We’re going to take a look at cryptocurrencies in this article and how they, and the blockchain, can shake up the financial system. In order to understand the impact that cryptocurrencies could have let’s first remind ourselves about how units (eg dollars) of national currency are created.

At the moment the private banks and central banks create money in computers. Each time a loan is made by a private bank new money is created, it is not taken from an existing pool of money. This is how most money comes in to being. In addition, central banks create money in a number of ways. This can happen when they implement Quantitative Easing policies. For example, central banks may create money to buy things such as bonds. Central banks can also print paper money.

As more money enters the economy, the value of existing money, such as any savings you have, become worth less. Fuelled by newly created money, asset bubbles with respect to things such as property, stocks and bonds may also appear. Hyperinflation such as occurred in Venezuela, is possible, which effectively vaporises currency based wealth. Alternatively, bubbles may burst, leading to deflationary collapses in asset prices.

Cryptocurrencies offer something new. In particular, the feature of the blockchain technology used for cryptocurrencies that we want to focus on here is the ability to limit the total number of currency units (such as Bitcoins) that can be created. For example, it is not possible, with the existing Bitcoin blockchain, to debase Bitcoin, as the number of Bitcoins that can be created is limited. That is unlike government issued currencies which can be created in infinite amounts. Consequently, cryptocurrencies have the potential to act as an alternative and, perhaps in some cases, more trusted form of money.

There have been recent dramatic movements in the price of cryptocurrencies. This might be a sign of speculation in some cases, but it may also indicate a loss of trust in national currencies as a result of bank action. For example, central banks in Europe and Japan created 1 trillion US$ equivalent worth of national currencies in the first quarter of 2017 according to Bank of America Merrill Lynch. This is a part of what has been termed the ongoing "Liquidity Supernova". This is reducing the purchasing power of those national currencies, as well as potentially contributing to the inflation of asset prices.

The current cryptocurrency price volatility seems likely to continue as long as banks are creating huge amounts of additional national currency units and given the nascent state of the cryptocurrency markets. The relatively low total market capitalisation of the cryptocurrencies makes them more prone to any overspill as a result of events in the wider financial system and the user confidence, or lack of it, in national currencies. It's like dropping a rock in to a bucket of water versus a swimming pool. A few billion $ going in to the cryptocurrency markets can have a big impact, whereas the same number of $ might enter in to the wider markets with only ripples. Consequently large spikes and drops in cryptocurrency $ valuation terms are possible depending on user confidence in the range of national currencies, cryptocurrencies and other forms of money available such as gold and silver. Occasional hyperinflationary events in particular countries might lead to sudden inflows also.

Since there is no limit on the number of different cryptocurrencies that can be created it seems possible that in the long term the price of them could tend to settle around some reasonable margin above the mining cost (ie the price would be "cost-based"). If, for example, Bitcoin prices rose way above the mining cost, as appears to be the case now, we would expect more market entry by alternative cryptocurrencies. That should tend to attract $ towards them and away from Bitcoin. However, even if this happens, it could take a significant period of time before it materialises.

A cryptocurrency could perhaps maintain a price premium (above a cost-based price) to the extent that:

users have more confidence in the cryptocurrency than alternative cryptocurrencies;
people have more faith in it than national currencies;
there is not a sufficiently large number of available cryptocurrency units to soak up demand;
shocks occur in the global economy and people perceive cryptocurrencies to be a safe haven.

Ultimately, if there is a strong brake on the number of cryptocurrency units that can be created, users will have more confidence in cryptocurrencies. That will increase the chance that cryptocurrencies will be used as alternatives to national currencies in the future. If cryptocurrencies become much more widely used and eventually represent a significant amount of all global transactions, cryptocurrencies might also limit the extent to which governments or central banks can affect the development of the economy though monetary policy. That is because central banks would be less able to affect economic outcomes based on the creation and spending of additional units of national currencies. Therefore, although economic fireworks may be more likely in the near to medium term, cryptocurrencies may contribute to greater financial stability in the long term if they encourage central banks to limit the creation of additional national currency units to reasonable levels. Of course, there is the possibility that governments and central banks may seek to regulate cryptocurrencies if they feel that they no longer have sufficient control of money creation.