Of State-Backed Digital Currencies and Cryptocurrencies
Gagan Jain Blockchain & DLT Consulting @ Cognizant
Coindesk published an article by Michael del Castillo recently where a CitiGroup exec called state-backed cryptocurrencies as being key for adoption of Blockchain Technology. It’s a point of view that I happen to agree with and so it was interesting for me to read a twitter discussion between a set of people who really know this space.
Ultimately, for me the discussion hinged upon the differences between a state-backed digital currency and state-backed cryptocurrency and what advantages the later could provide.
(Note: in this piece, when I refer to cryptocurrencies I’m NOT referring to stateless cryptocurrencies like Bitcoin, Ethereum, Litecoin etc.)
State-backed Currencies and Digital currencies
Let me start with attempting to define a state-backed currency for the context of this piece, irrespective of whether it is physical, digital, any other flavor.
A state-backed currency (USD, GBP, INR etc.) is a currency whose issuance and supply is completely centralized with the state itself. And in which one in which all assets, legal contracts and agreements happening within the jurisdiction of the state are denominated in.
A “digital” currency essentially signifies a digital rather than physical representation of the state-back currency. And since vastly more value of state-backed/sovereign currencies exist in digital form that in physical (note, coins) form, I’ll limit the scope of my argument here to digital manifestations of state-backed currencies.
However, a digital-currency NOT backed by cryptography is no different from a scanned copy of a physical photograph because it is impossible to prevent it from being double-spent without having a central nodes/clearing houses maintain centralized ledger(s) of who owns how many digital tokens of the currency in question.
Ultimately, all cryptocurrencies are digital currencies; but not all digital currencies are cryptocurrencies.
Representing this as a venn-diagram:
Limiting this piece to capital markets and transactions involving financial assets only, if digital tokens of financial assets such as bonds, shares, derivative agreements, etc. are also created on a similar non-cryptographic technological architecture, they will also need a clearing house to maintain a master list of asset ownership.
In terms of implications of such a technological model, there are multiple. But the biggest one pertinent to this discussion is that real-time Delivery versus Payment (DVP) and the benefits it can provide become difficult to achieve since multiple centralized ledgers need to come to a common consensus on the ownership of the financial assets and the digital currency tokens used to pay for these assets.
A state backed cryptocurrency on the other hand, is a state-backed digital currency which uses:
a) uses public key or asymmetrical cryptography to limit issuance and control of the supply of the currency to the state
b) uses distributed ledgers (and chaining of transaction or blocks made up of these transactions) to ensure that provenance of any individual token of the cryptocurrency be ultimately traceable to the state.
Since the provenance of all tokens of a state-backed cryptocurrency can be traced back to the state, they can be transferred and exchanged in a peer-to-peer manner without needing a centralized clearing house to maintain the ownership details of individual tokens.
This makes state-backed cryptocurrencies ideal for achieving real-time DVP in cases where the other financial assets (bonds, shares etc.) are also built on a similar distributed ledger based framework. As both can be transferred directly between the buyer and seller without having to go thru centralized intermediaries.
Cryptography here is used as the technology underpinning the issuance of currency. Not its value.
The ultimate value (or purchasing power) of any state-backed currency is still governed by principles of traditional economics (inflation/deflation, supply/demand etc.).
(Side-note: In state-less cryptocurrencies like Bitcoin and Ethereum, cryptography plays a much larger role in determining the value of the currency apart from providing security and traceability to the network. The value of the currency is ultimately a much more qualitative criterion based on (among others) perceived value of the currency and the trust its holders have in it.
Trust here is also dependent on how secure the currency and network is and therefore depends on the cryptography. Whereas in state-backed cryptocurrencies, trust is not just a function of how secure it is but primarily of the amount of confidence the currency-holders have in the state, which is the ultimate issuer of the security.)
The key place where the cryptographical underpinnings of a state-backed cryptocurrency start affecting its value is the increase in its liquidity the technology provides it. But again the question here is how much the liquidity of a currency affects its value. The answer should be looked from the perspective of purely economic models rather than being bogged down by the method of issuance of the currency.
Now coming back to the Coindesk article, if only financial assets and not the currencies in which they are denominated in are based on distributed, cryptographically based ledgers then only one leg of a transaction can be done in a peer-to peer manner but the other leg for making the payments for the assets in question would still need to go thru traditional payment channels, rendering the point of creating blockchain-based assets completely moot.
This is ultimately the reason why we’re seeing a number of banks join projects like the Utility Settlement Coin project. However such initiatives, though very valuable in the short-term, are only required because of the absence of state-backed cryptocurrencies.
(Disclaimer: I’m NOT an economist or a cryptographer (so there). These are my personal thoughts and points of view. I am not representing my current or previous employers through this post.)