability — regulatory certainty has a major part to play in this — they have an exciting prominent role to play in our future.
Kate Rhodes is founder of KRC, a regulatory and political risk management consultancy. She is also a commentator, lawyer and regulatory advocate. For more information please see www.katerhodesconsulting.com. Kate would like to thank Matthew Conway, U.K. Finance, Daniel Cayford, LSE and James Kaufman, RPC Law for contributing thoughts to this article.
Disclaimer: Kate Rhodes Consulting Limited (KRC) is a limited liability company registered in England and Wales registered company number 11649091. KRC offers consultancy services only. KRC does not represent, warrant or guarantee the use of its materials and or its services will lead to a particular outcome or result. KRC does not accept any liability for negative consequences that any individual or company may incur upon utilising KRC’s consultancy services. KRC does not offer legal and or financial advice. You should consult your professional adviser for legal or other advice. Whilst every reasonable effort has been taken by the author to ensure that its contents represent an accurate and not misleading portrayal of the issues considered herein at the date of writing, many of the topics considered in it are subject to current political, regulatory and legal debate, and risk. Accordingly, there can be no guarantee that the contents of this document, and any statements set out in it, will not be challenged, corrected, overruled or contradicted in the future.