How central banks can respond to cryptocurrencies

What are central banks – and governments – going to do about cryptocurrencies?

I was recently in New York to better understand what central bankers are thinking about – and doing – with respect to “Digital Fiat Currency.” The workshop was part of an ITU Focus Group Program on “Standardizing Digital Fiat Currency and its Applications.”

Central bankers, monetary policy and blockchain academics, NGOs, and blockchain fanatics of all kinds were well represented.

‘They are talking about using crypto technologies to express a different form factor of a country’s currency.’ – Carol Coye Benson, Founding Partner, Glenbrook

Here’s what I learned: A lot of people are thinking hard about this, but we are still in very early stages. Much is unclear, and there are serious debates on any number of issues.

I boil them down here into two fundamental questions: what and why?

What is Digital Fiat Currency?

There was a pretty clear consensus that we are talking about a government-issued or backed electronic currency of some sort – I guess that’s by definition! Most of the presentations and discussions were, of course, about the use of crypto technologies – the technologies behind cryptocurrencies and blockchains – to create substitutes for digital bank deposits and/or cash and currency.

Several points do seem to be abundantly clear. No one is talking about a separate currency – with a separate value – from a country’s current currency. Rather, they are talking about using crypto technologies to express a different form factor of a country’s currency: just as dollar bills and dollars-in-the-bank are different forms of U.S. currency today.

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Secondly, no one is actually talking about mining, in the Bitcoin sense. Government-backed cryptocurrencies will not be “created” by random people.

Within these general definitions, however, there are important technical and obligor distinctions.

Two technical approaches

I categorize the digital fiat technical approaches as being either crypto-ledger or crypto-object based. And note I am deliberately using my own terminology here.

1. Crypto-ledger based

Crypto-ledgers are another form of today’s digital money – the bank balances a customer keeps with a bank (commercial bank money) or a bank keeps with a central bank (central bank money).

With the crypto-ledger approach, a record of these accounts is kept digitally on an encrypted ledger. The ledger itself can have a variety of attributes that we associate with cryptocurrencies and blockchains: immutability; permissioned or not; publicly visible or not; subject to various forms of proof of work, etc.

‘A fun part of the whole cryptocurrency world is the “what is money?” discussion.’

There is nothing particularly radical about this idea – it is really just a different way of constructing and securing a database (i.e. ledger). This could even be implemented without customers being aware of it.

Payments systems interface with crypto-ledgers just like they do through “regular” digital ledgers – through messaging: an electronic message which results in one ledger balance going up and another going down.

2. Crypto-object based

Crypto-objects are an alternative to physical cash or currency – the easiest way to think of this is as something which has a serial number. A crypto-object would be kept in some kind of digital wallet. Payments systems for crypto-objects are like cash: you take an object you own and give it to someone else.

This approach has complexities in terms of securing, transporting, exchanging and converting the objects: think of this as the “how do you make change?” problem. (Of course, just to make it more complicated, a crypto-object may or may not also be recorded in a crypto-ledger.)

ITU Workshop on Standardizing Digital Fiat Currency (DFC) and its Applications, 19 July 2018

Two obligor approaches

A fun part of the whole cryptocurrency world is the “what is money?” discussion. I won’t go too far down that rabbit hole, but simply recognize that what we see as money is generally the obligation of some enterprise (a central bank, a commercial bank, a third party) or of the market itself (as with Bitcoin, etc.).

A commercial bank obligation, of course, may be further backed by a government through some form of deposit insurance. I’m categorizing the digital fiat approaches here as being either a direct obligation of the central bank or the obligation of a financial intermediary (such as a bank).

1. Direct obligation of the central bank

This would mean either a government-issued crypto-object (like cash) that people hold and exchange, or a central bank-kept crypto-ledger which records obligations of the central bank to the account holder. In the latter case, the accounts would be held by people and enterprises.

This is a very radical idea: today, only commercial banks, in most cases, are allowed to have accounts at the central bank.

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I’m going to ask you to reflect for a few minutes on deposits and banking.

Today, the bank balances that you (or your company) keep in a bank are the obligation of that bank. You (or your company) keep your money in the bank because it is safe, it allows you to make and receive payments, and it may allow you to earn some interest.

As a side-effect of your decision to do this, the bank has lendable deposit balances, and banking – and capitalism – as we know it is enabled.

‘Is it the government’s job to protect and defend banking as we know it?’

I think it is important to note that this is a side effect: it was not your goal to accomplish this when you put your money in the bank. If an alternative is offered to you that is better/faster/cheaper (possibly such as holding money in an account at the central bank), the result could be the end of banking as we know it.

It is interesting to speculate on how likely such an outcome might be, and how quickly it might happen. If it did happen, how easily could alternative lending models be enabled? And is it the government’s job to protect and defend banking as we know it?

2. Obligation of a financial intermediary

If government backing is assumed, this option implies either deposit insurance (perhaps up to 100%), and/or some kind of tiered or hierarchical arrangement, roughly modeled along the lines of today’s “central bank money” (commercial bank deposits at the central bank) and “commercial bank money” (customer deposits at commercial banks).

Today, banks play a role both as money obligors but also as distributors. One hybrid possibility is that the obligation is direct from the central bank, but the distribution function remains with commercial banks.

Why a Digital Fiat Currency?

This is the tough question. At the workshop and in my reading, I have heard two arguments: one around government control over money and the money supply, and one around the benefits of electronic payments.

1. Government control over money

Some central bankers (and academics) were saying, essentially, “this is a really important technology; our job is money; we need to understand if we should do something here.” An underlying fear (with no consensus on whether or not it is a reasonable fear) is that government could lose control of money or the money supply to non-government backed cryptocurrencies.

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Smart central banks are studying this topic and endorsing further studies and pilots. But it isn’t at all clear that this creates a compelling need. There is, in fact, concern that government action could create harm – to people, to the economy, or to the financial services industry.

One central banker, amusingly, said that she thought it likely that her central bank would do some small programs, but she hoped they wouldn’t be too successful; anything that happened on a large scale could be too disruptive – both to industry and to the money supply.

2. The benefits of electronic money

Many people talked about the advantages of electronic payments, especially with respect to financial inclusion, but also as the means to improve costs, risk management, and regulatory oversight. I’d argue this is well-trod ground: no one is making a case against the value of electronic payments.

Conversion to electronic payments is well underway in the developed world, and there are multiple well-funded, interesting initiatives in the developing world to introduce and accelerate the use of electronic payments (full disclosure: Glenbrook is closely involved with several of these).

‘Cryptocurrency is a fascinating technology, and I’m glad to learn that central bankers are taking it seriously.’

The question here is whether or not digital fiat currency represents a better model to realize the advantages of electronic payments than do these other approaches. There are potentially interesting arguments here, especially within the crypto-ledger approach (more secure, fewer intermediaries, faster, cheaper, etc.).

But simply talking about the evils of cash misses the point: there are a lot of good alternatives to digital fiat currency that accomplish this goal. I’d welcome more debate focusing narrowly on this point.

The right approach?

Evaluating the benefits and weaknesses of these approaches is tricky, given the fluidity (and infancy) of the market and the discussions. But I’ll give it a try, looking at each “pair” of the technical approach and the obligor approach:

• Crypto-ledger, Direct Central Bank Obligation: strengthens government, simplifies payments (all payments become “on-us” book transfers!), weakens banks. Arguably easiest and lowest cost; most disruptive; most dangerous with a rogue government
• Crypto-object, Direct Central Bank Obligation: most similar to physical cash; maintains or enhances government control; could be costly/complicated to deploy
• Crypto-Ledger, Obligation of a Financial Intermediary: most similar to today’s commercial banking; could be more secure/faster/cheaper than today
• Crypto-Object, Obligation of a Financial Intermediary: most complex but possibly most stable; lower disruption

All of these approaches are being studied and/or deployed (generally in small scale tests) somewhere in the world. If I were to bet, I’d guess that the third is the most likely to be adopted and spread. I realize that I may sound more skeptical on this than I actually feel.

Cryptocurrency is a fascinating technology, and I’m glad to learn that central bankers are taking it seriously. I’m not against disruption of the status quo. But I do think it is too early for my crystal ball to work.

The original version of this article first appeared on Glenbrook. Views expressed in this article do not necessarily reflect those of ITU.

Carol Coye Benson is a founding partnerof Glenbrook with more than 25 years of experience in product, marketing and strategy development with leading financial services providers in both wholesale and retail financial services.