The promise and pitfalls of crypto
The crypto universe is in turmoil. The implosion of the TerraUSD stablecoin and its
twin coin Luna is only the most spectacular failure in the sector, with many lesserknown coins having seen a collapse in price of more than 90% relative to their peak
in 2021. Crypto commentators have begun to refer to recent events as the start of
a “crypto winter”.
As dramatic as these recent price collapses have been, focusing on the price
action alone diverts attention away from the deeper structural flaws in crypto that
render them unsuitable as the basis for a monetary system that serves society
(Table 1, third column).
The prevalence of stablecoins, which attempt to peg their value to the US
dollar or other conventional currencies, indicates the pervasive need in the crypto
sector to piggyback on the credibility provided by the unit of account issued by the
central bank. In this sense, stablecoins are the manifestation of crypto’s search for a
nominal anchor. Stablecoins resemble the way that a currency peg is a nominal
anchor for the value of a national currency against that of an international currency
– but without the institutional arrangements, instruments, commitments and
credibility of the central bank operating the peg. Providing the unit of account for
the economy is the primary role of the central bank. The fact that stablecoins must
import the credibility of central bank money is highly revealing of crypto’s structural
shortcomings. That stablecoins are often less stable than their issuers claim shows
that they are at best an imperfect substitute for sound sovereign currency.
Stablecoins also play a key role in facilitating transactions across the plethora
of cryptocurrencies that have mushroomed in recent years. At the latest count there
were over 10,000 coins on many different blockchains that competed for the
attention of speculative buyers.
The proliferation of coins reveals another important structural flaw with crypto
– namely the fragmentation of the crypto universe, with many incompatible
settlement layers jostling for a place in the spotlight.
This fragmentation of the crypto universe raises serious questions as to the
suitability of crypto as money. Money is a coordination device that serves society
through its strong network effects. The more users flock to a particular form of
money, the more users it attracts. For this reason, money has the “winner takes all”
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property, in which network effects lead to the dominance of one version of money
as the transactions medium that is generally accepted throughout the economy. The
fragmentation of the crypto universe points in a very different direction: as explained
below, the more users flock to one blockchain system, the worse is the congestion
and the higher are the transaction fees, opening the door to the entry of newer
rivals who may cut corners on security in favour of higher capacity. So, rather than
the familiar monetary narrative of “the more the merrier”, crypto displays the
property of “the more the sorrier”. It is this tendency toward fragmentation that is
perhaps crypto’s greatest flaw as the basis for a monetary system.
Nevertheless, crypto offers a glimpse of potentially useful features that could
enhance the capabilities of the current monetary system. These stem from the
capacity to combine transactions and to execute the automatic settlement of
bundled transactions in a conditional manner, enabling greater functionality and
speed. Thus, one question to consider is how the useful functionalities of crypto can
be incorporated in a future monetary system that builds on central bank money.
In order to develop the deeper insights on the flaws and possibilities of crypto,
it is instructive first to explain some basic building blocks of the crypto world
