The Future of Money: How the Digital Revolution is Transforming Currencies and Finance

The rise in popularity of cryptocurrencies and fintech companies in both developed and developing world have changed the way money is perceived and being transacted. Eswar S. Prasad, Tolani Senior Professor of International Trade Policy at Cornell University and a senior fellow at the Brookings Institution, in his book discuss the impact of these 21st century invention and their future in a world where capital is easily moving across borders. Below are some highlights taken from the book.

Facebook now portrays Diem as a set of digital coins limited to serving as a means of payment fully backed by a reserve constituted by major hard currencies such as the US dollar and the euro. A digital Diem dollar coin will be issued only when, for example, an actual US dollar is deposited into the Diem reserve. The full backing Diem enjoys suggests that it will provide a stable store of value—hence the moniker stablecoin—and will have no monetary policy implications because it will not involve the creation of any new money. Central bankers remain concerned, however, that Facebook could one day deploy its massive financial clout to issue units of Diem backed by its own resources rather than by reserves of fiat currencies. It is an intriguing, and in some ways disturbing, prospect that major multinational social media companies as well as commercial platforms such as Amazon could become important players in financial markets by issuing their own tokens or currencies. Amazon Coins can already be used to buy games and apps on Amazon’s platform; it is conceivable that such tokens could eventually be used for trading a broader range of goods on the platform. The backing of a behemoth company could ensure the stability of the value of its coins and make them a viable medium of exchange, reducing demand for central bank money for commercial transactions.

Several factors make EMEs and developing economies fertile ground for Fintech innovations. First, as these economies become richer, there is enormous latent demand for higher-quality financial services (for example, wealth management, retirement planning) and products (such as mutual funds, stock options, automobile and mortgage loans) from their fast-expanding middle-class populations. The size of some of these economies also allows innovations to be scaled up quickly to reduce per-unit or per-transaction costs. Second, financial regulators in these countries seem to be more willing to take chances on such advances. In China, payment providers such as Alipay met little resistance from financial regulators in their early days. This enabled them to experiment and innovate, quickly moving from just providing payment apps to offering other financial products, with few constraints. Third, these countries often do not have large, powerful incumbents that thwart progress and block the entry of new firms. Fourth, some of the technologies that are powering financial innovations—especially mobile phone–based technologies—are widely available and do not need massive infrastructure investments.

Modern urban societies are more complex. There remain corners of the world in which the local pub or coffee shop allows regulars to keep a running tab that can be settled at the end of the month. But this is the exception. Most purchases of goods and services have to be paid for before or soon after the nonfinancial part of the transaction is completed. When you buy a new iPhone, paying with a credit card ensures the finality of that payment even though it puts off the day of fiscal reckoning—for a price, of course. The credit card company guarantees that Apple will get its money. After all, that company has ways of imposing a cost on you for defaulting on payments, including by reporting such behavior to a credit scoring agency and hurting your credit score. Thus, the need to establish mutual trust between two parties to an economic transaction can sometimes be circumvented by trust in a third party.

While new technologies hold out the promise of democratizing and decentralizing finance—eroding the advantages of larger institutions and countries and thereby leveling the playing field—they could just as well end up having the opposite effect. Consider network effects, the phenomenon that adoption of a technology or service by more people increases its value, causing even more people to use it and creating a feedback loop that makes it dominant and less vulnerable to competition (think Facebook and Google). Despite the lower barriers to entry, the power of technology could lead to further concentration of market power among some payment systems and financial services providers. Existing financial institutions could co-opt new technologies to their own benefit, deterring new entrants. Even currency dominance could become entrenched, with the currencies of some major economies or stablecoins issued by prominent corporations rivaling national currencies of smaller economies, as well as those with less credible central banks and profligate governments.

Additionally, Fintech and CBDC have social implications. Consider two integral precepts of a free and open society—anonymity (wherein the identities of the parties to a transaction can be concealed even if the transaction itself is not) and privacy (an individual’s control over the collection, dissemination, and use of their personal and transactional data). If cash gave way to CBDC and payment systems were overwhelmingly digital, any notion of maintaining anonymity and privacy in financial matters would be severely compromised. Central banks are, of course, under no obligation, legal or moral, to provide anonymous means of payment such as cash. Still, changing the form of central bank money risks pulling these institutions into debates about social and ethical norms, especially if a CBDC is perceived as a tool enabling the implementation of various government economic and social policies. Such a perception could compromise the independence and credibility of central banks, rendering them less effective in their core functions. In authoritarian societies, central bank money in digital form could become an additional instrument of government control over citizens rather than just a convenient, safe, and stable medium of exchange.

There is a key difference between inside money and outside money that may look like a simple matter of accounting but has important consequences. Inside money is an asset that is in zero net supply in the private sector. That is, if one were to look at the private sector as a whole—individuals, corporations, banks—inside money is, at any given time, entered on the asset side of some balance sheets, and exactly the same total amount is listed on the liability side of other balance sheets. To take one example, a mortgage loan would be a liability to a household that uses it to finance the purchase of a house; that amount would appear as an asset (in the form of a bank deposit) on the balance sheet of the entity that sold that property. The assets and liabilities generated by the creation of inside money exactly offset each other, leaving a zero net position on the overall private-sector balance sheet. Outside money, on the other hand, is a liability on the central bank’s balance sheet but an asset on the overall private-sector balance sheet. Why does inside money matter at all if it just cancels out on the private sector’s balance sheet? It is the creation of inside money by banks that facilitates economic activity. By providing credit to households and businesses, banks enable them to finance purchases of goods and services and undertake investments, thereby increasing economic activity. When a loan is paid back by the household or business that took it out, the corresponding deposit is extinguished, and inside money is destroyed.

In general, M0 characterizes currency in circulation (banknotes and coins). Certain types of bank deposits share some of the characteristics of cash—they are easily accessible and can be used to make payments. A measure of money that encompasses such deposits is M1. M1 typically includes M0, demand deposits, and checking deposits. A broader monetary aggregate, M2, is popular in academic and policy circles because it includes central bank money and various short-term deposits, and most countries by and large define it similarly. Not surprisingly, M2 is sometimes referred to simply as broad money. In the United States, M2 is defined as “a measure of the U.S. money stock that includes M1 (currency and coins held by the non-bank public, checkable deposits, and traveler’s checks) plus savings deposits (including money market deposit accounts), small time deposits under $100,000, and shares in retail money market mutual funds.”

The Chinese government has long recognized the risks of shadow finance and occasionally tightens the screws on this sector by subjecting shadow banks to greater control, but it has not quashed the sector completely. It turns out that, as they do in many other economies, shadow banks serve a useful function in China. For one thing, the government has been unwilling to crack down on the nexus between state-owned enterprises and state-owned banks, both of which are politically powerful. At the same time, the government recognizes that it needs the private sector to generate employment growth and contribute to the economy’s dynamism. The private sector cannot function without funds, so the government has allowed the shadow banking system to continue.

A key attribute of Chinese digital payments, in addition to their ease of use and high reliability, is their low cost. This renders such payments viable even for microscale transactions—purchasing a piece of fruit or an order of dumplings from a street vendor. The fee paid by merchants on Alipay and WeChat Pay is nominally 0.6 percent of the transaction amount. Both platforms refund the fees if a merchant’s monthly volume is below a certain threshold. And discounts on large volumes imply that the actual fees average out to about 0.4 percent of transaction amounts. This is in stark contrast to the high costs of retail payments in the United States, where credit cards dominate digital payments. Mobile credit card readers have become increasingly popular among small businesses in the United States, but payment processors usually charge 2.5 to 3 percent of the transaction amount plus a monthly fee, which is used to pay interchange fees to credit card companies and assessment fees to credit card networks. Why do these cost differences persist? For one thing, credit card issuers in the United States have effectively co-opted customers to advocate on their behalf. Virtually every major US credit card offers cash back or other types of rewards, making customers eager to use credit cards and forcing merchants to accept them for fear of alienating customers and losing business. Alipay and WeChat Pay, by contrast, do not have any regular rewards programs because their margin on each transaction is already wafer thin.

In some advanced countries, including the United States, regulation has tended to protect incumbents and limit competition in various parts of the economy. Network effects and outdated antitrust regulations enabled the ascendancy of the Big Tech firms—Amazon, Apple, Facebook, Google—that dominate their respective spaces and gobble up any competitors they cannot squash. The US financial sector does not suffer from such extreme concentration, although the United States certainly has a handful of major banks and payment providers. They do not exert the same degree of dominance as the Big Tech firms; still, stringent regulatory requirements have created barriers to entry in financial markets and kept competition in check.

Moreover, the rewards for validating a block are hardwired to fall over time as more bitcoins get mined. In this process, referred to as Bitcoin halving, the number of generated rewards per block is periodically divided by two to keep the total supply of bitcoins, which will never exceed twenty-one million, from growing too fast. This process of controlling supply is also seen as essential to preserving Bitcoin’s value. Bitcoin halving happens every 210,000 blocks and reduces the reward by 50 percent each time in a geometric progression. The latest Bitcoin halving took place in May 2020, when the reward fell to 6.25 bitcoins for each block mined. The initial block reward was 50, so this means that about 18.4 million bitcoins had been mined by the time this halving took place. The process is expected to end in 2140 with all Bitcoin having been issued.

Blockchain technology gets around the verifiability problem through its transparency and also ensures the finality of transactions. Once a block of transactions is validated and added to the blockchain, the transactions can easily be confirmed by anyone with an internet connection who knows where to look. After a transaction is validated through the consensus protocol, there is no going back to erase or modify the record. Given that copies of the blockchain exist on multiple nodes, attempts by one or a few nodes to tamper with the record of transactions would be noticed and rejected by the rest of the network.

The genius of Bitcoin is its simultaneous creation, out of thin air, of a digital asset that can serve as both a medium of exchange and a store of value. This duality of purpose distinguishes Bitcoin from other payment innovations. Debit and credit cards created a payment technology that makes transactions easier to execute, but they do not fundamentally alter the concept of money. These systems do not create new money but essentially charge a fee for serving as trusted intermediaries facilitating transactions between parties that do not know each other and have no particular reason to trust each other. Bitcoin’s innovations enabling secure transactions between such parties without the intervention of a trusted third party, and through this very process generating the medium of exchange that can be used for more such transactions, are truly ingenious and groundbreaking. For all the marvels of its technology, in practice Bitcoin has proven to be patently ineffective as a medium of exchange. This leaves open the question of whether scarcity by itself is enough for Bitcoin to create and maintain its value. On this point, it must be acknowledged that Bitcoin has (so far) worked better in practice than in theory. As will be discussed in Chapter 5, the values of some newer cryptocurrencies are backed by reserves of a fiat currency or linked to the prices of specific commodities. Such cryptocurrencies are also in effect just payment systems that do not constitute the creation of new money. Bitcoin is thus different in important ways from such cryptocurrencies as it has no backing of any sort, although it is no longer unique, as some cryptocurrencies such as Ether share similar features.

In Proof of Stake, the nodes engaged in validation are referred to as forgers or minters (or, more generically, as validators) because they forge or mint new blocks to be added to the blockchain. This process is less computationally demanding than mining under Proof of Work, and there is no block reward. While Bitcoin awards both a block reward and a transaction fee every time a new block is validated, anyone who contributes to the Proof of Stake system typically earns only a transaction fee. Proof of Stake typically takes on a linear structure, with the percentage of blocks a forger can validate rising as a constant ratio of that forger’s stake in the cryptocurrency. If Bitcoin used this protocol, a node that staked 1 percent of the total amount of staked Bitcoins would be able to validate 1 percent of new transactions that use that cryptocurrency, while another that staked 10 percent of the total would be able to validate 10 percent of new transactions.

The more you stake, the more you earn. At the same time, though, the more you lose if you go against the system. This model also prevents groups of nodes from joining forces to dominate the network just to make a profit. Instead, those who contribute to the network by freezing their coins are rewarded proportionately to the amount they have invested. When using a Proof of Stake consensus mechanism, it would not make financial sense to attempt a 51 percent attack. A malicious node would need to acquire a majority of the coins in circulation, which would lead to a rise in the price for the coins that might ultimately end up being worth less if trust in the network were damaged. Given all these advantages, the world’s second most valuable cryptocurrency, Ether, which runs on the Ethereum blockchain, is in the process of moving from Proof of Work to Proof of Stake. This process, which was slated to happen in early 2020, was pushed back to an indeterminate date that, as of May 2021, had not yet been finalized. When this eventually happens (probably in 2022), the number of Ether transactions that can be processed is expected to increase to thousands per second.

Smart contracts are self-executing computer programs that perform predefined tasks based on a predetermined set of criteria or conditions. These programs cannot be altered once deployed—their integrity is protected by the public and transparent nature of the blockchain. This ensures the faithful completion of contractual terms agreed to by the relevant parties. A smart contract in effect plays the role of the trusted third party normally invoked to complete such transactions. Instead of a middleman who holds the relevant assets (or asset and corresponding payment) in escrow to make sure both parties fulfill their commitments, the escrow account is operated autonomously via a smart contract with predefined rules. Smart contracts can include deadlines that make them useful for time-sensitive transactions and also reduce counterparty risk. Smart contracts are usually set up such that the entire transaction will fail if any of the multiple steps involved in it cannot be executed, a feature referred to as atomicity.

Some ICOs take the form of Equity Token Offerings (ETOs). A company conducting an ETO adds shares to its capital. These shares, which are recorded on a blockchain, grant investors a percentage of voting rights as well as titles of ownership within the company. This differentiates ETOs from normal ICOs, which do not involve any transfer of ownership stakes.

The outcry from central bankers and financial market regulators around the world was strident and predictable, although it seemed to have caught Facebook by surprise. The thrust of the criticisms was that if Libra were to gain traction, in light of the enormous international network of Facebook members, there would be scope for the cryptocurrency to be delinked from the reserve and for Facebook to become an unregulated creator of money, with implications for both monetary policy in individual countries and cross-border financial flows. Global central bankers led the charge, warning of the dangers posed by Libra. Their remarks were uncharacteristically sharp and forceful, departing from their normal understated style of commentary. At a congressional committee hearing a few weeks after the Libra announcement, Fed chair Jerome Powell stated that “Libra raises a lot of serious concerns, and those would include around [sic] privacy, money laundering, consumer protection, financial stability.” Soon thereafter, then-European Central Bank president Mario Draghi laid out a menu of concerns about Libra, including cybersecurity, money laundering, terrorism financing, privacy, monetary policy transmission, and financial stability. Mark Carney, who was then the Bank of England governor, defended the objectives of Libra but cautioned that Facebook could not expect a free pass from regulators: “In terms of how this will proceed or not going forward, this will not be like social media. This will not be a case where something gets up and starts running and the system tries to work out after the fact how it’s regulated. It’s either going to be regulated properly, overseen properly, or it’s not going to happen.” In September 2019, the French and German governments issued a joint statement announcing their intention to block Libra, noting that “no private entity can claim monetary power, which is inherent to the sovereignty of nations.”

To sum up, Libra is envisioned as a set of stablecoins that will be limited in function to serving as mediums of exchange. The coins will be fully backed by fiat currency reserves, and the issuance of the coins will not represent the creation of new, unbacked money. They will have many of the desirable properties of cryptocurrencies: the ability to send money quickly, the security of cryptography, and the freedom to easily transmit funds across borders. One crucial difference is that the trust model is very different from decentralized cryptocurrencies such as Bitcoin and Ethereum that are “open.” In Libra, network participation is limited or “permissioned” (this refers to validator nodes that must be approved, rather than users of Libra).

Cryptocurrencies might ultimately turn out to be nothing more than sophisticated and convoluted pyramid schemes that one day result in significant economic pain for cryptocurrency enthusiasts. When such schemes unravel, they can have a disproportionate impact on gullible and vulnerable investors who can least afford such losses.

The proliferation of cryptocurrencies and their relationship to fiat currencies, whether physical or digital, is likely ultimately to hinge on how effectively each currency delivers on its intended functions. In this sense, by parceling out the various functions, cryptocurrencies have already changed the nature of money. Fiat money bundles together multiple functions as it serves as a unit of account, medium of exchange, and store of value. Now, with the advent of various forms of digital currencies, these functions can be separated conceptually.

Thus, even if a CBDC was managed using blockchain or any form of DLT, it would be a permissioned blockchain in contrast to the decentralized, permissionless one of the sort used by Bitcoin. There are in fact a couple of government-issued digital currencies being designed to operate on permissioned blockchains. This group, which I will refer to as official cryptocurrencies, constitutes a third and somewhat peculiar conception of CBDC, which ostensibly provides greater user anonymity. Such a cryptocurrency is issued and managed by a government agency or a private agency explicitly designated for the purpose. The validation of transactions is done in a decentralized manner (usually through a Proof of Stake consensus mechanism) but only by approved entities rather than through an open decentralized mechanism.

The Riksbank notes that an e-krona could alleviate the problem of concentration in the payment infrastructure and also its potential vulnerability to loss of confidence. The digital currency would be based on a separate infrastructure that would also be open to private agents willing to offer payment services linked to the e-krona. The general public would have access to the e-krona, with both suppliers of payment services and Fintech companies allowed to operate on the central bank’s network. Thus, an e-krona system would be designed to promote competition and innovation rather than displace private payment systems.

The Bank of Canada, for instance, has indicated that it is conducting contingency planning for launching a CBDC, with two scenarios seen as triggers for a launch. First, the use of banknotes could decline to a point where Canadians could no longer use them for transactions. Second, one or more private-sector digital currencies could become widely used as an alternative to the Canadian dollar as a method of payment, store of value, and unit of account. Under either of these scenarios, “a CBDC could be one way of preserving desirable features of the current payment ecosystem, such as universal access to secure payments, an acceptable degree of privacy, competition, and resilience. The second scenario in particular would constitute a significant challenge to Canada’s monetary sovereignty—our ability to control monetary policy and provide services as lender of last resort.”

An account-based CBDC that replaced cash would free up monetary policy in a way that turns out to be quite important for economies facing severe recessions related to financial market meltdowns, as happened in 2008–2009, or other major adverse events such as the worldwide coronavirus outbreak in 2020. With an account-based CBDC, the central bank would find it easier to impose a negative nominal interest rate. In the absence of cash, the zero lower bound would no longer be a constraint on pushing down nominal interest rates. Even in an economy facing deflation, this would make it feasible to drive the real interest rate low or even negative in inflation-adjusted terms.

A money-financed fiscal stimulus is sometimes more effective than having the government finance its deficit expenditures by issuing more debt that is sold to private investors. The debt-financed approach can lead to higher interest rates, defeating the purpose of the stimulus. But even a money-financed fiscal stimulus could be less efficient than direct helicopter money drops to households and would also run into political complications about who benefits from the government’s largesse and who does not. Moreover, there is some wastage inherent to government spending and some types of spending might prop up economic activity but not afford direct benefits to those most in economic need. In the past, there was no channel through which the central bank could hand out money directly. That could soon change.

Statistics provided by the Riksbank show that in Sweden crimes linked to cash declined sharply as the use of cash plummeted. Reported bank robberies fell from seventy-seven in 2009 to eleven in 2018. Over this period, robberies of cash-in-transit operations fell from fifty-eight to just one, while taxi robberies fell to one-third and shop robberies to less than one-half of their previous levels. In 2013, a local newspaper reported a foiled bank robbery in central Stockholm. The robber left empty-handed because the bank branch did not deal with cash.

The size of the shadow economy is not an innocuous matter. Unpaid taxes mean lower government revenues that could have been used for social expenditures, infrastructure investment, and other productive government spending. This reduces a country’s economic growth and the welfare of its citizens. When the average Greek worker sees highly paid professionals blatantly cheating on taxes, it erodes trust in the tax system and the social norms supporting voluntary compliance as well as in the government as a whole. Moreover, the shadow economy can disadvantage honest businesses, lead to worker exploitation, and fuel illegal activities and illicit commerce. The shadow economy can thus undermine state institutions, encouraging crime and reducing support for institutions and ultimately threatening economic and political stability.

To sum up, a CBDC would discourage illicit activity and rein in the shadow economy by reducing the anonymity and nontraceability of transactions now provided by the use of banknotes. This point has been made forcefully by Kenneth Rogoff of Harvard University, especially in the context of high-denomination banknotes. A CBDC would also affect tax revenues, both by bringing more activities out of the shadows and into the tax net and also by enhancing the government’s ability to collect tax revenues more efficiently.

In principle, a central bank can even have a balance sheet that looks insolvent. This, too, does not matter since the central bank can print money and continue to function even if its liabilities exceed its assets such that its net worth is negative. Behind every central bank stands a government that has the authority to levy taxes, thereby generating revenues that can over time help the central bank bring its balance sheet back into shape. Thus, in the long run the central bank is intrinsically safer than any private financial institution, no matter how large that institution or how strong its balance sheet.

This semiapocalyptic vision of the postcash world runs counter to the notion that digital money would help the poor, deter tax evasion and certain forms of crime, and facilitate more efficient economic interactions. The irony in the libertarian position is that it calls for a central bank to provide the instrument (cash) that will, in effect, undermine the government’s ability to enforce its laws and regulations. This is akin to asking the government to build roads and then leave it up to drivers to make up their own laws rather than enforcing speed limits or other rules of the road since that would, presumably, impinge on individual liberties.

One major consequence of a CBDC is likely to be the loss of privacy in commercial transactions. Notwithstanding any protestations to the contrary by governments and central banks contemplating the issuance of CBDC, the traceability of all digital transactions effectively eliminates the possibility of using central bank money for anonymous transactions. Admittedly, there is little reason why a central bank should feel obliged to provide an anonymous payment mechanism. This is certainly not part of any central bank’s legal mandate. One could make the argument that easier monitoring of its citizens’ activities would make the state more effective in reducing illicit commerce and other illegal activities. And that is precisely what creates a risk. An authoritarian government could easily use this heightened surveillance of its citizens to smother dissent and protest. Worse, it could even enable a democratic government that takes an autocratic turn to tighten its control and attempt to subvert the very institutions that have traditionally served as checks and balances on such concentration of power. Fundamental rights such as free speech, free assembly, and peaceful dissent could be threatened.

Holders of the e-CNY receive no interest from the central bank unless the money is deposited into a bank account, where it earns the normal rate. Thus, the e-CNY does not compete with commercial bank deposits, reducing the risk of disintermediation of the banking system. In more technical terms, the e-CNY constitutes “a full reserve system with no derivative deposits or money multiplier effects.”

All merchants in China who accept digital payments such as Alipay and WeChat Pay are required to accept the e-CNY because it is legal tender. Moreover, the e-CNY can be used across apps, which is not the case with the two major private payment platforms that do not support each other. The e-CNY will have near field communication (NFC)–based payment options. This means that two persons with phones that hold e-CNY digital wallets can exchange money by bringing their phones into proximity, even if those phones temporarily lack internet or wireless coverage. Any risks of double-spending in the absence of immediate centralized verification by a payment platform or a bank can be overcome by the electronic traceability of all transactions. Thus, the e-CNY provides the important cash-like feature of portability and at least partial confidentiality for small-scale transactions.

The idea behind some government-issued cryptocurrencies appeared to be that the underlying cryptographic technology would sufficiently obscure the identities of those using the digital currencies, allowing foreign individuals and institutions to conduct transactions with the issuing country without falling afoul of US sanctions. If this logic does not appear sound, there is a reason—it is not. Not only would foreign financial institutions be unwilling to use such currencies that their home country regulators would frown upon, but the fact that even official cryptocurrencies would eventually have to be converted into more reliable currencies could vitiate any attempt to escape the dollar-centric international financial system.

When the Fed hikes rates, as noted earlier, money tends to flow out of EMEs as investors opt for a decent rate of return in a safe investment rather than a higher-return but riskier investment. Such “risk-on” and “risk-off” investor behavior leads to erratic swings in capital flows to EMEs. To the exasperation of policymakers in these countries, they end up being exposed to such volatility even when their policies are disciplined, and their economies are doing perfectly well. In other words, they suffer collateral damage when the Fed uses monetary policy levers to achieve its own (domestic) ends, with minimal regard for the effects of those policies on other economies.

One important requirement of a store of value currency is depth. That is, there should be a large quantity of financial assets denominated in that currency so that both official investors such as central banks and private investors can easily acquire those assets. There is a vast amount of US Treasury securities, not to mention other dollar-denominated assets, that foreign investors can easily acquire. Another characteristic that is important for a store of value, and one that is very much related to its depth, is its liquidity. That is, it should be possible to easily trade the asset even in large quantities. An investor should be able to count on there being sufficient numbers of buyers and sellers to facilitate such trading, even in difficult circumstances. This is certainly true of US Treasuries, which are traded in large volumes. For an aspiring safe haven currency, depth and liquidity in the relevant financial instruments denominated in that currency are indispensable. More importantly, both domestic and foreign investors tend to place their trust in such currencies during financial crises because they are backed by a powerful institutional framework. The elements of such a framework include an institutionalized system of checks and balances, the rule of law, and a trusted central bank. These elements provide a security blanket to investors, assuring them that the value of those investments will be protected and that investors, both domestic and foreign, will be treated fairly and not subject to risk of expropriation.

Having one global currency accepted for transactions in all countries would have some salutary effects. It would eliminate exchange rate volatility, for the simple reason that there would no longer be any national currencies and no currency exchange rates to speak of. There would be no incentive to undertake (or possibility of undertaking) competitive currency devaluations to promote a country’s exports. This disruptive and zero-sum game of currency wars could no longer be used to stimulate economic recoveries. A single and stable currency serving all the functions of money would reduce the need for hedging foreign exchange risk and also eliminate the volatility of import and export prices resulting from exchange rate fluctuations. More importantly, the United States and its central bank would no longer have such a massive impact on global financial markets. A single global currency would, however, impose considerable costs and constraints on national policymakers. It would mean the abandonment of monetary policy autonomy and the elimination of an adjustment mechanism for changing relative prices when a country finds itself hit with an adverse shock specific to it (as distinct from a global shock that has a common effect across all countries). Why, then, do countries voluntarily give up monetary independence and join currency unions such as the eurozone? For one thing, common currency zones bind economies together more tightly, increasing trade and investment flows between them. Eliminating exchange rate volatility within the zone essentially removes one source of uncertainty that affects trade and investment transactions. The second motivation is that, especially for countries with reputations for spendthrift governments and undisciplined central banks, a fixed exchange rate is one way of buying credibility by tying the central bank’s hands on monetary policy.

One major difference between the SDR and a national currency is that the SDR has no real backing. True, the IMF holds some gold and also has money on deposit from its member countries. But unlike a central bank–issued fiat currency that has a national government’s authority to levy taxes behind it, the IMF has no such power. The IMF functions more like a credit union where the shareholders keep deposits that can then be lent out to members in need of short-term loans.

The IMF declares that “the SDR is neither a currency nor a claim on the IMF. Rather, it is a potential claim on the freely usable currencies of IMF members. SDRs can be exchanged for these currencies.” In other words, the IMF guarantees that it will arrange for conversion of a country’s SDR balances, upon request from that country’s government, into any of the currencies that make up the SDR basket (at the relevant SDR exchange rate for each of those currencies). One could argue that this guarantee, which is based on rules that have been agreed to by all IMF members, constitutes a form of backing for SDRs.

Issuing SDRs increases global “liquidity” since they are tradable for currencies in the SDR basket (the central banks issuing those currencies would create the required amounts of money). It is not, however, the most efficient way to channel money to countries that need it the most given the rules that govern how SDRs are distributed. Moreover, making the SDR an international medium of exchange would require substantial changes to its design. Still, the SDR has its advantages. The IMF can essentially create any amount of SDRs out of thin air, which in principle makes it a pliable reserve asset, the supply of which can be increased whenever the need arises. All it takes is agreement among a majority of the IMF’s members. This requirement, however, complicates matters.

The reality has fallen short of these promises and is likely to continue to do so. The Chinese government has shown that when pressures build up for significant currency appreciations or depreciations as capital flow pressures shift, it is prepared to tighten capital controls and exchange rate management to offset those pressures and reduce volatility. It is hard to envision a government that has a command-and-control mentality leaving highly visible and consequential economic variables, such as the renminbi-dollar exchange rate, entirely to market forces. All told, it remains unlikely that the Chinese government will permit a truly open capital account, although it has certainly allowed the exchange rate to move more freely in both directions—appreciation and depreciation—since 2019.

The consensus has by now decisively shifted toward the view that central banks should in fact care explicitly about both key macroeconomic outcomes and financial stability. After all, goes this counterargument to the pure inflation-targeting view, central banks in fact have two tools at their disposal. The first is monetary policy, which comprises such instruments as interest rates, lines of credit to commercial banks, and direct purchases and sales of government securities and other assets. The second tool is the capacity to implement regulatory policies, either at the level of the entire financial system or applied to specific financial institutions. These policies can take a variety of forms. Banks can be instructed to hold more money in reserve in their accounts at the central bank, issue more equity capital that could help absorb any losses they incur, or require larger down payments on mortgage loans they provide. The two objectives—low and stable inflation (along with low unemployment) and financial stability—and the tools to achieve them have come to be seen as inextricably linked. For instance, financial instability can lead to gyrations in economic activity that make it harder to maintain stable inflation. But the lines between the two policies on occasion blur and get tangled up, making policy decisions less straightforward. There are periods of low inflation and decent growth when the stock market might show signs of rising too fast. In such cases, monetary policy might seem on track to hit the inflation mandate, but if it ignored frothy stock prices, it could forgo the opportunity to let some air out of the stock market rather than standing by while it soars and perhaps ultimately crashes. Tightening monetary policy by raising interest rates would cool off the stock market, but this could, on the other hand, come at the price of restraining growth.

the BoC also makes the broader point that the country’s monetary sovereignty would be threatened if a private digital currency not denominated in Canadian dollars were to assume major roles as a unit of account and means of payment in Canada. Such a development would threaten the central bank’s ability to achieve price and financial stability. Households’ spending power would depend on the value of a digital currency over which the BoC would have no influence. Moreover, the BoC notes that its policies related to the role of lender of last resort can be enacted only in the currency supplied by the central bank. The implication is that if an alternative currency were to establish a major foothold in the Canadian economy, the central bank’s firefighting tools would be rendered less potent amid a financial crisis.

One unresolved question is whether nonbank and informal financial institutions are more or less sensitive than traditional commercial banks to changes in policy interest rates. The available evidence on this subject is limited and rather mixed. It is unlikely that such institutions will be entirely isolated from changes in interest rates in the formal banking sector. Yet the sensitivity of these institutions to policy rate changes could be lower than that of commercial banks, especially if they do not rely on wholesale funding—funding from other financial institutions rather than through deposits—and have other ways of intermediating between savers and borrowers. In fact, there is accumulating evidence that both in China and the United States shadow banking interferes with the transmission of monetary policy—for instance, credit growth in this sector tends to rise during periods of monetary tightening, when the central bank is trying to reduce credit growth and cool down economic activity.

Apprehension about Fintech’s impact on systemic financial stability stems mainly from innovations that could displace existing financial institutions, lead to concentration of payment systems, and accentuate technological vulnerabilities. For EMEs, the expansion of conduits for cross-border financial flows with greater efficiency and lower costs could be a double-edged sword, making it easier for these countries to integrate into global financial markets but at the risk of higher capital flow and exchange rate volatility. Such volatility has often caused marked stresses for corporate and sovereign balance sheets in these economies, especially when many of their loans are denominated in foreign currencies.

The costs and benefits of a CBDC are inextricably tied to the reputation of the central bank issuing it. The value and acceptability of any form of central bank money is the product of the institution’s credibility, which in turn depends on its independence and the quality of a government’s fiscal and other economic policies. In other words, absent any other changes, the digital version of a central bank’s fiat currency is likely to fare no better or worse than cash in terms of its acceptability as a medium of exchange and stable source of value. Nevertheless, from other perspectives, such as those of increasing financial inclusion and improving payment systems, there might be advantages to issuing CBDCs even in countries that have macroeconomic problems such as high and volatile inflation and weak policy institutions. There are looming challenges on the external front. EMEs will have to manage new cross-border payment systems and other developments that facilitate easier, cheaper, and quicker international flows of capital. These changes will bring many benefits but also exacerbate capital flow and exchange rate volatility while making capital controls less potent. By promoting digital payments, CBDCs might hasten developments in domestic and cross-border payments and other financial technologies that come back to haunt EME central banks.

For it is hard to speak properly upon a subject where it is even difficult to convince your hearers that you are speaking the truth. On the one hand, the friend who is familiar with every fact of the story may think that some point has not been set forth with that fullness which he wishes and knows it to deserve; on the other, he who is a stranger to the matter may be led by envy to suspect exaggeration if he hears anything above his own nature. —Thucydides, “Pericles’s Funeral Oration,” The Peloponnesian War

Financial innovations will generate new and as yet unknown risks, especially if financial market participants and regulators put undue faith in technology and let down their guard. Decentralization and fragmentation cut both ways. They can promote financial stability by reducing centralized points of failure and increasing resilience through greater redundancy. Distributed ledger technologies (DLTs), for instance, are in many ways more secure and failproof than their centralized counterparts. On the other hand, while fragmented systems can work well in good times, confidence in them could prove fragile in difficult circumstances. If the financial system were to be dominated by decentralized mechanisms that are not directly backed (as commercial banks are) by a central bank or other government agency, confidence could easily evaporate. Thus, fragmentation might yield efficiency in good times and rapid destabilization when economies struggle.

Another irony is that the origin of cryptocurrencies can be traced to a desire to demonstrate that a trusted authority is not needed to accomplish payment clearing and settlement and also to limit government intrusion into private transactions. Instead, the proliferation of these currencies is goading central banks into issuing digital versions of their own currencies, which might end up putting the privacy of even basic transactions all the more at risk of government surveillance.


About Journeyman

A global macro analyst with over four years experience in the financial market, the author began his career as an equity analyst before transitioning to macro research focusing on Emerging Markets at a well-known independent research firm. He read voraciously, spending most of his free time following The Economist magazine and reading topics on finance and self-improvement. When off duty, he works part-time for Getty Images, taking pictures from all over the globe. To date, he has over 1200 pictures over 35 countries being sold through the company.
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