El Salvador has adopted Bitcoin as its official national currency. Other small countries with traditionally weak currencies might also replace their national currencies, or the US dollar, with a privately-created cryptocurrency. Large countries with geopolitical ambitions will adopt their own state-controlled cryptocurrencies so as not to give up seigniorage gains and to continue pursuing an independent monetary policy.
El Salvador introduces Bitcoin as an official means of payment
In Part 2 of our series, we showed that a state with a very weak currency could, in extreme cases, have difficulties buying goods with its national currency if the seller of those goods no longer accepts this currency. Instead of tackling competition from cryptocurrencies head on, there is the option of replacing the national currency with a privately-created cryptocurrency. El Salvador has chosen this radical path. In September, the central American nation became the first country to introduce Bitcoin as legal tender. Since 2001, the country had used the US dollar as a de facto means of payment. The outcome of this “experiment” to supplement or even replace the US dollar with Bitcoin is likely to be groundbreaking for other countries with traditionally very weak domestic currencies. El Salvador is now less dependent on US Federal Reserve policy. On the other hand, its new national currency (Bitcoin) is subject to enormous fluctuations against all other currencies. In theory, everyone in El Salvador must accept Bitcoin as payment. However, there is a loophole: Those technically unable to use Bitcoin may continue to use US dollars for payments, including tax payments. We will be watching closely to see if Bitcoin can prevail against the US dollar in El Salvador. One can assume that the Fed (and also other developing countries) will watch developments in El Salvador with a wary eye.
China chooses the opposite path
China has banned the use of cryptocurrencies for transactions, as well as the mining of them and their use as a store of value.
Which countries will choose which path?
Large countries, and all nations with “geopolitical ambitions”, will not renounce a self-created national currency (and thus an independent monetary policy and seigniorage profits) and will try to eliminate all other means of payment which threaten the standing of the national currency. These countries are likely at some stage to introduce sovereign cryptocurrencies, to be created by their respective central banks.
Should El Salvador’s experiment prove successful, small emerging market countries are likely to toy with the idea of introducing cryptocurrencies in the private sector. Presumably, such countries would also choose Bitcoin. These countries are hardly in a position to make seigniorage gains with their national currencies anyway, since demand to hold those currencies is very limited absent compensation via very high rates of interest. Scope for an independent monetary policy is also limited for these countries, as they are by definition “small”. To the extent their economies are “open“, scope to pursue an independent monetary policy is even more restricted.
A cryptocurrency, like any currency, must perform multiple functions if it is to gain traction:
1. unit of account Cryptocurrencies can have smaller units than “traditional money”. These small units could actually be used for so-called “micro-payments“. For example, the current smallest unit of Bitcoin is 1 Satoshi. And 1 Satoshi is “1 hundred millionth” (=10-8) of a Bitcoin. If 1 Bitcoin costs 60,000 CHF, the value of 1 Satoshi is 0.0006 CHF or 0.06 centimes. Cryptocurrencies could be well-suited for “micro-payments”. Providers are experimenting, for example, with charging customers a “mini-bill” for reading one page of a book. Stablecoins, which replicate the value of state fiat currencies, and Bitcoin (or other cryptocurrencies whose value fluctuates strongly) are equally suitable for such “micro-payments”.
2. means of exchange function: Most business costs (wages, financing costs, the purchase of many inputs) will have to be paid for in the respective national fiat currency for the foreseeable future. If goods and services are now to be sold against cryptocurrencies, the value of those sales in terms of the national fiat currency will be hard to estimate since all cryptocurrencies (except Stablecoins) can be subject to very strong fluctuations on a daily basis. The same applies to the buyer: If he buys an item with Bitcoin in the morning and Bitcoin rises by 25% against the local currency (in which the buyer earns his income) in the afternoon, the buyer may find out in the evening that he has paid 25% more than originally thought (in local currency) for the item. Therefore, cryptocurrencies (with the exception of Stablecoins) are currently less likely to be used as a medium of exchange. This would only change if the majority of producers and consumers had both their income and expenditure in cryptocurrencies, something not (yet) in prospect. Therefore, cryptocurrencies function less well as a medium of exchange than traditional currencies, again with the exception of Stablecoins, whose value is linked to the value of fiat currencies.
3. store of value function: Bitcoin is subject to wide fluctuations in value and is considered by many investors to be a speculative asset. Stablecoins replicate the value of government fiat currencies.
The 4th function of cryptocurrencies
Some argue that cryptocurrencies fulfill functions that go beyond the three traditional functions of currencies outlined above and represent a technical revolution. This technical revolution it is said will “guarantee” the future success of cryptos and therefore traditional fiat currencies will increasingly lose ground against them.
Many cryptos were therefore not primarily created with the aim of resisting the arbitrary money multiplication of central banks, but rather to use the blockchain for business applications, smart contracts and “De-Fi”. The protection against the arbitrary expansion of the money supply, and thus against inflation and the risk of traditional currencies losing value, is especially in the foreground with Bitcoin.
Notwithstanding the potential fourth function of cryptocurrencies outlined above, any currency must at least fulfill the three basic functions examined in this paper: unit of account, medium of exchange and store of value.
We intend to estimate in a later paper how revolutionary the yet to be more precisely defined “4th function” of cryptocurrencies might be.
We also try to give a rough estimate of how high one should weight cryptocurrencies in an investment portfolio.
Contact: Thomas Härter, CIO, Investment Office
Telephone: +41 58 680 60 44
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