Monetary policy of cryptocurrencies, explained

Monetary policy in crypto refers to the mechanisms used to manage the supply and circulation of cryptocurrencies. These mechanisms are intended to ensure the sustainability, stability and predictability of a coin’s value over time.

Cryptocurrencies rely on decentralized protocols to handle their monetary policy, as opposed to conventional fiat currencies, which are controlled by central banks and governments. These protocols may contain a number of tools for regulating the cryptocurrency’s supply, including block rewards, changes to the mining difficulty and issuance rates.

For instance, Bitcoin (BTC) has a fixed supply cap of 21 million coins. As time goes on, the pace at which new coins are introduced to the supply continuously declines, eventually causing a deflationary situation as the rate of new supply gets closer to zero.

On the contrary, certain cryptocurrencies may employ alternative mechanisms to govern their monetary policy, like proof-of-stake (PoS) consensus systems, which use staking to encourage network activity and control the cryptocurrency supply.

Cryptocurrencies have monetary value because people assign value to them, much like any other currency or asset. 

A cryptocurrency’s value is primarily influenced by market forces of supply and demand. A cryptocurrency will become more expensive if there are more buyers than there are sellers prepared to accept their offers. The price will fall, however, if there are more sellers of a cryptocurrency than there are buyers ready to purchase it.

Related: What is tokenomics? A beginner’s guide on supply and demand of cryptocurrencies

Other factors that can influence the value of a cryptocurrency include its utility, security and adoption. For instance, a cryptocurrency that is widely recognized as a form of payment and has a clear use case will probably be worth more than one that is not extensively accepted. Furthermore, cryptocurrencies with robust security features and a track record of dependability will often be more valuable than those with lax security or a history of hacks and flaws.

Although the precise impact will depend on how widely cryptocurrencies are used and integrated into the current financial system, cryptocurrencies have the potential to influence monetary policy in a number of ways. 

Here are some possible ways in which cryptocurrencies could affect monetary policy:

• Reduced control over the money supply: Due to the decentralized nature of cryptocurrencies and the lack of a central controlling entity, standard monetary policy tools like printing money or changing interest rates may not have the same effect on them as they do on fiat currencies. This might restrict central banks’ power to affect the total amount of fiat money in circulation.
• New sources of data: Large amounts of transactional data generated by cryptocurrencies could be used to get important insights into consumer behavior and broader economic patterns. It may be necessary for central banks to figure out how to include this data in the decision-making process.
• Increased competition: Since cryptocurrencies provide an alternate method of payment and a store of value, they may become more competitive than traditional fiat currencies. This can put pressure on central banks to keep their currencies stable and valuable to remain competitive. Additionally, banks are experimenting with CBDC projects in response to the potential threat of cryptocurrencies, which could disrupt traditional banking and payment systems.
• Enhanced financial inclusion: Cryptocurrencies have the potential to give people and enterprises who might not have access to traditional banking services better financial access and inclusion. As a result, monetary policy may shift as central banks may need to consider how a more diversified and decentralized financial system will behave.

Related: What is a CBDC? Why central banks want to get into digital currencies

BTC’s monetary policy is controlled by the rules built into the Bitcoin software protocol, which is open-source and operates in a decentralized manner. 

The protocol’s rules dictate how new BTC is created and distributed over time. Moreover, any proposed changes to the protocol must be approved by a majority of the network’s users, making Bitcoin’s monetary policy subject to the consensus of its users.

Particularly, the protocol’s built-in issuance schedule serves as the foundation for Bitcoin’s monetary policy. The total number of BTC that will ever be created is 21 million. New Bitcoin is produced through a process called mining, where users compete to solve challenging mathematical problems in exchange for rewards that include newly created BTC.

The mining reward is automatically reduced by half every 210,000 blocks (approximately every four years), a process known as halving. This indicates that as time passes, the rate of new BTC generation declines, eventually resulting in a maximum supply of 21 million. One of the main components of Bitcoin’s monetary policy is its constant supply, which works to maintain scarcity and prevent inflation.

Stablecoins may function outside of conventional banking and payment systems and may offer an alternative form of payment and store of value, which has the potential to change how monetary policy is transmitted.

A classic monetary policy transmission mechanism involves the employment of various tools, such as changing interest rates by central banks to affect the money supply, the actions of financial institutions and the behavior of people. Stablecoins, however, might operate separately from these conventional dynamics and might not be directly impacted by adjustments to interest rates or other monetary policy instruments.

For instance, stablecoins may be considered a safe-haven asset, particularly during periods of market turbulence or economic unpredictability. Stablecoins may see a surge in popularity during these times, which may lessen the impact of conventional monetary policy tools like interest rate increases.

Moreover, stablecoins might alter the demand for conventional fiat currencies and affect the effectiveness of monetary policy if they were to gain widespread adoption. Nonetheless, in order to account for stablecoins’ effects on the whole economy and incorporate them into their policy frameworks, central banks may need to develop new strategies.

The design choices, such as the level of privacy — i.e., anonymous or fully traceable transactions — implemented in the creation of a CBDC can have significant implications for monetary policy. 

Continuing the privacy design choice example, let’s understand its impact on monetary policy in the following two scenarios.

Scenario 1: Anonymous and untraceable transactions

It might be more challenging for central banks to develop certain monetary policy instruments that depend on transaction data to monitor and control the money supply if a CBDC is created to be entirely anonymous and untraceable. 

For instance, if a CBDC is entirely private, it could be more challenging for central banks to identify and stop illegal activity, such as money laundering and tax evasion, which might have an influence on the stability of the financial system and the efficacy of monetary policy. The use of CBDCs to execute policies such as capital limits or negative interest rates may also make it harder for central banks to monitor and regulate.

Capital limits are limitations on the total amount of CBDC that a person or organization may own. Capital restrictions can be used as a measure to prevent CBDCs from being hoarded and promote consumption, which will help the economy thrive. Capital restrictions, however, may also have unforeseen effects, such as increasing demand for alternative assets or changing the composition of the money supply.

When the interest rate on deposits is negative, depositors must pay the bank to store their funds rather than earning interest — i.e., interest rates on deposits fall below zero. This is referred to as a negative interest rate at banks, when a central bank uses a negative interest rate policy to encourage investment and expenditure during economic downturns. 

A CBDC may also enable central banks to execute negative interest rate policies that promote expenditure and discourage hoarding if they are intended to be interest-bearing. Negative interest rate policies, however, may also have unintended consequences that could increase financial instability by decreasing the incentive for savers to deposit their money in banks.

Scenario 2: Transparent and traceable transactions

On the other hand, a CBDC might possibly offer central banks useful data insights into consumer behavior and economic patterns, which could guide their policymaking processes if it is created to be completely transparent and traceable. However, it could also raise concerns about privacy and surveillance.

Therefore, central banks will need to carefully consider the trade-offs between these policies and ensure they are designed in a way that supports economic growth and stability while minimizing the risk of another global financial crisis.