Money without Innovation
Fiat money takes three forms - electronic deposits at commercial banks, banknotes (and coins) and central bank (CB) reserves. None of these are great starting points for innovation.
Electronic payments (cards, direct debits, credit transfers etc), exchanges of deposits between and within commercial banks, are increasingly displacing banknotes as a means of exchange. Last year I blogged about this (Finextra 6 Feb 17), highlighting how
we are sleepwalking towards a cashless society. It is happening by default, driven principally by the adoption of contactless cards, using old technology and ageing card networks. There is little innovation in electronic payments to preserve cash’s unique
and beneficial characteristics as a bearer asset*.
Additionally, innovation in electronic payments is too dependent on the commercial banking system and on legacy infrastructure. Witness for example, the strong objections of the European Fintech Alliance on regulatory proposals for PSD2 to ban screen scraping
in Europe, and on their fears banks will develop substandard APIs to fend off competition. In the UK, the Government has set-up an economic regulator, the PSR to drive innovation in electronic payments, evidence of their concern that a commercial banking oligopoly
may be restricting payments innovation.
Unsurprisingly, there is little room to innovate banknotes (ignoring the switch to polymer), while opportunities to innovate the exchange of central bank reserves, typically through a RTGS, are limited. Central bank reserves are unavailable to consumers
and non-FI businesses, so innovation tends to be focused on CB priorities - the implementation of monetary policy, financial stability and systemic risk reduction. For example, CBs have implemented liquidity savings mechanisms, but other areas await innovation
e.g. 24/7 operations, while potential RTGS innovations such as real-time clearing between end user (business) accounts and better end-user experiences are in the commercial banking domain.
Central Banks to the Rescue
However, CBs play a critical role in payments – their liabilities (banknotes and commercial bank reserves) are used in the settlement of all payments in an economy. CBs print banknotes and sell them to commercial banks (to distribute through ATMs and branches)
in exchange for reserves, and they settle interbank obligations due from electronic payments between commercial banks through their reserve accounts held at the CB, typically using a RTGS.
CBs therefore are positioned uniquely to unlock true innovation in payments, but their ability to do so within the existing three forms of fiat-money is limited.
Instead, CBs have it in their power to create a new form of fiat-money to open up innovation by exploiting crypto-technology. Simply, they can introduce a fourth form of fiat-money to co-exist with the other three forms – a crypto-currency: crypto-$, crypto-£,
crypto-€ etc, let’s call it crypto-cash to be generic.
Focusing on their objectives, crypto-cash gives CBs significant additional capability to reduce risk in the banking system, conduct market operations and maintain financial stability, while leaving it to others to develop end-user propositions and services
(as CBs do for banknotes). It would create a new domain of payments innovation open to all, removing dependencies on commercial banks (but still open to them), and promoting open competition and financial inclusion.
Many CBs are in fact exploring crypto-currencies and researching what they call CBDC (central bank digital currency) e.g. the Bank of Canada; some are experimenting with blockchains e.g. MAS (Singapore); and some are openly thinking about issuing a CBDC
A big concern for CBs is that issuing crypto-cash might disrupt the fractional reserve system of banking they supervise, where commercial banks are responsible for holding deposits and creating new money. In effect, it might mean consumers and businesses
holding accounts directly with the CB, whereas CBs have no experience or appetite to deal with non-FI customers. It might also mean big increases in the liabilities on CB balance sheets and CBs taking over credit allocation from commercial banks to lend deposits
into the economy.
However, it is possible for CBs to create crypto-cash to co-exist with commercial bank deposits, and without disrupting commercial banking
Implementing Crypto-Cash in Central Bank Money
Implementing a new form of money is a bold step for a CB, but here is my vision of how they can take it:
- Create a crypto-cash token in the national fiat currency
- Issue the crypto-cash on a national blockchain, and manage issuance through a RTGS
- Allow commercial banks to buy and use the crypto-cash in exchange for reserves, through the RTGS (using a similar process to buy banknotes)
- Leave it to commercial banks to issue crypto-cash wallets to their customers and allow customers to withdraw crypto-cash from their bank accounts into their wallets
- This is the digital equivalent of withdrawing cash from an ATM
- Commercial banks buy crypto-cash on the blockchain with reserves held at the CB
- Commercial banks give the crypto-cash to their customers by sending it to the private key of the customer’s wallet, and debiting the customer’s bank account by the same amount
- Consumers use their crypto-cash wallets to exchange crypto-cash with each other and to pay retailers for goods, just as they do with banknotes and coins
- This process could be made seamless, where customers only see one balance, and one set of payments (in and out) irrespective of whether they are on the wallet or bank account
- In fact, it is possible when a consumer pays a retailer, that the bank allocates funds to the wallet, the blockchain sends the funds to the retailer wallet/private key, and the retailer’s wallet credits the retailer’s bank account, all in the space of seconds.
And all in the same fiat money, but in different electronic forms, and all invisible to the payer and payee
- Existing payment methods such as bank account credit transfers, direct debits, debit card payments can co-exist and remain in place, for the consumer to choose from as alternatives
5.Encourage Fintechs and other third parties to issue crypto-cash wallets
- There is no need to have a bank account to have a crypto-cash wallet, those without bank accounts can still participate – the unbanked/financially excluded, children, foreigners/tourists, anyone
- Users of crypto-cash wallets without a bank account can get crypto-cash, for example from another person with a crypto-cash wallet, from a government benefit payment, or a transfer from someone else with a bank account (gift, pocket money etc) including
overseas through a FX payment.
As you can see, a CB need only make the crypto-cash available and accessible on a national blockchain. Non-bank innovators and commercial banks can do the rest, independent of each other, independent of payment processors and independent of the CB (other
than operational requirements the CB may have on commercial banks). CBs have no need to favour one form of fiat-money over another, nor any particular payment system over another, consumers and business users can choose. In doing so, anyone can innovate –
permissionless innovation using the CB blockchain.
And very importantly, since crypto-cash is distributed only through commercial banks rather than directly from the CB, the CB avoids becoming the de facto bank for citizens and businesses, and the existing fractional reserve systems of banking are preserved.
The technology is already available to issue crypto-cash, as evidenced by the 1500+ non-fiat crypto-currencies already in existence, which at one stage had a combined value of over $800bn (but currently $390bn), comparable to the banknote value of most countries
(e.g. UK £71bn/$99bn, Eurozone €1.2trn/$940bn, USA $1.6trn). Blockchain technology is still at an early stage for complex uses such as for securities processing and nostro reconciliation (see SWIFT’s conclusions on its recent proof of concept), but for payments
the technology is much more proven. Scaling and capacity are often cited as a key failing of cryptocurrencies, but this is only temporary as the technology improves, with Ripple for example already capable of 1500 transactions per second (in comparison, the
UK Faster Payments system, the world’s largest real-time payments system by volume averages 60 tps, peaking at less than 1000 tps).
Why Central Banks Should Act
So what is in it for a CB, why would they act?
Firstly, if CBs do not issue crypto-cash, others will. This is happening already with Bitcoin, Ethereum and around 1500 other non-fiat crypto-currencies. A CB’s role is to control their financial system and keep it stable. CBs have no control over non-fiat
cryptocurrencies as they are borderless (and Bitcoin has no governance other than that built into its protocol). Crypto-cash competition to contain non-fiat crypto-currencies is likely to be more effective than regulation.
Secondly, crypto-cash gives a CB a mechanism to allow a commercial bank to fail while keeping the financial system stable, without causing bank runs and national panic. CBs could require commercial banks to issue crypto-wallets to all their customers (whether
they use them or not), and in the event of a default can shift the failed bank’s customer funds onto the national blockchain. Customers always have access to their funds through their wallets, and a mechanism can be put in place to transfer funds seamlessly
to a solvent bank of the customer’s choice. The CB will be burdened by a big increase in liabilities on its balance sheet and it will need to sequestrate what assets it can from the failed bank to match them. This resolution process will be just as difficult
as it is now, but the seamless transition of customer funds at the point of failure give governments and CBs more choice (fail, bail out/in) and more time to make decisions.
Thirdly, CB money on a national blockchain provides the CB with seignorage income (crypto-cash is issued in exchange for commercial bank reserves, which can be used to purchase income-generating assets, typically government securities).
Fourthly, crypto-cash can help reduce financial crime. Transactions on the national blockchain are permanent and transparent (at least to the CB), and can be used to track down any criminal activity on it, although appropriate controls are needed to respect
the anonymity valued by law-abiding citizens. CBs can restrict issuance of banknotes for use in the domestic transactional cycle, by phasing out high denomination banknotes. Criminals will no longer have high denomination notes as a store of value and will
be at risk if they use crypto-cash instead.
Fifthly, over time, some volume is likely to migrate to the national blockchain away from traditional interbank and card systems, decreasing the overall settlement risk in the system, as the national blockchain has no settlement or liquidity risk, unlike
existing payment systems.
Finally, a CB could eventually stop using its RTGS altogether and hold reserves on the national blockchain. Commercial bank obligations from other payment systems can be settled continuously through reserves held on the national blockchain. This could be
extended further to link cross-border with other CB blockchains for interbank FX settlement to avoid Herstatt risk as an alternative to CLS, and to implement bilateral swap lines with other CBs (important in a crisis where a CB can lend domestic commercial
banks a foreign currency where they need it).
CBs tend to be proponents of the “crypto-technology good, (non-fiat) cryptocurrency bad” mantra – now is the time to convert those words into action, primarily to promote financial stability by reducing risk in payment systems, but also to enable true payments
innovation, financial inclusion, open competition and independence from commercial bank payments systems, all for the greater good of society.
In fact, instead of sleepwalking towards a cashless society: powering up a crypto-cash society. That, in my opinion, is likely to be the future of payments, and money.
* Unique characteristics of cash include: a bearer instrument, spontaneous use, ubiquitous acceptance, anonymity, permissionless use, registration-less, no settlement intermediary (peer-to-peer), immediate finality, viable for micropayments, real-time budgeting,
always-useable and fee-less.