How Can Central Banks Shape The Future of Cryptocurrencies?

Cryptocurrencies are driving financial revolution. By eliminating third party involvement, they call into question the paradigm of conventional fiat currencies and the role of financial institutions or central banks. However, influential financial institutions and central banks worldwide can play a major role in shaping cryptocurrency landscape. Responding to this new paradigm, banks and financial sectors are prototyping their own cryptocurrencies.

Central banks posses the unique convening power required to bring together different players in the financial sector to minimize market fragmentation and lay a strong foundation for the use of cryptocurrencies.   

Central banks that act now can shape the future of cryptocurrencies

Distributed Consensus Ledger (DCL), the technology that fosters cryptocurrencies is creating a revolution. It helps create and maintain complete and secure transaction records without requiring any central registry. This allows direct peer-to-peer transactions, making intermediary functions redundant, like that of financial institutions or clearing houses.

Central banks that act now can shape the role that digital currencies can play in the economy. A cryptocurrency issued by the central bank can reinforce bank’s mandate to maintain economic stability, customer protection and controlling money supply. To accomplish the same, central banks need to expand their conventional roles. They can issue fiat currency on the blockchain similar to the way they issue fiat currency as physical cash.

The money in circulation today, except for cash in the hands of individuals, is owned by the central bank and commercial banks of given currency’s legal jurisdiction. The bank is liable to the depositor, but can utilize the money to give it as a loan to others.

When it comes to cryptocurrency, people holding private keys are the owners of the funds. Commercial banks could serve to issue and safeguard keys – wallets rather than bank accounts.

Understanding DCL

The DCL is a ledger of transactions distributed on multiple nodes on the internet or a virtual private network (VPN). Each participant on the network signs a transaction using a private key. Transaction integrity and confirmation are ensured through cryptography. DCL can be built using blockchain and it can be private or public. Blockchain distributed ledger algorithms are being used by many industry players for crypto exchange development.

Parameters of a DCL

A DCL entails seven core characteristics or parameters.

1. Object – a unit of value or account which can be a currency, token or vote.
2. Protocol – the rules or protocols in the network which can be public or private.
3. Consensus – the process leveraged by the network to reach an agreement.
4. Identification – it defines if network participants need to identify themselves and to what extend – anonymous, pseudo-anonymous or complete identification.
5. Access – can be open, closed or limited, depending on the application.
6. Hierarchy – defines whether the network is autonomous or attached to another network or asset.
7. Data structure – can be a blockchain, a DCL or another data structure.

How can a financial market launch a cryptocurrency?

Financial markets can leverage an open or a closed system to launch cryptocurrencies. An open distributed and decentralized cryptocurrency can be exchanged for fiat currencies. On the contrary, a closed cryptocurrency, being centralized, can only be utilized in the environment it was designed for.

In an open-distributed network, a cryptocurrency token serves as the object. A PoW (Proof of Work) method is leveraged to reach an agreement. The access is open, which means it is permissionless and allows anyone to participate in the network. The identity of participants is pseudo-anonymous.

In an open-centralized crypto exchange development process, the system is permissioned, allowing only the members to participate in the network.

Key success factors

The cryptocurrency market is highly competitive and fragmented. However, the following factors can fuel the success of cryptocurrencies, enabling them to be used in the broader economy for trade and finance. The cryptocurrency needs to be:

1. Cost effective to issue
2. Immediately available
3. Governed and regulated
4. Instantly liquid
5. Secure and immutable
6. Trusted, transparent and legitimate
7. Free from fractional reserve banking
8. Have a sustainable value and add purpose to economic activity
9. Have standards to allow interoperability

Given the success of Bitcoin and other cryptocurrencies gaining rapid traction, it would not be a mistake to conclude that cryptocurrencies could be the future of finance industry. A central bank can bring together market participants and build a governance structure where cryptocurrencies can flourish and gain wider acceptance.