On August 13, San Francisco Fed Governor Lael Brainard gave a promising speech on digital currencies, including Central Bank
Unheard of 2 years ago, it is refreshing to see a Central Bank embracing technological innovation with such fervor, including assistance from MIT. The Fed Governor discussed the opportunities of CBDC in regard to resilient payment infrastructure, financial inclusion and monetary policy execution. At the same time the Governor expressed apprehension regarding risks associated with privacy, cybersecurity, illicit activity and financial stability, pertaining to the crowding out effect of private endeavors, like Bitcoin and Facebook’s Libracoin.
Before moving into more detail, I like to share the following definitions to help clarify the taxonomy of digital money. Digital money is currency not held in physical form. It can either be token (digital) or account based. Crypto-currency is digital money, which is supported by distributed ledger technology (DLT, often by extension referred to blockchain), allowing for peer-to-peer transfers over a network. Furthermore, it uses cryptography to validate underlying transactions (to a block). CBDC is digital money issued by a Central Bank. Stablecoin is a crypto-currency, whose underlying value is pegged to some form of collateral.
A speech is often more revealing by the topics it didn’t address. As such there was no reference in the Fed Governor’s comments regarding the impact on seigniorage, the disintermediation risk for commercial banks (credit granting privilege) and the democratic oversight of money in general and the new digital currency in particular. The Governor didn’t mention the opportunity to weaken the increased incidence of banking crises nor the scope to enhance the reserve currency status of the US dollar. And finally, the Governor remained silent about the option, in the face of the current five-headed crisis (public health, climate change, financial, social justice and public trust (in institutions and international trade) to create a new CDBC to alleviate these societal ills and/or a CBDC stablecoin as a proxy for a new anchor currency to mitigate market concerns about fiat currencies. Let’s unpack each of the topics not mentioned in the address.
Seigniorage is the return generated by a Central Bank for printing cash money (coins and notes) at cost of the physical bank note, precious metal and printing press and the sale at face value of such cash money to commercial banks. Removing the cash printing component to the benefit of digital currency would neutralize that return. Maybe it was considered insignificant given the magnitude of the overall challenges.
Disintermediation Risk For Banks
Contrary to general belief, Central Banks only create money when cash money is printed and when non-traditional monetary policy is executed by means of Quantitative Easing (QE). Regarding the former, there are currently about $2 Trillion of physical coins and notes in circulation. The money printing by QE is facilitated by a digital credit line, availed by Treasury to the benefit of the Central Bank, which the Central Bank subsequently taps into to buy distressed assets from institutional investors and financial institutions as part of a bail out strategy.
The Fed’s balance sheet on August 12, 2020 stood at almost $7 Trillion, representing cumulative QE assets to the tune of about $6 Trillion, of which roughly $3 Trillion have been added since the onset of COVID-19.
The money measure, called M3 or broad money, stands at the moment at about $18 Trillion. M3, adjusted for the coins and notes in circulation, represents money being generated by commercial banks as a result of their credit granting capacity and (digital) money printing privilege. Figuratively speaking, M3 complements the space between the coins and notes in circulation and the amount of QE outstanding, both issued by the central bank. CBDC would offer retail customers opportunity to move out of physical cash and/or bank deposits in favor of the Central Bank’s digital offering. As such commercial banks might fret about the potential infringement on their credit granting license and money printing privilege. Will their rebuke be met with an outsourcing offering of the CBDC through commercial bank accounts or will full disintermediation take place by designating BigTech to facilitate the digital currency offering on behalf of the central bank?
Money Control and Banking
Since the breakdown of Bretton Woods in 1971, “…the world has suffered from 12 financial crises, beginning with the oil shock of 1973 and culminating in the financial crisis of 2008-09 and the debt crisis in Europe in 2012, and the growing deficit crisis in the U.S. Conversely, between 1947 and 1971, there was only one currency crisis, involving the British pound, and no major bank failures or Wall Street and corporate bailouts in the U.S.”
The extent of money printing and credit extension, in absence of a tie to a finite, precious good, can hugely influence markets’ financial stability.
Since 2000, we have seen M3 increase by 360%, fueled by tremendous bank credit and QE policy expansion, in response to the 2008 financial crisis and COVID-19 pandemic. The amount and pace at which (fiat) money is printed or credit is granted, and the subsequent allocation to the real economy (loans and credits to industry) or the financial economy (loans and credits into financial instrument position taking) each determine the occurrence and size of boom and bust cycles. All of which influence the overall health and well-being of society.
Banks’ prudential oversight is currently addressed through the Dodd-Frank regulation, promulgated by Congress in 2012. The regulation has been successful in ensuring financial institutions’ adequate liquidity health and overall solvency strength. The Quantitative Easing and respective bail out practices, on the other hand, make it very strenuous to scrutinize to whom money has been extended and to what benefit of society at large.
How could the introduction of central bank digital currencies make money creation more transparent? Who would control the size of the digital currency issuance? Which risk management metrics and algorithm will be applied to determine who will receive what amount when? Would Congress monitor that activity? Could the mechanism level out boom and bust cycles? How could it improve the resiliency of the planet and its people? How could it positively impact the financial and economic health of society and its individual members at large?
Reserve Currency Status
Brainard’s speech didn’t address recent concerns regarding the reserve currency status concerns of the US dollar or China’s current lead in the CBDC race, which could advance its national interests. The reserve currency status is among others determined by the resilience of a country’s payment system, depth and trust in the well-functioning of the capital markets and exchanges, appeal to and innovation acumen of its tech industry and financial market infrastructure, international thought leadership, lead into climate change solutions and the global military might and power base, which reinforces adoption of a currency. (Customers pay for oil in the currency of the nation which offers regime protection at the oil fields. Asians and Europeans move every month out of their home currency in favor of the US Dollar to pay for their imported oil bill). Global adoption can also be ensured if censorship or control concerns, linked to the use of the CBDC, can be substantially mitigated.
Referring to innovation acumen and climate change solutions, could the central bank digital currency project incorporate scientific data observations regarding climate change triggering terrestrial and atmospheric trends? Could TRACE, a consortium tracking greenhouse gas emissions 24/7 by satellite, foster a balance between monetary policy and a thriving planet and be made part of this initiative? Could monetary policy be framed incorporating observations from those data trends, with support from climate scientists? Could digital currency be directed at ZIP code levels, impacted by climate change calamities? From a supervisory perspective, could solvency weightings for banks’ asset exposure be dynamically set as a function of the data observations and the remaining finite carbon budget? Could bank stress testing scenarios under CCAR (Comprehensive Capital Assessment and Review), undertaken to assess the banks’ adequacy of solvency levels, be articulated as an extended continuum of such climate change observations?
Innovative monetary design ingenuity linked to climate change solutions can only solidify the continued appeal in the US dollar as the global reserve currency.
The Current Five-Headed Crisis
The current crisis is five-headed in nature, characterized by a public health crisis, a financial crisis, a social justice crisis, a climate change crisis and a trust crisis in institutions and international trade.
Could a central bank digital crypto currency address each of the crisis challenges? How could financial inclusion offer a dent into the social injustice paradigm? How could distributed, decentralized and crypto-graphed data sharing enhance trust in institutions? How could the Central Bank consensus protocol be made more energy efficient than the private crypto-currency protocols? How could smart contract design introduce a central bank digital currency-based reward economy?
Instead of offering mere helicopter money, could compensation be offered in exchange for contributions to the regenerative (climate change) and caring economy (childcare and parental care at home)? How could blockchain supported supply chain data trace the global export and import flows in relationship to FX trades and exchange rates? How could market intervention and/or sustainable change to circular economic paradigms be steered on the back of those data?
Need For A New Anchor Currency
The debasing of currencies by the most important central banks ($6 Trillion of QE in the US alone), the arising currency tensions in the emerging markets (e.g. Lebanon, Turkey, South-Africa,….) and the COVID-19 default impact on total debt outstanding of $258 trillion per Q1 2020 will only accelerate the need and call for debt rescheduling and ensuing FX rate mechanism interventions. If gold is no longer an option, could a central bank issued stablecoin, finite in supply, become a store of value or new anchor currency to manage the restructurings and market support activities?
Brainard’s speech makes reference to a new initiative with the Bank of International Settlement’s Innovation Hub. This initiative could provide a useful avenue to design such Central Bank stablecoin.
The collateral base of the stablecoin could consist of a reserve of natural capital assets, consisting of 50% of land and forests, 35% In renewable energy initiatives, and 10% in the top 100 most compliant ESG companies and 5% in biotech research. The collateral base would be managed dynamically, but would also benefit from monetary policy and prudential supervisory decisions aimed at regenerating the natural capital base on earth and replenishing its finite carbon reserve. The supply could be managed, within a range, as a function of the TRACE observations.
On the occasion of Bretton Woods II, the new Central Bank Stablecoin could be introduced and offered, akin to the gold standard, as a fixed rate against all other fiat currencies, including the US dollar.
Milton Friedman once observed, only a crisis – actual or perceived – produces real change. When that crisis occurs, the actions that are taken depend on the ideas that are lying around. Then, ideas once dismissed as unrealistic or impossible might just become inevitable.