Tag: digital currency

A shift in monetary regimes?

By Warren Coats[1]

This Sunday, August 15, is the 50th anniversary of President Richard Nixon’s closing of the gold window as part of the “Nixon Shock.” “Fifty years later Nixon’s August surprise still reverberates”  He announced on that day that the U.S. Treasury would no longer redeem its dollars for gold at $35 an ounce. Over the subsequent few years, the world moved from national currencies whose values were anchored to the market value of gold, to currency values determined by central banks’ regulation of their supply relative to the market’s demand. The value of one currency for another floated in the foreign exchange market. Central banks have deployed various approaches to determining the supplies of their currencies and most have now settled on targeting an inflation rate (often 2% per year) in one way or another.

With the rapidly increasing interest in cryptocurrencies, some have asked whether we are on the brink of another monetary paradigm shift? Specifically, might the dollar be replaced as the dominant international reserve currency. To explore that question we need to understand how the existing monetary systems work and how the widespread use of cryptocurrencies might add to or change these systems.  

In describing the existing and potential future monetary systems, we need to distinguish “money” from the “means of payment.” Money is the asset that people accept in payment of debts or for the purchase of goods and services. The U.S. dollar and the Euro are “money.” The means of payment refers to how money is delivered to the person being paid. Do you personally hand dollar bills and coins to the Starbucks cashier, write out a check (bank draft) and put it in the mail, or electronically transfer “money” from your bank account to an Amazon merchant via eWire, Zelle, Venmo, PayPal, or some other digital payment service? Or perhaps you purchase goods and services with borrowed money (Visa, MasterCard, American Express) that you pay back at the end of each month or over time. Or if you don’t have a bank account (a form of digital money) you might hand-deliver physical currency to a Hawala dealer or a MoneyGram or Western Union office to be electronically transferred to their office nearest to the person you are sending it to, potentially anywhere in the world. If you are paying in a currency that is different than the one the payee wishes to receive, your currency will be exchanged accordingly along the way in the foreign exchange market.

Discussions of cryptocurrencies include both the latest and evolving means of payment (digital payment technologies) as well as new, privately created moneys such as bitcoin, Ethereum, or Ripple.  Private currencies vary enormously with regard to how their value is determined. By private currencies I do not mean privately created assets redeemable for legal tender, such as our bank accounts. When we speak, for example, of the U.S. dollar, we invariably include dollar balances in our bank accounts, dollar payments made via our Visa card, etc. These are all privately produced assets that are ultimately redeemable for Federal Reserve currency or deposits at a Federal Reserve Bank. They are credible claims on the legal tender of the United States. Most U.S. dollars are privately created.

The value of all money is determined by its supply and demand. The demand for money arises from its acceptability for payment of our obligations and the quantity of such obligations (generally closely related to our incomes). Within each country, its legal tender money (e.g., the U.S. dollar in the U.S.) must be accepted by payees. In particular, it must be accepted by the government in payment of taxes.  Truly private currencies (those not redeemable for legal tender, of which there are over 11,000 at last count) have a serious challenge in this regard. Very few people or businesses will accept bitcoin, or any other such private cryptocurrency. As a result, the demand for such currencies for actual payments is very low. The demand for bitcoin, for example, is almost totally speculative–a form of gambling like the demand for lottery tickets. Such private currencies are more attractive in countries whose legal tender is rapidly inflating or has unstable value (e.g., Venezuela). 

The acceptability of a currency in cross border payments raises special challenges. My currency is not likely to be the currency in general use in other countries. Someone in Mexico paying someone in Germany will generally have Mexican pesos and the recipient in Germany will want Euros. The pesos will need to be exchange for Euro in the foreign exchange market. It would be very costly for dealers in the FX market to maintain inventories of and transact in every bilateral combination of the world’s 200 or so currencies. It has proven more economical to exchange your currency for U.S. dollars and to exchange the U.S. dollars for the currency wanted by the payee. The dollar has become what is called a vehicle currency.

The economy of a so-called vehicle currency can be illustrated with languages. Two hundred and six countries are participating in the 2021 Olympic Games in Japan. To communicate with their Japanese hosts participants could all learn Japanese. It is unrealistic to expect the Japanese hosts to learn 205 foreign languages. But what about communicating with their fellow participants from the other 205 countries. For this purpose, English has become the default second language in which they all communicate. Unlike more isolated Americans, most Europeans speak several languages, but one of them is always English. English as the common language is the linguistic equivalent of the dollar as a vehicle currency.  

The rest of the value of money story focuses on its supply. Bitcoin has the virtue of having a very well defined, programmatically determined gradual growth rate until its supply reaches 21 million in about 2040. The supply today (Aug 2021) is 18.77 million. See my earlier explanation: “Cryptocurrencies-the bitcoin phenomena”  The other 11,000 plus cryptocurrencies each have their own rules for determining their supply, some explicit and some rather mysterious. The class of so called “stable coins” are linked to and often redeemable for a specific anchor, sometimes the U.S. dollar or some other currency. The credibility of these anchors varies.

The highly successful E-gold (from 1996-2006) is an example of a digital currency that had well-defined and strict backing and redemption for a commodity at a fixed price. “E-gold”  The supply of such currencies is determined by market demand for it at its fixed price–what I have elsewhere called currency board rules. I describe how currency board rules work in my book about establishing the Central Bank of Bosnia and Herzegovina:   “One currency for Bosnia-creating the Central Bank of Bosnia and Herzegovina”

The dominance of the U.S. dollar in cross border payments reflects far more than its use as a vehicle currency. Many globally traded commodities, such as oil, are priced in dollars and thus payments for such purchases are settled in dollars. Pricing a homogeneous commodity trading in the global market in a single currency makes that market more efficient (the same price for the same thing).  Making cross border payments in dollars (or any other single currency) also avoids the costly need to exchange one for another in the FX market. The dollar is most often chosen because its value is relatively stable, and it has deep and liquid securities markets in which to hold dollars in reserve for use in cross border payments.

So, what are the chances that current cryptocurrency developments might precipitate a shift from the dollar to some other currency and means of payment. Several factors of U.S. policy have heightened interest by many countries in finding an alternative.  Specifically, from my recent article in the Central Banking Journal on the IMF’s $650 billion SDR allocation:

“Cumbersome payment technology. Existing arrangements for cross-border payments via Swift are technically crude and outmoded.

The weaponization of the dollar. The US has abused the importance of its currency for cross-border payments to force compliance with its policy preferences that are not always shared by other countries, by threatening to block the use of the dollar.

The growing risk of the dollar’s value. The growing expectation of dollar inflation and the skyrocketing increase in the US fiscal deficit are increasing the risk of holding and dealing in dollars.”  “The IMF’s 650bn SDR allocation and a future digital SDR”

Most central banks are upgrading their payment systems. But the Peoples Bank of the Republic of China (PBRC) is one of the most advanced in developing a central bank digital currency (CBDC), the e-CNY. However, it has little potential for displacing the dollar for several reasons. The Federal Reserve is also modernizing its payment technology, including exploring the design of its own CBDC, and can match China’s payment technology in the near future if necessary. More importantly, China’s capital controls, less developed Yuan financial markets, and less reliable rule of law make the Yuan an unattractive alternative to the dollar. These latter impediments do not apply to the Euro, however. “What will be impact of China’s state sponsored digital currency?”

Rather than looking for another national currency to replace the dollar, there are several advantages to using an international one. These include greater ease in making cross border payments and the reduced risk of political manipulation, or a national currency’s domestic mismanagement.  Bitcoin, for example, can make payments anywhere in the world without being controlled by any one of them. The serious drawbacks of Bitcoin’s blockchain payment technology might be overcome with one or another overlaid technology. But to become a serious currency, bitcoin must be dramatically more widely accepted in payment than it is now. Widespread acceptance in payments could generate the demand to hold them for payments, which would tend to stabilize its very erratic value. This seems very unlikely. A digital gold-based currency, such as the earlier E-gold, would enjoy the advantage of an anchor that is well known and that has enjoyed a long history. However, gold’s value has been very unstable in recent years. Aluminum has enjoyed a very stable price and elastic supply and will be the anchor for Luminium Coin to be launched in the coming weeks: https://luminiumcoin.com/

But the world has already established the internationally issued and regulated currency meant to supplement if not replace the dollar, the Special Drawing Rights of the International Monetary Fund. The IMF has just approved a very large increase in its supply.  “The IMF’s 650bn SDR allocation and a future digital SDR”  The SDR’s value is determined by the market value of (currently) five major currencies in its valuation basket. While all five of these currencies have a relatively stable value, the value of the basket (portfolio) of these five is more stable still. The rules for determining the SDR’s value and supply, as well as its uses, are well established and transparent and governed by the IMF’s 190 member countries. In short, the SDR is truly international. However, it can only be used by IMF member countries and ten international financial institutions such as the World Bank and the Bank for International Settlements.

While the SDR has played a limited useful role in augmenting central bank foreign exchange reserves, it has failed to achieve a significant role as an international currency because of the failure of the private sector to invoice internationally traded goods and financial instruments (such as bonds) in SDRs and the absence of a private digital SDR for payments. If the IMF is serious about making the SDR an important international currency it should turn its attention to encouraging these private sector uses of the unit. “Free Banking in the Digital Age”

In the long run the IMF should issue its official SDR according to currency board rules and anchor its value to the market value of a small basket of commodities rather than key currencies: “A Real SDR Currency Board”

[1] Warren Coats retired from the International Monetary Fund in 2003 where he led technical assistance missions to the central banks of more than twenty countries (including Afghanistan, Bosnia, Egypt, Iraq, Kazakhstan, Kenya, Kyrgyzstan, Serbia, South Sudan, Turkey, and Zimbabwe). He was a member of the Board of the Cayman Islands Monetary Authority from 2003-10. He is a fellow of Johns Hopkins Krieger School of Arts and Sciences, Institute for Applied Economics, Global Health, and the Study of Business Enterprise.  He has a BA in Economics from the UC Berkeley and a PhD in Economics from the University of Chicago.

Whither Libra?

Every other day, it seems, we witness the launch of a new crypto (digital) currency.  Each combines a medium of exchange (a currency) and a means of payment (a technical process of delivering the currency—of making a payment with it). While many of us have watched the ups and downs of bitcoin and its imitators with amusement, none of us (hopefully) take it seriously as a currency. Bitcoin is a speculative vehicle for gambling.  Processing bitcoin payments is too slow, and its value is too volatile to succeed as a medium of exchange or as a means of payment. Only about 1% of bitcoin transactions are actual payments.  Many new means of payment do not involve a new currency.  Thus, debit and credit cards, checks, wire transfers, PayPal, Popmoney, Zelle, etc., are means of payment of US dollars, or Euros or other sovereign currencies.

Unlike the bitcoins of the world, Libra is a currency and means of payment that is designed to ensure that its tokens will have a stable value.  The legacy members of Facebook, Visa, Uber, and other partners in the Libra Association promise the possibility of rapid adoption. Libra’s value will be fixed to that of a basket of major currencies, its supply will be regulated by market demand at that fixed price (issued via currency board rules), and it will be fully backed by assets of the same value ensuring that holders of Libra can redeem them for the same value at any time.

Suddenly potential regulators are on high alert such as witnessed in the recent Congressional testimony of David Marcus, head of Facebook’s Calibra, to Congress.  By whom and how should Libra be regulated?  Obviously, it will need to comply with Anti Money Laundering (AML/CFT) requirements and whatever else each jurisdiction in which its participants reside (holders of “accounts” with Libra or of its tokens) require of money service providers. Banks take deposits and lend, so Libra would not be a bank. While its tokens might be treated as deposits, it will not lend (its purchases of government debt and other securities with the money paid to buy Libra are investments not loans).  In this short note I will explain why Libra—the coin/token/currency—is not a claim on a mutual fund and thus should not be regulated in the US by the Securities and Exchange Commission.  I will not, however, examine its claim to be a more efficient means of payment.

The nature of Libra’s claim of stability rests on how its value is determined.  Its value is to be fixed to the market value of a basket of currencies yet to be determined. But how does that work exactly?  The world already has an internationally determined and managed unit of account, the Special Drawing Right (SDR) of the International Monetary Fund.  Rather than introduce yet another, competitive unit the case for Libra to fix to the SDR is so overwhelming that I will illustrate the difference between a currency basket as a unit of account and as an investment portfolio with the SDR. The composition of the SDR’s valuation basket is established by international agreement following a well-specified and transparent process.  Fixing the value of a Libra to that of the SDR would remove any risk of its value being manipulated by Facebook or other Libra shareholders. That would strengthen the status of the Libra but also contribute to enhancing the IMF’s SDR as a supplement or substitute for the dollar in international reserves, as called for in the IMF’s Articles of Agreement.

The SDR’s value is determined by a basket of five currencies (the dollar, euro, pound sterling, yen and renminbi).  The IMF computes the dollar value of one SDR (and thus the value in every other currency) daily on the basis of the market exchange rate of each of the five currencies in the valuation basket into dollars.  The dollar values of each currency are added up to determine the dollar value of the basket.  By fixing the value of one Libra to one SDR it sets the price at which Libra can be purchased and the currency value that would be returned if Libra were redeemed.

This might seem similar to, but is in fact very different than, the value of one Libra being determined by the value of the portfolio of investments that back it.  The “Reserve” backing Libra would consist of SDR denominated assets (e.g., SDR bonds) or assets in each of the five basket currencies in the same proportion as in the SDRs valuation basket. Thus, it would bear no exchange rate risk.  However, the investment would have other risks, specifically interest rate and default risks.  To the extent that some of the Reserve’s investments are relatively long term (say ten-year Treasury bonds), changes in market interest rates would change the current market value of these investments. While Reserve investments would presumable be made only in the safest assets and would be limited to relatively short-term instruments, the risk of default or loss in value would not be zero.  So, if one Libra is a claim on its share of the Reserve, its value could differ from the daily dollar value of the SDR valuation basket.

Libra wishes to include the unbanked in its market, thus opening financial and payment services to this broad group now unable to enjoy them. If Libra’s value is fixed to the value of its Reserve, and thus regulated by the SEC (in the US), consumer protection investment regulations would likely exclude the very people Libra is most interested in serving. Thus, Libra should fix its value to that of a unit of account and not to the value of its Reserve.

 

Free Banking in the Digital Age?

By Warren Coats[1]

Introduction

A number of central banks are considering issuing digital currency either in place of the paper currency they now issue or in parallel with it.  The advantages of central bank digital currency (CBDC) over paper currency for the issuer is the much lower cost of supplying and maintaining the currency (printing, storing, transporting, safekeeping and replacing old and damaged notes). For the users, there are the benefits of much greater speed and lower cost of making payments of currency across distances.  The use of paper currency (cash) in economies with proliferating electronic means of payment (Visa, PayPal, Zella, popmoney, etc.) has been and will continue to fall.  In addition, digital currencies can and do extend digital payment services to the unbanked.  This note explores some of the policy issues raised by CBDC, by which I mean digital claims on the currency issued by the official monetary authority, whether directly or indirectly.

Payment with digital currency involves transferring ownership of a claim on the issuer without needing to or providing any information about the payer, in particular without providing information about the payer’s bank account if she has one.  In this respect it mirrors the payment of traditional paper currency.  A primary issue for a central bank when considering issuing a digital currency is whether it should be offered wholesale or retail, i.e., offered only to banks and maybe other financial firms, or offered to the general public.  If a central bank offered CBDC directly to the general public it would transform and greatly expand the role of the central bank and could potentially end the role of commercial banks in the payment system.

Offering CBDC only to banks and other financial firms would offer little that is not already available via central banks’ acceptance of deposits from these entities, which of course are digital.  In fact the distinction between digital currency and traditional deposits is not always clear or important.[2]  Currently Fedwire settles payments between account holders, including government agencies, in domestic and foreign banks licensed in the U.S.  It does not settle USD payments between accounts in non-resident banks and resident banks.  Such payments could occur with CHIPS (Clearing House Interbank Payments System) correspondent banks, but could also potentially be made by the transfer of a central bank digital currency.

If a digital currency is issued to the general public by banks in the two-tier fashion of today’s bank money, in which banks maintain deposits of national money with their central bank to secure the deposits of national money held by banks for the general public, there is an issue of what assets banks should hold or be required to hold against their deposit or currency liabilities to the public.  Digital currency issued to the public by the central bank would have no default risk, whereas digital currency issued by banks or other entities, being a liability of the issuing bank, would have default risks.

It is also possible to permit non-banks to issue digital currency as has been done very successfully in Kenya by a phone company.[3]  Over half of Kenya’s population participates in this so-called mobile phone money service. Public acceptance of a digital currency requires that its claim on central bank money is credible.  Safaricom, the issuer of Kenya’s digital currency, M-Pesa, backs the deposits of participants 100% with Kenyan shilling deposits with banks.  While M-Pesa balances are generally paid from one person or firm to another, they can be withdrawn via an agent at their face value in shilling currency issued by the central bank at any time.

A study issued by the Bank of International Settlements explores issues raised by central bank digital currency (CBDC) more generally.[4]

Background

A review of the free banking era in the U.S. (1837 – 1913) provides a useful framework in which to analyze the options and implications of digital national currencies.  Banks in that period could issue their own U.S. dollar denominated banknotes.  Because banks lend some of the money deposited with them – so-called fractional reserve banking – issuing their own currency when their depositors wished to withdraw cash, was stabilizing as explained below.  The issue of whether CBDC should use block chain (DLT) or centrally administered ledgers will not be considered here as DLT is too expensive and inefficient to take seriously as an option at this time.[5] Project Jasper of the Bank of Canada concluded that: “the versions of distributed ledger currently available may not provide an overall net benefit when compared with existing centralized systems for interbank payments.  Core wholesale payment systems function quite efficiently.”[6]

The report does not exclude the possibility that future versions might overcome existing defects and have net advantages for some applications.

The feature of so called free banking that is relevant here was the ability of commercial banks to issue their own currency (banknotes).  These banknotes did not represent private currencies in the way bitcoin does.  In the case of the United States, all bank issued currency was denominated in US dollars and redeemable for gold (or silver) at its fixed price for the dollar.  Historicallybanknotes were originally created by goldsmiths in post Medieval England – first as warehouse receipts to depositors of cash – and then as a form of lending as an alternative to having the borrower’s account credited.  For an interesting account see the article by Benjamin Geva.[7]

Banks generate most of their income by lending at interest or investing the money deposited with them by the public.  As a result, not all of the money deposited is available to pay out to the depositors should they all want their money back (as cash or by transfer to another bank) at the same time (a so-called bank run).  Only a modest amount of depositors’ money (it is actually the bank’s money once it is deposited) is available in the bank in the form of cash or deposits at the central bank.  These so called reserves must be, and virtually always are, sufficient to satisfy the cyclical (monthly and seasonally) variations in the public’s preferences for cash over deposits.  This system is referred to as fractional reserve banking because the amount of bank “reserves” are less than the amount of their deposit liabilities.  The difference in the amount of deposits and of reserves consists of bank loans and investments in less liquid assets.

In today’s banking systems all banknotes (cash) are issued by a central bank.  Thus when a deposit is withdrawn for cash, the bank’s assets (cash) and deposit liabilities both fall by the same amount.  If a bank does not hold sufficient cash or deposits with the central bank to satisfy these periodic demands, the bank is said to be illiquid.  When banks were able to issue their own currencies (Citibank dollars and Chase dollars) only the mix of bank liabilities changed (from deposits to cash) with no change in their assets.  Their total liabilities and assets remained the same.  This was a very desirable feature of note issuing banks and eliminated the risk of illiquidity from cash withdrawals.  These banks might still suffer illiquidity from deposit transfers/payments to entities with deposits in other banks.

In the free banking era when the public came to doubt the solvency of their bank (loan and investment losses that exceeded a bank’s capital—i.e., when the value of a bank’s assets falls below the value of its deposit and other liabilities) it was pointless to withdraw deposits as the bank’s own banknotes because the bank did not have sufficient assets to redeem them.  Bank runs in such cases would take the form of converting deposit or cash claims on the bank into claims on another, hopefully sounder, bank.  Those who failed to do so before the insolvent bank was closed and liquidated would lose part of their claim, i.e. they would be forced to absorb their share of the bank’s asset shortfall (its negative capital).

Thus a ten dollar bill issued by Citibank and one issued by Chase, being claims on two different banks, could have different values (even if redeemable in theory for the same amount of gold) if the public lost confidence in the solvency of one or the other. Merchants needed to pay attention to whose banknotes they were accepting.

When you pay someone by transferring some of your bank balance to the payee’s bank account (e.g. by writing a check), your bank and the receiving bank must both participate in the same clearinghouse (or have an account with a correspondent bank that participates) enabling their obligations with each other to be settled in central bank money.[8]  This role is now generally performed by each country’s central bank and the deposits that banks keep there are called reserve deposits.  In some countries a minimum amount is required (a reserve requirement) and in others it is fully voluntary but needs to be sufficient for net payments between banks.

While this fractional reserve system worked well most of the time, banks were occasionally hit with unusually large or panic withdrawals that they were not able to satisfy even when they were fully solvent (had positive capital).  A key function of the central banks being established all over the world a century or more ago was to provide temporary liquidity to such illiquid but solvent banks (though it is difficult to evaluate the solvency of a bank in real time—i.e. the soundness of their loans and investments).  Thus central banks were so-called Lenders of Last Resort.

In 1933, in the midst of America’s Great Depression, a group of University of Chicago economists proposed, among other things, that banks be required to hold reserves (cash and deposits with the Federal Reserve) of at least 100% of their demand deposit liabilities (checking accounts).  This is often called “The Chicago Plan.”  If banks’ demand deposit liabilities and their reserve assets are segregated from the rest of their balance sheet it removed any default risk to the public of holding demand deposits at any bank.  Instead of the Chicago Plan, the U.S. Congress enacted deposit insurance to reduce the risk of bank runs.

To review:banknotes issued by banks in the free banking era eliminated the risk of a bank becoming illiquid when its depositors withdrew cash, but imposed on the public the need to judge the solvency of the note-issuing bank before accepting its currency.  The risk of losses on demand deposits remained.  While that risk could have been eliminated with a 100% reserve requirement (The Chicago Plan), it was eliminated for smaller deposits by deposit insurance.

Central banks around the world now have a monopoly on issuing legal tender currency.  This eliminates the default risk of accepting such currency but reintroduces a liquidity risk for banks that promise to convert customer deposits into (central bank issued) cash on demand.  This risk is substantially reduced by central banks’ lender of last resort function.

Structuring Digital Currency

The above considerations can help us evaluate options for central banks wishing to issue digital currencies.  So-called “digital currencies” can take different forms.  “Digital coins” are the closest digital counterpart to paper currency.  Both have unique serial numbers for each unit.  “Tokens” or “claim check centralized digital currency” pass from one owner to another P2P via block chain or central registry and can be redeemed for central bank base money at any time.  “Deposits” function the same as tokens without pretending that they are not deposits.  The distinctions between these are primarily technical and may be of little if any relevance to users.  Thus I will use “digital currency” to refer to any and all of them.

Our two-tiered system for supplying money to the public (central banks issue base money that is their own liability and commercial banks create deposit money fractionally backed by central bank base money) has the very considerable benefit of outsourcing the competitive creation and management of money to many banks.  Banks develop and service their own relationships with their customers from tens of thousands of offices around the country (speaking now of the U.S.).  However, this money creating and payment function performed by banks is also comingled with their lending activity intermediating between savers and borrowers. There are synergies as well as risks from providing both services under one roof.[9]

Should central bank digital currency be provided retail or wholesale?  A central bank could issue its digital currency to anyone who signed up (registered, i.e. opened an account directly with the central bank). As all uses of this digital currency would be between participants in the system, transfer would be simple and instantaneous.  It would be essentially the same as logging into your current bank account and transferring money to another depositor in the same bank.

In addition to the above advantages of speed and simplicity, this central bank retail approach carries the burden of an enormous expansion of central bank staff to interface with the general public in establishing and managing this new digital currency. Equally troublesome is the likelihood, if not certainty of a “digital run” from bank deposits to the central bank’s digital currency.  This would be a permanent shift from banks to the central bank, which would force banks to liquidate a significant share of their assets in order to finance the outflow of their demand deposits into the central bank’s payment system.  The transition would need to be carefully managed. The magnitude of the digital run could be limited by limiting the size of CBDC payments.  This could leave most business payments with the banking system.

There are advantages to a single, monopoly provider of digital currency because payments would take the form of transfers between accounts/participants within the same system (in effect intra-bank).  But there would be the usual disadvantages of monopolies as well (e.g. sluggish technical innovation).[10]  Central banks generally have a monopoly in printing paper currency, but their sale to the public is done by competitive commercial banks.

Central banks could leave the provision of digital cash to banks and other qualifying financial firms.  This would parallel the two-tier system now in place with central bank base money and commercial bank broad money (deposits of the public).  Digital currency would be supplied only by banks, as was the case during the free banking era when individual banks supplied their own currency notes.  Thus there would be many digital dollars (Citibank digital currency, Chase digital currency, etc.).  As with free banking banknotes, each digital currency would be the liability of the issuing bank.  The risk of default for each bank’s digital currency could be eliminated by requiring 100% reserves with the central bank against any digital currency issued and segregating these assets and liabilities from the rest of bank balance sheets. It would also be possible for commercial banks to sell and administer central bank digital currency on behalf of the central bank.  Adoption of a full Chicago Plan (100% reserves for both currency and demand deposits and legal segregation from the rest of the bank’s activities) would fully protect all payment system assets (money) from bank failures. Policies would also be needed with regard to close substitutes for demand deposits such as time and savings deposits.[11] Alternatively the risk could be limited via the equivalent of deposit insurance.

Non Central Bank Digital Currency

Digital currencies issued by commercial banks would eliminate the risk of “digital runs” on bank deposits to the central bank’s digital currency flagged by the BIS in its report cited above.  Non-national digital currencies (or deposits) fixed in value to a foreign currency, to SDRs, or to gold, for example, issued by an entity playing the role of a central bank for that currency (e.g. the BIS) would also minimize the risk of a “digital run” from bank deposits in national currencies.  Such digital currencies could also adopt a traditional two-tier model by which commercial banks issue the digital currency to the retail public. In all cases of multiple, individual bank issued digital currencies, arrangements would be needed (as now) to settle payments from holders of digital currency issue by one bank to holders of digital currency issued by a different bank.  The transfer of deposits from one issuing bank to another on the books of a common institution (the traditional central bank) is the most likely mechanism for settling such payments as is now the case for deposit payments.

In the digital world the distinction between a digital deposit and a digital currency is notional. Both are liabilities of and claims on the bank or other entity that issued them.  Distinctions blur.  In addition, digital currency need not necessarily be issued by a deposit-taking bank. M-Pesa is the digital mobile phone currency version of the Kenyan shilling issued by a trust operated by the Kenyan mobile phone operator Safaricom.[12]  The trust is not licensed as a bank as it does not lend any of the money deposited with it.  One hundred percent of the money deposited with M-Pesa is placed with commercial banks. If these deposits were with the central bank, they would be risk free—an example of the Chicago Plan.

Conclusion

My conclusion from the above considerations is that digital currency should be issued by banks or by entities adhering to the Chicago Plan if and when they prove superior to existing electronic means of payment.  Commercial bank digital currency liabilities should be insured or should adhere to the Chicago Plan segregated from the rest of the bank and thus from any losses the bank’s other activities might suffer.  If bank demand deposits were also 100% reserved, bank digital currency would feature the same stability benefit as was enjoyed in the free banking era by bank note issuing banks without the default risk of that era.  Such digital currency can extend the benefits of digital payments to the non-banked as it has in Kenya and a growing number of other countries.  It is a model also well suited to the issue of global, non-national currencies such as market SDRs or gold backed currency.

[1]Dr. Coats is retired from the International Monetary Fund, where he was Assistant Director of the Monetary and Capital Markets Department.

[2]Michael D. Bordo and Andrew T. Levin, “Central Bank Digital Currency  and the Future of Monetary Policy” Economics Working Paper 17104, Hoover Institution, August 2017. https://www.hoover.org/sites/default/files/research/docs/17104-bordo-levin_updated.pdf

[3]Warren Coats, “The Technology of Money”Cayman Financial Review,January 18, 2012.

[4]“Central Bank Digital Currency,” Bank for International Settlements, March, 2018. https://www.bis.org/cpmi/publ/d174.pdf.

[5]Warren Coats, “Bitcoin, Cybercurrencies, and Blockchain” March 12, 2018. https://wcoats.blog/2018/03/12/bitcoin-cybercurrencies-and-blockchain/

[6]Project Jasper: Are Distributed Wholesale Payment Systems Feasible Yet?Bank Of Canada, Financial System Review, June 2017.  https://www.bankofcanada.ca/wp-content/uploads/2017/05/fsr-june-2017-chapman.pdf

[7]Benjamin Geva, “Banking In The Digital Age – Who is Afraid of Payment Disintermediation?”  EBI Working Paper Series, 2018 No 23, March 23, 2018.  https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3153760

[8]In the “good ol days” representatives of all local banks would meet in a room and exchange the physical checks that their customers had written to each other and settling the net differences between each bank via a common correspondent bank.

[9]Warren Coats, “Changing direction on bank regulation”Cayman Financial Review, April 2015.

[10]For an elaboration see Geva, op.cit.

[11]Warren Coats, “The Money Problem-Rethinking Financial Regulation” by Morgan Ricks, Cayman Financial Review April 26, 2017.

[12]op. cit. Coats, 2012

Bitcoin, Cybercurrencies and Blockchain

What would we do without money/currency? Money is the unit in which we express prices (making it easer to compare the relative cost of things) and the asset with which we pay for our purchases and debts. A good currency has a stable value relative to goods and services (low or zero inflation) and is universally (or very widely) accepted in payment. The U.S. dollar receives high marks by these criteria. Bitcoin, however, fails miserably in all of these respects.

Why would anyone want to hold a highly volatile “currency” whose value one year ago was $1,230, then rose to $19,343 on December 16, 2017, dropped to $6,915 February 5 of this year and is now $9,364 (March 10, 2018). In addition, bitcoin is not accepted in payment almost anywhere? See my earlier explanation of bitcoin: “Cryptocurrencies-the bitcoin phenomena”

Bitcoin is better characterized as a security – an investment asset. It’s sort of like an option on a lottery, except that a lottery promises to pay something to the lucky person(s) holding the ticket. Bitcoin doesn’t promise to pay out anything to anyone. Its value is simply what you can get someone else to pay you for a bitcoin you want to sell. Buying bitcoin is a bet that its value will rise for some reason while you own it. Its ideological appeal for some is that it exists and functions totally independent of government; and its economic appeal is that it allows the transfer of funds (illegally gained or not) without much chance of being detected. For an excellent review of these points see Peter Morici’s: “Bitcoin-investors-have-reason-to-worry”.

Even if bitcoin had a well-behaved value and was widely accepted, the engine for maintaining and delivering it, a permissionless distributed public ledger of all bitcoin transactions linked together in blocks attached to an ever growing chain (blockchain), is deeply flawed. Records of who owns bitcoins and all transactions involving them are maintained in a database (ledger) copied to everyone with a bitcoin address (account). The system is open to everyone (permissionless) and not dependent on trusting any participants. Each bitcoin transaction is directly between the seller (or payer) and the buyer (payee) peer-to-peer without passing through a central registry such as would be maintained by a bank. Given the ease with which electronic data can be copied, preventing the spending of the same money multiple times when it openly exists in thousands of copies one as official as the other (the so-called double spending problem) in an environment where no one is trusted by design is the main challenge that blockchain ledgers need to overcome.

The majority of payments today are made by digitally transferring the ownership of digital records of money, i.e. electronic transfers of bank deposits. Our deposits of money with banks, which are a bit over half of so-called narrow money in the U.S. (M1= Currency outside of banks + demand deposits in banks), exist as digital records in each bank’s central deposit registry. Banks are so called trusted third parties responsible for insuring that our deposits are not touched and moved without our permission and are responsible for resolving any disputes or problems with regard to our deposits.

If we are paying money to someone who has their account in the same bank, we can go on line and transfer the money from our account to theirs in a millisecond without a service charge. These central registries are fortified with very robust protocols that insure their safety. The process is a bit more complicated if we are making a payment to someone whose account is in a different bank and there is scope for the speed, efficiency and cost of such interbank payments to be improved.

Blockchain’s claim to eliminate the need for trusted third parties by transferring ownership (e.g. of bank balances) directly peer to peer and publishing copies of the ledger containing the record of our transactions and resulting ownership in hundreds of nodes (our computers) around the world. The objective of a system that eliminates the need to trust anyone to safeguard your money from double spending necessitates some very complex and costly operations to substitute for a trusted third party.

For bitcoin, so called, miners are given increasingly difficult mathematical problems to solve to establish that the latest blockchain transaction is unique rather than a copy. The first miner to solve the problem cryptographically stamps the digital transaction record as genuine (in effect notarizes it) adding a new block of transactions to the chain and distributes it publically to all nodes. The winning miner is rewarded with new bitcoin (for as long as they continue to be created). Not only is the manpower and computer capacity required for this competition enormous, but the electricity consumed in bitcoin mining is now greater than is consumed in all of Ireland. https://powercompare.co.uk/bitcoin/

It takes around ten minutes to confirm the authenticity of a bitcoin transaction on average. Ten minutes standing at the check out counter waiting for your payment to be confirmed is an unacceptable eternity. “A familiar critique of Bitcoin is that “it does not scale” in the sense that, as it is currently implemented, the network is not capable of supporting a global payments system that requires many thousands of transactions per second. At the moment, this is true; Bitcoin can support up to 7 transactions per second as compared to the 2,000 transactions per second typically processed by Visa (with the potential to scale to an estimated 56,000 per second).” “The-bitcoin-scaling-debate”

Moreover, most bitcoin users don’t have the IT sophistication to operate and manage their own copy of the blockchain and thus deposit their bitcoins (or other cyptocurrencies) with exchanges that manage transactions for them. These trusted third parties in all but name are in effect banks (though they do not lend your bitcoins to others while waiting for you to use them). “Every-disadvantage-has-its-advantage-reviewing-blockchain”

To participate in the bitcoin system (to buy, use or sell bitcoin, to take the example of the best known cybercurrency) you must register to obtain an address (account). It is a closed system in that you can only deal in bitcoin with other registrants (account holders). If a central bank, for example, issued a digital version of its currency, it would also be a closed system in the same way. Participants would need to be registered with it (i.e. open accounts with it) in order to participate and could only use this Central Bank Digital Currency (CBDC) with other account holders.

When problems arise or views differ on whether and what changes might be desirable in the permissionless blockchain world, there is no one responsible to address it. There is no trusted third party to take responsibility. The bitter disputes among bitcoin “leaders” and its several hard forks (breaking off different versions of bitcoins) illustrate the seriousness of this problem.

The claim is often made that even if blockchain-DLT systems are fatally flawed as the vehicle for making payments, the blockchain technology may have revolutionizing uses for other public records such as property ownership and its transfers. However, the blockchain has so many serious disadvantages that even this more limited claim is very doubtful. “Blockchain Demystified”

To address or minimize these serious drawbacks of Distributed Ledger Technology, cryptocurrencies (there haven’t been any other applications of blockchain after ten years talking about it) have been rapidly moving away from the purer, permissionless, Proof of Work version used by bitcoin to more restricted and limited permissioned, Proof of Stake approaches. None of these to date are as efficient and secure as centralized ledges of the sort used by our banks. “What-if-blockchain-is-useless?”  “Ten-years-in-nobody-has-come-up-with-a-use-case-for-blockchain”

This is not to say that exciting things aren’t happening in the ownership registry area. Digitizing ownership records introduces dramatic economies in tracking ownership and transfers of ownership. Automating many or all of the steps involved in real estate sales with the use of digitized smart contracts can significantly shorten the time and cost of the many steps (mortgage loan agreement and disbursement, collateral confirmation, settlement, title transfer, etc.). “A-pioneer-in-real-estate-blockchain-emerges-in-Europe.” In addition, a number of central banks are considering issuing digital versions of their currencies. These will probably use central registries rather than blockchains. “Central Bank Digital Currency: Bordo-Levin.” But does blockchain technology have any advantages to outweigh the many disadvantages that can’t be achieved quicker, cheaper and more securely with central registries operated by trusted third parties. Probably not. Project Jasper of the Bank of Canada concluded that: “the versions of distributed ledger currently available may not provide an overall net benefit when compared with existing centralized systems for interbank payments.  Core wholesale payment systems function quite efficiently.”  https://www.bankofcanada.ca/wp-content/uploads/2017/05/fsr-june-2017-chapman.pdf    “SWIFT says blockchain not ready”