The Wider Impact Of A National Cryptocurrency

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Global Policy, June 2018The Wider Impact of a National CryptocurrencyDennis Ng and Paul GriffinSingapore Management UniversityAbstractThis study looks at the impact of a national cryptocurrency on the payment landscape in themidst of the rise of global public cryptocurrencies and interest from central banks in a possiblenational cryptocurrency. The impacts are analysed for consumers, merchants, banks, paymentproviders, international money transfer operators and central banks. The study analyses thepros and cons for each player with an overall impact ranking. There is a particular emphasison central banks as they hold key regulatory oversight for economic and financial mattersaffecting a country. Whilst finding that there is an overall benefit, there are also significantrisks. A sandbox approach is proposed for specifically mitigating some of the risks ofintroducing a national cryptocurrency.Policy recommendations Governments should explore the potential benefits of the technology behindcryptocurrencies because the benefits to payment players is overall positive. Central banks should consider a crypto-sandbox approach to mitigate the potentialrisks of issuing a national cryptocurrency. The crypto-sandbox should include paymentplayers and specific testing for special cyber-security attacks and economic changes. A possible area of immediate benefit from cryptocurrency technology is B2B transfers.Central banks should consider how this technology can benefit funds transfers betweenbanks and companies without the complication that comes with using the technologyamong consumers at large. Once more experience and learnings is gained from the sandbox, the technology canthen be slowly expanded to the consumer and cross-border markets after a thoroughexamination and controls have been put in place for possible risks and policy changes.

Global Policy, June 2018IntroductionA cryptocurrency is currently defined as “a purely peer-to-peer version of electronic cash [that] wouldallow online payments to be sent directly from one party to another without going through a financialinstitution”.1 This definition is obviously meant to describe international cryptocurrencies like Bitcoinand Ethereum. On the other hand, a national cryptocurrency is more likely to have properties ofbeing regulated and backed by the government since it would be issued by the central bank itself.Amongst other questions on top of the minds of central bankers, one of them must surely be whetherthey should issue a national cryptocurrency to enjoy the benefits that the new technology offers. Thispaper attempts to analyse the wider effects of a government deciding to implement a nationalcryptocurrency and how risks could be mitigated. We included a wide range of players in the industryin our comparison. Central banks in particular have a macro environment mandate and their decisionneeds to take into account the overall effects on the whole economy including the industry andfinancial ecosystem.Background of cryptocurrenciesThere are many electronic methods for making domestic payments. Each country has their owndomestic players, together with familiar international brand names like PayPal, SWIFT andVisa/MasterCard who offer their international clearing systems to domestic payments.Cryptocurrencies on the other hand differ in that the transaction processing is no longer centralisedto one company (e.g. Visa, PayPal) but is decentralised within a network, either public such as forBitcoin, or in a consortium such as Ripple. No one company owns all the data and processing. Allthe participants in the network can access the transaction data which is kept in consensus within thenetwork. This is a small change in the paradigm but a major shift in how the participants worktogether.International cryptocurrencies are a recent invention. Early forms of online currencies surfaced evenbefore 2008. Table 1 below contains a short historical background. We juxtaposed cryptocurrency’sgrowth against other developments in the global economy to highlight the larger forces contributingto its growth.Table 1: History of Cryptocurrency & Key Global Developments 1, 2, 3, 4PeriodKey Cryptocurrency DevelopmentKey Global DevelopmentsPre2008Various attempts to create online currencies 2006: WikiLeaks launchedsecured by encryption. B-Money and Bit Goldare some examples of early development in 2007: Steve Jobs announcesiPhonecryptocurrencies.2008sFirst cryptocurrency, Bitcoin, released around - Black Monday in worldwide2008 by “Satoshi Nakamoto” taking the pre- stock markets and Bloody Fridayexisting digital coin market further by where many world’s stockdecentralizing the currency and freeing it from11

Global Policy, June 2018hierarchical power structure using a peer-to- exchanges experiencepeer network.declines in history.worst- Start of global financial crisis,beginning in the US- Global financial crisis spreadsacross the world, plunging manycountries into recession2010sFirst publically traded Bitcoin – owner swaps - Countries slowly begin to10,000 Bitcoins for two pizzas.emerge from the recession2011sLitecoin released. It modified Bitcoin’s protocol - Other countries beginby making it faster and more appropriate for recover from recessiondaily transactions. Other cryptocurrencies alsobegan to emerge, like Namecoin and thousand - Wikipedia turns 10 yearsothers.2013sPrice of Bitcoin crashes after reaching 1,000 - European Commission forecastfor first time.2013 growth of 0.1%to- Japan remains in recession aseconomy shrinks by a is launched using a model different -Psy’sGangnamStylefrom Bitcoin. Peercoin launches with technology becomes first video to reach 2using own mechanism, proof-of-stake (PoS), billion views on YouTubeemployingahybridnetworksecuritymechanism. NuShares/NuBits introduced inAugust 2014, using a dual currency model. Atthe same time, scams started appearing, withworld’s largest Bitcoin exchange Mt. Gox goesoffline with missing Bitcoins to the value of 450million.2016sA blockchain organisation, Ethereum, becomespopular by attracting investors over sed smart contracts (code run onthe blockchain) and decentralised applications.Initial Coin Offerings (ICOs) emerges, allowinginvestors to use these fundraising platforms totrade digital assets such as stocks or shares instart-up ventures, real estate and to raise funds- UK votes to leave the EUthrough the Brexit referendum- Google’s DeepMind artificialintelligence wins Go challengeagainst Lee S-dol- China’s super computer tallyovertakes the US12

Global Policy, June 2018for new projects. Chinese government bans - Pokémon Go releasedICOs while the US SEC warns investors of thelack of oversight over these ICOs. Other - Amazon announcesregulators, such as MAS in Singapore, clamp delivery by dronedown on ICO tokens that appear to beinvestment schemes and need to be licensed.2017s2018Bitcoin’s price reaches 10,000 against abackdrop of increasing growth in places wherethe cryptocurrency could be used. More moneystarts flowing into cryptocurrencies. Marketcapitalization of all crypto coins rises from 11Billion to 300 billion. Banks expand theirexperimentation of the technology andphenomenon – interested in harnessing theefficiencies while cautious about how thephenomenon might play out in the real financialeconomy. New crypto-currency Bitcoin Cashcreated due to a fork in the blockchain.first- Britain introduces first newpound coin in 30 years withsecret security feature to stopcounterfeiting- Apple becomes first companyto be worth more than 800billion- Apple unveils premium iPhoneX, together with iPhone 8- US Federal Research starts tounwind bond portfolio employedin wake of financial crisisBitcoin price rises to close to 20,000 and then - Google unveils a new quantumcrashes to around 10,000. A correction or the computing chip with 72 quantumstart of a demise?bitsA few key developments seem to parallel the growth of cryptocurrencies as can be seen from Table1 above – the recovery from the global financial crisis and the growth of computer and mobile power.Furthermore, the usage of the internet and social media has been perceived to have massivelyincreased even affecting politics by allowing fake news to potentially influence voters. 5 Onlinepurchases have also doubled in the last four years and expect to quadruple by 2021.6Cryptocurrencies were born during the tumultuous times of the global financial crisis. Theirsubsequent growth parallels the recovery of the world from the recession. Author Timothy Earlementions the loss of trust in financial institutions as a side effect of the global financial crisis. 7 It ispossible that cryptocurrency growth rode on the lack of this trust. This is aptly described by the thenChairman of the Fed, Ben Bernanke, “As in all past crises, at the root of the problem is a loss ofconfidence by investors and the public in the strength of key financial institutions and markets”. 8Another factor in the rise of cryptocurrencies which is not captured in the table above is moneylaundering. Author He Ping, writing in the Journal of Money Laundering Control as early as in 2004,mentioned that criminals everywhere try every possible way to launder money. 9 However, with thecontinued efforts of national and transnational government efforts to reduce money laundering,launderers have started to switch their activities to cyberspace with the help of electronic money due to having fewer know-your-customer (KYC) requirements and even less audit trails.13

Global Policy, June 2018Cryptocurrencies, with no jurisdictional oversight, fit into this nicely. Furthermore, it remains unclearhow cryptocurrencies fit into existing legal frameworks making it easier to escape anti-moneylaundering laws.10Has the growth of cryptocurrency correlated with money laundering? Unfortunately, the statistics forsuch a shadow economy activity is difficult if not impossible to retrieve.However, an estimate of the shadow economy output, using Indonesia as an example, can be seenin Figure 1 below.Figure 1: Indonesia, formal and shadow output (1980 100)Source: Solis-Garcia & Xie (2018)11Figure 1 above gives an indication of the size of the shadow economy for an average developingmodern economy like Indonesia. The key point to note is that the shadow output increases in linewith the formal output. Therefore, assuming a similar trend for the amount of total global shadowoutput given the recovery the world has enjoyed over the last decade, the global shadow economymust be 100s of billions of dollars. An area for further research could be to confirm the correlationand causal relationship between money laundering and the growth of cryptocurrency.Growth of cryptocurrenciesThere are various other practical reasons for the increasing popularity of cryptocurrencies.Convenient. Blockchain technology offers fast, secure and convenient payment transactionprocessing. It is also easy to set up digital wallets with little or no requirement for KYC forms andbackground checks and there are no bank applications forms to fill in.Low-cost. Blockchain infrastructure works without bank and other commercial paymentintermediaries, thus cutting out the middlemen and making them generally lower cost than theconventional banking and money-transfer products.14

Global Policy, June 2018Decentralized. There is no regulatory oversight and restrictions since the network and accounting isdecentralized across many individual players in the global market.Transparent: Blockchain technology allows storage of the details of every single transaction thatever happened in the network and these records or audit trails are available for everyone to inspectand cannot be modified.Appreciating value. Investors and speculators alike have moved funds into cryptocurrencies as ahedge against various risks like currency devaluation, or simply to make a profit quickly from therapid rise of Bitcoin.Pseudonymity. With most public cryptocurrencies the users have a state of pseudonymity whereaccounts are not anonymous as they have a unique identifier, but as long as the identifier cannot belinked to an individual the owner of the account remains unknown. There are blockchains such asMonero which do claim to provide full anonymity.12However, cryptocurrencies also have drawbacks alongside the inherent risks of new technologiesand unregulated activities. These include:Security. Whilst the bitcoin consensus protocol has never been hacked, the various componentsaround bitcoin such as wallets and exchanges have been hacked. For example, Mt Gox, which wasthe largest bitcoin intermediary and the world's leading bitcoin exchange, had a security breach on19 June 2011 when it announced that approximately 850,000 bitcoins belonging to customers andthe company were missing and likely stolen, an amount valued at more than 450 million at the time.On top of this, smart contracts have unique security issues that has led to problems such as theDAO losing US 55 million in 2016.13Power costs. The most popular method to maintain consensus in a cryptocurrency blockchain is“Proof of Work” which requires a significant amount of electric power.14 There are alternativeconsensus mechanisms such as “Proof of Stake” but must still prove themselves to be as reliableas Proof of Work at large scales.15Performance. As with any technology, there are trade-offs with functionality, speed and volume. Fora cryptocurrency the speed at which transactions are validated by the blockchain is one of the mostimportant factors. For example, Bitcoin validates a few thousand transactions in each block in aroundevery 20 minutes (equivalent to around 2 transactions per second). This is a reasonable speed butis much less than credit card transaction processing rates of around 24,000 transactions persecond.16 Blockchains are now improving with Ripple claiming similar transactions speeds and avalidation time of 4 second.17 However, transaction volumes in Ripple are around 5 million per daywhereas Visa Net processes an average of 150 million transaction each day. 18,19 While Ripple’stransaction speed is becoming close to the average for credit card processing, the need for bothvolume and speed is necessary for cryptocurrencies to be a taken up as a national currency.20Analysis of central bank responsesThe same reasons for cryptocurrency’s popularity has been the very reasons for them drawingincreasing regulatory attention.21 Central banks today are intrigued not only by the tremendousappreciation in value of Bitcoin over a short time, but also the technology behind it.15

Global Policy, June 2018Below is a sample list of approaches taken by central banks on this issue including the use of aregulatory sandbox. A sandbox typically limits the amount of business that can be done and ensuresthat customers are aware that the technology is not mainstream. The UK’s Financial ConductAuthority, in their report to Her Majesty’s Treasury, defines a regulatory sandbox as “a ‘safe place’in which businesses can test innovative products, services, business models and deliverymechanisms without immediately incurring all the normal regulatory consequences of engaging inthe activity in question.”22 The regulatory sandbox allows new financial service providers toimplement innovative services without being too cautious because of normal regulatory requirementsand avoids negative outcomes for promising innovations.Table 2: List of Central Bank’s General Responses To Date 15 May 2018*23,24,25CountryGlobal and National Regulatory Sandbox Approach orCryptocurrency Status Experimental ApproachAustraliaAllowed, but regulatedIcelandAuroraCoin, 2014SpainSpainCoin,2014;PesetaCoin, 2014GreeceGreeCoin, 2014ScotlandScotCoin, 2014CyprusAphrodietCoin, 2014IrelandIrishCoin,2014,GaelCoin, 2014PortugalCryptoEscudoGermanyDeutsche eMark, 2013ScandinaviaEkrona, zaCoin, 2014CanadaMapleCoin, 2014IsraelIsraCoin, 2014Sandbox likely in 201816

Global Policy, June 2018ChinaICOs bannedSouth KoreaICOs bannedHong KongAllowed, subjectfuture regulationsConsidering sandboxtoTaiwanThailandConsidering sandboxAllowed, subjectfuture regulationsto Sandbox likely as first step, 2017Recognises BitCoin as legal tender,Apr 2017JapanSandbox likely as first step, 2017IndiaSandbox likely as first step, 2017Allowed, rules vary bystate, need AML/KYC.USUKSandbox implemented, 2017SingaporeProject Ubin sandbox implemented,2017*Correct as at 15 May 2018, subject to change with passage of timeAn analysis of the responses to date reveals a few key points on the history of regulatory approachestaken thus far: A rush to issue national cryptocurrencies took place in 2014 during the early days ofcryptocurrencies (see table 2). The reasons for issuing national cryptocurrencies ranged from“fixing” the economy from the aftermath of the 2008 financial crisis, to “nostalgia coins”primarily among the Eurozone countries to drum up sentiments among citizens andintroduced as alternatives to current financial systems.23 Amidst some exceptions, most did not have much economic design or planning behind themto allow these national cryptocurrencies to be accepted like a fiat currency as a medium ofexchange, a unit of account and a store of value. The current approach to national cryptocurrencies seems to take a more experimental andanalytical approach. This approach is to firstly implement a regulatory sandbox to experimentwith the technology with the aim of harnessing the benefits while considering ways to limitthe potential risk before coming up with a decision on how to implement the technology.17

Global Policy, June 2018 Even those who may have earlier banned cryptocurrencies may be currently mulling over asandbox approach before issuing new regulations or tweaking regulations further. TheChinese authorities whom earlier banned ICOs are now considering a sandbox approach totest the technology.26 Japan is another case in point. Japan had earlier legalised Bitcoin aslegal tender, but this did not prevent them from also considering a sandbox approach in2018.27Analysis of players in the payment landscapeThe impact of a national cryptocurrency affects many players in the payment processes and ananalysis is now provided for each player in terms of its potential advantages and challenges andsummarised in table 3.ConsumersFrom a consumer point of view for purchases, having a national cryptocurrency alongside currentpayment options and a global cryptocurrency, merely introduces another electronic payment optionfor purchases which, if they are already free and fast, is unlikely to add any benefit. However, forinternational money transfers the current choices are costly and take significant time. Globalcryptocurrencies typically have lower fees compared to traditional options like Western Union andPayPal. They are also faster but have higher exchange risks due to the necessity to convert to andfrom fiat currencies to cryptocurrencies on both sides, unless earning in the cryptocurrency or payingin cryptocurrency. The overall impact of the introduction of a national cryptocurrency for a consumeris expected to be positive due to possibly cheaper international money transfers and, possibly, evenlocal payments.MerchantsFor the merchant, it is likely they will offer to accept national cryptocurrencies for payment of theirgoods and services if their customers request it, and the cost of acceptance is not prohibitivelyexpensive. Therefore, a national cryptocurrency will exist alongside the prevailing domestic paymentoptions. The impact is seen to be negative as merchants will need to further complicate the paymentoptions they offer and will not see any benefit unless there is a significant reduction in the servicecost by avoiding or “disintermediating” payment providers.CorporatesCommercial organi

Central banks should consider a crypto-sandbox approach to mitigate the potential risks of issuing a national cryptocurrency. The crypto-sandbox should include payment players and specific testing for special cyber-security attacks and economic changes. A possible area of immediate

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