The rise of digital currency
This column is a lead commentary in the VoxEU Debate “The Future of Digital Money“
A battle is raging…for your wallet. With sharp elbows, new entrants are vying to occupy the space once used by paper bills, or that reserved for your debit card.
Alipay, Libra, M-Pesa, stablecoins – we first need to make sense of just who is attempting to pry our wallets open. We propose a simple framework to do so.
We then argue that the adoption of new, digital means of payment could be rapid. It could bring significant benefits to customers and society, including efficiency gains in payments, greater competition, financial inclusion, and innovation in related sectors. But risks are also paramount to financial stability and integrity, monetary policy transmission, and anti-trust. These must be tackled with innovative approaches and heightened collaboration across borders and sectors.
Policymakers will not be able to remain bystanders. In fact, their actions will influence the adoption of new means of payment, and their design. One approach is for central banks to engage in a public–private partnership with fintech firms to provide a safe, liquid, and digital alternative to cash – synthetic central bank digital currency, or sCBDC for short – which comes with its own benefits and risks.
The literature is quickly picking up on the potential disruption caused by new means of payment (e.g. Duffie 2019, BIS 2019).
A framework of analysis
To help make sense of the plethora of new entrants in the payments space, we offer a simple classification scheme that we call the ‘Money Tree’ (Adrian and Mancini-Griffoli 2019). At its heart are four key features that help distinguish different forms of money: type, value, backstop, and technology. We illustrate this scheme in Figure 1 by contrasting bank deposits and stablecoins. Further details and discussions of other forms of money are in Adrian and Mancini-Griffoli (2019).
Figure 1 Simplified money tree to classify different forms of money
Bank deposits are the most popular means of payment in many countries. These are claims on banks, as opposed to objects with intrinsic value. Bank deposits have fixed value to the extent they can be redeemed into currency – or cash – at face value. Ten euros deposited in a bank can be redeemed against a ten-euro note with reasonable certainty in many countries. That is an incredibly useful feature, allowing payments in bank deposits to be made without concern for exchange rate risk.
Trust in the redemption guarantee rests on government backstops: deposit insurance, lender of last resort and emergency liquidity facilities, as well as careful supervision and oversight of banks. And finally, the settlement technology is usually centralised, as banks and central banks collaborate to maintain a shared ledger of account balances.
New means of payment such as stablecoins differ in important ways. Most stablecoins continue to be claims on the issuing institution. Many also offer redemption guarantees at face value – a coin bought for ten euros can be exchanged back for a ten-euro note (a sort of money-back guarantee).
However, trust in this pledge does not rest on government backstops. It must be generated privately by fully backing coin issuance with safe and liquid assets. Finally, the settlement technology is usually decentralised, based on the blockchain model.
Some stablecoins do not offer redemptions at fixed prices, but at market prices instead. We say their value is variable relative to the domestic unit of account. This is the case of commodity tokens, such as gold coins, and of coins that are exchanged or redeemed for the going value of the assets backing them. One example is mutual fund shares written to digital tokens that can be readily exchanged. Libra may fit this model.
Adoption of new forms of money will depend on their attractiveness as a store of value and means of payment. Cash fares well on the first count, and bank deposits on both. So why hold stablecoins? Why are stablecoins taking off? Why did USD Coin recently launch in 85 countries,1 Facebook invest heavily in Libra, and centralised variants of the stablecoin business model become so widespread? Consider that 90% of Kenyans over the age of 14 use M-Pesa and the value of Alipay and WeChat Pay transactions in China surpasses that of Visa and Mastercard worldwide combined.
The question is all the more intriguing as stablecoins are not an especially stable store of value. As discussed, they are a claim on a private institution whose viability could prevent it from honouring its pledge to redeem coins at face value. Stablecoin providers must generate trust through the prudent and transparent management of safe and liquid assets, as well as sound legal structures. In a way, this class of stablecoins is akin to constant net asset value funds which can break the buck – i.e. pay out less than their face value – as we found out during the global financial crisis.
However, the strength of stablecoins is their attractiveness as a means of payment. Low costs, global reach, and speed are all huge potential benefits. Also, stablecoins could allow seamless payments of blockchain-based assets and can be embedded into digital applications by an active developer community given their open architecture, as opposed to the proprietary legacy systems of banks.
And, in many countries, stablecoins may be issued by firms benefitting from greater public trust than banks. Several of these advantages exist even when compared to cutting-edge payment solutions offered by banks called fast-payments.2
But the real enticement comes from the networks that promise to make transacting as easy as using social media. Economists beware: payments are not the mere act of extinguishing a debt. They are a fundamentally social experience tying people together. Stablecoins are better integrated into our digital lives and designed by firms that live and breathe user-centric design.
And they may be issued by large technology firms that already benefit from enormous global user bases over which new payment services could spread like wildfire. Network effects – the gains to a new user growing exponentially with the number of users – can be staggering. Take WhatsApp, for instance, which grew to nearly 2 billion users in ten years without any advertisement, based only on word of mouth!
Risks of stablecoins
Risks are multiple, though that is not an excuse for policymakers to throw in the towel. On the contrary, they must create an environment in which the benefits of technology can be reaped while minimising risks, as discussed in Lipton (2019). Policymakers will need to be innovative themselves and to collaborate – across countries, but also across sectors. Central bankers, regulators, ministries of finance, antitrust authorities, currency issuers, and technology experts will need to speak a common language for a common purpose.
The first risk is to the disintermediation of banks, which could lose deposits to stablecoin providers. However, banks will try to compete by offering their own innovative solutions and higher interest on deposits. And stablecoin providers could recycle their funds back into the banking system or decide to engage themselves in maturity transformation by turning themselves into banks.
Second, we could face new monopolies. Tech giants could use their networks to shut out competitors and monetise information. At the heart of this power is proprietary access to data on customer transactions. We need new standards for data protection, control, and ownership.
Third, there is a threat to weaker currencies. In countries with high inflation and weak institutions, people might give up local currencies for stablecoins in foreign currency. This would be a new form of ‘dollarisation’ and might undermine monetary policy, financial development, and economic growth. To avoid this, countries must improve their monetary and fiscal policies. The question is whether they can or should restrict foreign currency stablecoins in the interim.
Fourth, stablecoins could foster illicit activities. Providers must show how they will prevent the use of their networks for activities like money laundering and terrorist financing. This means complying with international standards. New technologies offer opportunities to improve monitoring. So, supervisors will need to adapt to the more fragmented value chain of stablecoins, including wallet providers, crypto exchanges, validation nodes, and investment vehicles.
The fifth risk is loss of ‘seigniorage’. Central banks have long captured, on behalf of taxpayers, the profits stemming from the difference between a currency’s face value and its cost of manufacture. Issuers could siphon off profits if their stablecoins do not carry interest but the hard currency backing them is invested at a return. One way to address this issue is to promote competition so issuers would eventually pay interest on coins.
Sixth, we must ensure consumer protection and financial stability. Customer funds need to be safe and protected from runs like the one that took down Lehman Brothers investment bank. In part, this calls for legal clarity on what kind of financial instruments stablecoins represent.
One approach would be to regulate stablecoins like money market funds that guarantee fixed nominal returns, requiring providers to maintain sufficient liquidity and capital. We could call this the ‘shadow banking’ approach, which attempts to extend prudential regulation beyond the classic banking perimeter.
Synthetic central bank digital currency (sCBDC)
Another option is the ‘narrow banking’ approach. In this case, the central bank could require stablecoin providers to back coins with central bank reserves. The approach is not unheard of. The People’s Bank of China requires giant payment providers AliPay and WeChat Pay to abide by these standards, and central banks around the world are considering giving fintech companies access to their reserves – though only after satisfying a number of requirements related to financial integrity, interoperability, security, and data protection, among others.
Clearly, doing so would enhance the attractiveness of stablecoins as a store of value. Competition with banks would only grow stronger. The social price tag is up for debate.
But there are also clearer-cut advantages of offering stablecoin providers access to central bank reserves:
- stability, given the backing in perfectly safe and liquid assets;
- regulatory clarity as narrow banks would fit neatly into existing regulatory frameworks;
- interoperability among stablecoins (as client funds would be exchanged between reserve accounts) and thus greater competition;
- support for domestic payment solutions rivalling foreign currency stablecoins offered by monopolies that are hard to regulate; and
- better monetary policy transmission, thanks to lower pressure on currency substitution, and more immediate transmission of interest rates if reserves held by stablecoin providers were remunerated.
A final consideration jumps out: if stablecoin providers held client assets in reserves at the central bank, clients would essentially be able to hold, and transact in, central bank liabilities. That, after all, is the essence of CBDC.3
Bingo! We have thus manufactured what we call synthetic CBDC (sCBDC). We remain, however, fully aware that the stablecoins are the liability of private-sector firms despite the public determining the size of central bank liabilities.
sCBDC offers significant advantages over its full-fledged cousin. The latter, discussed widely in the literature and envisioned by central banks, requires getting involved in many of the steps of the payments value chain. This can be costly and risky for central banks. Steps include interfacing with users and managing brand reputation; complying with integrity standards; offering clients an interface to hold and trade the payment instrument; picking, managing, and evolving technology; offering a settlement system; and managing data and monitoring transactions.
In the sCBDC model – which is a public–private partnership – central banks would go back to focusing on their core function: providing trust and efficiency by means of state-of-the-art settlement systems. The private sector – stablecoin providers – would be left to satisfy the remaining steps under appropriate supervision and oversight, and focus on their own competitive advantage – innovating and interacting with customers.
Whether central banks adopt CBDC at all is another matter and will result from carefully weighing pros and cons. But to the extent central banks wish to offer a digital alternative to cash, they should consider sCBDC as a potentially attractive option.
That is only one of the incarnations of stablecoins. Others will no doubt materialise and colour the future of payments and the financial industry. If anything, existing players will be induced to offer new and more attractive services in the payments – and especially cross-border payments – space. From desktop publishing, the digital revolution has finally reached the shores of consumer finance too.
Editor’s Note: The views expressed are those of the author(s) and do not necessarily represent the views of the IMF and its Executive Board
Adrian, T, and T Mancini-Griffoli (2019), “The rise of digital currency”, IMF Fintech Note 19/01.
Bank for International Settlements (2019), “Big tech in finance: Opportunities and risks”, Annual Report, Chapter III.
Duffie, D (2019), “Digital currencies and fast payment systems: Disruption is coming”, presentation at the Asian Monetary Policy Forum, preliminary draft, Graduate School of Business, Stanford University.
Lipton, D (2019), “Digital upstarts need to play by the same rules as everyone else”, Financial Times Op-Ed, 15 July.
Mancini-Griffoli, T, M S Martinez Peria, I Agur, A Ari, J Kiff, A Popescu and C Rochon (2018), “Casting light on central bank digital currency”, IMF Staff Discussion Note.
 See Coindesk (2019), “Coinbase rolls out trading in USDC stablecoin to 85 countries”, 14 May.
 Fast payments allow near-instantaneous and final settlement of transactions in central bank money. A prominent example is the euro area’s Target Instant Payment Settlement (TIPS) service launched in November 2018.
 Importantly, appropriate legal structures would be needed to protect client assets from the bankruptcy of stablecoin providers. See Mancini-Griffoli et al. (2018) for a detailed discussion of CBDC.