This is the first in a three-story series on innovating central banking. See also part 2, What Does Interoperability Mean for CBDCs? and our concluding article, What If Central Banks Screw This Up?
Central banks ensure economic and financial stability, including the stability of money. They maintain or supervise financial infrastructure. Through the setting of overnight interest rates and open-market operations, they are the keystone to prices throughout the economy.
The twin blows of the 2008 financial crisis and the COVID-19 pandemic have put central-bank models under intense strain.
The response to the financial crisis in the U.S., eurozone and U.K. was ultra-low or even negative interest rates and quantitative easing, a program of asset purchases meant to impact the longer end of the interest yield curve, to spur credit creation by commercial banks.
Although central banks saved the world from a calamitous depression, they have destroyed the ability to save, fueled asset-price speculation, worsened inequality, fomented asset bubbles, and prompted fears of currency debasement (although this last concern is probably more on the shoulders of governments’ fiscal policies).
No exit
And this was before COVID struck, forcing central banks to turbocharge QE and related measures. It is now even more difficult for central banks to restore some degree of normalcy: financial markets are thoroughly addicted to money’s being virtually free.
“The challenge is policy normalization after 10-15 years of non-standard approaches,” said Ulrich Bindseil, director-general for market infrastructure and payments and the European Central Bank, speaking at this year’s Sibos event.
That task has only gotten harder. Central banks face new political pressures to guide financial markets toward a new model of sustainable investment to combat climate change, as well as calls to boost financial inclusivity and wealth equality. One of the bright spots is that global growth is improving, but that good news is threatened by the specter of inflation.
And then came fintech
Amid this long list of challenges, central banks must also face the fintech revolution. The digitization of payments and the rise of cryptocurrency are now impacting central banks’ ability to supervise markets, regulate operators, and advance their nations’ sovereignty.
Some central banks have responded with elan, forging new paths in payment infrastructure, blockchain-based pilots, and even issuing their own digital currency.
“We’re not just asking banks to digitalize, but digitalizing ourselves, in how we collect data, and use structured and unstructured data to supervise and conduct macro surveillance,” said Howard Lee, deputy CEO at Hong Kong Monetary Authority.
The HKMA is an example of a monetary authority that has been building new infrastructure for the digital economy, such as its soon-to-launch Commerial Data Interchange, an open-API engine to support lending to small businesses.
The People’s Bank of China is developing a digital renminbi, while the Monetary Authority of Singapore has a range of payment and infrastructure projects on the go. Thailand and Cambodia’s central banks are also at the forefront of payments, digital supervision, and digital currencies.
The U.S. Federal Reserve System, by contrast, is a notable laggard. Perhaps for good reason: it is the single most critical financial institution in the world and the backstop of the world’s reserve currency. The U.S. market is, however, overly influenced by Wall Street’s biggest banks, who often have more to lose than to gain by modernizing America’s financial infrastructure.
Even in America, however, there is no escaping the impact of fintech on infrastructure and its disruptive power to banking models. Add it up, and fintech is forcing central banks to rethink how they regulate and supervise. Inevitably the response by central banks will be to go digital and to innovate.
Looking to innovation
One place to start is cross-border payments, traditionally the realm of correspondent banks.
The ECB, for example, has several working groups trying to update this infrastructure. “Technology has evolved,” Bindseil said. “I can do a lot of video calls for free. But cross-border payment fees have not declined over the past 20 years.” Remittances still cost on average 6 percent for small values, and a lot more in and out of emerging markets. “This is astonishing,” he said.
The biggest challenge to central banks is how to bring the innovations of crypto into a regulated manner. Many are exploring central-bank digital currencies, but each central bank is looking at unique designs, meant to address specific needs.
Meanwhile the private market is bounding ahead, with everyone from J.P. Morgan to Facebook issuing blockchain-based coins alongside crypto like bitcoin, ether, and ephemera like dogecoin, as well as stablecoins meant to tie a digital asset to a fiat currency, gold, or even other cryptocurrencies.
Central banks are looking at this development warily. They don’t want to squash innovation, but they also want to be sure their own initiatives are safe and constructive.
Tom Mutton, director of the Bank of England’s CBDC unit, says trust is vital. “If new forms of digital money arrive, they need to offer people the same confidence, resiliency and security [as existing formats].” He argues this can only be achieved if they are regulated.
Central banks will have another important role, Mutton said: interoperability, so that assets can trade across blockchains, be they run by governments, corporations, or decentralized operators. “Fragmentation causes inefficiency and leads to poor outcomes.”
This three-part series continues with our look at what really lies behind the jargon of “interoperability”.
