Source: Federal Reserve Bank of Richmond
Alibaba — an e-commerce platform in China similar to Amazon — has created its own payment system (Alipay) to provide currency-like services: facilitating transactions, supporting peer-to-peer transfers and paying interest.
Platforms like Facebook and Amazon are also researching creating their own digital currencies, but so far they have relied primarily on existing payment methods. What drives platforms to develop their own digital currency rather than use existing cash and card options? And should central banks and financial regulators worry about platforms issuing their own currency?
In June 2019, Facebook announced plans to launch a digital currency called Libra. It was not the platform's first foray into digital currencies. Facebook Credits, launched in 2009, could be used to purchase items in games and non-gaming applications on the platform. Facebook ended the Credits system in 2013 but continued to explore creating its own digital currency. Libra was intended to have wider applications outside of Facebook itself and would have been pegged to a basket of financial assets, including various government-issued currencies.
The prospect of digital currencies issued by widely used online platforms has raised concerns among regulators and central bankers. Among the concerns is that these currencies would compete with traditional money issued by central banks and that widespread adoption could reshape the retail payment landscape and influence the functioning of the monetary system. In Libra's case, the project drew sharp criticisms, for example, from both Democrat and Republican senators during a July 16, 2019, hearing before the U.S. Senate Banking, Housing and Urban Affairs Committee.1
In response to these critiques, Facebook placed Libra on hold then rebranded the digital currency as Diem at the end of 2020. Facebook reportedly plans to launch Diem later this year, but the new digital currency will be more limited than its original proposal.2
While platform-issued currencies are in their infancy in the U.S., other countries have seen digital currencies — for example, Alibaba's Alipay and Tencent's WeChat in China — dominate the retail payments system for years. Why might platforms be interested in creating their own currencies? And how should regulators and central bankers respond to these developments?
Why Does a Platform Issue Digital Currency?
A platform is a business that facilitates connection and matching among users. Issuing digital currency offers many benefits to a platform, including building loyalty, harvesting transaction data and minimizing the settlement risk.
One of the key financial benefits of issuing a currency is access to seigniorage revenue. Seigniorage refers to the difference between the income from the sale of currency and the cost (for example, production, distribution, maintenance and anti-counterfeiting measures). Historically, this revenue has been reserved for sovereign nations, which have long held a monopoly on money creation. A private digital currency would grant the issuing platform the same perk.
However, the costs of currency — especially creating a new digital one — are notable. Researching and developing a new payment system takes time and money. And once the new system is built, the platform must secure its digital currency against cyberattacks to protect its value and ensure a stable user base.
Private digital currency also comes with some risk to users: The issuing platform could go out of business or abandon the project. Consumers need a reason to accept the risk of holding the new currency over existing money. If some goods and services are only available on the platform issuing the currency, that provides greater incentive for consumers to adopt the currency and gives the platform more power to dictate the terms of transactions.
The platform can also mitigate the risk to consumers by backing the platform currency with some liquid safe assets like U.S. government bonds as reserves. Of course, these liquid safe assets tend to have low yields, so holding reserves would reduce the seigniorage revenue the platform could earn.
In contrast to an untested digital currency, time-honored payment methods like cash and cards are generally safe and secure. A platform can freeride on the existing payment system built by the central bank or the financial intermediaries. Accepting credit cards or debit cards involves some cost to the platform, but in most cases those costs are likely to be lower than the expense of developing and securing a new digital currency from scratch. A platform can also still earn profits through existing payment systems. It can charge fees to buyers and/or sellers on any cash and card transactions taking place on the platform.
When existing payment methods are used, the platform's ability to maximize profits from these fees depends upon the inflation and interest rates in the economy. If inflation is high, consumers seek to minimize cash holdings (including bank account and debit card balances) because its purchasing power is low. Likewise, consumers will be more reluctant to draw on credit cards in a high-inflation environment because interest rates are higher. These factors will limit the fees that a platform can extract from cash and card transactions.
A platform-issued digital currency could be an attractive alternative to cash for consumers in a high inflation environment because its value can be protected by the platform. The platform — such as Alipay or Diem — could pay interest to its currency holders (traditional banknotes in wallets pay nothing) or sustain the currency's value through open market operations (like stock buybacks). Of course, these features are attractive to the currency holders but costly to the platform.
Understanding Platform Decisions
In a recent working paper, two of the authors of this brief (Chiu and Wong) model these trade-offs to understand why some platforms issue their own digital currencies.3 The choice comes down to a few factors, most notably:
Cost of creating a digital currency
Market share of the platform
When inflation is low and stable and the cost of setting up a digital currency is high, it is optimal for the platform to use existing payment systems. When inflation is high enough that consumers prefer to minimize cash holdings, the cost of establishing and securing a new digital currency system is low, and the platform's market share is sufficiently large, then it is optimal for the platform to issue its own currency.
In their model, Chiu and Wong show that it is suboptimal for a platform to accept both digital currency and cash: It is more profitable to choose one or the other because accepting cash cannibalizes the demand for the digital currency.4
Chiu and Wong's model can help illustrate why, for example, Amazon has so far chosen not to issue its own digital currency while Alibaba has. In their paper, Chiu and Wong used U.S. Commerce Department data from the first quarter of 2020, which reported that e-commerce accounted for about 12 percent of total retail. Since Amazon accounts for about half of the U.S. e-commerce market,5 Chiu and Wong estimate its retail market share is about 6 percent. For each item sold on its platform, Amazon charged the seller a referral fee of about 15 percent.
For it to be profitable for Amazon to issue and only accept its own digital currency, Chiu and Wong estimate that interest rates would need to be higher than 11 percent or that Amazon's market share would need to be much larger. The model also suggests that regulatory costs in the U.S. are sufficiently high to dissuade platforms from issuing their own currency.
In the case of Alibaba, interest rates in China are higher on average. Additionally, Alibaba accounts for a larger share of China's retail market, at about 11 percent. These factors provide greater incentive for Alibaba to issue its own currency. Regulatory costs associated with creating a digital currency were also lower in China when Alibaba launched Alipay.
Another important factor in Alipay's success was the underdevelopment of China's electronic payment infrastructure. Compared to the U.S., consumers in China used credit and debit cards much less frequently in the early 2000s. Alibaba's introduction of Alipay was a way to overcome frictions in the payment systems and enable online transactions that were previously infeasible. These factors help explain why Alibaba created its own digital currency, while Amazon has yet to launch its own.
Regulatory Response to Platform Digital Currencies
Should U.S. regulators and the Fed be concerned that platforms here might issue their own digital currencies? From Chiu and Wong's model, it is possible for the platform's decision to be suboptimal from society's perspective since the platform only considers its own profits and doesn't internalize the other consequences — positive or negative — of its choice.
This can be particularly problematic if the platform issues a digital currency that circulates outside of the platform. In that case, the digital currency competes directly with government-issued cash. This can also reduce the seigniorage the central bank earns from issuing cash. If widely adopted, platform digital currency can also subject the financial system to cybersecurity risks and bank runs. On the flip side, the platform's failure to consider the positive social benefits may prevent it from issuing a digital currency when it would be socially optimal for it to do so, which should also be a consideration for central banks.
Drawing a parallel between platform currency and bank deposits, Chiu and Wong examine whether some common financial regulations like deposit insurance and reserve requirements can optimize the decisions of platforms when it comes to issuing their own currency.
On the whole, they find that these regulations are not very helpful. Raising reserve requirements for platforms issuing their own currency can reduce welfare for both consumers and platforms as it may discourage the provision of beneficial features like interest-bearing currency or low fees. A reserve requirement improves welfare if it dissuades a platform from issuing its own currency when it would be suboptimal to do so. Further research would be needed to determine if other policy tools might be more effective.
One such tool, which is in its infancy, is digital currency issued by the central bank. China has already begun issuing its own central bank digital currency, or CBDC, and many other central banks are researching issuing one as well. According to a survey by the Bank for International Settlements conducted in late 2020, 86 percent of central banks are researching CBDCs, although most are moving cautiously. About 60 percent of central banks said they were unlikely to issue any type of CBDC in the near future, but a growing number see it as a possibility in the medium term.6 The payment landscape and policy environment vary a lot country by country, so there is no universal argument for or against the issuance of a CBDC. At the Fed, research into CBDCs is ramping up but remains ongoing.7
Jonathan Chiu is a director in the Banking and Payments Department at the Bank of Canada. Tim Sablik is a senior economics writer and Russell Wong is a senior economist in the Research Department at the Federal Reserve Bank of Richmond.
"Examining Facebook’s Proposed Digital Currency and Data Privacy Considerations," Hearing before the U.S. Senate Banking, Housing and Urban Affairs Committee, July 16, 2019.
Ryan Browne, "Facebook-backed Diem Aims to Launch Digital Currency Pilot Later this Year," CNBC, April 20, 2021.
Jonathan Chiu and Russell Wong, "Payments on Digital Platforms: Resiliency, Interoperability and Welfare," Federal Reserve Bank of Richmond Working Paper No. 21-04, Feb. 17, 2021.
There are platforms that accept both digital tokens and cash as payment. Chiu and Wong (2021) speculate that this could be because either there is a law mandating that platforms accept cash, or consumers are heterogeneous in terms of their costs of adopting digital currencies. Chiu and Wong leave this analysis to future research.
Ingrid Lunden, "Amazon’s Share of the U.S. E-Commerce Market Is Now 49%, or 5% of All Retail Spend," Tech Crunch, July 13, 2018.
Codruta Boar and Andreas Wehrli, "Ready, Steady, Go? Results of the Third BIS Survey on Central Bank Digital Currency," Bank for International Settlements Papers No. 114, January 2021.
On May 20, 2021, Fed Chair Jerome Powell announced that the Board of Governors will release a research paper this summer exploring the issuance of CBDC. See Jeff Cox, "The Fed This Summer Will Take Another Step in Developing a Digital Currency," CNBC, May 20, 2021. For additional information on the Fed and CBDCs, see the collaboration between the Boston Fed and the Massachusetts Institute of Technology's Digital Currency Initiative, and Jessie Romero, Zhu Wang and Russell Wong, "Should the Fed Issue Digital Currency?" Federal Reserve Bank of Richmond Economic Brief No. 21-10, March 2021.