A national cryptocurrency for emerging countries?

While Central banks and Governments are worried about the advance of Stablecoins develop on top of blockchains, this new technology presents an interesting opportunity for emerging countries with high inflation.

Some emerging countries tend to have continuous episodes of inflation and even hyperinflation from time to time. This makes its citizens distrust their own monetary unit and save in other foreign currencies which in turn makes things worse.

Some propose dollarization as a solution, where the dollar is used for transactions and unit of account (just as Ecuador currently does). The problem with this is that in the presence of inflexible downward prices, those countries could find themselves in situations of lack of liquidity and competitiveness that could end up in situations of high unemployment.

An additional option arises in the world of cryptocurrencies. It was briefly described at the end of 2016 by George Danezis and Sarah Meiklejohn in their paper "Central Bank Cryptocurrencies" where they promoted the issuance of RS Coin. The idea would be to have a national cryptocurrency where a central bank could define its issuance speed and the transactions would be recorded in a blockchain.

Why a cryptocurrency?

A cryptocurrency would allow the validation of transactions to be carried out by validators independent of the central bank that issued the currency. This characteristic is fundamental so that the users can trust the system and so that  no authority that can harm some users against others (or that uses the monetary issuance to finance itself). In this way, it takes advantage of the main quality that cryptocurrencies offer, which is decentralization.

Why is a Central Bank (BC) necessary?

In the case of Bitcoin, the issuance is preset in the code and therefore it isn’t adjusted to the demand for Bitcoins. It is for this reason that we observe (and will continue to observe) volatility in its price (as is the case with gold). While a limited supply may be attractive as a secure reserve of value, it is not convenient as transactional money and much less as a unit of account.

Advantages of this approach vs. the current scheme.

  • The inflation tax disappears: The issuance of currency can be done proportionally to the stake of each user. In this way, every time the BC decides to increase the monetary base, it does not harm any user. This implies that the government loses the incentive to generate inflation since everything that the user could lose in purchasing power due to inflation would be recovered via a greater amount of currency in wallet. To ensure that the equitable distribution cannot be modified by the central authority, it would be codified in the “Smart contract” that creates the currency and therefore could not be modified by the central authority.

  • Negative issuance: in case inflation is higher than desired, it would be convenient to have negative issuance, or what in the crypto ecosystem is called “burn tokens”. In this way the BC could define the burning of currency generating a rise in its value which would help decrease inflation. This burning would also be done proportionally as I mentioned in the case of the issuance. This possibility could probably be difficult to implement due to political reasons. In that case, an inflation target could be defined (say 5% per year) and if inflation exceeds that number the emission could be stopped until it returns to the desired target.

  • Direct monetary policy: an advantage of digital currencies issued by central banks (central bank digital currencies) is the possibility that users have their own bank account at the central bank without the need for intermediaries such as commercial banks. This could significantly improve the effectiveness of monetary policy. In the case of the mentioned proposal, the “bank” accounts will not exist in the central bank ledger but in a blockchain (technology behind cryptocurrencies), maintaining the effectiveness of the mentioned monetary policy anyway.

  • Flexible exchange rate: perhaps the most obvious advantage vs the dollarization is the possibility of conserving a national currency, which would allow a flexible exchange rate against other currencies that cushion situations of lack of liquidity and competitiveness mentioned above

  • Foreign direct investment: One of the most interesting characteristics of cryptocurrencies is the possibility of transmitting value internationally without intermediaries. The possibility that foreign capital could invest directly in private projects can be a source of financing that could be a great opportunity.

Suggested platform: Algorand.

Within the world of cryptocurrencies, the two largest platforms (by far) are Bitcoin and Ethereum. In both cases, the technology that supports them is called “Proof of work”

Without going into much technical detail, let me say that the important thing is to understand that to achieve security and decentralization in the generation of transactions a  "Proof of Work" system requires time and high energy consumption.

These characteristics make them slow, expensive, and non-scalable, and therefore could not be used as a national currency.

There is another technology called Proof of Stake. In it, the idea is that whoever validates the transactions has blocked a certain amount of assets that he would lose in case of bad behavior. This technology gains in speed and cost which would make it applicable (in fact, the Facebook’s Libra project will use this type of validation). The problem with this approach, however, is that security is lost. Let us think that in case the amount of money to be made was large enough it could mean that those blocked assets could become irrelevant vs what it could be earned with bad behavior.

There is, however, a third approach called "Pure Proof of Stake" that was launched in June 2019 by Turing award winner Silvio Micali and his team. This new cryptocurrency called Algorand, uses a very innovative system that uses a cryptographic lottery to select transaction proponents and validators, which allows it to maintain the security and decentralization required from a BlockChain system and at the same time gaining the scalability, low cost and speed required by a national payment system.

Just in October of this year, Silvio Micali announced the launch of “Algorand Smart contracts in Layer 1”. Without wanting to go into much technical details, this includes the possibility of issuing “new currency” and “shares in an asset or a corporation” without the need to require Smart Contracts and without losing security and decentralization as other chain Layer 2 solutions tend to do.

In Algorand webage, you can find a more broad description of these new features that allow, as mentioned there, for the issuance of Stablecoins, Securities, Gov't Issued Flat, Whitelists and Escrow Accounts among others. Any developer wanting to try them has access to the Betanet page.

These developments are perfect for this kind of projects and should be taken into consideration. In the case of the RS Coin paper mentioned above, the authors talk about miners and explain a very complicated transaction validation format that implies a great difficulty for its real applicability. Thanks to the Algorand platform, these obstacles disappear generating the possibility of issuing a national currency on a blockchain.

Emerging countries with high inflation are in serious risk of losing their monetary sign for good. New technologies like stablecoins pegged to the US dollar present huge challenges for them. The option that arises with greater force is that of dollarization. This situation is far from ideal and could generate great unemployment. Blockchain technology creates an opportunity to maintain the national currency without users having to trust a central authority. This approach would allow those countries to adjust easily to the needs of liquidity and competitiveness.

While elsewhere in the world Central Bank Digital Currencies are becoming a closer reality (article), I think emerging markets should move forward and be a pioneer in the matter.