The Federal Reserve and European Central Bank should be given a mandate to monitor threats bitcoin and digital currency systems pose to the broader financial system, a new report from a Suffolk University researcher argues.

Entitled “$=€=Bitcoin?”, the report speculates as to the potential dangers that the more widespread use of bitcoin as a digital money with no government backing, analyzing how circumstances arise where this threatens national and international economies.

The paper follows a February 2014 statement from Federal Reserve chairwoman Janet Yellen, who said that the US central bank does not have the authority to regulate digital currencies. Further, the European Central Bank published a report last year that, while largely dismissive the technology, indicated the bank is monitoring developments.

More broadly, the report argues that the mandate is necessary given that the general population is not aware of central bank boundaries, meaning the central bank could “bear responsibility” for a systemic crash should it affect either or both markets.

The report reads:

“Even if the central bank had no mandate to regulate virtual currencies, a failure of a widely-used virtual currency could imperil confidence in the central bank, which could adversely affect its ability to govern the more traditional money supply and payment systems.”

The author argues that the decentralized nature of bitcoin suggests government action will be necessary should any “bad conduct” materialize in the market.

“The result is likely to be an increased need for ex-post intervention, and it would be preferable if the intervention plan were well thought-out, rather than a messy, ad hoc plan developed in the heat of a crisis,” it continues.

Overall, the author makes the plea for action to be taken to address how governments should respond in times of digital currency crises before they become more widely used as a store of value and payment method.

Elsewhere, the full paper explores the definitions of money, while providing detailed overviews of the history of bitcoin, the US dollar and euro, as well as the variations in responsibilities between entities such as the Federal Reserve and European Central Bank.

New shadow banking

For purposes of the report, the author argues that potential bitcoin crises are perhaps best considered as analogous those that have occurred in the shadow banking system, the network of non-bank financial intermediaries that provide services to traditional commercial banks.

The author argues this should hold true, even though in the bitcoin ecosystem, the blockchain effectively replaces traditional financial intermediaries like non-bank institutions.

Of note, the author contends, is the absence of an intermediary should bitcoin face a crisis, something she argues could incentivize speculators to drive down its price. A lower price, the paper continues, would likely lead the digital currency to be a less attractive means of spending, damage that would perhaps not be limited to the alternative economy.

“If the failed virtual currency had previously been widely used to affect everyday purchases, the resulting payment system failure could impact the normal flow of funds in a way that could retard broader economic growth,” the paper said.

Furthermore, it contends that the failure of a widely-used virtual currency could contract the available money supply, thereby slowing economic growth.

Hybrid system

Should digital currencies be more widely adopted, the paper argues, financial institutions could be adversely affected by any extreme fluctuations in the price of digital currencies.

In this scenario, the paper suggests financial institutions could be caught in situations where they no longer have the funds to cover needed obligations.

“In a panic, the financial institution would no longer be able to exchange the virtual currency for the fiat currencies needed to discharge the fiat currency-denominated obligations,” it reads. “Instead, the financial institution would either have to sell other assets, or borrow, to raise the necessary fiat currencies to discharge its fiat-currency denominated obligations.”

This situation could be compounded as institutions seek to sell assets that are depreciating to reduce their exposure and stem their shrinking balance sheet, which in turn, could limit their ability to borrow more funds.

However, the paper does note that bitcoin swaps, such as those offered by CFTC-approved TeraExchange, could be used to allow financial institutions exposure to digital currency without the burden of owning the asset.

Interbank exchange

Should the blockchain take off as a way for institutions to settle obligations, the author implied that the collateral for repo agreements would be affected, which would again limit their ability to secure short-term funding.

In turn, the paper speculates on the effects of this development on the larger economy.

“If a serious systemic crisis were to result, interbank lending would seize up entirely because of a general lack of confidence in financial institutions and their collateral – and if interbank lending seizes up, then the flow of credit to the economy at large will also seize,” it reads.

If financial institutions face such a crisis, they would in turn need liquidity assistance, which would most likely come, ironically, in the form of a government intervention.

Financial crisis visualization via Shutterstock