Rather than displacing banks, digital currency, such as Bitcoin, threatens a new form of banking crises caused by disintermediation runs through withdrawals of digital currency, says Dr. David R. Skeie, an Assistant Professor of Finance and Mays Research Fellow at Mays Business School.
In his recently published study,”Digital Currency Runs“, Dr.Skeie argues that such withdrawal runs also emerge as a new threat on banks taking deposits in publicly issued digital currency from the central bank. A central bank can act as lender of last resort to prevent the threat of such withdrawal runs for banks with public but not private digital currency deposits, study says.
According to Dr.Skeie, there is a trade-off for holding private digital currency. It avoids the costs of central bank inflation borne by fiat money. However, it loses the liquidity value creation of bank deposits if held directly. If instead, it is held in the form of private digital currency bank deposits, it is subject to fragility in the form of digital currency runs.
The rapid development of cryptocurrency has prompted widely acclaimed interest about its potential impact on the financial system and the economy. A primary motivation behind the development of cryptocurrency, such as Bitcoin, is that it has a fixed supply rather than the discretionary supply of fiat money issued by central banks.
Questions have emerged about whether cryptocurrency may eventually displace central bank fiat money and the banking system. In response, central banks worldwide are considering issuing their own form of digital currency. Concerns have also arisen about whether cryptocurrency may create fragility in the financial system.
The paper “Digital Currency Runs” develops a model of an economy under a modern central bank monetary system with banking to study how digital currency may compete with fiat money and affect financial stability. Dr. David R. Skeie shows that privately issued digital currency, such as Bitcoin, will be held if the cost of distortionary central bank inflation on fiat money is large enough. While such digital currency does not require a banking system, banks that take digital currency deposits can emerge to provide efficient liquidity risk sharing without the inflationary risk of fiat money.
Public vs Private digital currency
“In my model, two forms of digital currency are introduced into an economy based on banking with fiat money,” Dr.Skeie explains.
“Digital currency that is issued by the central bank, referred to as public digital currency, is an alternate form of outside fiat money that can be held by consumers in direct accounts at the central bank and hence outside of the banking system. Digital currency such as Bitcoin that is privately issued, referred to as private digital currency, can also be held as a form of outside money directly by consumers. Both forms of digital currency can be used by consumers to make payments for buying and selling goods without relying on holding bank deposits to make payments for such transactions,” the paper reads.
“I show that if the central bank has a bias for higher short-term output, there is distortionary fiat inflation enabled by the central bank’s discretion over the money supply and short-term nominal interest rates,” says Dr.Skeie.
Privately issued digital currency can provide a store of value and will be held, leading to the displacement of fiat money, if the cost of discretionary central bank inflation on fiat money is large enough. While either form of digital currency permits the displacement of the banking system, banks that take private digital currency deposits can emerge to provide consumers with efficient liquidity risk sharing without the inflationary risk of fiat money. The economy based on fiat money can transition to a private digital currency while still featuring a fractional reserve banking system similar to that with fiat money.
Bitcoin price volatility
The potential for a cryptocurrency to be adopted as a widespread form of money is a highly debated question along additional dimensions that are not considered in this paper. For example, the ability for private cryptocurrency to be widely adopted as money may be viewed in part as an economic coordination problem. Bitcoin has displayed extreme price volatility, limited acceptance and use, and large competition from other cryptocurrencies, which in turn further limits its acceptance and use. However, if a private digital currency were to be broadly adopted in an economy as the predominant monetary system, such widespread acceptance and use may lead the private cryptocurrency to have a stable value, further supporting its use.
Additionally, whether private cryptocurrency can ultimately displace central bank fiat money is also in part a political question. Bitcoin and other private cryptocurrencies are currently viewed by many as primarily a means for black markets. Several less developed countries have wavered between the extremes of officially supporting the adoption of private digital currency, such as Bitcoin, for its potentially greater stability as a monetary form, and banning its use because of its possible ability to take the place of a country’s own fiat money.
Developed countries are also considering developing public digital currencies in part because of the perception for private cryptocurrency to potentially displace fiat money. However, the development of broader applications of blockchain technology beyond digital currencies may become so widespread and ubiquitous in the financial system and economy that cryptocurrency maybe a required complementary feature.