As dollars, euros, and yuan are replaced by bytes, some changes will be supported, while others may not.
Money has changed human society by enabling commercial and trade transactions even between geographic regions that are far apart. It has made possible the movement of wealth and resources across space and time. But for most of human history, it has also been a subject of greed and waste.
Now money is about to undergo a change that could transform banking, finance, and even the structure of society. Most remarkably, the era of physical, or cash, money is coming to an end, even in low- and middle-income countries; the era of digital currencies is coming. In both the national and international arenas, a new phase of competition between official and private currencies is about to begin. The proliferation of digital technologies that is driving this transformation could spur useful innovations and increase access to basic financial services. But there is a risk that technology could increase the concentration of economic power and allow large corporations and governments to further interfere in our financial and personal lives.
Traditional financial institutions, especially commercial banks, are having difficulty with their business models, as new technology makes online banks, which can reach more customers, and online platforms, which provide a direct link between depositors and borrowers, more common. These institutions and platforms increase competition, foster innovation and reduce costs. Depositors have access to an expanded array of savings, credit and insurance products, and small businesses can secure financing from sources other than banks, which typically have strict credit assessment and collateral requirements. Making domestic and international payments becomes cheaper and faster, which benefits consumers and businesses alike.
Concerns about stability
Initially, it seemed that the emergence of cryptocurrencies such as bitcoin was likely to revolutionize payments. Cryptocurrency transactions do not depend on central banks or trusted intermediaries such as commercial banks and credit card companies, eliminating the inefficiencies and added costs associated with these intermediaries. However, their price volatility, as well as transaction volume and processing time constraints, have made cryptocurrencies inefficient as a medium of exchange. New forms of cryptocurrencies, called “stabelcoins,” most of which, oddly enough, are backed by central bank reserve money and government securities, have become more common as a means of payment. The underlying distributed ledger technology is driving a massive monetary change that will deeply affect households, businesses, investors, central banks, and governments. This technology, by providing secure ownership of purely digital objects, is even driving the emergence of new digital assets, such as non-interchangeable tokens.
At the same time, central banks are concerned about the implications for financial and economic stability if decentralized payment systems (offshoots of bitcoin) or private stackcoins displace both cash and traditional payment systems run by regulated financial institutions. A payment infrastructure that is entirely in the hands of the private sector can be efficient and cheap, but some parts of it may cease to function if credibility is lost in times of financial turmoil. Without a functioning payment system, the modern economy would grind to a halt.
In response to such concerns, central banks are considering issuing central bank money in digital form for retail payments – central bank digital currencies (CBCs). The rationale ranges from increasing financial inclusion (providing easy access to a free digital payment system even for those without a bank account) to improving the efficiency and stability of payment systems by creating a public option for payments as a support mechanism (cash currently plays this role).
The CSEC has other potential benefits as well. It will discourage illegal activities such as drug transactions, money laundering, and terrorist financing that rely on anonymous money transactions. It will help bring much of the economic activity out of the shadows into the formal economy, making tax evasion more difficult. Small businesses would benefit from lower transaction costs and avoid the hassles and risks associated with using cash.
The risk of mass withdrawals from bank accounts
However, CSEC also has disadvantages. First, it poses risks to the banking system. Commercial banks are critical to the creation and distribution of credit that keeps the economy running smoothly. What if households moved their money from regular bank accounts to digital wallets from the central bank, perceiving them as more secure, even if they do not accrue interest? If commercial banks ran out of deposits, the central bank could find itself in the undesirable position of having to take over the distribution of credit and deciding which sectors and firms deserve to borrow. Moreover, the central bank’s retail payment system could even wipe out private sector innovations aimed at making digital payments cheaper and faster.
Of equal concern is the potential loss of privacy. Even with privacy protections in place, any central bank will want to keep verifiable records of transactions to ensure that its digital currency is only used for legitimate purposes. Thus, the CFTC poses the risk of ultimately destroying any vestiges of anonymity and privacy in commercial transactions. Careful design of digital currencies using rapidly evolving technical innovations can mitigate many of these risks. Nevertheless, despite all of its benefits, the prospect of eventually supplanting cash with CSDs should not be taken lightly.
New technology could make it difficult for a central bank to perform its key functions, namely keeping unemployment and inflation low by regulating interest rates. When a central bank, such as the Federal Reserve, changes its key interest rate, it understandably affects interest rates on commercial bank deposits and loans. However, if the proliferation of digital credit platforms reduces the role of commercial banks in mediating between depositors and borrowers, it will be unclear how this transmission mechanism of monetary policy will continue to function and whether it will continue to function.
Competition of currencies
The basic functions of money issued by the central bank are on the verge of change. Just a century ago, private currencies competed with each other and with government-issued currencies, also known as fiduciary money. The emergence of central banks has decisively shifted the balance in favor of fiduciary money, which serves as a unit of account, a medium of exchange, and a means of savings. The emergence of various forms of digital currencies and the technology behind them has now separated these functions of money and created direct competitors to fiduciary money in some areas.
Unless market forces are controlled, some money issuers and payment technology providers could become dominant.
Central bank currencies are likely to retain their importance as a means of savings and, for countries that issue them in digital form, also as a means of exchange. Nevertheless, the importance of payment systems that mediate privately is likely to grow, increasing the competition between various forms of private money and central bank money for the role of medium of exchange. Unless market forces are controlled, some money issuers and payment technology providers could become dominant. Some of these changes may affect the very nature of money – how it is created, what forms it takes, and what role it plays in the economy.
International money flows
New forms of money and new channels of movement of funds within and between countries will change international capital flows, exchange rates and the structure of the international monetary system. Some of these changes will have great benefits; others will create new difficulties.
International financial transactions will become faster, cheaper and more transparent. These changes will be a boon for investors seeking to diversify their portfolios, firms seeking to raise money in global capital markets, and economic migrants sending money back to their home countries. Faster and cheaper cross-border payments will also stimulate trade, which will be especially beneficial for emerging and developing countries, which depend on export revenues for a significant share of their GDP.
However, the emergence of new channels for cross-border flows will facilitate not only international trade but also illicit financial flows, creating new challenges for regulators and governments. It will also make it more difficult for governments to monitor cross-border flows of legitimate investment capital. This poses particular problems for emerging economies, which periodically suffer economic crises as a result of large sudden outflows of foreign capital. These countries will be even more vulnerable to monetary policy measures by the world’s major central banks that could trigger capital outflows.
A central bank’s digital money is as reliable and trustworthy as the institution that issues it.
Neither the emergence of a central bank, nor the lowering of barriers to international financial flows, will by themselves have a significant impact on changing the international monetary system or the balance of power between major currencies. The cost of direct transactions between pairs of emerging market currencies is falling, reducing the need for “key currencies” such as the dollar and the euro. However, the major reserve currencies, especially the dollar, are likely to maintain their dominance as a savings vehicle because this dominance depends not only on the size of the economy and the depth of the issuing country’s financial market, but also on the strength of the institutional framework that is needed to maintain investor confidence. Technology cannot replace an independent central bank and the rule of law.
Similarly, central banks will not address major deficiencies with respect to central bank credibility or other issues, such as the government’s disorganized fiscal policy, which affects the value of the national currency. When the government runs significant budget deficits, the assumption that the central bank can be instructed to create more money to finance these deficits tends to increase inflation and reduce the purchasing power of central bank money, both physical and digital. In other words, central bank digital money has as much credibility and trust as the institution that issues it.
The role of government
In the coming years, central banks and governments around the world will have important decisions to make about whether to resist the adoption of new financial technologies, passively embrace the innovations offered by the private sector, or take advantage of the potential efficiency gains that new technologies provide. The emergence of cryptocurrencies and the prospect of CSDs raise important questions about the role the state should play in financial markets: whether it should intrude into areas preferably left to the private sector and whether it can compensate for market inefficiencies, especially the large number of households unbanked or underbanked, in developing countries and even in advanced economies such as the US.
As the recent ups and downs associated with cryptocurrency show, regulation of this sector will be important to maintain the integrity of payment systems and financial markets, provide adequate investor protection, and promote financial stability. Nevertheless, given the vast demand for more efficient payment services at the retail, wholesale, and cross-border levels, private-sector-led financial innovation can bring significant benefits to households and businesses. In this respect, the key challenge for central banks and financial regulators is to balance financial innovation with the need to reduce risks to uninformed investors and overall financial stability.
New financial technologies promise to facilitate even poor households’ access to a range of financial products and services, thereby democratizing finance. But technological innovations in finance, even those that can deliver more efficient financial intermediation, can have double-edged consequences for income and wealth inequality.
The benefits of innovations in financial technology can come mainly from wealthy individuals who can use them to increase financial returns and diversify risk, while existing financial institutions can exploit these changes for their own benefit. Moreover, because those who are economically excluded have limited access to digital technologies and lack financial literacy, some changes may create investment opportunities for them whose risks they are not fully aware of or which are unacceptable to them. Thus, the implications for income and wealth inequality, which have increased dramatically in many countries and contribute to political and social tensions, are far from clear.
Another key change will be an increase in stratification, both nationally and internationally. Small economies and countries with weak institutions may see their central banks and currencies lose weight, with even more economic and financial power concentrated in the hands of large economies. Meanwhile, large corporations, such as Amazon and Meta, could increase their influence by controlling both trade and finance.
Even in a world with decentralized finance built around bitcoin’s innovative distributed ledger technology (which is likely to be its true legacy), governments play an important role in enforcing contractual and property rights, protecting investors, and ensuring financial stability. In the end, it seems that cryptocurrencies and innovative financial products also work better when they are built on trust from government oversight and control. Governments have a responsibility to ensure that the laws and measures they pass promote fair competition, rather than favoring incumbent market players or allowing larger players to stifle smaller competitors.
Centralization or fragmentation
Financial innovation will create new and as yet unknown risks, especially if market players and regulators place undue trust in technology. Decentralization and its corollary, fragmentation, have advantages and disadvantages. They can increase financial stability by reducing centralized weaknesses and increase resilience through greater power reserves. On the other hand, while fragmented systems can work properly under good conditions, in difficult circumstances, confidence in them can be fragile. If the financial system is dominated by decentralized mechanisms that are not directly supported (like banks) by a central bank or other government agency, confidence can easily evaporate. Thus, decentralization can provide efficiency in good conditions and lead to rapid destabilization in tough economic times.
Also, significant changes in the structure of society are possible in the near future. The displacement of cash by digital payment systems could eliminate any residual privacy in commercial transactions. Bitcoin and other cryptocurrencies were designed to provide anonymity and eliminate dependence on governments and large financial institutions to conduct trade. However, they could precipitate changes that would eventually lead to privacy breaches. Societies will struggle to control the power of governments as individual freedoms are increasingly compromised.