Money 2.0: Towards A New Institutional Paradigm
Keith Bear, Associate Partner at Elixirr Consulting Limited; Michel Rauchs, Managing Director, Paradigma; and Tania Ziegler, FinTech Benchmarking Specialist
Originally published in the GDF Annual Report 2020
The growing popularity of digital assets is raising important questions about the nature of money and the structure of the underlying monetary system. New entrants and new instruments are challenging long-established institutional arrangements and testing the boundaries of existing legal and regulatory frameworks. Will we witness a monumental reconfiguration of our monetary system, and how will regulators and policymakers respond to these developments?
New instruments for digital payments
Bitcoin started out as a peer-to-peer electronic cash system and, for some years, was considered a promising niche product for cheap and fast online payments. Regardless of what it then became, Bitcoin — and other early cryptoassets — had successfully proven that the growing demand for (near) real-time digital payments at negligible costs could be addressed outside traditional payment rails.
It took a few more years before stablecoins took the scene, developing into a new form of on-chain cash equivalent. They quickly gained traction as an efficient cross-border tool for moving value between offshore exchanges and other cryptoasset service providers.
Stablecoins have experienced considerable growth over the last two years: total on-chain volumes alone (excluding bank coins) have exceeded the $1 trillion mark in 2020, facilitated by an aggregate $34 billion outstanding supply as of mid-January 2021 (up roughly 10x since early 2019). Today, stablecoins are a driving force behind much of the innovation that is occurring on all layers of the blockchain ecosystem.
Stablecoins and the monetary system
The line between ‘money’ and ‘credit’ has been blurred ever since the public-private partnership between governments (via their central bank) and the private sector was institutionalised through deposit protection schemes guaranteeing at-par convertibility between central bank money and bank deposits. In exchange for this exclusive privilege, banks were subjected to strict and onerous regulatory requirements.
Over time, an alternative offshore currency system developed in the second half of the 20th century. Different types and forms of ‘shadow money’, ranging from eurodollar deposits to money market mutual fund unit shares and repo transactions, began circulating among market participants as money-like instruments in global financial markets. Operating largely outside the purview of central banks, this ominous ‘shadow banking’ system grew to such a scale that it nearly took down the entire financial system in the dark days of 2008. Unlike bank deposits, there are no formal institutional safeguards or backstops in place to support these private liabilities. And although regulators are increasingly aware of the issue, the international financial system continues, to this day, to be heavily reliant on this opaque offshore system to function properly.
So given this backdrop, where do stablecoins fit in this money landscape?
Stablecoins are but the latest manifestation of privately-issued liabilities that have gained traction as money-like instruments for payment purposes. With the growing move towards ‘Digital’, the demand for new forms of money that are natively digital, globally accessible, and convenient and cost-efficient to move has exploded. The private sector has always been quick to adapt to changing behaviours and the resulting shifts in demand — and stablecoins can be seen as a direct response to that demand. Unlike ‘conventional’ types of shadow money, however, stablecoins are not limited to wholesale money markets. In fact, quite the opposite: most are directly available — and marketed — to consumers and businesses.
The regulatory challenge
This universal availability — across borders, organisations, and groups — presents significant challenges to regulators. Stablecoins managed to mostly remain under the radar for years; mainly a result of low volumes and a modest outstanding supply. This changed considerably in June 2019 when Facebook & Friends formally announced the Libra project. The news took the world by storm, causing a public outcry and compelling regulators, policymakers, and legislators to strongly condemn the plans of a BigTech-led consortium venturing not only into the business of payments — outside traditional rails (and thus supervision) — but also, crucially, in the ‘business’ of money creation.
A broad range of regulatory issues, including concerns about money laundering, terrorist financing, capital evasion, currency substitution, attacks on the monetary sovereignty of states, and many others, have been identified in various reports and investigations since. Libra, recently rebranded to Diem, has mostly disappeared from the news, and appears to be quietly working towards a controlled launch in a significantly watered-down form. The regulatory scrutiny it has brought on stablecoins, on the other hand, has remained. In particular concerns about the potential impact of stablecoins on financial stability have been growing in lockstep with rising volumes.
Stablecoins are a driving force behind the growing integration of the broader cryptoasset ecosystem with the financial system. Issuers rely on commercial banks not only for processing deposits and withdrawals, but also for custody of most of the collateral that back the assets. Given the scale of potential issuers such as /Diem and the way that these arrangements are structured, stablecoin reserves may act as gigantic collateral sinks that could further exacerbate the global collateral shortage, thereby creating a new source of systemic risk that may pose a significant threat to financial stability in an already tense macro environment.
Some stablecoin issuers have been accused of wilfully engaging in regulatory arbitrage, piggybacking on the regulated banking sector while avoiding adherence to the same strict requirements. Others are under scrutiny for the auditability of their fiat currency reserves. In the absence of a European-like e-money regime, most issuers in the US currently fall somewhere in between a money service business (MSB) and a bank. The proposed STABLE Act bill attempts to address this loophole by requiring any deposit-taking entity — including, but not limited to, stablecoin issuers — to operate under a banking license. Some issuers have indeed filed applications for receiving a banking charter, while a growing number of traditional banks — encouraged by the recent interpretative letter by the Office of the Comptroller of the Currency (OCC) — are contemplating the launch of their own stablecoins.
Opponents argue that a banking charter requirement for the issuance of e-money like instruments represents too much of a burden for many market participants, and would provide an unfair advantage to incumbents and well-funded competitors. Instead, they propose the creation of a special-purpose ‘FinTech’ licensing regime as an alternative solution that addresses the new realities of digital money and finance. While the debate is ongoing, the rise of central bank digital currencies (CBDC) may provide an alternative opportunity.
Enter CBDC
The rationale for a central bank to issue a digital currency is now well documented; i) ranging from offering a public counter to private money alternatives in the context of declining cash usage, to (ii) transforming the payments landscape to support a future digital economy. Over the last years, we have witnessed the change from early Bank of England theoretical research reports in 2016 to the practical implementations currently happening with the People’s Bank of China (PBoC) e-CNY pilot in 4 major cities, and the Bahamian Sand Dollar as the world’s first CBDC in production (or so it is reported). Research by the Bank for International Settlements (BIS) has revealed that some 80% of the world’s central banks are now researching, experimenting or piloting CBDC.
Why are the changes happening now?
The evidence points to central banks using CBDC as an additional lever to manage financial and monetary stability, leaving the distribution and management primarily to the private sector. But as political and economic norms evolve, alongside the rapid technology-driven transformation we are witnessing, the need for that lever becomes even more important. How CBDC is designed and implemented will vary from one country to another, but will have wide-ranging implications on both private forms of money and their respective issuers.
CBDC may increase the central bank’s control over the total monetary supply, but also significantly alter the composition and structure of the private system of intermediaries upon which the monetary system depends. Will CBDC reinforce the role played by the commercial banking system, perhaps at the expense of FinTechs and TechFins alike? Or will CBDC lay the groundwork for increased competition by allowing more private enterprises to access the privilege of money creation in new ways? In the latter case, BigTech and FinTechs/TechFins may take a much more active role in the management and operation of the monetary systems than ever before.
How these major state initiatives will play out and impact the private sector remains an open question, but China’s e-CNY pilot can offer some insights into one potential course of action. Today, Alipay and WeChat Pay account for over 80% of mobile payments, and their savings, loans and wealth business have been taking market share from the traditional commercial banks over recent years. In the current e-CNY pilot, however, it is so far the commercial banks — not the FinTechs — that are distributing the CBDC and managing the corresponding digital wallets. This may give the commercial banks a headstart on how to leverage that advantage to win back share, or at least slow the flow of business to China’s major FinTechs.
In order to do so, they will need to demonstrate the same agility, innovation and relentless focus on customer experience as the FinTechs have shown in building their current businesses. This also raises the question as to why a consumer would want to leave the convenience of existing apps to use a CBDC wallet. The e-CNY pilot may show us whether having a claim on the central bank matters to a consumer, or whether CBDC’s ability to offer offline payments, anonymous low-value transactions, and low to zero fees will draw consumers away from their existing platforms.
Conclusion
So, where does this leave us? Fundamentally at a crossroads, with roads ahead leading to differing configurations of public and private money, facilitated by different types of actors. The CBDC debate provides a generational opportunity for the reconfiguration of the monetary system that makes it fit for purpose for a 21st century digital economy. Private sector innovation in money and payments has always been an essential driver of the development of monetary systems. A new institutional arrangement may provide a formal role for new actors — such as FinTechs and BigTech — in the operation and management of the monetary system.