By the Blouin News Business staff

Bitcoin’s rise and the future fall of central bankers

by in Global Economy.

Bitcoin/USD exchange rate

Source: Bitcoin

Quick quiz question: Which country’s currency has risen threefold against the U.S. dollar over the past 12 months, a period in which the U.S. currency strengthened by 4% against all currencies overall? Trick question. The contrarian outlier is Bitcoin, a virtual currency with a controversial history, and whose recovery Bloomberg highlighted Monday with its chart of the day. The (virtual) world’s largest online currency has risen to $18.56 from $5.29 since Jan 28, 2012, according to Bitcoin Charts, though it remains well below its speculative record high of $29.58 in mid-2011.

Bitcoin is issued by a decentralized network of computers. It does not have a central clearing house, nor are there any financial or other institutions involved in the transactions. This all makes it a libertarian’s dream – and a government’s nightmare.

Willard Foxton, writing in The Telegraph, captured the essence of the currency:

An online, virtual currency created in 2008, it is unpoliced by any central authority, almost immune to money-laundering rules, and incredibly hard to track. It’s a huge boon to those suspicious of governments or big banks, and has a legion of vocal advocates online, who love both the idea of an Austrian-economics inspired currency immune to meddling politicians, and the open-source spirit of the cryptography software required to “mine” the currency.

That makes it effectively digital cash, and thus a currency of choice both for those with honorable and for those with dishonorable intentions. Drug-dealing sites have used it. Kidnappers have reportedly demanded ransoms be paid in it. Stories of scams, Ponzi schemes and thefts abound.

The greater threat may be to central banks. Virtual currencies – Bitcoin is only the most prominent among the many that have proliferated in recent years – not only challenge their oversight of banking and payment systems, they could also circumnavigate their, and thus the state’s monopoly on money. Virtual currencies have the potential to become competitors to the U.S. dollar, the euro and other legal tender. The European Central Bank raised just this concern in a report last October.

Estimates of the size of the virtual economy that virtual currencies support vary widely, but range up to high single figures of billions. That is chump change compared to the $3 trillion that turns over daily in the foreign exchange markets for real currencies, but there are at least 50 countries whose GDP is smaller. At this point, the circulation of virtual currencies is too small to pose a threat to price stability or central banks’ management of monetary policy. Similarly, too-big-to-fail is not a systemic risk to financial stability.

Yet. If virtual currencies’ usage increases significantly that could change. For example, as the ECB points out,

a widespread substitution of central bank money by privately-issued virtual currency could significantly reduce the size of central banks’ balance sheets, and thus also their ability to influence the short-term interest rates. Central banks would need to look at their existing tools to deal with this risk (for instance, trying to impose minimum reserve requirements on virtual currency schemes).

For now virtual currencies pose most risk to their users. They constitute credit, liquidity and operational risks without any underlying legal or supervisory framework. They are another unregulated, decentralized global technological innovation outside the realm of governments that could one day upend traditional national regulation. Central bankers have good reason to be fearful of them.