Cryptocurrency and Financial Stability

Abstract

This paper introduces cryptocurrency into a two-country open-economy model. Based on the theoretical model, we employ the TVP-VAR model to study the dynamic interdependence among interest rate spread (a proxy in the monetary market), exchange rate (a proxy in the forex market), and Bitcoin transactions (a proxy in the cryptocurrency market). The key finding is that Bitcoin has an effect of de-fiatization in the global financial market. When there is a higher divergence in monetary policy between the US and China, Bitcoin attracts greater attention with a higher price, posing a competing force against USD. When there are greater fluctuations in the exchange rate of USD/CNY, Bitcoin diverts investors from CNY. The fiat currencies of the two largest economies are both losers while Bitcoin gains. Therefore, cryptocurrency not only decentralizes the role of commercial banks as a medium of payment, but also decentralizes the role of central banks as a monetary policymaker. In face of this challenge, it is suggested that central banks should embrace blockchain technology and develop their own digital currency to restore the trust lost in the global financial crisis. International collaborations in terms of regulation are necessary given its borderless and authority-less feature.