Why cen­tral banks could mint their own dig­i­tal cur­rency

Only 8 per­cent of global fi­nan­cial trans­ac­tions to­day in­volve cash, but that fig­ure will di­min­ish even fur­ther as dig­i­tal cur­ren­cies gain promi­nence.

Financial Nigeria Magazine - - Contents - By Strat­for

From the Mar­shall Is­lands to Rus­sia, it seems ev­ery­one's on board with the year's hottest trend: dig­i­tal cur­rency. Fol­low­ing the boom and (par­tial) bust of var­i­ous pri­vate cryp­tocur­ren­cies over the last six months, sev­eral cen­tral banks are now se­ri­ously con­sid­er­ing in­tro­duc­ing their own na­tional dig­i­tal cur­ren­cies in the near fu­ture. These cur­ren­cies won't just be bit play­ers in a field dom­i­nated by the likes of bit­coin; in­stead, the cen­tral banks' en­try into the crypto game could have a sig­nif­i­cant ef­fect on in­di­vid­ual cus­tomers, com­mer­cial lenders and the in­ter­na­tional mone­tary sys­tem it­self.

From the Phys­i­cal to the Dig­i­tal

Money emerged in­de­pen­dently in every cor­ner of the world, but the Bri­tish Em­pire was es­pe­cially in­flu­en­tial in lay­ing the ground­work for many coun­tries' mod­ern fi­nan­cial sys­tems. In re­sponse to the oner­ous task of trans­port­ing gold to make pay­ments, gold mer­chants in the United King­dom be­gan to is­sue ex­change notes – in ef­fect, pa­per money – as proof of funds. The sys­tem de­vel­oped into a con­stel­la­tion of pri­vate banks, each of which is­sued cur­rency in its own name, and soon drove up in­fla­tion as the in­sti­tu­tions over­printed cur­rency to im­prove their own prof­its. To rec­tify the is­sue, the Bri­tish gov­ern­ment chose one bank, the largest, to be­come the sole is­suer of na­tional cur­rency. And so the mod­ern cen­tral bank was born.

Thanks to its gov­ern­ment-en­forced mo­nop­oly, the cen­tral bank be­came an arm of the ad­min­is­tra­tion over time. It be­came the safest re­pos­i­tory for the funds of other banks, since its fate was tied to and guar­an­teed by the gov­ern­ment's own bal­ance sheet, and the source of bailouts when they en­coun­tered trou­ble. At the same time, as it stopped re­ceiv­ing de­posits from pri­vate cit­i­zens, the cen­tral bank ceased to func­tion as a com­mer­cial lender on its own be­half and turned its fo­cus solely to its of­fi­cial re­spon­si­bil­i­ties in the larger sys­tem.

To­day, the mone­tary sys­tem con­sists of two main parts: phys­i­cal money and dig­i­tal money. Phys­i­cal money – cash – is the last di­rect link most cit­i­zens main­tain with the cen­tral bank through bank notes and coins, which es­sen­tially are IOUs tied to the gov­ern­ment bal­ance sheet. Dig­i­tal money, by con­trast, em­bod­ies cit­i­zens' re­la­tion­ship with com­mer­cial in­sti­tu­tions and in­volves a trans­fer of funds be­tween banks (as­sum­ing the payer and payee do not use the same in­sti­tu­tion) in a process that the cen­tral bank over­sees and un­der­writes. Cash cur­rently ac­counts for just 8 per­cent of global trans­ac­tions, and its use may di­min­ish even fur­ther as rapid de­vel­op­ments change the global econ­omy.

Chang­ing the Game

Tech­no­log­i­cal pro­gres­sion, ef­forts to fight crime and the de­sire to im­ple­ment neg­a­tive in­ter­est rates have all prompted a de­crease in world­wide cash use. Some gov­ern­ments have ac­tively tried to ad­vance the trend, most no­tably in the case of In­dia's dra­matic de­mon­e­ti­za­tion ini­tia­tive in 2016. In more de­vel­oped coun­tries, the push to­ward a cash­less so­ci­ety is un­even; while the United States, Ger­many and Ja­pan are still at­tached to phys­i­cal money, more than one-third of Swedes say that they never use cash at all.

The emer­gence of pri­vate cryp­tocur­ren­cies is likely to have an even big­ger ef­fect on the world's cur­rent mone­tary sys­tem. Bit­coin, which first ap­peared in 2008, has in­duced worry among gov­ern­ments, be­cause na­tional fi­nan­cial au­thor­i­ties have lit­tle or no con­trol over the cur­rency, which could be­come a means of pay­ment in their

economies. As the use of cash de­creases, of­fi­cials fear that cryp­tocur­ren­cies could soon fill the void. Wary of the sol­vency of banks – es­pe­cially in the wake of the 2008 fi­nan­cial cri­sis – and un­able to safely store wealth in phys­i­cal cash, more and more peo­ple have rea­sons to turn to bit­coin or one of its nu­mer­ous de­riv­a­tives. Gov­ern­ments may as a re­sult lose the abil­ity to in­flu­ence the money sup­ply for the first time since they granted cen­tral banks a mo­nop­oly on the is­sue of bank notes and coins.

If You Can't Beat 'Em, Join 'Em

Hop­ing to con­tain the threat posed by pri­vate cryp­tocur­ren­cies, some coun­tries have re­sorted to reg­u­la­tory crack­downs. Oth­ers have be­gun con­sid­er­ing whether it's time to wade into the fray them­selves. In fact, sev­eral cen­tral banks, in­clud­ing the Bank of Eng­land and the U.S. Fed­eral Re­serve, have be­gun re­search into whether to is­sue dig­i­tal cur­ren­cies. Swe­den's cen­tral bank, the Riks­bank, has led the way in ef­forts to launch a dig­i­tal cur­rency, the e-krona, and the gov­ern­ments of many other coun­tries are ea­ger to ex­pe­dite the in­tro­duc­tion of their own cryp­tocur­ren­cies.

Venezuela has rolled out the most ad­vanced – al­beit per­haps least sub­stan­tial – dig­i­tal cur­rency so far in the form of the petro. As hy­per­in­fla­tion plagues the na­tional cur­rency and the threat of pun­ish­ing U.S. sanc­tions looms large, Cara­cas took a chance with the in­tro­duc­tion of the petro Feb. 20. The new cur­rency, built on ex­ten­sive oil reserves, pro­vides an en­tic­ing op­tion for those want­ing to buy into the bit­coin wave and a po­ten­tial av­enue to evade sanc­tions. Still, it seems un­likely to pique the in­ter­est of too many in­vestors. Venezuela's gov­ern­ment, which di­rectly con­trols the petro, has proved it­self a ques­tion­able stew­ard. Fur­ther­more, pow­er­ful buy­ers such as the United States, China and Rus­sia have signed deals to snap up a large por­tion of the coun­try's oil reserves, and U.S. Pres­i­dent Don­ald Trump slapped sanc­tions on the new cur­rency March 19.

Be­yond the petro, Rus­sia's cryp­toru­ble is the cen­tral bank dig­i­tal cryp­tocur­rency that is clos­est to be­com­ing a re­al­ity. Rus­sia has a long his­tory with money laun­der­ing and il­licit fund trans­fers into and out of the coun­try. Dig­i­tal cur­ren­cies have pro­vided a new route for these trans­ac­tions. Like many of its coun­ter­parts abroad, the Rus­sian gov­ern­ment has cracked down on pri­vate cryp­tocur­ren­cies as it plans to launch its own dig­i­tal cur­rency. The Krem­lin, how­ever, in­tends to in­clude a 13 per­cent trans­ac­tion fee payable to the gov­ern­ment when in­vestors buy into the cryp­toru­ble with­out doc­u­ment­ing the ori­gins of their funds. The pro­posed pol­icy sug­gests that Moscow rec­og­nizes the fu­til­ity of try­ing to halt black money flows and wants to cash in on them in­stead. In ad­di­tion, Rus­sia is billing the cryp­toru­ble as a way around sanc­tions, though the de­tails and ef­fec­tive­ness of that strat­egy re­main to be seen.

Es­to­nia, mean­while, is also think­ing of launch­ing a cryp­tocur­rency, the est­coin. The cur­rency would help the tiny Baltic state raise funds while also but­tress­ing its pi­o­neer­ing vir­tual res­i­dency en­deav­our. Be­cause it is al­ready a mem­ber of a larger cur­rency area – the eu­ro­zone – the coun­try could face com­pli­ca­tions in achiev­ing its am­bi­tions, but Tallinn ap­pears com­mit­ted to pur­su­ing them any­way.

Most con­se­quen­tial, though, are China's ef­forts to is­sue a dig­i­tal cur­rency. Ex­ert­ing max­i­mum con­trol has long been im­por­tant for the coun­try's lead­ers, and Bei­jing has ex­hib­ited sin­gu­lar de­ter­mi­na­tion in stamp­ing out pri­vate cryp­tocur­ren­cies. At the same time, the Peo­ple's Bank of China has em­pha­sized its in­tent to in­tro­duce a dig­i­tal cur­rency that will en­able the cen­tral gov­ern­ment to bet­ter track the move­ment of money.

En­ter the Cen­tral Bank

Dig­i­tal cur­ren­cies op­er­at­ing un­der the aus­pices of a cen­tral bank could have ma­jor ef­fects on sev­eral lev­els. To start, they would greatly in­crease ef­fi­ciency in dig­i­tal trans­ac­tions. Un­der the cur­rent sys­tem, a dig­i­tal pay­ment must first go to a pri­vate bank and then pass through a cen­tral bank be­fore ar­riv­ing at an­other pri­vate bank. Im­ple­ment­ing dig­i­tal pay­ments at the cen­tral bank level would elim­i­nate the need for a third party – the com­mer­cial banks – thereby ac­cel­er­at­ing the whole process and re­duc­ing trans­ac­tion costs.

Ac­cord­ingly, cryp­tocur­ren­cies is­sued by cen­tral banks could threaten the busi­ness mod­els of com­mer­cial lenders. The cen­tral bank's bal­ance sheet would rep­re­sent the safest liq­uid as­set avail­able to po­ten­tial in­vestors, since the na­tional gov­ern­ment guar­an­tees it di­rectly, while a pri­vate bank is at greater risk of ex­pe­ri­enc­ing bankruptcy. The roll­out of cen­tral bank dig­i­tal cur­ren­cies could in­tro­duce a gi­ant ri­val into the bank­ing mar­ket and com­pel com­mer­cial banks to be­come ul­tra­com­pet­i­tive in their lend­ing prac­tices. If a cri­sis were to oc­cur, more­over, cus­tomers could lead a stam­pede to pull their funds from pri­vate lenders for the com­par­a­tive safe har­bor of­fered by the cen­tral bank. Con­trols would be nec­es­sary to pre­vent such a run. Al­ter­na­tively, the in­tro­duc­tion of cen­tral bank dig­i­tal cur­rency could presage the im­ple­men­ta­tion of nar­row bank­ing, in which cen­tral banks guar­an­tee all com­mer­cial bank reserves but also re­scind lenders' au­ton­omy to "cre­ate" money by is­su­ing loans not backed by hard de­posits.

The mone­tary sys­tem that has emerged over many cen­turies is un­der­go­ing sig­nif­i­cant changes to­day. Though cen­tral banks will be care­ful not to make sud­den or dras­tic moves on the money sup­ply, the ad­vent of cryp­tocur­ren­cies and the im­mi­nence of a cash­less era are forc­ing them to in­no­vate and adapt. The struc­tures of the new era will be­come clearer in time, but, what­ever form they take, dig­i­tal cur­ren­cies will be here to stay.

“Why Cen­tral Banks Could Mint Their Own Dig­i­tal Cur­rency” is re­pub­lished un­der con­tent con­fed­er­a­tion be­tween Fi­nan­cial Nige­ria and Strat­for.

Wary of the sol­vency of banks – es­pe­cially in the wake of the 2008 fi­nan­cial cri­sis – and un­able to safely store wealth in phys­i­cal cash, more and more peo­ple have rea­sons to turn to bit­coin or one of its nu­mer­ous de­riv­a­tives.

US Fed­eral Re­serve Bank in Wash­ing­ton DC

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