Three trends that will shape cryptocurrencies' future

21 February 2021

By Ganesh Viswanath-Natraj 

The last year has been a watershed year for cryptocurrencies. Bitcoin and Ethereum, the two largest cryptocurrencies by market cap, saw a five and 10-fold increase in price respectively between January 2020 to January 2021.

Despite this surge in price and Tesla's recent adoption of it, whether Bitcoin will one day be used for mainstream payments is a big question. Central to this discussion is whether the trend in Bitcoin is sustainable. Bitcoin may struggle to replace the dollar as the dominant medium of exchange due to limitations of traceability, efficiency and scalability of its payment system.

Also, what about Ethereum’s growth? While Ethereum remains second in the pecking order of cryptocurrencies, its long-term outlook is promising due to the harnessing of decentralised finance applications through its system of smart contracts.

But will the emergence of central bank digital currencies (CBDCs) fundamentally change the cryptocurrency landscape? Policymakers still need to address a number of questions relating to its design and whether it is consistent with financial stability and the creation of private money.

This year could well be pivotal in cryptocurrencies' future, but here are the three trends that will shape their course in 2021 and beyond.

 

1 Is the boom in Bitcoin sustainable?

One bullish view on Bitcoin is that it is the new 'digital gold' and a hedge against the threat of inflation and dollar devaluation due to recent balance sheet expansions by central banks.

But that argument does not hold up when we look at the data; inflation has been subdued, with the US Bureau of Labour Statistics' estimates for the US CPI inflation rate for 2020 at just 0.4 per cent. During this period, the greenback has maintained its value vis-a-vis international currencies like the euro, yen and pound.  

Another bullish view rests on the distributed ledger technology becoming more mainstream, especially as in July 2020 the US Office of the Comptroller (OCC) published a letter announcing that US banks could provide cryptocurrency custody services for customers.

The private sector has also taken strides towards adopting Bitcoin: in October 2020 Paypal obtained US Government approval for supporting payments in cryptocurrencies. Most recently, on February 8 Elon Musk endorsed Bitcoin by investing up to $1.5 Billion with Tesla accepting Bitcoin as a means of payment.

However, Bitcoin is far from being hailed as the future of the payments system. Unlike stocks that pay a dividend, Bitcoin is an asset that has no stream of income, while research estimates up to half of Bitcoin transactions from 2009 to 2017 were for illicit sales and purchases of goods and services.

Regulators are clamping down on the lack of traceability, with a recent US Treasury proposal that requires exchanges to collect and report information on large transactions of un-hosted wallets.

In the event Bitcoin is used increasingly for goods and services payments, there are fundamental reasons why it may not replace the dollar as a medium of exchange. First is its limited scalability: while Visa and Mastercard can process up to 24,000 transactions per second, Bitcoin can action up to just seven per second.

A second concern is one of efficiency. Bitcoin’s transactions are authenticated via its proof of work system, in which miners compete to solve complex algorithms to authenticate transactions on the ledger. There’s no free lunch - the annual power consumption of authenticating Bitcoin’s blockchain is greater than that of a medium-sized country like Argentina.

These limitations of Bitcoin makes it less likely to reach sufficient scale to rival the dollar as the new dominant currency of the international monetary system.   

 

2 The rise of Ethereum and decentralised finance

While Bitcoin's recent boom can be attributed to investor sentiment, what about Ethereum? Ethereum's outlook is promising for several reasons.

First, a report by crypto research firm Messari shows that in 2020 trading on the Ethereum blockchain overtook the Bitcoin blockchain.

Second, the Ethereum blockchain has higher scalability, faster processing of transactions, and a planned upgrade to  ETH 2.0. This will add several features to increase scalability, security and adopting a proof of stake design, in which miners stake their holdings of Ether to become a validator in the network. More efficient than Bitcoin’s proof-of-work, this system uses less computing power to authenticate transactions on the blockchain.

Perhaps the most important feature of Ethereum’s long-term growth is that its blockchain has enabled the creation of numerous applications through its system of smart contracts. This has led to a surge in decentralised finance applications, colloquially known as 'Defi'. 

For example, one trend in Defi is 'yield farming', where lending platforms running on the Ethereum blockchain, such as Compound, set interest rates and allocate funds automatically through algorithms with no need for any paperwork.

Benefits include the instantaneous settlement of contracts, and minimising counterparty risk for lenders, so reducing the likelihood that any party involved will default. This is done through a system of smart contracts where borrowers are required to post sufficient collateral.

Other Defi applications that use the Ethereum blockchain are automated market makers, which are exchanges that trade based on algorithms without the need for a limit order book, something normal exchanges use to record orders to buy or sell securities.

One such major exchange that has a "constant product" algorithm - meaning it can always provide liquidity no matter how large the order size - is Uniswap. The advantages are simple: by getting rid of a market maker, a sufficiently liquid exchange can execute trades with minimal transaction costs.

While these mechanisms do work in theory, they do come with some practical risks. For example, traders may incur large slippage costs relative to order book exchanges. These costs are due to the algorithm adjusting the execution price in an adverse direction to the price immediately before the order.

Similarly, liquidity providers may find themselves “front-run” by informed traders, a scenario in which a trader can execute your trade before you, and unwind their position following algorithmic price adjustment to make a systematic profit.

    

3 The rise of CBDCs and Facebook's Diem 

The growth of Bitcoin and Ethereum has attracted the attention of mainstream financial institutions and policymakers alike, with the benefits of blockchain technology and smart contracts that cryptocurrencies bring now being pitched as a solution to consumer payments and central banking.

Facebook announced in 2019 its intention to launch a global stablecoin: Libra, renamed Diem. While its white paper makes clear the project is all about making international payments near-frictionless, the project has faced much scrutiny from financial institutions and central banks alike.

In a critical analysis of Libra/Diem by myself and Barry Eichengreen, a former Senior Advisor at the IMF, we discuss unresolved issues, such as whether the proposed capital buffer will be sufficiently backed with liquid dollar reserves, and if the Federal Reserve is able to provide an emergency backstop.

Turning to public alternatives, CBDCs are still at the developmental phase, with pilots such as China's digital currency electronic payments (DC/EP) project, and Sweden's E-Krona

While CBDCs present obvious advantages - by increasing financial inclusion of the unbanked population, improving cross-border payments and facilitating fiscal transfers - there are still many unresolved issues in their design.

First, will the CBDC be a retail or wholesale system? A retail system increases financial inclusion of the unbanked by giving every individual a direct claim on the central bank. A wholesale system instead gives banks the right to distribute the CBDC.

Perhaps the optimal design is somewhere in-between: China’s DC/EP pilot project is a hybrid system in which consumers have a direct claim on the central bank, and banks are in charge of distributing the CBDC to retail customers. Advocates for a hybrid system claim that it combines the credibility of a direct claim on the central bank with the convenience of private-sector payment services.

Second, how will transactions be authenticated on the network? A viable alternative design for CBDCs may be to use a permissioned distributed ledger, in which a set of authorized participants authenticate the blockchain through a majority rule.

Third, how will a digital currency interfere with the role of credit creation and financial stability? Critics of a digital euro argue that it may result in an increase in the likelihood of runs on bank deposits. 

Many of these questions are still being hotly debated among central bankers. A Bank for International Settlements (BIS) report lays out the following three foundational principles for a successful CBDC: first, a digital currency should not compromise monetary or financial stability, second, a CBDC can co-exist with private money (bank deposits), and third, contribute to payments innovation and efficiency. 

It will be interesting to see how the proliferation of CBDCs affects markets for Bitcoin, Ethereum and “Defi” applications. The widespread adoption of the underlying technologies, such as the distributed ledger technology and a system of smart contracts, bring us ever closer to the ideal of frictionless payments.

 

Ganesh Viswanath-Natraj is an Assistant Professor of Finance with research interests in international finance and cryptocurrencies. He teaches Empirical Finance for the MSc Finance and Finance 1: Financial Markets on the Undergraduate programme.

Follow Ganesh Viswanath-Natraj on Twitter @ ganvisnat.

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