Is blockchain sufficiently trustworthy for public finance? Karolina Grabowska via Pexels

Is blockchain sufficiently trustworthy for public finance?

The word ‘blockchain’ can evoke images of scandals related to cryptocurrencies. So it might be surprising that some central banks are adopting Central Bank Digital Currency, a form of currency based on blockchain technology. Are governments venturing into issuing their own versions of bitcoin?

Central Bank Digital Currency (CBDC)

A CBDC represents a government-controlled digital currency, functioning as legal tender, much like physical coins and bills, as well as their digital counterparts. However, it's crucial to distinguish CBDC from the digital currency used in credit card payments or banking apps. Although both are digital currencies, they differ significantly in terms of the underlying digital technology and the degree of control exerted by the issuing organisation.

Let's first delve into the matter of controlling the money supply, directly tied to the operational methods of central banks and commercial banks within financial markets. Central banks, typically government-owned institutions, play a crucial role in the financial landscape by overseeing the entire banking system and formulating monetary policy. In contrast, commercial banks, predominantly privately owned or publicly traded entities, focus on providing financial services directly to individuals and businesses.

While one might assume that all circulating money is issued by central banks, that’s not entirely accurate. The majority of our daily currency is created by commercial banks operating under a system known as fractional-reserve banking. In this system, banks can lend out more money than they have in deposits.

For instance, if the reserve percentage is set at 10%, a bank can lend out 100 euros for every 10 euros in deposits, thereby effectively creating 90 euros. However, fractional-reserve banking carries inherent risks. Excessive lending might render banks unable to fulfil their obligations to depositors in the event of a bank run, leading to failures and a loss of confidence in the banking system. These types of vulnerabilities were shown to be acute in the 2007–2008 Global Financial Crises when financial institutions that were generally assumed to be “too-big-to-fail” actually went bankrupt.

With CBDC, central banks aim to sidestep the risks associated with fractional-reserve banking by directly controlling the supply of digital currency, akin to the issuance of physical bills and coins. Unlike fractional-reserve banking, where commercial banks indirectly influence the money supply, central banks maintain direct control over the total currency supply. This exclusive authority enables central banks to effectively manage monetary policy and steer economic stability.

Blockchain as a Distributed Ledger Technology (DLT)

The second crucial distinction lies in how the banking system operates. At its core, a banking system serves two essential purposes: enabling seamless money transfers between individuals and organisations, and maintaining accurate records of these transactions to ensure transparency and prevent discrepancies. The way a bank keeps a record of every time we pay or receive money is called a ledger. Similar to your personal bank statement, a bank ledger is a detailed record of all financial transactions conducted by its customers. It meticulously tracks each deposit, withdrawal, and transfer, maintaining a comprehensive overview of each account's balance. Unlike your individual statement, a bank's ledger encompasses the transactions of all its clients, providing a holistic view of the institution's financial activity.

Conventional banking systems rely on centralised ledgers controlled by the banks themselves. This centralised model places our trust in the bank's security, the reliability of its ledger, and the integrity of its employees and systems to safeguard our finances. However, if security or integrity are compromised, either by error or intent, the bank becomes a single point of failure, endangering our financial assets. The emergence of blockchain technology offers a refreshing alternative to this centralised approach.

Blockchain technology, initially introduced with Bitcoin, has evolved over the past 15 years, presenting both promising advancements and challenges. While the highly secure and anonymous nature of cryptocurrency has facilitated illegal activities, it has also empowered financial inclusion, enabling millions worldwide to access financial services previously unavailable. Moreover, blockchain has streamlined cross-border transactions, making them faster and more affordable.

Unlike a centralised system with a single ledger, blockchain copies the entire ledger across a vast interconnected network of computers. In this network, these computers are known as nodes. Each node holds an exact copy of the ledger thus forming a 'distributed ledger,' and hence the name Distributed Ledger Technology (DLT).

When a transaction occurs in a Decentralized Ledger system, the nodes conduct security and balance checks using highly advanced algorithmic protocols and then compare their results. If consensus is reached by the nodes that the transaction is legitimate, it is recorded in the ledger across all nodes. This system operates securely and at a higher speed than existing banking systems. As the entire network is connected through the existing internet infrastructure, the system has been found to be cost-effective for both operators and users.

Furthermore, a blockchain system offers transparency by design, with each transaction recorded and directly accessible for its users. So we are no longer relying on the intermediary function of a bank to provide us with insight into our financial transactions and holdings. We can access them directly and without any restriction. The technology prevents alterations to the ledger, and its distributed nature eliminates a single point of failure, as there are as many ledger copies as there are nodes in the system. Control is not vested in a single entity; any changes to the ledger require approval from a predetermined percentage of nodes.

With these potential advantages, it is not surprising that central banks worldwide, including those in Europe, the United States, and China, are actively pursuing CBDC initiatives despite numerous challenges that still need to be addressed.

Please note that some liberties have been taken by the authors in describing banking systems and blockchain technology in the interest of readability.


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