By Chorobek Imashov, Former Minister of Finance of the Kyrgyz Republic

Cryptocurrency trends and their influence on monetary policy

Over the past decade, the markets for crypto assets have expanded significantly, with their composition and trajectory evolving rapidly. The recent introduction of exchange-traded products in the United States has heightened interest in crypto assets, as prices have experienced renewed acceleration. Against this backdrop, institutional investors, including central banks—are actively evaluating their exposure to crypto assets and considering the potential benefits of incorporating these instruments into their portfolios.
Since the start of the COVID-19 pandemic and amid unusually loose global financial conditions, crypto-asset transaction volumes have surged worldwide. With market capitalization now surpassing $3 trillion, cryptocurrencies are becoming a significant part of the global financial system. Despite the uncertainty caused by the pandemic, the crypto market flourished—possibly fueled by what economists call “animal spirits.”

“Animal spirits” is a Keynesian expression referring to human psychological factors influencing investment decisions. See also Akerlof, G. and Schiller, R. (2009), Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism, Princeton University Press.

The central question that emerges in this context is as follows. Can distributed ledger technology, known as decentralized finance, fundamentally alter the financial ecosystem? If crypto assets replace central bank money as the primary unit of account for most economic activities, central banks may lose their ability to influence monetary policy effectively. In such a scenario, monetary policy could become less effective or even obsolete, as central banks would no longer control the primary means of exchange or the unit of account within the economy.

The empirical findings of the World Bank experts (Feyen, Kawashima, Mittal, 2022) suggest that crypto-asset volumes are strongly associated with a set of forward-looking global macro-financial factors—which may ultimately shape domestic macro-financial conditions — rather than recent domestic macroeconomic developments. For example, controlling for a range of global and domestic factors, a 10-basis-point increase in monthly U.S. inflation expectations (on a 5-year, 5-year forward basis as embedded in U.S. Treasury yields) increases monthly crypto volumes by about 28 basis points. In contrast, country-level macroeconomic indicators (e.g., inflation and the exchange rate) do not appear to be strongly related to country-level volumes.

Additional relevant factors for crypto-assets adoption may also include high expected returns from speculative investment (Auer and Tercero-Lucas (2021)), their role as a perceived macro hedge protecting against macro-financial instability and excessive inflation despite their high volatility (Blau et al (2021) and Conlon, et al (2021).

In certain developing countries, dollarization offers a useful comparison. When much of the domestic financial system conducts business in a foreign currency, local monetary policy often loses its direct influence over the economy.

All cryptocurrencies are a type of digital currency, but not every digital currency is a cryptocurrency. Typically, digital currencies operate within centralized systems managed by an authorized entity, allowing for straightforward processes and unified monetary policies. In contrast, cryptocurrencies use decentralized models that rely on distributed networks, ensuring no single institution or authority holds all the power. This structure encourages more democratic control over both resources and transactions.

Despite everything, the relationship between cryptocurrency and monetary policy continues to grow. The rise of crypto assets has attracted both individual investors and major financial institutions such as banks, pension funds, and mutual funds.

In this context, emphasis should be placed on the integration of cryptocurrency into the financial systems of the largest economies. United States monetary policy may also exert an indirect influence on the cryptocurrency market through the US dollar valuation channel, given its role as the primary funding currency and unit of account within the sector. Crypto tokens are predominantly denominated in dollars; consequently, when the US dollar appreciates, these tokens become comparatively more expensive for investors whose purchasing power is based in other fiat currencies. This dynamic tends to reduce inflows into the cryptocurrency market.

In the past, times when the FED reduced interest rates have often aligned with bullish movements in the crypto market. Lower returns from traditional assets during these periods encourage investors to look for higher yields elsewhere, such as in cryptocurrencies. This shift of capital into crypto has pushed Bitcoin’s price and contributed to a wider upward trend across the market.

Some crypto assets, such as Bitcoin, in principle have limited inflation risk because supply is limited. However, they lack three critical functions that stable monetary regimes are expected to fulfill: protection against the risk of structural deflation, the ability to respond flexibly to temporary shocks to money demand and thus smooth the business cycle, and the capacity to function as a lender of last resort.

Crypto adoption in developing economies has outpaced that of advanced economies. According to IMF survey, the top five countries using or owning crypto assets in 2020 were emerging market and developing economies, whereas the lowest adopters were generally advanced economies (Statista 2021).

Implication of cryptocurrencies on monetary policy

While the exact impact will depend on how widely cryptocurrencies are used and integrated into the current financial system, cryptocurrencies can influence monetary policy in several ways. As crypto assets grow, its macro-criticality is likely to increase.

Here are some possible ways that cryptocurrencies could influence monetary policy:

• Reduced control over the money supply. Due to the decentralized nature of cryptocurrencies and the lack of a central controlling authority, standard monetary policy tools such as issuance or interest rate changes may not have the same effect on them as they do on fiat currencies. This may limit the ability of central banks to influence the total amount of fiat money in circulation.
• New data sources: Large volumes of transaction data generated by cryptocurrencies can be used to gain important insights into consumer behavior and broader economic patterns. Central banks may need to figure out how to incorporate this data into decision-making.
• Increased competition. Because cryptocurrencies provide an alternative payment method and store of value, they may become more competitive than traditional fiat currencies. This may put pressure on central banks to maintain the stability and value of their currencies to remain competitive. In addition, banks are experimenting with CBDC projects in response to the potential threat of cryptocurrencies disrupting traditional banking and payment systems.
• Expanding financial inclusion. Cryptocurrencies can provide people and businesses who may not have access to traditional banking services with better financial access and inclusion. As a result, monetary policy may change, as central banks may have to think about how a more diversified and decentralized financial system will behave.

The classic mechanism of monetary policy transmission involves the use of various instruments, such as interest rate changes by central banks, to influence the money supply, the actions of financial institutions, and the behavior of individuals. However, cryptocurrencies can operate separately from these traditional dynamics and cannot be directly affected by interest rate adjustments or other monetary policy instruments.

For example, stablecoins can be considered a safe haven asset, especially during periods of market turbulence or economic unpredictability. During these times, stablecoins may experience a sharp increase in popularity, which could reduce the impact of traditional monetary policy tools such as interest rate hikes.

Increased demand for crypto assets could facilitate capital outflows that affect the foreign exchange market. Crypto exchanges play the crucial role of facilitating the conversion of local currency to crypto assets and vice versa. South Korea’s brief martial law declaration caused market chaos, plunging stocks and sparking a record $34.2B crypto trading surge. To calm the situation, the government announced plans to inject nearly $7 billion into the market to prevent further chaos.

Central Asian countries face new risks from digital asset adoption

Moreover, crypto assets may change the demand for conventional fiat currencies and affect the effectiveness of monetary policy if they become widely adopted. However, central banks may need to develop new strategies to account for the impact of crypto assets on the entire economy and incorporate them into their policies.

Crypto assets as posing considerable risks to macrofinancial stability. Central Asia countries’ growing involvement in digital asset transactions and cross-border flows presents multiple risks.
The decreased transparency in financial flows associated with cryptocurrencies presents additional challenges for tracking capital movements, thereby intensifying the issue of existing “errors and omissions” within the balance of payments.

The risk of capital leaving the country rises, since digital assets allow funds to be withdrawn quickly, particularly during periods of instability. as both banks and non-bank institutions could indirectly increase their exposure to highly volatile crypto assets. There are risks to the financial system, both banking and non-bank financial institutions may incur indirect exposure to highly volatile crypto assets.

The increased adoption of cryptocurrencies has the potential to exert pressure on the foreign exchange market, which may diminish the efficacy of monetary policy and lead to heightened dollarization through alternative channels. Regulatory challenges have emerged as the sector’s swift expansion surpasses the advancement of oversight frameworks.