This is the third of a 3-part series on central banks. Part 1 looks at how central banks are turning to digital solutions. Part 2 explores challenges around interoperability.
“Innovation may not be the first thing that comes to mind about central banks,” said Banque de France’s governor at this year’s Singapore Fintech Festival, in November. “After all, our institutions have been around for quite some time.”
Francois Villeroy de Galhau noted that France’s central bank has been around for two hundred years:
“We are more associated with stability than disruption. Yet the blossoming of digital innovation has the potential to transform the financial system in its entirety.”
In the early days of central banking, these institutions could also be sources of instability – as any French central banker should know.
Experiment gone wrong
Banque de France emerged from the ashes of France’s first attempt at a central bank, Banque Royale. Banque Royale was run by John Law, a maverick Scottish financier, with the support of the French monarchy. It was a time of experimentation with newfangled ideas such as paper money, and as governments attempted to get their heads around this financial innovation, they made mistakes.
Banque Royale’s mission was to get France out from under massive war debts, but Law turned it into a private speculative machine that bankrolled another of his gambits, the Mississippi Company, which had supposedly found an El Dorado in North America.
Banque Royale pioneered issuing paper money, but it printed more than its reserve of coinage could repay. The gains from the Mississippi Company were meant to go to retiring government debt, but the company never made a profit. For a while, this mismatch didn’t matter: speculators in Paris and London, suffering a severe case of FOMO, eagerly bought Mississippi shares. With monarchal backing, it seemed like a sure thing.
Until, of course, the market realized that Mississippi was a sinkhole, prompting a run on Banque Royale. The bursting of the bubble, in 1720, bankrupted France and forced the closure of the central bank. It would be another hundred years before France dared dabble in paper money again – or even attempted central banking. Banque de France was only named the government’s sole issuer of money by Napoleon, in 1800, on the condition it stuck to minting coins.*
New experiments required
Today we are at a new turning in financial history, with the transformation of payments by fintech and the emergence of blockchain-based finance. These movements are now too big for central banks to ignore. Technology has a way of hollowing out institutions. They must either race to help shape the new trends, try to catch up, or expire.
It’s a risk for the world if these institutions fail to keep up or see their authority badly eroded. The entire world relies on central banks to maintain stability, supervise markets, and support economic growth. These guardians are now hard pressed to find ways to moderate a world of stablecoins, cryptocurrency, and a proliferation of payment rails outside of traditional infrastructure.
Harking back to the failure of Banque Royale, it seems likely that as governments attempt different models to participate in digitalized finance, some of them will get it wrong. Even Banque Royale-level, bankrupt-the-country wrong. El Salvador comes to mind.
Authorities recognize what’s at stake.
“Money, finance, and the internet will impact economies and societies,” said Ravi Menon, head of the Monetary Authority of Singapore, during Singapore Fintech Festival. “Authorities, financial services and technology communities need to work together so we can expand opportunities, enhance social inclusion, foster stability, and protect the planet.”
That’s a tall order for central banks.
It’s no longer about the tech
But the ball is increasingly in their court. The most revolutionary aspects of fintech – smartphones, cloud computing, blockchain – are already here.
Even the most recent initiatives involving the future of money are not about the tech. Take Partior, a company to clear and settle payments using blockchain co-founded by DBS, J.P. Morgan and Temasek. Takis Georgakopoulous, global head of payments at J.P. Morgan, described Partior’s tech as “maturing”.
“The challenge is more around regulatory questions,” he said, such as compliance, streamlining documentation, and establishing rules for handling cross-border payments and transactions. But: “There’s no sense of strategy among regulators.”
Both commercial banks and their regulators are trying to maintain the status quo and traditional ways of doing things while also adapting to disruption, or even being disrupters themselves. Nowhere is this most evident than in discussion around central-bank digital currencies.
Stablecoins and CBDCs
There are a few small countries pioneering CBDCs, such as the Bahamas and Cambodia. Medium-sized wealthy countries like Canada, Sweden, and the United Kingdom have advanced research. China is already piloting a retail CBDC (ie, digital cash for ordinary citizens and businesses). China hopes its digital renminbi will provide an escape hatch from dollar dependency in trade, and make the renminbi a global reserve currency.
But the real change will come when one of the big three currencies used in global trade and payments comes up with a digital version of cash: the yen, the euro, or the dollar.
What is this change? There’s been reams of research into designs and use cases. Initiatives like Project Dunbar are experimenting with questions of interoperability, which, at the wholesale level, can allow central banks and qualified commercial banks to make cross-border payments without intermediaries. Local standards and practices are left to participating central banks in their own markets, with Dunbar as a layer on top that can connect to everyone’s domestic payments systems.
Proponents of CBDCs tend to roll their eyes when the Federal Reserve or European Central Bank are mentioned. The Fed in particular has been skeptical of the need for a digital dollar. The U.S. system, including its regulators, is diverse and other institutions seem more proactive on this question. But the Fed is the key institution for questions of money and its issuance.
However, the Fed may not be as backward as its critics assume. Its focus lies elsewhere.
Christopher Waller, a member of the Federal Reserve Board of Governors, says in a recent paper that the rapid innovation in payments, driven by fintechs, may render a U.S. CBDC irrelevant. But he recognizes the importance of stablecoins as the bridge between the traditional financial system and crypto.
Waller’s November 17 paper, “Reflections on Stablecoins and Payments Innovations”, suggests regulating stablecoins to avoid a destabilizing run, and ensure their integration into traditional payments systems is done securely.
Important to his argument is to say that stablecoins do not need to be fully regulated as banks. Banks fulfill dual functions of facilitating payments and lending against deposits, a means of money creation. So long as stablecoins are merely payment instruments, and that market forces and competition keep them from monopoly positions, they can be regulated as such.
Act now before this spins out of control
The big economies are a ways off from figuring out what to do. China would appear to be the first to get ahead of the curve and develop its own digital cash. Whether the others respond in a timely manner has yet to be seen. But crypto is no longer a niche, isolated market. It is increasingly penetrating the traditional financial markets, often from directions that would surprise a central bank analyst, such as video games.
If securities tokenization takes off, the blockchain-based world of finance will demand central banks respond to safeguard trust in their currencies and maintain financial stability.
Central bankers say they welcome these changes. They recognize that competition and innovation is good for their citizens. They are not, however, about to let go of their roles. As Villeroy put it: “I strongly disagree with the idea that confidence in rules and public institutions can be replaced by some form of ‘algorithmic confidence’ once and for all.”
But what really matters is that digitalization and new rails just makes finance bigger and bigger. Ideas like Web3 and the metaverse – the subject of our next series – will accelerate this exponentially. More derivatives, more coins, more ways finance and its seedier side gets embedded into everyday lives.
If central banks are going to remain guardians of stability and trust in money, they have to be at the heart of the future of finance. But, as the history of early central banking shows, the danger of invention is the possibility of getting it very wrong.
*To scratch your financial-history itch, see Jame DiBiasio’s “Cowries to Crypto: The History of Money, Currency, and Wealth.”
