In our previous column, we provided an overview of the fintech business domain and compiled our firm's hypotheses regarding what types of fintech businesses could be created in this field going forward. In that column, we summarized five hypotheses as major fintech trends expected in the future. Regarding these five hypotheses, based on developments over the past year and a half, we believe there have been fundamentally no "unexpected events" requiring significant revisions or retractions. On the other hand, particularly in the cryptocurrency domain, there have been remarkably diverse and active developments that could not have been anticipated at the time of our previous column.

Therefore, in this column (planned as a three-part series), we would like to delve deeper into the fifth hypothesis regarding "the decline of existing currency transactions and the neutralization of traditional monetary policy due to the development of cryptocurrency technology," taking into account recent discussions and trends. Let us begin with our conclusions.

• Cryptocurrencies with price volatility, including Bitcoin and Ethereum, will not displace major currencies, at least. This is because mechanisms to ensure "quantity stability" are not designed into the system, which is one of the two elements that constitute currency stability and reliability: "quality stability" and "quantity stability."
• The J Coin with a fixed exchange rate against the yen, conceived by a domestic commercial banking consortium centered around Mizuho Bank, is a cryptocurrency with high development potential.
• To theoretically maximize the benefits of cryptocurrencies utilizing blockchain technology, the most rational approach would be for the Bank of Japan to issue a digital yen currency, but early realization is likely difficult.

■ The "Quality Stability" Required of Currency

In this column, we define the stability requirements that currency must fulfill as "1. quantity stability" and "2. quality stability." We will examine each in order. First, what is "1. quality stability" of currency? It can be said to consist mainly of the following three points.

① It is difficult to counterfeit, and severe penalties can be imposed on those who counterfeit it.
② All currency can be supplied with uniform quality.
③ Distribution costs are low.

Historically, enormous power (state authority) was necessary to guarantee such currency quality. For example, the excavation, casting, processing, and mass production of rare metals such as gold, silver, and copper with consistent quality required the securing of technology and labor force. Additionally, police power capable of thoroughly punishing currency counterfeiting crimes was essential. The stability of currency quality and the securing of trust could not be achieved without enormous authority. As mentioned in the recently popular "Sapiens: A Brief History of Humankind," currency has always been integrated with power throughout history.

However, cryptocurrency data recorded in a virtually unalterable form on distributed ledgers across networks using blockchain technology has the potential to solve through technology the problem of ensuring currency quality stability that previously only state authority could achieve. This is undoubtedly the primary reason Bitcoin and similar currencies attract attention. At least in this regard, it is certainly a revolutionary event that no nation in history has ever accomplished.

This column also considers it highly feasible that Bitcoin and other cryptocurrencies using blockchain technology can solve this issue of currency quality assurance through technology. In other words, we proceed on the premise that Bitcoin and other cryptocurrencies satisfy the three points of being ① impossible to counterfeit, ② consistent in quality, and (being electronic data) ③ having extremely low distribution and management costs. These points are positioned at the center of cryptocurrency discussions and have already undergone sufficient debate and verification. Even if technical problems were to arise in the future, they would likely be improved promptly.

■ The "Quantity Stability" Required of Currency

Next, to simply confirm the importance of currency "quantity stability," let us conduct a thought experiment assuming an extremely primitive closed economy on an island with only 10 pieces of obsidian and 10 apples. Here, "apples" represent goods in the real economy. And "obsidian" naturally represents money. In this closed economy, if all obsidian and all apples are exchanged just once, the value of apples becomes equivalent to one piece of obsidian. In other words, the value of apples measured in obsidian is "1 obsidian." Let us call this "1k."

Next, suppose 10 new pieces of obsidian are mined from a cave in the south of the island. If all obsidian is again exchanged for all apples just once, the value of apples measured in obsidian becomes 2k. This means the value of obsidian as money has halved relative to apples as real economic goods, resulting in a decline in monetary value. A decline in monetary value equals inflation.

This way, when the money supply increases, monetary value decreases and inflation occurs—this is the theory known as the classical quantity theory of money. However, in reality, if newly excavated obsidian is held rather than exchanged for apples, inflation does not occur. Therefore, the frequency of transactions between apples and obsidian also affects inflation. This transaction frequency is called velocity of circulation in economic terms. When these relationships are expressed mathematically, they form the following equation known as "Fisher's equation of exchange."

MV=PQ

M: Total amount of currency in circulation at any point T during a given period
V: Velocity of money circulation (number of times money is exchanged among people within a specific period)
P: Price level at any point T during a given period (usually a deflator with a base year set at 1)
Q: Transaction volume (total quantity of transactions conducted among people within a specific period)

What Fisher's equation of exchange demonstrates is that managing the money supply M is extremely important for maintaining a stable price level P in the real economy (i.e., the exchange ratio between money and goods). This appropriate management of money supply is one of the most important missions of modern monetary authorities.

However, at least currently, cryptocurrencies like Bitcoin do not appear to have algorithms built into their basic system design for appropriate management of currency issuance volume and the price stability this could achieve. The foundation needed for this currency supply stability is a management entity for currency demand volume to continuously achieve price stability, which is not a problem that can be solved by algorithms.

Bitcoin is newly issued as a reward to validators who successfully participate in transaction record verification and complete bookkeeping. This activity is called mining, requiring computing systems with advanced computational power, and major miners are currently said to be concentrated in China and other locations with low electricity costs.

This algorithm is not essentially designed with the mission of ensuring quantity stability required of currency (securing stable supply volume relative to demand). The detailed intentions of the mysterious Bitcoin designer "Satoshi Nakamoto" in creating this Bitcoin mining algorithm are unknown. We imagine the intention was likely to create a situation where Bitcoin demand always exceeds supply (Bitcoin is slightly scarce), preventing Bitcoin from losing value.

However, as Bitcoin gained attention, massive speculative demand occurred simultaneously, causing Bitcoin prices to surge. Subsequently, due partly to Chinese regulatory authorities' actions, prices have recently plummeted. For Bitcoin to truly become capable of displacing other major currencies, it must have functions and mechanisms to adjust for such price fluctuations.

In cases of rapid currency value changes like Bitcoin's recent experience, for example, with the yen, the Bank of Japan would absorb funds from the market to suppress inflation, or conversely, if prices declined (currency appreciation, i.e., deflation), the Bank of Japan would supply funds to the market and implement inflationary policies to lower currency value—exercising so-called monetary adjustment functions to maintain value stability.

However, such mechanisms are not built into Bitcoin and other cryptocurrencies. Nor will they be built in going forward. As already mentioned, this is not an algorithm problem but rather an institutional design/system issue—the absence of participants, specifically the non-existence of counterparties (monetary authorities) to conduct opposite transactions in response to currency value fluctuations. This becomes one of the conclusions of this column.

■ Are cryptocurrencies then only niche currencies suitable merely as speculative instruments?

So, are all cryptocurrencies merely luxury items for a small number of speculation enthusiasts? Is it impossible to overcome value instability from adopting floating exchange rates while enjoying the benefits of blockchain technology: counterfeiting prevention, uniform quality assurance, and low distribution costs?

Regarding this, our firm holds the hypothesis that the J Coin by commercial banks harbors great potential and possible impact on the Japanese economy, and most fundamentally, the ultimate ideal (though probably unrealizable) would be for the Bank of Japan itself to issue digital yen currency and collaborate with private IT companies to manage blockchain ledgers.

We would like to write about this in subsequent columns.