The Effects Of The FED on Cryptocurrency

Cryptocurrency has emerged over the past 10 years as one of the most transformative threats to fiat currency and the financial systems that regulators like the Federal Reserve (Fed) maintain. Born from mistrust of governments and financial systems, the goal of cryptocurrency was to provide a ‘pure’ form of money that would never be beholden to centralised power. Currencies such as Bitcoin and Ethereum sought to provide an alternative to fiat currency, operated by central banks like the Fed. How cryptocurrency works, how it challenges fiat currency, and what role the Fed plays in this landscape are crucial for understanding the future of finance.

Cryptocurrency: An Overview

Cryptocurrencies are a type of currency that exists as digital and/or virtual entries that use cryptography to secure transactions. Unlike standard currencies that are issued by a central body, cryptocurrencies are not backed by any institution and are considered to be theoretically immune from government interference or manipulation. The first (and to this day most widely used) cryptocurrency is Bitcoin, released in 2009 by an individual or group of individuals known as Satoshi Nakamoto. Since then, thousands of other cryptocurrencies have been created with a range of different properties and applications.

One of the distinguishing characteristics of cryptocurrencies is the blockchain, a shared digital ledger of all transactions, recorded on computers around a decentralised network. It is used to overcome the need for a trusted third party – such as a bank or a government – to verify each transaction. Ethereum’s smart contract capabilities are one of the reasons it has grown in prominence since Bitcoin, allowing developers to turn the blockchain into a decentralised application (dApp) platform.

Cryptocurrencies have provided the backbone for an increasingly decentralised financial system, which is what groupings such as ‘Decentralised Finance’ or DeFi refer to. Spreading across these networks, DeFi users can now lend, borrow, trade and invest in digital assets, without the need for intermediaries such as banks. The proliferation of DeFi represents a potentially existential threat to the financial status quo – something that governments and central banks are now taking seriously.

The Role of the Federal Reserve

The US Federal Reserve was created in 1913 as the nation’s central bank. Its primary responsibilities include influencing monetary policy, regulating banks and other financial institutions, providing certain financial services, and preserving financial stability. Perhaps most critically for the economy, the Fed’s role is to control the money supply to maintain price stability while promoting economic growth. The Fed performs these important functions through a variety of mechanisms, including setting interest rates, purchasing and selling US government bonds, and controlling the money supply.

The issuance of US dollars by the Fed, which is the reserve currency of the world, is perhaps the most important element of that power. Monetary tools such as control over the amount of money created and the ability to lift or lower interest rates help the Fed manage economic cycles. If inflation becomes too high, the Fed raises interest rates so as to dampen economic activity. In times of lacklustre growth in the economy, similarly, the Fed lowers interest rates to induce people and businesses to borrow and invest.

Its system is also highly centralised, very different from the decentralised nature of most cryptocurrencies, setting up the possibility of conflict between conventional centralised monetary systems and decentralised digital mints.

Cryptocurrency vs. Centralized Monetary Policy

Cryptocurrencies are fundamentally incompatible with centralised monetary policy, which requires government control over money to avoid inflation. The fixed supply of just over 21 million coins in Bitcoin, for example, means that no inflationary policies (like those deployed by the Federal Reserve in the wake of the financial crisis of 2008 or the COVID-19 pandemic) are possible.

The fixed supply of Bitcoin and other cryptocurrencies has attracted those who worry about inflation and currency devaluation. Take the global response to the COVID-19 pandemic. Massive stimulus packages and bond-buying programmes have been used to avoid the worst of the economic fallout from lockdowns and emergency public-health measures. In the US, the Federal Reserve has worked to support the economy, but this has included injecting trillions of dollars, effectively printing money. Those developments also stoked talk of a long-term threat of inflation. Cryptocurrencies, then, with a fixed number of units available and with no one in charge, have been viewed by some as a hedge against just such problems.

But volatility is also a problem. Although Bitcoin enthusiasts often talk of it as ‘digital gold’ because it has precisely the deflationary characteristics of gold, in practice its price is extremely volatile. This is a property that makes it a less solid store of value than the stable purchasing power of even a highly inflated fiat currency such as the US dollar, which the Fed can at least maintain fairly high and stable.

The Fed’s Response to Cryptocurrency

With the rise in interest in cryptocurrency, however, the Fed and other central banks around the world have also taken note. The Fed hasn’t yet issued any kind of central bank digital currency (CBDC), but seems to be interested in at least studying the idea. A CBDC would be a cashless, digital version of the US dollar, fully controlled by the Federal Reserve. This would not be akin to decentralised cryptocurrencies like Bitcoin.

More recently, a number of central banks, including the Fed, have initiated investigations into the viability of CBDCs. In 2020, the Fed stated that it had begun experimenting with forms of digital currencies through its Technology Lab, and in 2021 the central bank published a discussion paper that outlines the potential advantages of, and risks associates with, a US CBDC.

Advocates of CBDCs point to the potential for increased financial inclusion by giving those without bank accounts a digital payment option. By enabling the Fed to see transactions in real time, a CBDC could also make monetary policy more efficient, since administering interest rates and other tools can be done with more precision.

But if implemented, CBDCs would sacrifice some traditional aspects of banking. For one, all financial activity would be recorded and stored, which could lead to a loss of privacy. And a CBDC could disrupt traditional incentives, with customers potentially wanting to hold onto their money at home in digital dollars instead of opening a bank account.

Regulatory Challenges

The most important is regulation. Although cryptocurrencies initially emerged as a largely unregulated space, their association with money laundering, tax evasion and fraud has raised regulatory concerns. For instance, governments and central banks must grapple with how to regulate this new asset class without quelling the innovation it has introduced.

The US government has been slow to develop a unified regulatory framework for cryptocurrencies – the Fed is just another of the myriad regulatory authorities now trying to oversee crypto. Regulatory authority is spread out: the Securities and Exchange Commission (SEC), for example, has determined that some cryptocurrencies should be categorised as securities. The Commodity Futures Trading Commission (CFTC), meanwhile, has said that cryptocurrencies are commodities.

A resulting lack of clarity has encouraged various forms of lawless behaviour, while industry participants have moaned that the absence of a clear regulatory framework thwarts innovation, depriving pertinent industry players of guaranteed legal standing. However, the Fed and other government agencies are now playing catch-up in crafting a more coherent regulatory approach.

The Future of Cryptocurrency and the Federal Reserve

But there is promise, and the emergence of cryptocurrencies as a challenge for the Federal Reserve remains to be determined. Cryptocurrencies offer an alternative to monetary existence, a rejection of the complexities and unfairness of existing global monetary systems. Digital currencies could eventually replace cash, irreversibly altering society’s relationship with money and even requiring a redefinition of what ‘serious’ money actually means. However, they are also confronting significant obstacles to scalability, regulation and volatility, which must be addressed if cryptocurrency is to have a long-term impact on the monetary status quo. Meanwhile, Federal Reserve officials and others at the frontiers of central banking research are working on a digital dollar, or at least investigating it, while attempting to counter the threat that decentralised finance poses to their accounts.

One possibility is that cryptocurrencies and CBDCs could peacefully coexist. In this scenario, cryptocurrencies would persist as a decentralised parallel currency for those seeking privacy and self-sovereignty rights, while CBDCs serve as a digital counterpart to fiat currencies for those who expect a stable government currency.

Another way that CBDCs can reduce the need for decentralised cryptocurrencies is that if central banks can get their monies right (ie, enjoy the savings from faster payments and reduced transaction costs) without importing the volatility and distrust of Spam and Ponzi schemes that afflict many cryptocurrencies, then people might start to want less of those too.

In the end, it comes down to the decisions that governments and central banks make about regulating crypto and folding digital currencies into the overall monetary system. As financial systems develop, tensions between centralised digital currencies and decentralised digital assets will be a prominent challenge in the years to come for policymakers and bankers, but also for investors and consumers.