Updated: Mar 2
Paper money (and coin) will eventually disappear
Paper money is a paradox - a technology which is thousands of years old that has, until recent times, been impossible to recreate in an alternative format. Even though paper money use is still dominant in many countries, the movement to electronic payments is inevitable (short of our global leadership facilitating a return to the stone age). Covid-19 has exaggerated a pre-existing trend towards cashless payments, where retailers and consumers now fear physical money as a mode of infectious transmission. Good news - we now have the technology to replace cash. Sweden predicts that it could completely stop utilizing paper money by 2023. India has banned larger currency notes to curb tax cheating and illicit markets. China uses distributed ledger technology (DLT) for its digital renminbi, which is currently being tested in a few cities with the expectation for full roll-out nationwide by 2021. Paper money is in a losing game.
The responsibility to maintain stability
Governments have a role to play in the maintenance and stability of our monetary systems. One way that they do this is through a legal requirement to know your client (KYC), particularly concerning transactions over a monetary threshold. KYC protocols are a conventional approach to curbing illicit movements of money.
In an environment where electronic transactions are relatively private and anonymous (i.e. Bitcoin), even with pseudo layers of KYC/AML precautions, there is an argument to be made that monetary stability is at risk. A transaction is anonymous if no one knows who you are. A transaction is private if what you purchased, and for what amount, are unknown. Bitcoin is anonymous but not completely private because every transaction is visible in the ledger. Once transactions become recurring or regular, those transactions can be analyzed to determine who you are, making cryptocurrencies less anonymous than cash. Cash, and to lesser degree cryptocurrencies, both provide easy routes to laundering and illicit trade, presenting a threat to the governmental responsibility of maintaining stability. Governments are therefore obliged to find a relevant alternative on behalf of their electorate.
Transaction processing is currently too expensive
Conventional digital transactions impose costs ranging from a small percentage (e.g., 1–3% for credit card purchases) up to highs of one-fifth of transferred amounts (e.g., international remittances). High transaction costs are a problem largely created by banks and other intermediaries that ask for significant fees to pay for infrastructure that may have little or no bearing on the actual cost of the service.
High transaction fees are a significant problem for small value digital transactions; this disproportionately affects poorer populations that purchase on an as-needed as-can basis. In this sense, high transaction fees contribute to a dangerous pattern of un- and underbanked people (currently at 1.7 billion worldwide). Lacking access to finance forces them to rely on physically holding currency, thereby limiting themselves and economic exchange to those available within their physical proximity.
The promise of a mobile phone, with a digital wallet and digital currency, opens up a new world of transaction and investment possibilities. (Of course, it’s not as simple as that, but it is exceedingly more possible than it would have been in a pre-smartphone era.) Small value transactions are particularly well suited to be run on a distributed ledger, where transaction fees can be lower than our fiat systems. However, right now, the transaction processing industry is being inhabited by the new VISA’s of the world. WeChat and Alipay are your new banks. It is a step forward, but is it a step forward down the best path?
People inherently trust government-backed financial systems (if elected by consensus)
The inherent trust that government-backed financial systems have is a complex product of history, the reserve system, and the inability for suitable competitor systems (i.e. cryptocurrencies like Bitcoin) to go mainstream. With this inherent trust, governments and regulated banks are beginning to provide banking services in a digital way (even when the currency itself is not yet in digital form). For example, the digits in your bank account stand for dollars, and you can pay with dollars with your credit card. But the digits in your bank account are debts that your bank owes you. Confidence in your ability to reclaim or use those dollars comes from the government that backs the banks.
Going further, in most countries, a government IOU is less risky than an IOU from a commercial bank, particularly during an economic crisis or pandemic. Corporate credit can be less risky than country credit, although the corporate economy of many global entities far exceeds those of sovereign states. Nonetheless, companies still lack the power to print new money – rightfully so.
The inherent trust that a consensus elected government can provide enhances the case for its particular role in a distributed ledger financial system.
Alternative digital currency systems don’t hold much promise for going mainstream (yet)
Eleven years into Bitcoin’s life, the technology still lacks some of the necessary features of a currency. It is difficult to use, transactions can take more than an hour to process, and the currency’s value is extremely volatile. As already noted, the supposedly anonymous transactions that the Bitcoin network enables, can be traced. The slowness in the current systems is a design facet, not a design flaw. They forsake scale, speed, and cost, favouring decentralization and resistance to censored activity (i.e. the exchange of illicit goods or services, to provide anonymous support to political causes, to subvert cross border currency controls, etc.)
Changes to ethereum (another cryptocurrency network) are proving to be difficult, and the switch to a proof of stake model (how consensus is achieved in verifying transactions) may remain to be a bridge too far. Until these projects can scale to process transactions quickly, securely and inexpensively, they cannot compete with the incumbent systems – even in their new clothes (CBDC).
The rise of Central Bank Digital Currencies (and the fate of existing cryptocurrencies)
CBDCs are in vogue, and for good reasons. A few front runners are China and South Korea. The Bank of Korea, South Korea's central bank, is set to test digital currency for pilot transactions in 2021, and China is already in the testing phase. This progress will give these countries a huge advantage in banking efficiency. Many people (including those outside of China’s geopolitical borders) may start using and storing value in these digital currencies. Once a digital currency gains adoption in a certain jurisdiction and has the required network computer infrastructure, the features will become so attractive, its user base will grow extremely rapidly. This growth could create bank runs inside and between countries as people shift money into CBDCs, especially if cross-border controls don’t get established. This trend may further inflate when interest rates go negative in some countries.
A shift from fiat to digital currencies will certainly challenge the comprehensiveness and effectiveness of existing regulatory, supervisory and oversight controls of the central banks of each country. These countries will have to follow quickly, or they may become forced into adopting another country’s system. Central banks with a digital currency would be in charge of the issuance and redemption of the digital currency. Depending on the wholesale and retail, direct or indirect structure of CBDCs, the role of private financial institutions will change or entirely disappear.
Once a single country makes the final push towards a digital currency, all countries will face extreme pressure to follow to prevent a potential underground market economy based upon foreign digital currency use for transactions (value exchange) within domestic borders.
Private companies will be quick to adapt and will be looking to monetize spending data. However, it becomes exceedingly difficult to imagine a private digital global currency such as Facebook’s Libra being successful. The case for a government-backed distributed ledger financial system is strong and amplified (for better or worse) by the strength of interests at play (including but not limited to control through transaction tracking and taxation.)
For all of the other existing cryptocurrency projects, the best-case scenario would see their efforts rewarded by being adopted by countries for use as the base system in creating their CBDCs. For this to happen, they would need to demonstrate greater capability (than currently possible) in handling complex transactions at greater speeds (without compromising security or scalability) for global trade via tokens. In this frame, the underlying currency of trade will be digital avatars of current global currencies. It will be interesting to see who will be the winner of this huge prize.
A government authority that is elected by consensus is in the best position to lead the charge. When trusted, governments can establish a distributed ledger while managing multiple nodes for security and redundancy. In doing so, a government must be ready to maintain the security systems and prosecute bad “digital” actors. The true test of governments will be their ability to coordinate across borders.