Digital Currency Development Patterns, Potential Risks and Suggestions for Response

As a new form of virtual assets and financial instruments, digital currencies are emerging and evolving, and their influence is growing stronger day by day.

Digital Currency Development Patterns, Potential Risks and Suggestions for Response

Author.

Rui Min Pei Researcher, Institute of Strategic Consulting, Chinese Academy of Sciences

Researcher, Institute of Strategic Consulting, Chinese Academy of Sciences

With the rise of the modern information technology revolution, technology has had an unprecedented impact on finance and money, and digital currencies have emerged as a new form of virtual assets and financial instruments, and are constantly evolving and gaining more influence. As a result, the price of bitcoin has reached record highs, triggering public attention and much debate in the industry. In response, we tracked and analyzed the latest digital currency landscape, focusing on the main risks and impacts on China, and put forward preliminary response suggestions.

I. The latest situation of digital currencies

International organizations generally divide digital currencies into legal digital currencies (also known as “sovereign digital currencies”), private digital currencies (also known as “crypto assets”), and stable digital currencies with both sovereign and non-sovereign characteristics, according to the different ways of currency issuance and management. The three types of digital currencies are legal tender (also known as “sovereign digital currency”), private digital currency (also known as “crypto asset”), and stable digital currency (stable coin” anchored to sovereign currency or valuable asset) with both sovereign and non-sovereign characteristics.

(i) Private Digital Currency

Private digital currencies are “currencies” issued by private organizations without government credit backing and encrypted with blockchain technology. Bitcoin, born in January 2009, is the first private digital currency. Currently, there are about 7,000 different private digital currencies in the world, with a total market value of hundreds of billions of dollars. Because of their high price volatility, low transaction efficiency and poor value recognition, private digital currencies are difficult to use as trading currencies and are mainly used for speculative and hedging investments. The recent listing of the first digital currency trading platform (Coinbase) on NASDAQ and the admission of the first bitcoin financial product (ETF) to trade on the Toronto Stock Exchange have become milestone events in the history of bitcoin development. At the same time, with public figures such as Musk “carrying the load”, the price of bitcoin continued to climb, and by the end of April 2021, bitcoin’s single price peaked at nearly $65,000, an insane price increase of more than 60,000 times in a decade. On the other hand, the lack of liquidity has led to dramatic shocks in the price of the currency, with the cumulative amount of bitcoin contracts blowing up to hundreds of billions of dollars in 2021, involving millions of users.

(ii) Stable Coins

In order to overcome the risk of violent price fluctuations in private digital currencies such as Bitcoin, stable coins that anchor sovereign currencies or real assets and maintain a fixed exchange ratio have emerged. At present, there are about 50 kinds of stablecoins around the world, 23 of which are realized for trading, with a total market value of about ten billion dollars, and the rest are still under R&D testing. Among the operational stablecoins, the U.S. dollar-anchored TEDA coin (USDT) appeared the earliest (in November 2014) and is currently the stablecoin with the largest market share [1]. At this stage, the main use of stablecoins is to act as a transaction intermediary between private digital currencies and sovereign currencies to facilitate the circulation of private digital currencies. In the future, stablecoins have the potential to realize transaction as the main purpose and become an important channel for cross-border transactions and payments. The Facebook Libra coin, which is currently being developed and tested, has temporarily abandoned its goal of being a “super-sovereign currency” and transformed into a “Diem” under strong financial regulation. However, its design concept has a profound impact on the development of subsequent stable coins.

(iii) Legal Digital Currency

Bitcoin’s insane growth and the emergence of “super-sovereign currencies” have challenged the status of traditional sovereign currencies, forcing central banks to carefully assess the risk of paper currency replacement and consider the feasibility of issuing digital currencies. The legal digital currency is issued by the central bank and backed by credit, equivalent to banknotes, and is a payment instrument with value scale and legal compensation. The earliest legal digital currency originated from the report “Payment Technology Innovation and the Rise of Digital Currency” published by the Bank of England in 2014 [2], and the Bank of England then started the “Digital Pound Project”, which set off the biggest reform of the sovereign monetary system ever. In the fourth quarter of 2020, the Bank for International Settlements (BIS) sent a questionnaire to 65 central banks around the world, showing that 86% of central banks said they were conducting research or experiments on central bank digital currencies (CBDC) [3], and legal digital currencies have attracted high attention from central banks around the world. /EP) pilot use, becoming the first country to issue and test legal digital currency among large economies in the world.

II. Main Risks Raised

(I) Risks arising from private digital currencies

Private digital currencies are characterized by anonymous transactions, free flow of funds across borders, and irreversible transactions, etc. Because they are outside of regulation, their risks are accumulating as the price coins “roller coaster”, bringing potential risks to market participants and the entire financial system. First, crypto assets are prone to money laundering and terrorism financing risks. The anonymity of service providers and users in the crypto-asset system and the blurred transaction chain make it easy for wrongdoers to conceal the source and destination of their funds, which facilitates money laundering, terrorist financing and sanctions evasion. Secondly, the lack of transparency and regulation in the crypto asset system brings multiple risks to consumers such as legal transaction risk, capital settlement risk, price fluctuation risk, technical vulnerability risk, and capital raising fraud risk. Third, with the improvement of technology and the expansion of the scope and scale of the use of crypto-assets, crypto-assets have to some extent replaced cash, bank deposits and non-bank payment instruments, and the probability of the risk of individual crypto-asset system evolving into systemic risk is increasing.

(2) Risks arising from stable coins

Stable coins have important value in maintaining currency stability and facilitating cross-border transactions, and have the potential to grow into “super-sovereign currencies”, but there are many challenges in financial stability, regulatory compliance, technical security, privacy protection, cross-border money laundering, etc. First, the lack of regulation of the stable currency is difficult to adhere to the fixed exchange ratio commitment, stable currency overissuance and market manipulation scandals repeatedly occur; second, the stable currency challenges the current cross-border payment regulatory system. The main cost of cross-border payments comes from the differences in national regulatory systems, but new technologies and new payment tools just bypass rather than fundamentally solve the problem; third, stablecoins change the way digital assets are identified and traded, circumventing the existing data regulation methods and rules, especially they will greatly change the data regulation methods and rules, bringing new challenges to data flow regulation; fourth, they may contribute to the financing of terrorism, the give rise to new channels for cross-border money laundering. Stable currencies that ride on dissemination tools can transfer funds globally “as easily as sending a text message or sharing a photo”, which is undoubtedly a “nightmare” for cross-border financial flow regulation.

(iii) Potential risks of fiat digital currencies

Although legal digital currencies have the advantages of universal accessibility, no transaction intermediary costs, and can help improve the effectiveness of monetary policy and combat criminal activities compared to private electronic payment methods, developed countries are generally very cautious in the practical application of legal digital currencies. According to a study on digital currencies for retail central banks published by the International Monetary Fund (IMF) in June 2020 [4], legal digital currencies may raise the following potential risks.

First, the introduction of a legal digital currency may affect the transmission of monetary policy. For example, legal digital currency may change the demand for base money and its composition in an unpredictable manner, and may also change the sensitivity of money demand to changes in interest rates.

Second, it affects financial stability and commercial bank operations. Banks with a large share of deposits will face competition from legal tender, especially interest-bearing legal tender, making it necessary for banks to attract deposits by raising interest rates, or to shift to wholesale funding. This will reduce the overall net interest margin of commercial banks, leading to higher lending rates and increased operational risk for banks. The instability of bank funding will cause banks to hold more liquid assets or lend less.

Third, it will have an impact on the balance sheet of the central bank. If financial disintermediation occurs, commercial banks will lose deposits to the central bank, which can lend this money to commercial banks so that they can continue to engage in lending business. This would be a significant departure from the traditional role of the central bank, which would decide how to allocate funds, opening the door for policy intervention.

Fourth, a readily available, secure, and more liquid legal digital currency than bank deposits could accelerate bank runs, but this would depend on the availability of a deposit insurance system and the type of crisis.

Fifth, legal digital currencies that can be used as reserve currencies in cross-border transactions may exacerbate currency substitution in countries with high inflation rates and volatile exchange rates.

Third, the main challenges for China

Digital currency is a new form of currency in the era of digital economy, a product of highly developed modern commodity economy and continuous progress in cryptography technology, and also represents the development direction of modern credit currency forms, which to a certain extent promotes the innovative application and development of blockchain technology in China and also drives the development and utilization of idle energy in remote areas of China. However, with the soaring price of coins, cross-border financial activities and coin mining activities under the banner of “digital currency” are having a certain impact on China’s financial market, currency market and even energy and commodity markets.

On the one hand, domestic companies set up websites outside of China and return to provide illegal and illegal financial services in China. For example, through offshore platforms to carry out foreign exchange margin trading in the territory or ICO trading in the territory, through the purchase and sale of digital currencies to complete cross-border transfer of funds or money laundering, through digital platforms or applications for cross-border gambling, cross-border speculation, stock speculation activities, etc., which damage the order of China’s financial market. Some domestic institutions engage in cross-border “gray” financial services through websites set up in China, mainly in the traditional Internet financial sector. For example, through traditional fraudulent and misleading means and methods, they promise high returns, disguise the transaction process, use the pyramid scheme model to develop customers, and carry out pyramid scheme fraud overseas under the banner of China, damaging China’s national image.

On the other hand, the high price of coins has led to a large amount of resources flowing to the “mining” industry in China, which may damage the realization of China’s “carbon peak” and “carbon neutral” goals. Although many countries support “coin minting” through clean energy, as the price of digital currencies skyrockets, more and more fossil energy is being used to generate electricity to support “mining”. According to a study published by the Cambridge Centre for Alternative Finance (CCAF) at the University of Cambridge, bitcoin-related electricity consumption reached an all-time high in 2020, with global mining using more than 7 gigawatts (7GW) of electricity (about 63.32 terawatt-hours), which power is roughly equivalent to seven nuclear power plants or 21.8 million solar panels. Among them, China is responsible for 65.08% of the energy consumption, followed by the United States (7.24%) in second place and Russia (6.90%) in third place [5]. A study by a team of experts from the Chinese Academy of Sciences and the Department of Earth Series Science at Tsinghua University also found that without any intervention, the energy consumption of the Bitcoin blockchain within China is expected to peak at about 296.59 TWh in 2024, which means that by 2024 within China alone, Bitcoin mining will consume nearly 300 billion kWh of electricity a year. This will result in 130.5 million tons of carbon emissions [6]. While mining will cause energy tensions, it is a huge threat to China’s ability to meet its “peak carbon” and “carbon neutral” targets, and must be taken seriously as soon as possible. At the same time, the computing power and hardware resources required for mining continue to be tight, which has a significant impact on the normal consumption demand of the market.

IV. Suggestions for Response

In general, in the face of many challenges such as monetary sovereignty, financial stability, regulatory compliance, technical security, privacy protection and cross-border money laundering, it is still unclear whether non-sovereign digital currencies can “travel steadily and far”. At present, in order to prevent the impact of the surge and plunge of the currency price and ensure the overall safety of China’s financial system, it is still a priority to prevent risks and seek stability. It is recommended that China insist on the keynote of “seeking progress in a stable manner” and “concentrating on our own affairs”, vigorously promote the research and application of China’s sovereign digital currency, and simultaneously do a good job in dealing with the following risks.

First, the potential risks of private digital currency. Considering that its application prospect and situation are not yet clear, it is recommended to closely track the latest progress, make a good risk study and prediction, reserve risk response technology and solutions in advance, and take the initiative to explore the inclusion of bitcoin and other private digital currencies into China’s foreign exchange asset reserves.

Second, for the potential risks of stable coins. At present, major developed countries and international organizations are gradually tightening regulation. It is recommended that China closely track changes in foreign regulatory attitudes, strengthen innovative exploration and risk assessment of new concepts and structures of stable coins, and at the same time take the initiative to dovetail with regulation and do a good job of compliance development.

Third, test applications for sovereign digital currencies. It is recommended to draw on the useful experience of Internet finance risk prevention, and relevant regulatory authorities to cooperate closely to do a good job of relevant risk prevention and control, and provide technical support to combat illegal acts carried out by digital RMB and blockchain to ensure the stability of the financial and monetary system.

Fourth, for specific cross-border violations, it is recommended to strengthen the transfer of clues and coordination of case investigation in accordance with the State Council’s anti-money laundering, anti-terrorist financing and anti-tax evasion regulatory mechanism to form a joint effort to combat crimes. It is recommended to include digital currency and blockchain risk response plans in China’s 2030 “carbon peak” and 2060 “carbon neutral” roadmaps to ensure the smooth achievement of related goals.

Fifth, in view of the risk challenges caused by non-clean energy mining, it is proposed to include digital currency and blockchain risk response plans in China’s 2030 carbon peak and 2060 carbon neutral roadmap to ensure the successful achievement of the relevant goals.

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/digital-currency-development-patterns-potential-risks-and-suggestions-for-response/
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