Setting the stage
The debate on digital currencies, which are often seen as competing with central bank issued money, intensified significantly during 2019. Facebook’s Libra initiative forced the issue centre stage and previously reluctant parties have been forced to scramble for a position. Given the level of current discussion, and action, it seems probable that we will see one or more digital money proposals launch in 2020.
Currently there are three categories of initiatives addressing the same opportunity: public, private and consortium. The main public variant is bitcoin (based on a public blockchain) while the best resourced known consortium initiative is Libra; other consortium initiatives are probably in the wings but in stealth mode. The public sector and regulators seem resolved to block the launch of Libra, even if this has a semblance of ad hoc regulation. At the same time central banks are creeping towards introduction of (private) digital currency themselves.
Private (as opposed to public or consortium) digital currency would be issued and managed by the central bank, as is the case with current currency, hence the moniker CBDC, or Central Bank Digital Currency. The concept first materialized as Estonia’s Estcoin proposal in 2017, which was soon forced to a halt by Mario Draghi, Governor of the European Central Bank (ECB).[i] Today the best known CBDC initiatives are the eKrona of Sweden’s Riksbanken and the digital yuan of the Peoples Bank of China.
In this paper we argue that the developed country most incentivized and best positioned to issue a CBDC could in fact be the United Kingdom and it would likely specifically be purposed for international institutional use.
Why would a central bank issue digital currency? On a high level, there are 5 main motivations for a CBDC that address different policy needs and use-cases.
- Financial intermediation efficiency – both in-country and cross-border.
- Financial inclusion – including people without access to regulated banking accounts into the financial system.
- Competition in payments markets – new alternatives for consumer and institutional users.
- Payments security – CBDC’s could be designed to facilitate reduced fraud and risk of money laundering, if so decided.
- Financial stability – CBDC’s have potential to be equally or even more stable than existing fiat-currencies.
- Monetary policy implementation – CBDC design could enable more efficient and direct influence mechanisms between central bank monetary policy and the real economy.
In broad terms the main motivations and use cases for CBDC’s fall into two categories: retail use as a proxy for disappearing cash with enhanced new features (micropayments, instant transfers) and lower costs; and institutional use on national or on global level for value transfer and transaction clearing benefitting of improved speed, security and efficiency. In both instances, novel opportunities for integration into other digital processes are at the heart of the efficiency gains.
In public commentary, Swedish eKrona has been positioned towards the consumer use while the Chinese digital Yuan more towards the institutional use.
Cross-border payments and transfers with digital currencies have been a prominent theme, both in retail and institutional contexts. With respect to retail use, remittances constitute 10% or more of many developing countries GNP. Used for institutional cross-border payments digital currencies may potentially augment the stability of the international monetary and financial system[ii], but also relate to important national security and economic benefit considerations.
Growing global cross border trade means there is increased demand for the currency used in pricing and settlement of trade. Open economies dependent on trade also require significant reserves of the settlement currency both to ensure their ability to continue to trade in all circumstances, as well as to secure their domestic currency’s resilience against external shocks. The demand and liquidity of the trade settlement currency is further enhanced by the securities markets. Securities issuers prefer the same currency when issuing new financial instruments and securities holders place a premium for securities denominated in the currency with most liquidity and broadest acceptance.
Currently this position is clearly held by the US dollar. Over 50% of all cross-border trade is invoiced in dollars and two-thirds of both global securities issuance and official foreign-exchange reserves are denominated in dollars. The US benefits by being able to monetize its deficits and enjoys significantly lower borrowing costs due to the global demand for dollars. It also allows the US to enforce major political and economic pressure globally via regulating access to the dollar-system. For this reason, some leading US politicians also see China’s CBDC activity as a national security policy challenge.[iii]
The leading contestant to the dollar’s reserve currency position are currently the Japanese yen and the euro. If a digital yuan is seen as a risk on multiple fronts in the western countries (including regulatory, political, privacy and even national security risk) the challenges with an eEuro are very different but equally insurmountable. The EU is generally preoccupied by internal issues and there is considerable rift in how fiscal and monetary policy should be coordinated across the euro-area, if at all. Promoting the euro as an international reserve currency is sometimes recognized as an objective, but ultimately the EU’s external and global agenda is of secondary consequence. Any agreement or progress on an ECB issued eEuro is likely to be slow or non-existent for years to come.
However, for the UK currently exiting from the EU and no longer tied by European institutions, the situation is very different. The UK is seeking to re-establish a more global position for its economy and is in the process of renegotiating trade agreements with EU, US and other countries. Any potential for sterling to defend its role as a conduit of international trade must seem highly compelling to pursue. Any opportunity to increase the global demand for sterling and improve the liquidity and stability of the currency would appear lucrative. Any steps, however small, to ascertain sterling’s continued role in international payments and finance, would be beneficial for UK and the City of London.
The CBDC opportunity for UK stems from the unique confluence of technology, economics and politics at this point in time. As Mr. Carney has noted, “history shows that the rise of a reserve currency is founded on its usefulness as a medium of exchange, by reducing the cost and increasing the convenience of international payments. The additional functions of money as a unit of account and store of wealth come later and reinforce the payments motive.”[iv] Digital currencies represent the technology driven opportunity for the future of money, as they would bring unquestionable advantages relative to ‘analogue’ fiat currencies.
In trade these benefits would include seamless integration of agreements, documentation, authentication, auditing, collateralization and, payment-for-delivery settlement in addition to increased speed and reduced transaction costs. In financial markets digital currencies can facilitate faster and cheaper emission of securities, reduce dependencies and costs imposed by intermediaries and allow improvements in information sharing and liquidity. Altogether, the realized effect would be cost savings, improved returns, improved access to capital and more depth and width in financial markets.
The performance advantages are of an order where it is certainly feasible that “technology has the potential to disrupt the network externalities that prevent the incumbent global reserve currency from being displaced.”[v]
On the political front, the trust in US Dollar is being eroded by deeply divided internal politics in US. The current President of the US is determinedly undermining multilateral global institutions, including those underpinning trade, finance and security policy. US has engaged with China on a trade war and a strategic hegemony battle, that will last for years, if not decades to come. The current dominance of the US dollar and the willingness of current US administration to engage in trade wars and to “weaponize” the access to the dollar-based banking system, is destabilizing for international financial stability. There is ample political will to look for dollar alternatives.
For the purpose of supplementing the dollar in the international financial system Mark Carney in August floated the idea of a digital synthetic currency (the SHC abbreviation used stems from systemic hegemonic currency), which would be backed up by a basket of other (fiat) currencies.
In December, Bank of France Governor Francois Villeroy de Galhau mused that “there would be some advantage in moving rapidly to issue at least a wholesale CBDC, as we would be the first such issuer in the world and would thus reap the benefits of having a benchmark CBDC,”[vi] later adding that “the French central bank is eager to get experiments running that would use a CBDC for exchanging and settling tokenised financial assets between financial companies.”
Unfortunately, the Bank of France is in no position to issue currency (digital or analogue), and while the SHC concept is attractive it lacks a credible issuing authority and home market. No such constraints apply to the Bank of England. The ability is there, the opportunity seems obvious and the motive has been established. We will next look at some of the practical considerations.
Governance and stability
IMF economist Gita Gopinath wrote in the FT “the dollar’s status is bolstered by the institutions, rule of law, and credible investor protection that the US is seen as providing.”[vii] Additionally, there is the suitability of US law for commercial agreements and easy access to adjudication through courts or arbitration. In short, much of the attraction of the dollar is conferred by stability, which has been entrenched due to network effects.
The UK does, in fact, have similarly strong institutions of an independent central bank, rule of law, established financial market regulation and investor protection, a body of law well adapted to commerce, and an independent legal system that already provides services on a global scale. Arguably, the relevant UK institutions are more fitted to global scaling than those of the EU (some history at play here).
The size of the UK economy is obviously not comparable to the US and the implications of that for currency stability need to be recognized in the early days – over time these could be overcome by network effects. Nevertheless, these factors can be mitigated by technology, and it would be perfectly feasible to engineer stability into a digital sterling.
The retail aspect
While the key driver for a BOE issued digital sterling probably would be the institutional use-case for global trade and finance, it is worthwhile to briefly consider the retail aspects and implications as well.
One of the key considerations highlighted by some central banks considering CBDC has been the declining acceptance of physical cash and the need to ensure continued access to central bank money (i.e. independently of private financial institutions) for consumers. Most notably, Sweden’s Riksbanken has highlighted this as a concern as their country is fast giving up on the use of cash.
Retail transactions increasingly take place online rather than on the high street, and money is transferred through electronic payment rails such as credit cards. Current electronic and instant payment networks, while generally ubiquitous and useful are in fact very high-cost and market-specific solutions, and these costs are only amplified in the case of cross border payments.
This has created an obvious opportunity for innovation, and to the dismay of regulators, the shadowy line between payment networks and currencies has been breached by new de-centralized network solutions adopting totally new principles of ledger keeping, transaction settlement and payment processing.
The most high-profile of these new initiatives has been Libra, backed by Facebook. In fact, this has been high-profile enough to scare multiple regulators into unprecedented hasty action (including some commentary that distinctly lacks the academic standards traditionally expected of central banker discourse). In considering Libra, however, the important issue to bear in mind is that this is unlikely to be a unique initiative – only the one we are so far aware of.
Libra has been described as a new payment infrastructure based on an international stablecoin fully backed by reserve assets in a basket of fiat currencies including the US dollar, the euro, and sterling. Libras may be exchanged between users on messaging platforms and with participating institutions and merchants. [viii] With the backing of Facebook and other powerful launch partners both user and merchant uptake could rapidly achieve critical global mass for network effects to not only reinforce its usefulness but to lock-in its use.
The motivation for private companies to sponsor a digital currency stem from the systemic opportunities it generates. Money is one of the key mechanisms that binds together what we call the economy. And, just as the value premise to users is in creating new financial and commercial connections on a systems-level, so the ability to tap into the data created by these transactions would be an incredibly powerful competitive asset to the system sponsors The opportunities for monetizing that knowledge, whether through advertising, intermediation, financial service sales or other are literally worth billions.
This value has already been verified in the digital financial platforms operated in China by TenCent and Alibaba and is made tangible in the valuations of these companies. Industrial and Commercial Bank of China is the largest bank in China, and also the largest bank in the world by assets (2017 and 2018) and has a market value of USD270bn (Feb 2020). In contrast Tencent has a market value of USD510bn and Alibaba USD590bn[ix].
From the commercial banking perspective, this a straightforward defensive battle to avoid redundance. From a central bank perspective, it should not be about denying the commercial opportunity, but to secure those advantages for public benefit. Herein also lies the paradox: for a tech company looking at an opportunity to develop a (multi-)hundred billion euro value opportunity, investing a billion in costs in the process is totally warranted. For a public institution, investing even a tenth of that (10 million) in costs to develop or defend the same value opportunity is considered highly contentious, as it is seen exclusively in cost terms.
Network effects and first-mover advantage
Regulators have taken the view that for any new private payments system that may be adopted by billions (yes!) of users, the terms of engagement must be negotiated and in place well in advance of any launch. In this instance, it may be noted that even a year back most regulators dismissed the need for such advance consideration and at face value Libra seems to in-fact meet all the rules and regulations that ex ante have been put in place. The true underlying issue was voiced by Bruno Le Maire, France’s economy and finance minister: “The Libra project would mean a private company controlling a common good and taking over tasks normally discharged by states. This is unacceptable for both economic and political reasons.”[x]
The network effects are an incredibly powerful continued motivator for private sector initiatives and the search for first mover advantage. The value premise to users is in creating new financial and commercial connections on a systems level. The more users, the more use cases, the more value to users and the more data to reinforce personalization, customization and to support proprietary new business cases. As Metcalfe’s law states, the value of a network grows as the square of the number of network participants. For a network of billions, the value premise may become incredibly powerful with winner-take-all market characteristics.
Even if the central bank considerations do not stem from, or aim for system value maximization, the benefits of currency adoption are recognized and the same logic of maximizing value to participants through network effects still applies.
The private adoption of new technology is difficult to halt simply through prohibition. It is highly likely that even central bankers have recognized that the only sustainable way to ensure that state prerogatives may continue to be monopolized is for the state itself to adopt and deploy the new technology – and even that may not be enough.
From the UK perspective, we would see the retail market as a secondary consideration with respect to the launch of a digital sterling. Having said that, there is an established and well documented need for it in the context of the global remittances market. Were a digital sterling to become entrenched as the principal facilitation mechanism for remittances, this would be an undoubted boost to international adoption especially across the emerging economies, and it might well have ramifications for the reserve currency policies of these economies as well.
Stability and the role of the commercial banking sector
A currency is strikingly simple in its fungibility and in the belief system it captures, and at the same time it is fiendishly complicated as well as complex in the technicalities it needs to resolve. Key considerations include topics such as financial and economic stability, role of the commercial banking sector and data ownership and privacy.
In our view all three issues are intertwined around the topic of monetary architecture. Should digital sterling be a purely fiat-currency akin to the existing GBP, or should it be backed by a body of reserves, and what should the issuing mechanism be?
In the first instance, considering CDBC purely as fiat, the central bank could mint new money solely at its discretion (equivalent to printing an unlimited supply of paper money) and all the CBDC in circulation would be a net increase to the money supply. Both issuance and distribution of the digital sterling could be independent of the commercial banks and if the volume of the digital currency grew to be significant this would undoubtedly undermine the economic basis of the current commercial banking sector over time.
Prior to dismissing this scenario, we would raise the consideration that that current commercial banking sector has been awarded a unique regulatorily protected position to exercise financial intermediation. Given recent performance through the financial crisis and its aftermath, it is by no means obvious that the sector is discharging this intermediation either as efficiently as possible, or as cost effectively (to society) as possible, or that socially and economically better alternatives could not be found.
The second alternative is that digital sterling would be wholly or partially backed by a distinct pool of reserves. Most likely, these reserves would be deposits of ‘analogue’ currency collected by the central bank in exchange for the issuance of the digital version. In other words, every digital pound sterling would be issued only in exchange for a pound sterling (or equivalent) deposited at the BOE. In this scenario, the digital currency would have no net effects on financial, economic or monetary stability. If the conversion facility was made open primarily to commercial banks and other central banks, this would maintain the current position of the banking sector as intermediaries virtually unchanged[xi].
Commercial banks would retain the retail opportunity of mediating digital sterling to their customers. Furthermore, their ability to create money through lending underpinned by fractional-reserves and the social guarantee on their liabilities would be maintained.
The most radical (and unlikely) alternative would be to issue the CBDC as a purely asset-backed currency, independent of the existing fiat currency, leading to a variable exchange rate between the two. This would certainly be technically feasible (and would come close to the Libra structure), but rather begs the question of “why?”. We see little motivation for even considering this alternative in a developed-economy context.
Professor Jonathan Haskel, a member of the BOE Monetary Policy Committee, has described monetary policy as the “setting of interest rates and asset purchases by an independent Central Bank, which takes place against the background of (a) changing transmission mechanisms by which short-term policy influences the economy and (b) a trending long run “natural” real interest rate (R* for short)”. The objectives of monetary policy being to stabilise prices and economic output.
The introduction of a digital currency should obviously not change the policy objectives. Nor does it change the ability of the central bank to set interest rates or to make asset purchases. Further assuming that it has no direct impact on R* the main outstanding question should be that does it change the policy transmission mechanisms, and if so, is it for better or for worse? It is by no means evident that the answer to this would be the latter.
The main exception to the above would seem to be the ability of the central bank to set interest rates below zero. It is possible that a digital currency might reinforce the zero-bound of monetary policy. On the other hand, the zero-bound itself is in many ways a reflection of the structural weaknesses of current financial transmission mechanisms[xii].
Privacy vs transparency
Privacy, or conversely transparency is a fundamental design feature of a digital currency architecture. Blockchain or any other distributed ledger technology creates an immutable record of all transactions and all holders, but this may be anonymized to a varying degree. The operative question is that does someone have access to this record and under what conditions is the access granted? In short, a digital currency makes tangible the fact that the control of money laundering, tax evasion, etc. are fundamentally political questions and the ability to avoid or ‘fudge’ these questions will be reduced by new technology.
A large portion of the current cost and complexity of modern banking relates to anti-money laundering and terrorism finance regulation. In the context of a digital currency this burden could be much reduced by requiring the use of verified digital identities in the creation of ‘wallets’ and/or the execution of transactions. Another side-benefit of attaching ownership of currency to verified identity (natural person or legal entity) could be the security it creates – if only verified entities were able to transact then the opportunities for theft and fraud could be significantly reduced.
Our monetary systems and their institutions have evolved over several centuries. It would be rash to undermine them just because it may now be possible. On the other hand, there are proven challenges in current structures and new technology appears to strengthen the competitiveness of new digital forms of money. Inaction does not stop progress – it just gives up control on how the future shapes up. The genie is already out of the bottle.
In a free market economy spontaneous demand for something, in this case digital currency, is likely to lead to alternative solutions to fulfil that demand. If the solutions are not offered as a matter of public prerogative, it is highly likely that private commercial solutions will then seize the opportunity.
The UK today finds itself in a unique position to issue digital sterling and benefits from multiple strengths that would help the endeavour to become a success. A first mover advantage would be important to secure the network effects that we may now recognize as hugely valuable. A digital sterling could be one of the pillars of the new financial order of the 21st century and extend the position of London as a centre for global trade, finance and insurance. Competition amongst currencies has not always been seen fondly, but this time it would hardly be mercantilistic. Lastly, the rise of unprecedented private actors such as Facebook, Google, Alibaba, et al., creates an onus on public institutions to renew themselves and secure the economic and social advantages that may be generated for public benefit, not just for private profit. This onus should apply both
on and off the European continent, but it now seems Britain which is better poised to act.
The authors are founding partners of Smart Contract Company.
ECB President Mario Draghi in news conference, September 7,2017 as reported by
Reuters and others.
[ii] Bank of England Governor Mike Carney in his speech at the
Jackson Hole conference in November 2019. https://www.bankofengland.co.uk/-/media/boe/files/speech/2019/the-growing-challenges-for-monetary-policy-speech-by-mark-carney.pdf
US Treasury Secretary Steven Mnuchin in White House press conference over
digital currencies in July 2019 according to Foreign Policy January 24, 2020
of England Governor Mike Carney in his speech at the Jackson Hole conference in
by Mr Villeroy de Galhau, Governor of the Bank of France and Chairman of the
Autorité de contrôle prudentiel et de resolution (ACPR), at the ACPR, Paris, 4
December 2019. https://www.bis.org/review/r191204f.htm
currencies will not displace the dominant dollar: Proposals of a ‘synthetic
hegemonic’ alternative face steep obstacles.
Gita Gopinath, Financial Times 07.01.2020. https://on.ft.com/2tEoNC5
Bank of England Governor Mike Carney in his speech at the Jackson Hole
conference in November 2019.
US tech giants obviously have even higher valuations, but arguably a higher
proportion of the Tencent and Alibaba value is attributable to the respective
financial ecosystems they have created.
the moment commercial banks may post lower-quality assets as collateral with
the central bank to access central bank liquidity. In principle there is no reason this would
not work with issuance of CBDC as well.