Cryptocurrencies like bitcoin cannot replace money, says Bank for International Settlements

Cryptocurrency devotees have a dream that one day humanity will be free from the yoke of money issued and control by governments through central banks.

But the central bank for central banks has hit back to tell them they're dreaming.

The venerable Bank for International Settlements, a 90-year-old institution based in Switzerland, has issued a research report concluding that cryptocurrencies are afflicted with inherent contradictions that make their widespread use as money impossible.

First of all, one has to understand what money is.

It is a unit of account that allows us to compare the prices of different goods and services; a medium of exchange that allows us to buy and sell these without having to organise swaps; and, finally, a store of value that allows us to save to buy things in the future.

For all three of those functions, it is desirable that money is stable — that its value doesn't fluctuate wildly over short periods.

This hasn't always been the case for many forms of money, as the BIS acknowledges.

"Sustained episodes of stable money are historically much more of an exception than the norm," the BIS reported noted.

However, while it may be institutionally biased, the BIS found there is one model that does generally ensure monetary stability.

"The tried, trusted and resilient way to provide confidence in money in modern times is the independent central bank."

Cryptocurrencies fail the test of stability

There's no doubt that current cryptocurrencies fail spectacularly on the test of stability.

This is the first fundamental contradiction of cryptocurrencies — most of them generate trust by limiting the amount of currency available, in the case of bitcoin to 21 million.

The problem with that is that during periods where there is greater demand for them, the supply is unable to respond.

This is theoretically a good feature for the store of value function of money, as your savings theoretically cannot be debased by creating more of the currency.

But it's not so good for the stability required for price comparisons or making transactions.

And it can backfire too for those trying to store value — just as there is no central bank to put downward pressure on the value of money, there's also no institution there to absorb potential losses and prop up the value of cryptocurrencies in times of crisis.

$57 to buy a cup of coffee

The second contradiction is that the very thing that gives money legitimacy — widespread acceptance and use — causes cryptocurrency transactions to become slower and more expensive.

"Money has value because it has users, we use it as money," explained the BIS's head of research Hyun Song Shin in a video.

"Without users it would simply be a worthless token and that's true whether it's a piece of paper with a face on it or a digital token."

When demand for cryptocurrencies spikes, the cost of transactions increases dramatically as miners charge more for verifying them through the blockchains.

Mr Shin observed that bitcoin transaction costs peaked at $US57 last December.

"If you bought a $2 coffee with bitcoin you would have had to pay $57 to make that transaction go through."

But surely you can ramp up the system's ability to handle transactions?

Yes, but there are three fundamental limitations.

"If you increase the capacity to the extent that it becomes costless to use the system, this will drive away the miners because there's no fees being paid," Mr Shin observed.

Cryptocurrencies 'become an environmental disaster'

The second problem is the amount of data that needs to be both stored and transmitted to verify the blockchains in a distributed ledger handling millions of transactions a day.

"With every transaction adding a few hundred bytes, the ledger grows substantially over time. For example, at the time of writing, the bitcoin blockchain was growing at around 50 GB per year and stood at roughly 170 GB," the report noted.

To handle the volume of transactions that go through major global payment networks like Visa, Mastercard or Paypal, you would quickly need banks of servers to store the data.

But the problem worsens when you consider that this information must be shared each time a new transaction has to be added to the chain.

"Only supercomputers could keep up with verification of the incoming transactions," the report warned.

The third problem is the immense waste of computing power and electricity needed to verify transactions.

"Individual facilities operated by miners can host computing power equivalent to that of millions of personal computers," the report noted.

"At the time of writing, the total electricity use of bitcoin mining equalled that of mid-sized economies such as Switzerland, and other cryptocurrencies also use ample electricity.

"Put in the simplest terms, the quest for decentralised trust has quickly become an environmental disaster."

Cryptocurrencies still open to fraud and debasement

Aside from these inherent contradictions, the BIS also warns that cryptocurrencies remain more vulnerable to fraud and even potential debasement than currencies managed by responsible central banks.

One way this can happen is through "forking", where one blockchain becomes split due to a change in protocol introduced by those with a majority of computing power.

This can leave "orphaned" chains, or result in others continuing to add to the original pre-split chain, thus creating two diverging transaction records — effectively two currencies being born from one.

"Cryptocurrencies can be manipulated by miners controlling substantial computing power, a real possibility given the concentration of mining for many cryptocurrencies," cautioned the BIS.

Last, but not least, as with any part of the financial sector, the cryptocurrency space is frequently the target of outright fraud.

This is particularly the case with initial coin offerings (ICOs), where investors put conventional money into the launch of new cryptocurrencies.

Clearly the BIS comes into this with a significant institutional bias — the death of central banks would rob it of its raison d'être.

But the recent price collapse in many cryptocurrencies indicates that the BIS is not alone in its scepticism of their long-term future as a widely accepted form of money.