In terms of digital currencies, central banks will have to quickly clarify their intentions

In terms of digital currencies, central banks will have to quickly clarify their intentions

By Philippe HENRY
CEO Dewenson Partners

« Four legs good, two legs bad »

George Orwell, Animal Farm

The fashion for private crypto currencies and decentralized finance is passing, and faster than the time taken for its advent. Victim of the lack of process transparency, complex algorithms, and the deflation of speculative bubbles. To some extent, this wave of crypto assets was strongly linked to the measures (quantitative easing, negative interest rates, etc.) taken to contain the 2008 financial crisis and the Covid crisis.

What will be left of all this? What have we learned from this live proof of concept which have carried – for the happiness of some and the misfortune of the vast majority – on hundreds of billions of dollars? Does this pave the way for central bank digital currencies (CBDCs) that could retain the creative components from crypto assets but within a more regulated and controlled framework? 

 In any case, a good moment to take a close look at their interest in the real economy at a time when there are a lot of other priorities to manage given the macroeconomic and geopolitical issues surrounding us. 

 Do we really need Retail CBDCs?

A recent study by Bank for International Settlements indicates that at least half of central banks consider it possible that they will issue a CBDC in the foreseeable future”. The question to ask is: “What could a CBDC be used for?”. In fairness, money has been dematerialized for a long time and, from the end user point of view, there is little difference with the use that he makes of payment apps today, such as Alipay or Apple Pay, or even a contactless payment by debit card.

The currency is, in fact, largely scriptural these days (90% of total currency). It consists of deposits in banks. Concretely, scriptural money is a debt of the banking system with regard to individuals and it is already electronic. We also commonly speak of electronic money to designate the automation of scriptural monetary instruments. Thus, today, the only form of central bank money available to the public is coins and notes, which represent less than 10% of the total money supply. 

If, in the future, a new form of central bank money was accessible in digital form – a kind of digital banknote -, in addition to physical coins and notes or which would replace them, this would result in the direct holding of central bank money by the public. With the necessity for central banks to develop and run customer services associated to this offer, including KYC, onboarding, control of money laundering, fraud and corruption. And any outsourcing of some of the functions to private banks would need to be carefully managed to keep the public trust in the CBDC. This would substantially modify the balance and the distribution of tasks between the commercial banks and central banks.

With, in addition, very complex algorithms to run to optimise the blockchain and solid tech solutions to ensure payments can be made even when the power goes down or you can’t get a phone signal. Let’s not forget that a blockchain allows users to verify the token’s authenticity and to do so keep historical data. It is as if you know all the users who have used the €5 note you have in your hand now… limited interest except in an Orwellian view of the world … In any case, a proper retail CBDC must respect technically and financially its payment instrument of last resort status.

This is also likely to affect the structure of the money supply. For commercial banks, this could mean fewer deposits. Because bank deposits are created as part of credit transactions. This is the process of money creation. If tomorrow a substantial part of these bank deposits – which also constitute a very important resource for banks to ensure the financing of the economy – were to be converted into central bank digital currency, it would be as much less resources and bank reserves at central bank level for commercial banks. In the same way that a flight of bank deposits and reserves from commercial banks to fiduciary money leads to a fall in the credit multiplier and the ability of banks to lend to the economy. Not ideal, given the current economic situation….

Exploring a role for Wholesale CBDCs

A second way could be the use of CBDCs to facilitate and secure only large cross-border payments. On condition of determining a threshold – by amount – high enough to avoid problems of saturation of the blockchains. Membership would be limited to large clearers representing smaller players and corporates in the ecosystem. But this raises the question of interoperability and future of payment infrastructures. Are we going to keep traditional payment infrastructures such as SEPA or TARGET2. Or are we going to replace them with DLTs?

Finally, central banks could decide to focus only on programmable money and programmable payments. They would work with commercial banks to establish the taxonomy of rules and smart contracts that would trigger automatic payments. The variety of business processes that can be mapped by such rules is very large and covers a wide area ranging from securities services to the processing of secured loans, including the world of trade finance and supply chain; especially if at the same time the different national laws recognize the electronic form of legal contracts and negotiable securities (MLETR). In general, electronic negotiable instruments incorporate a right (obligation to pay sums of money, right to obtain the performance of an obligation which may be the delivery of a thing or a service).  There is a role to play for the CBDCs acting at trusted third party, controlling the transfer of rights process, and stopping it automatically if conditions are not met. Definitively an interesting route to explore. A clever way to use the “Machine of Turing” philosophy.

Either way, the creation of CBDCs should not just be a counter-reaction to crypto currencies or a desire to subscribe to the fashion of the moment. It must respond to a real economic or financial need and must remain within the framework of the strict mission assigned to central banks, especially ensuring financial stability.  The recent Terra Luna crash is here to remind us that there is no money without trust, and no trust without monetary reserves even in the stablecoin world. Should CBDCs be limited to payments, or should they be used as cash and be interest bearing? Let’s hope that the central banks will clarify their strategy sooner rather than letter. In the meantime, a first good step would be to see the MiCA regulation implemented, ensuring at least all players providing access to crypto assets to be under the same regulation than traditional banks and financial players.

In any case, the economic development of nations requires a harmonious coexistence between central banks and commercial banks. We must therefore work on these subjects in cooperation. It’s time to get out of the labs and back to real life….

« Do not have two different weights in your bag, one heavy and one light. Do not have two different measures in your house, one large and one small. So that you may live long in the land, the Lord, your God is giving you »

Deuteronomy 25:13-16

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