In the past few years there has been a wholesale shift by central banks into digital currencies, with northward of 50 nations actively exploring the concept, some rolling out pilots, and China’s central bank, The People’s Bank of China, recently filing 84 patents in relation to digital currencies. This indicates that digital currencies are here to stay. There is little doubt the unveiling of Facebook’s digital currency Libra and its ability to potentially engage two billion people (representing a quarter of the world’s population) had caused central banks and regulators to sit up and take notice with The Bank of England amongst others taking a hardened stance on Libra, requiring it to meet its highest standards prior to launch in the UK.
Central banks control price stability, inflation and employment and walk the tightrope to ensure that the economy grows, and jobs are created, whilst keeping inflation in check. Former Fed Chairman William McChesney Martin described the Fed’s role as “to order the punch bowl removed just as the party is really warming up”. Central banks and regulators have flexed their muscles against Libra, which some have suggested was the reason for the withdrawal of high-profile partners such as Paypal, Visa, and Mastercard from the Libra Association, along with Facebook and its remaining partners now considering extending the olive branch with a redesign to accept multiple coins, including those issued by central banks.
Although Libra may have been a catalyst, the drivers for this shift have been in place for several years. Physical cash has seen dwindling use globally. The inconvenience of carrying and spending cash has been exasperated by FinTech and payment companies focused on removing friction from the process. The world is ever changing, and in the current black cloud of the COVID 19 virus, there is also the health benefit of not having to handle cash which has been in circulation – it has been found that banknotes harbour a long list of toxic shock syndromes and a variety of gastro-intestinal diseases.
To be clear, the use of credit cards or other phone-based payment services are not strictly digital currencies in the same way that cryptocurrencies such as bitcoin are. Where traditional payment methods are backed and underpinned by central bank-issued fiat currency, with payment providers such as banks acting as intermediaries, cryptocurrencies do not need such intermediaries but instead are based on a pure peer-to-peer transfer of value.
Libra, a stablecoin, is peer-to-peer, backed by a collection of low-volatility assets, including bank deposits and government securities, and controlled by Facebook-backed Libra Association which, through the purchase of government bonds and other central bank issued products, would potentially have enough global market share to start to dictate to the central banks. Both, cryptocurrencies and stablecoins have the potential to upend traditional finance and macroeconomics, which has the central banks shifting in their seats. Whilst advocates of fully distributed cryptocurrencies will balk at the idea of a centralized national digital currency there are certainly several pros and cons for both central banks and the general public.
In line with the change in spending behavior, research suggests that digital currencies have a positive impact on the economy through the simple fact that they are easier to spend. This in turn would provide central banks with more efficient ways of implementing monetary policy. The economist at The Bank of Canada Mohammad R. Davoodalhosseini believes that being able to accurately trace money flows on the blockchain and, as a result, being able to execute a more active monetary policy is perhaps one of the most significant selling points for a central bank digital currency. In addition, the ease of distribution and reduced cost of transactions would provide further efficiencies for central banks especially when transacting cross borders. FinTech in the developing world has focused on financial inclusion and demonstrated that through mobile payments the unbanked can be brought into the digital realm.
On the flip side of these benefits, setting up and implementing a digital currency is costly for central banks and there are still concerns with scalability issues related to blockchain-driven solutions. Besides, the reduced privacy of citizens, particularly if the digital currency is set up through a centralized blockchain, is seen as a big issue especially in the eyes of the cypherpunks and bitcoiners as this goes against the fundamentals of why cryptocurrency were set up in the first place – a centralized ledger in combination with the transparent nature of blockchain would give the central bank information on each and every transaction. At this stage, however, it is estimated that there are only 5.8 million active bitcoin users compared to 736 million Visa credit card accounts, but it does highlight the threat of an instant mass user base such as Facebook’s.
During a speech given at the London School of Economics, Bank of England Deputy Governor Sir Jon Cunliffe, in reference to cryptocurrencies explained that “the supply of credit to the real economy through the banking system could become weaker or indeed disappear. That would be a change with profound economic consequences”.
In reality, central banks have issued digital currency for decades, but only ever to a select group of financial institutions under the guise of the Reserves in their role as the lender of last resort. They have never done so directly to retail customers.
Central banks have options as to how they roll out digital currencies, and the plethora of published research, multiple pilots underway and a central bank digital currency policy-maker toolkit released at the World Economic Forum early this year highlight the importance of this shift.
What has become abundantly clear is that if central banks are going to continue to issue money and implement monetary control and regulation to keep the party in check, it is going to have to be at least in part, in digital form and if the central banks do not adapt in 2020 or the very near future they will not be able to maintain control for much longer, and who knows how that party will turn out?