Are local and virtual currencies about to change finance?
By Fabien Hassan, guest posterPolitical attempts at reforming the financial system will eventually succeed, and the world will have to move toward more sustainable finance. But it is taking a long time. Those who do not want to wait are already challenging the financial system through innovations in the monetary system. Local and virtual currencies have developed quickly in the last few years. The fascination for Bitcoin is reflected in the press. There is also an impressive volume of academic research dedicated to new currency schemes. Is it just a temporary fashion, or could it one day change the financial system permanently? In this article, our guest blogger Fabien tries to summarise the main features of those schemes and separate the artificial from the real innovations.
The first question about new currency schemes is why have they become so interesting? Why do people think that they could lead to a better financial world? As pointed out in the previous article, a growing number of observers consider our monetary system to be problematic. In particular, money creation by credit has been a key driver in the explosion of both public and private debt levels.
A mix of ideology and pragmatismIn addition, the crisis fuelled mistrust in governments and financial institutions. For instance, unconventional policies of central banks have led to fears of a “debasement”, a loss of value of paper money, especially in the United States.
This lack of trust cannot be separated from an ideological element. Using alternative currencies is a way of rebelling against the system. American antifederalists use Bitcoins to denounce the policies of the Fed, while local currencies provide a way to protest austerity. There is something subversive about stepping away from the official money system. Using alternative currencies is the monetary equivalent of living without a cell phone.
These concerns motivated the founders and early adopters of these currencies. But there must have been more pragmatic motives to explain successes with the broader public.
Some alternative currencies can be used for tax evasion, because fiscal administrations have not yet developed means of controlling transactions based on those currencies. Obviously, this attracted criminals. Bitcoins became famous in the press when the FBI announced the seizure of Silk Road in October 2013, a website that used the virtual payment system to sell illegal drugs. Silk Road 2.0, its follower, had less media attention despite impressive results. According to the FBI, “As of September 2014, Silk Road 2.0 was generating sales of at least approximately $8 million per month and had approximately 150,000 active users”. Like its predecessor, it “operated exclusively on the “Tor” network [a hidden Internet] and required all transactions to be paid for in Bitcoins in order to preserve its users’ anonymity and evade detection by law enforcement”.
However, the country that has the most Bitcoin users is not the United States, but China. One hypothesis for this success is the possibility to circumvent restrictions on capital movements.
Finally, there is an element of speculation for digital currencies: many early users of the Bitcoin system made millions of euros when the value of the Bitcoin started to skyrocket in 2013.
Preventing such abuses is a major challenge for advocates of alternative currencies. But the potential for criminality should not be a barrier to innovation. In fact, borderline and illegal industries like porn and drugs sometimes prove extremely innovative, because they structurally need to move faster than legal industries and authorities. The adoption of a payment technology by criminals is more likely to be the first step toward market maturity than the last step before abandonment.
How innovative are virtual currencies?If we look beyond the Bitcoin phenomenon, it is not that easy to define a virtual currency. Since 1971 and the collapse of the Bretton-Woods system, money is not convertible into gold or any other kind of physical asset. For example in England, the traditional phrase signed by the Governor of the Bank of England (BoE) on a ten pound sterling note, “I promise to pay the bearer on demand the sum of £10”, is purely circular: notes can only be exchanged for other notes of the same face value (Jackson & Dyson, 2012). In modern economies, all money is virtual, or at least backed very partially and indirectly by assets as vague as ‘the ability of government to collect money’.
To be fair, this is not just a modern feature. Contrary to common misbeliefs, coins did not degenerate into electronic money when mankind invented computers. “There’s nothing new about virtual money. Actually, this was the original form of money. […] History tends to move back and forth between periods dominated by bullion – where it’s assumed that gold and silver are money – and periods where money is assumed to be an abstraction, a virtual unit of account” (Graber, 2014). Present times clearly correspond to the latter: electronic money represents 97% of the money supply. To put it more abruptly, “the financial system is already simply a set of digital records” (Ali et al., 2014a).
Part of the confusion is due to the word ‘virtual’. It can designate three different things: money that is not fully backed by physical assets, electronic cash which we use every day with credit cards, or Internet-based currencies like Bitcoins. In this article, we use virtual currency to refer exclusively to Internet-based currencies. The question becomes: what is the feature of such virtual currencies that makes them different from, say, electronic cash?
A revolutionary payment technologyThe founder of Bitcoin, Satoshi Nakamoto, was trying to solve what he saw as a salient problem of the digital economy: “Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments” (Nakamoto, 2008). The purpose of Bitcoins is to eliminate those third parties and to provide a purely peer-to-peer cash system. Nakamoto does not talk about economics or money theory. He only builds on a genius mathematical intuition to apply the horizontal nature of the Internet to a payment system. The project is ideological, not economic: it is about removing the need for centralised institutions and governments, thanks to technology. Public goods like regulation should be integrated and distributed within a network.
The fundamental issue of a payment system is the double-spend problem. How do you make sure that everybody has the money that they are spending, and that they cannot spend it twice? In the traditional banking system, payments are based on regulated and trusted entities: banks. Users trust their banks to pay and receive payments. Thus, they do not need to trust their counterparty. But what happens if you do not trust banks, or want them to have access to all your data? Then, you need a technology that distributes the information on the whole network, so that everyone can verify everything. And then, you need that verification process to be automatic and secure.
This is what Bitcoin provides, or at least pretends to provide. For the BoE, “The key innovation of digital currencies is the ‘distributed ledger’ which allows a payment system to operate in an entirely decentralised way, without intermediaries such as banks […]. It may be possible in the future – in theory, at least – for the existing infrastructure of the financial system to be gradually replaced by a variety of distributed systems” (Ali et al., 2014a). The essential argument here is that some of the famous aspects of Bitcoin are unimportant: the limited money supply, the way newly created bitcoins are received by ‘miners’ as they verify transactions, the speculation element… These are just parameters that can be set differently, and there is in fact an immense variety of Bitcoin-inspired currencies competing online. The real innovation is in the conceptual advance to the payment system. And it is here to stay.
Regulatory responsesRegulatory responses to the development of Bitcoin vary. In the UK, the BoE essentially took a consumer protection approach. Concerns about financial stability may appear in the future, but at the moment “about 20,000 people in the UK have a significant holding of Bitcoins [and] as few as 300 transactions may occur per day” (Ali et al., 2014b). This is still too little to worry regulators. But the BoE goes further in the analysis and wonders whether Bitcoin could expand and become a dominant payment system. Interestingly, the technicalities of the system and especially the rising cost of mining* “pose significant challenges to their widespread adoption” (Ali et al., 2014b). However, the Bank acknowledges that such money systems could be able to overcome those obstacles with minor structural changes. Despite the vision of Nakamoto, Bitcoin may fail to reach a more significant scale, but it will remain a pioneer that has paved the way for followers.
In the rest of Europe, financial authorities tend to be more severe with the “dangers of the Bitcoin system” (Banque de France, 2013). The European Banking Authority (EBA) recognised that Bitcoin was extremely hard to regulate in the short term. It recommended national authorities to discourage financial institutions to hold virtual currencies, in order to “shield regulated financial services from [virtual currency] schemes” (EBA, 2014).
In China, financial institutions are prohibited from engaging in Bitcoin transactions. However, as of today, only a handful of countries have banned Bitcoins for individuals (see – with caution – this table summarising regulatory responses on Wikipedia). The Bitcoin network of foundations, companies, trading platforms, lobbyists, and volunteers is already very well developed and prepared to fight any regulation that would jeopardise their passion, or their business.
Local currencies as a response to globalisationUnlike virtual currencies, which dissolve the problem of trust within a network, local currencies are based on interpersonal relationships or shared local identities.
Some local currencies are best defined as vouchers, which are issued by an association and which are not universally accepted. They can only be spent in the local economy. This prevents leakage from local wealth toward bigger and exterior actors. The objective is usually to fight poverty and to restore the social fabric.
The leading contemporary thinker on local currency schemes is Bernard Lietaer, a Belgian economist. He believes that the international monetary system is unable to provide well-being to local communities. So he recommends, as a complementary tool, the implementation of small-scale trade systems, which guarantee a minimum level of economic solidarity (Kennedy, Lietaer & Rogers, 2012).
This is exactly what happened in the small town of Volos, in Greece, with the TEM scheme. As explained by the New York Times, TEM is a hybrid system, “part alternative currency, part barter system, part open-air market”. The introduction of the local currency was a way to have citizens participating in a system of exchange of goods. Local currencies are not purely economic tools; they are also aimed at reviving communities.
Losing value, generating wealthAround 1890, German economist Silvio Gesell developed the concept of “demurrage” to designate periodic and systemic devaluations. Demurrage creates an artificial cost associated with holding currency. This feature is sometimes added to local currency schemes, so the currency automatically loses value over time. Consequently, people are incentivised to spend their money as fast as possible, which boosts the economy. It corresponds to a Keynesian vision: instead of hoarding money, people should spend it and keep it circulating.
Wörgl is a small town in Austria. In the 1930s, it became famous for the “Wörgl miracle” To get the economy back on track, the Mayor introduced a new local currency that lost one per cent of its value every month. The experiment was very successful. But it only lasted 14 months before the Austrian central bank decided that it was illegal and it had to stop (Bundesbank, 2013).
Demurrage is commonly, but not systematically introduced. In fact, most local currencies function in a simple way: you get them in exchange for the official currency at a fixed rate, and then you cannot convert it the other way around, or if you can, you are charged a fee. Apart from that basic principle, as with virtual currencies, an almost infinite variety of additional features can be introduced to achieve specific objectives. For example, in the French Basque country, stores that want to participate in the Eusko experiment also have to respect social and environmental specifications.
Local currencies and moneyAs with virtual currencies, the BoE is probably the regulator that took the most constructive approach to local currencies. First, the institution is structurally more open to the question, because in Scotland and Northern Ireland, it is not the monopoly issuer of banknotes. Seven private financial institutions are allowed to issue banknotes. Legislation ensuring that noteholders would be able to redeem their notes at face value was only introduced in 2009.
The BoE also has a more flexible conception of money. From a theoretical perspective, it rejects a purely legal definition of money as a universal means of payment backed by the central bank: “legal tender has very little practical application, as whether or not an instrument is used as a means of payment is subject only to the mutual agreement of the parties to the transaction”. Pragmatically, the BoE recognises the existence of “many other physical media of exchange available for transactions. One example is retail vouchers” (Naqvi & Southgate, 2013). In that perspective, local currencies are just another variation.
In the UK, the leading local currency is undoubtedly the Bristol Pound, with the equivalent of £250,000 in circulation (Naqvi & Southgate, 2013). Its promoters present it as a cultural and economic weapon to fight the standardisation of ways of living induced by globalisation. On their website, they explain that they “don’t want Bristol to be another clone town. Bristol Pounds supports independent business by helping us commit to spend locally, and helps forge new business relationships because choosing Bristol Pounds means that businesses spend locally too”.
Promoting solidarity, at a cost?Green, local and sustainable: in short, local currencies are hip. In addition to Germany, they are developing all around Europe: in Greece, in France, and in the United Kingdom, where they can also take the form of LETS – Local Exchange Trading Systems. Earlier this month an EU-backed project, Community Currencies in Action (CCIA), launched an information portal on community currencies showing the breadth of objectives they can have – for example SME liquidity, social inclusion or waste-reduction - as well as their issuance mechanisms, monetary elements and other aspects. But how much do local currencies really benefit the local economy?
In 2006, a Bundesbank economist claimed that: “the theoretical assumptions of the Schwundgeld concept are highly flawed” (Rösl, 2006). At the time, there were already 16 local or regional currencies in Germany, but the overall amount was very low, at roughly € 200,000. Did the crisis make the Bundesbank change its mind? Absolutely not: “Local currencies do not support the local economy, they generate costs instead” (Bundesbank, 2013). They are also accused of facilitating tax dodging.
By design, local currencies force customers to buy goods within a local area, which curtails competition. “By segregating off different regions by means of local currencies, users and enterprises are deliberately opting out of an efficient division of labour across regional borders. Day-to-day goods and services are supplied not by the provider best placed to produce them, but by one’s neighbours” (Bundesbank, 2013).
On the other hand, one could argue with the BoE that this is precisely the rationale of the system: helping your neighbour instead of always going for the cheaper goods. “Participation by both local businesses and consumers might also reduce environmental footprints as well as signal a commitment to supporting the local community” (Naqvi & Southgate, 2013). In this perspective, local currencies could be a fruitful way to promote solidarity at the community level, but their limited economic efficiency prevents them from being a real alternative to official currencies. As the Mayor of Volos claims in the Guardian: “It won't ever replace the euro but it is really helping weaker members of our society”.
Local and digital currencies are both consequences of globalisation, developing beyond the control of states, either at the local scale, or thanks to the distributive power of the Internet. It is a radically different conception of the world, where trust is not a product of a pyramidal institutional system. Trust is generated by horizontal relationships. At this stage, finance is not likely to be radically changed by those innovations, but they are clearly in the direction of history.
References* Mining is the verifying of Bitcoin-based transactions thanks to asymmetric cryptography (public-key / private-key). These operations require computer power. As a reward for the services that they provide, miners get newly created Bitcoins plus fees on verified transactions. Miners are competing with each other and their revenues are proportional to the number of achieved calculations (for more details, see: www.bitcoinmining.com).
- Ali, R., Barrdear, J., Clews, R., & Southgate, J. (2014a). Innovations in payment technologies and the emergence of digital currencies. Bank of England Quarterly Bulletin, Q3.
- Ali, R., Barrdear, J., Clews, R., & Southgate, J. (2014b). The economics of digital currencies. Bank of England Quarterly Bulletin, Q3.
- Banque de France (2013). Focus n°10 - Les dangers liés au développement des monnaies virtuelles : l’exemple du bitcoin, Paris.
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- European Banking Authority, EBA (2014). Opinion on ‘virtual currencies’, EBA/Op/2014/08.
- Graeber, D. (2011). Debt: The first 5,000 years. Melville House.
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- Des monnaies locales complémentaires, FutureMag, broadcast on Arte on October 11, 2014. [in French or German]
- Deutsche Bundesbank (2013). “The cost behind the moniker: local currencies in Germany”.
- Kennedy, M., Lietaer, B. A., & Rogers, J. (2012). People Money: The Promise of Regional Currencies. Triarchy Press Limited.
- Naqvi, M., & Southgate, J. (2013). Banknotes, local currencies and central bank objectives. Bank of England Quarterly Bulletin, 53(4), 317-325.
- Rösl, G. (2006). “Regional currencies in Germany-local competition for the Euro?”, Deutsche Bundesbank, Frankfurt-am-Main.
- "Proud to Accept the Bristol Pound", Poster (URL: http://bristolpound.org/poster)