Everyone seems to be discussing cryptocurrency these days. The Reserve Bank of India has expressed concerns about legalising cryptocurrencies in the country, while the government seems to be willing to discuss their introduction with stringent regulation. The problem with cryptocurrencies is that they are highly volatile, unregulated and could be used for nefarious activities. This article is an attempt to approach the issue from the perspective of an economist.
If we go strictly by the definition of currency, cryptocurrency does not fit the bill. It is neither a unit of account nor a store of value. Money is a store of value because it is the most liquid asset and is accepted in transactions everywhere within the jurisdiction of a country. In contrast, can cryptocurrency be used in everyday transactions? Is it easily available and does it enjoy universal acceptability? Can a currency on which national authorities have no control be provided legal backing?
The age of commodity money
A study of the evolution of money will tell us commodity money preceded the introduction of paper currency. In the case of commodity money, the value assigned to the currency is equivalent to the value of the commodity. Gold is a good example of commodity money. The value of gold is equivalent to the worth of the gold coin. In some civilizations, silver was also used as commodity money. Paper currencies, which came into existence later, were legal tender.
It is the responsibility of the government to ensure that the legal tender is respected. The governments also need to ensure that the legal tender is not easily replicable. When Muhammad bin Tughlaq introduced leather currency in the 13th century, it did not succeed because it could be minted by anyone and fake currency started to circulate.
Tughlaq tried alternate currencies made of brass and copper, and every household in the country became a mint and started producing copper and brass currency. Tughlaq had to withdraw his orders within eight days. But, the repercussions of the attempts lasted many decades. Tughlaq lost parts of his empire because of his misadventures.
In monetary policy, it is imperative that money supply is regulated and supervised. To cover the cost of minting, regulating and supervising the monetary system, a substantial amount of seigniorage income is provided. In broader terms, money supply is not only currency and coinage (generating seigniorage), but also banking credit. Cryptocurrency does not meet this requirement. Cryptocurrencies are minted outside the legal system of the country and the jurisdiction of central banks.
The quantity of money supply has economic implications. Money can be invested, and real rate of interest and inflation are associated with the money supply in the economy. Cryptocurrency, unregulated and unaccounted, cannot be factored in investment decisions or inflationary expectations.
Cryptocurrency and gold
The logic that gold is a universal currency and cryptocurrency can also be treated similarly is misplaced. Gold is commodity money. As explained earlier, the value of gold in a gold coin is known. Market determined price is based on cost of mining, supply and demand. The production process of gold is transparent and the value of gold has generally been stable.
Cryptocurrency lacks these characteristics. It is an unseen commodity/ currency and there is no value assigned to cryptocurrency in terms of its content. As the value of cryptocurrency is volatile, its holding can cause wild fluctuations in the balance sheet of the central bank, unlike its holdings in gold.
Cryptocurrency is not very popular in advanced countries but it has picked up in developing countries and emerging markets, where it is seen more as an asset class. There is a lack of investible assets in developing countries, which probably contributes to the popularity of cryptocurrency. It is difficult to make a currency popular without the backing of trade, country or value of commodity. For example, SDR, IMF’s currency, could not become popular or universally accepted despite various efforts in the last 50 years.
Another example of this is the euro, which, despite the efforts by European Central Bank in the last two decades, is still struggling for acceptability. The euro has also not been able to replace the dollar or UK’s pound sterling. China, with its booming economy and large share in global trade, is attempting to make Renminbi globally acceptable, but not been able to displace gold or the dollar.
Caution always paid for India
Introduction of a new instrument or currency also has associated risks. In India, there have been instances that point to the need for caution. The RBI delayed the introduction of complex financial derivatives because of the risks involved. The US authorities experimented with it under their light-touch regulation and the move led to the collapse of Lehman Brothers and the meltdown of global financial markets. Another illustration in the Indian market is the foreign exchange exposure of the private sector that was tightly regulated by the RBI.
In October 2008, the RBI relaxed the foreign exchange exposure norms for private firms. The consequences were severe. The firms did not understand the risk and their responsibility associated with it. Foreign exchange risks are difficult to measure and complex. The foreign exchange markets were hit severely in 2009 and the firms approached the RBI seeking accommodation for the exposure and associated losses.
India’s conservative approach to regulation paid rich dividends in the issue of capital account convertibility (CAC). This is a relevant example in the context of cryptocurrency. There was immense pressure on India from multilateral agencies to adopt CAC after the financial sector reforms were introduced in the early 1990s. The RBI held its ground that the Indian markets are still not ready for global competition. The multilateral agencies argued that CAC is helpful in integrating domestic market with global markets.
The Indian authorities argued that the domestic financial system was not prepared to receive the type of resources that CAC provides. Consequently, two committees led by former RBI Deputy Governor SS Tarapore were set up. They presented the conditions necessary for the successful implementation of CAC in India.
Two decades later in 2012, multilateral agencies realized that prudential norms and a robust financial system are needed for the successful implementation of CAC. The global pressure on emerging markets to accept cryptocurrency must been seen in similar light. It needs to be evaluated as India did in the case of CAC. India carefully opened up capital accounts, taking small steps at a time.
The responsibility of the government and the regulator is to ensure the financial wellbeing of citizens. The financial health of citizens can be impacted if the financial instruments are risky. In a continent-size economy like India, with various levels of financial literacy and different capacities to absorb risk, introduction of any new instrument has to be very cautiously examined.
The evaluation of cryptocurrency is fraught with difficulty as it is not regulated by any government or sector-specific regulator. It is minted by digital mechanisms and whenever there is a breach in the firewall, there is a possibility of heavy losses to the investors. In an emerging economy, financial resources are scarce.
It takes decades of hard work by the government and the regulator to create a robust ecosystem and investor-friendly environment. Therefore, to retain confidence in the regulatory framework and financial markets, it is necessary for the investors to be adequately educated on the risks associated with the instruments available in the market.
The regulator should ensure that prickly instruments that have the potential to hurt the investor and the investment climate are tightly regulated and isolated from plain vanilla instruments. This regulatory approach towards cryptocurrency is of utmost importance, especially in the post-Covid recovery phase of the economy.