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Wealth Management: Strategy blog – Digital money goes mainstream

Strategy team: Victor Balfour

The crypto bug is catching: A hyperbolic tech entrepreneur, Redditers and now Central Banks?

It's perhaps not so surprising. Private cryptocurrencies – or unofficial digital currencies backed by secure cryptographic technology to be more specific - have emerged as one of the more exciting financial innovations of the past decade. The Distributed Ledger Technology (DLT) and the cryptography that underpins Bitcoin, Ethereum and the like, is digital, immutable, and private.

But it is not only private or 'unofficial' digital currencies – estimated to exceed 9,000 in number – that are gaining momentum: Central Bank Digital Currencies (CBDC) have the potential to upend payment systems and accelerate the demise of paper money.

In late 2019, the BIS estimated that almost four-fifths of monetary authorities were investigating the implications and feasibility of such virtual currencies, with some at pilot study stage. Among the majors, the European Central Bank is set to decide on a digital euro in mid-2021; the Bank of Japan may start to test a digital yen as a payment system this year; China's official digital currency, DCEP, is perhaps the most developed, and has already been rolled out across many major cities.

At present, central banks create money in the form of notes and coins, and (more importantly) electronic accounts. Physical currency in fact only accounts for just over a third of the US' monetary base, for example - the remainder exists digitally as commercial bank deposits ('reserves') at the central bank. These commercial banks can in turn create wider money by granting loans in excess of these reserves (the "fractional reserve banking" and "money multiplier" model). The new money lives digitally in the banking system's accounts.

A CDBC would potentially disrupt this existing model, by offering a digital payment instrument to the public at large. The intention is that such a digital currency would run in parallel to existing tender – there would be no change to the existing money supply.

The infrastructure is the distinguishing feature: though most transactions are already recorded digitally, the current system requires commercial banks to reconcile these movements. A CBDC would be potentially be recorded via a distributed ledger – though it could remain centralised - without the need for banks to intermediate such transactions.

There are some obvious benefits to a central bank validated virtual currency:

  • Reduces the costs associated with managing cash
  • Simple settlement and instantaneous clearing
  • Promotes financial inclusion – virtual currencies are potentially more accessible for the unbanked
  • Increases the stability of the payment system – away from large banks
  • Enhances monetary policy transmission – strengthening the pass-through to deposit rates

However, it is not without its challenges – not least of which is the possible disintermediation of banks. If there is less demand for their ledgers to validate digital transactions or store value, will they lose part of their raison d'etre? Would loans end up being more closely matched to deposits, leading to a narrower model of banking? If such a model followed – and banks were no longer able to easily (and profitably) extend loans - would a crucial channel of credit creation be weakened?

Given such complex issues, much of the policymaker discussion is still at the conceptual phase.

As for digital currencies more broadly, there are some notable differences between 'unofficial' and 'official' central bank varieties. CBDCs that utilise a decentralised ledger would rely on a so-called private network – in contrast, most cryptocurrencies, such as Bitcoin rely is public or 'permissionless' distributed ledger.

Such private ledgers are typically verified by a particular group, such as collection of banks or members of the same network – some unofficial currencies operate in this manner, including Facebook's Libra Coin. Crucially, these digital currencies are not 'mined', i.e. they don't rely on the 'Proof of Work' model that rewards public miners for validating a transaction, removing the wasteful energy consumption typically associated with Bitcoin and other public networks.
One obvious question is whether the current appeal of the new unofficial currencies would be undermined by a mainstream digital currency, backed and operated by a central authority. It will depend on how people view that appeal to begin with.

Traditionally, we think of "money" as having three functions: a means of payment; a unit of account; and a store of value.

People buying bitcoin expecting it to be a widely accepted form of tender or unit of account may be disappointed. Its wild volatility and clunky transactional times limit its widespread adoption.

In practice, of course, many buyers of bitcoin are hoping that its near 10-fold return over the past year (notwithstanding recent weakness) is heralding further gains in the future – they are buying it not so much as a store of value, but in expectation of its value rising even further.

But there is also genuine demand from savers who see private money as being less likely to be created profligately (the thousands of private currencies already in existence notwithstanding). In a potentially inflationary world, they do see bitcoin as likely to be a better store of value than official money (again, despite it having no track record in inflationary times).

For such bitcoin holders, CBDCs – as another variant of 'official' money, and so capable of being created when governments and central banks see fit – can never replace what they see as private currencies' most important and defining characteristics: their role as a hedge against monetary debasement, and their freedom from central authorities' scrutiny.

China's DCEP, for example, is being introduced under the guise of broadening the social agenda and connecting the largely unbanked rural poor (estimated to be nearly a fifth of its population). However, Beijing's authoritarianism, and its desire to diminish Tencent and Alibaba's dominant position in digital payments, shouldn't be overlooked. It has been suggested that DCEP amounts to a new form of potential surveillance.

Of course, we are still be some way away from CBDCs becoming a reality in many countries. The practical implications are yet to be fully fleshed out and the design will likely vary country-to-country. But the jury is also still out on whether today's unofficial, private moneys – such as bitcoin – do eventually morph into credible stores of value, or simply evaporate. It would be ironic – but not surprising, perhaps – if most private cryptocurrencies were to be outlived by the new forms of official money that arguably wouldn't exist had it not been for bitcoin's trailblazing.

Disclaimer

Past performance is not a guide to future performance and nothing in this blog constitutes advice. Although the information and data herein are obtained from sources believed to be reliable, no representation or warranty, expressed or implied, is or will be made and, save in the case of fraud, no responsibility or liability is or will be accepted by Rothschild & Co Wealth Management UK Limited as to or in relation to the fairness, accuracy or completeness of this document or the information forming the basis of this document or for any reliance placed on this document by any person whatsoever. In particular, no representation or warranty is given as to the achievement or reasonableness of any future projections, targets, estimates or forecasts contained in this document. Furthermore, all opinions and data used in this document are subject to change without prior notice.

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