Technology

Deutsche Bank Sees Inflation Protection Benefit Behind Cryptocurrencies

When Deutsche Bank CIO Christian Nolting looks at cryptocurrencies and blockchain, like many institutional professionals he separates the two concepts. But it is in the application where his thoughts are nuanced. While noting the highly speculative nature of an investment in cryptocurrencies such as Bitcoin, Ethereum, IOTA and litecoin, he and Markus Muller, global head of the CIO office, see benefits as well as risks, pointing to the need for a central bank to back a cryptocurrency for it to gain meaningful traction.

By Tiagodimas2 (Own work) [CC BY-SA 4.0], via Wikimedia Commons

Cryptocurrencies protect against inflation in crisis nations

“Blockchains and connected cryptocurrencies are probably the inventions with the most disruptive character for the finance sector and the public since the invention of the internet,” Nolting and Muller noted in a December 2017 presentation that as the title implies looked at “Cryptocurrencies and blockchains –their importance in the future.”

DB notes there are cryptocurrencies like IOTA, which have apparently solved this problem with a new blockchain structure.

Avoiding the now predictable rhetoric that cryptocurrencies are a “fraud” or “bubble,” the Deutsche Bank report took a balanced view.

One benefit of a cryptocurrency is for those locked in a sovereign region where runaway inflation transforms the local currency into a worthless store of value. “Because most cryptocurrencies are limited the inflation risk is low,” the report noted. Venezuela had an inflation rate of 250% in 2016 and the IMF expects a rate of 700% in 2017. “Cryptocurrencies could, in fact, represent a form of protection against inflation in crisis countries,” as the volatility is relative to a local currency’s volatility.

But the inflationary benefits are not built on an entirely sound foundation. “Reproductions and splittings could have an impact on the inflation rate as this could increase the number of available currency units,” the report noted, pointing to the splitting of Bitcoin and Bitcoin Cash.

The report notes:

Known cryptocurrencies are Bitcoin, Ethereum, Ripple, Litecoin and IOTA. In a sense they are scarce commodities as the amount of available currency units is in this case limited by mathematical algorithms. After every digital currency unit is issued there is no way to generate additional currency units from it (e.g. Bitcoin is limited to 21 million units). Furthermore every cryptocurrency has their own currency generating process.

Such monetary expansion in cryptocurrencies could have similar negative currency valuation ripples as has been seen in Venezuela if uncontrolled replication is not limited.

Deutsche Bank explains the current process of “mining” the cryptocurrency:

The function of mining is the confirmation, synchronization and digital booking of these transactions like Bitcoin. The participants in this process compete with each other, because the confirmation of one block is rewarded with a fraction of transaction costs and new bitcoins. To make this process fair, every participant has to solve a cryptographic puzzle. A hash with a unique structure must be created, like a combination of figures and letters. There is no possible way to know the structure of this hash before it is created. The participant who solves this puzzle first is able to generate a new block and gets the reward.

While creating cryptocurrencies was at one point something that individuals, it has largely become impractical. “While it was worthwhile for someone to mine alone a few years ago, this is because of high hardware and energy costs not profitable anymore,” the report noted.

The electricity used to mine cryptocurrencies has skyrocketed. Digiconomist estimates that bitcoin mining currently uses more electric power than the nation of Serbia. Bitcoin emits what amounts to 17.7 million tons of carbon dioxide every year, making the production of the digital currency an environmental nightmare that is likely to grow.

Cryptocurrencies need a central bank help to gain “general acceptance”

In addition to societal concerns that are holding cryptocurrency adoption back, there are also issues of the “criterion of general acceptance,” the Deutsche Bank report noted, a feature that is currently not fulfilled by cryptocurrencies. The bank had previously mused over the end of fiat money.

In order to become legitimate, a central bank would be required to vouch for the legitimacy of the cryptocurrency. When US Fed Chair Janet Yellen revealed they were in discussions with another unnamed central bank to examine the production of a cryptocurrency, this was a start, even though such a move was not judged as viable or necessary at this point.

The government in Dubai, one of a handful of financial hubs in the Middle East, is the first to fully embrace a cryptocurrency. They created their own cryptocurrency called emCash for government transactions and daily payments. In Japan, a nation that Deutsche Bank said was “holding up” the bitcoin market, the cryptocurrency is now a legal payment method.

“Cryptocurrencies will raise further attention,” Deutsche Bank noted, particularly “in crisis countries they could represent an alternative to inflation threatened currencies. It will be very interesting how the blockchain technology evolves beyond cryptocurrencies in the public and financial sector.”

Which ones will win? Impossible to say but Deutsche Bank notes some further advantages of IOTA:

The IOTA foundation, located in Berlin has revolutionised IoT*. IOTA represents a third generation of Blockchain after the development of Bitcoin and Ethereum were developed. It actually isn’t a simple blockchain anymore, but rather a completely new concept.
•The scale problem is solved through a new developed structure. Instead of a chain the blocks are processed in parallel strands. A transaction is processed after being confirmed by several participants (not miners like Bitcoin). There are basically three steps during a transaction:
1.I have to confirm a minimum of two transactions (the software does this automatically, unlike miners for Bitcoin).
2.These two transactions must be verified and checked (also done by the software).
3.The authentication is processed through a nonce (number used once)*. This guarantees spam protection.
•In conclusion: IOTA has solved the fundamental problems of blockchain, because it is scalable and does not cause any costs. The problem is, that this payment system only works if cryptocurrencies are compatible with each other, because IOTA does not have blocks and chains.