ECON120: Monetary History

The invention of Bitcoin has changed money for- ever and forced central banks to respond with their own iteration of cryptocurrency. Worldwide, central banks are preparing to launch central bank digital currencies (CBDCs) as another second-layer monetary instrument originating from their balance sheets on par with reserves and paper currency. But nobody quite knows how CBDCs will be constructed, how similar or different their technology will be to Bitcoin's, or the impact they'll have. This chapter will look at where central banks are in the process of launching their crypto-competitors, and speculate on the interaction between CBDCs, stablecoins, and Bitcoin in the future.

Change the Game

Central bankers of the Federal Reserve and an economic brain trust from around the world have gathered in Jackson Hole, Wyoming since 1982 to evolve the science and practice of central banking. At the 2019 symposium, then Governor of the Bank of England Mark Carney made a speech that delivered a dire message about the international monetary and financial system: "In the longer-term, we need to change the game". He bemoaned a unipolar currency regime in which the dollar is the sole reserve currency as unsustainable and gave life to the exploration of a post-dollar metamorphosis of money. The problem is that with long- term changes potentially decades away, planning for them becomes an overwhelming task. Laying new tracks for money's future is easier said than done.

Helicopter Money

In 2016, Ben Broadbent, a senior Bank of England official, delivered a speech titled "Central Banks and Digital Currencies" at the London School of Economics that must also be catalogued into monetary history. The speech sought to touch on the following questions:

The speech tried to grapple with the magnitude of Bitcoin's innovation and its implications for how we think of currency, and it also took the conversation forward by admitting that central banks could use the idea of a token-based digital cash like Bitcoin to their own benefit by widening access to who all could hold central bank liabilities, or second-layer money.

What is the attraction of central bankers to issuing their own digital currencies? The answer lies in wider access to second-layer money. Recall that the Federal Reserve issues two types of money, wholesale reserves for private sector banks and retail cash for people. In order to provide monetary stimulus, the Fed issues reserves and hopes that private sector banks will use those reserves to circulate third-layer deposits into the economy by lending money. With a CBDC, the Fed could issue second-layer money directly to people in the form of digital helicopter money; the phrase "helicopter money" comes from Milton Friedman, who in 1969 provided the imagery of dropping cash out of a helicopter in order to stimulate economic demand.

The Fed wouldn't necessarily be able to provide this type of economic stimulus without a larger political debate; a CBDC blurs the line between the central bank's independent monetary policy and government-controlled fiscal policy. Helicopter money has been explored as a monetary policy tool for decades, and with the popularity of political ideas such as Universal Basic Income, CBDCs are the ideal vehicle to transmit direct payments to citizens in the future. Broadbent formally introduced the CBDC acronym that is sure to dominate the monetary conversation for many years to come. Since his speech, the central banks of China, Sweden, and Australia have started testing CBDCs. The European Central Bank, Bank of England, and Federal Reserve are all several years into their research efforts and have all indicated that a form of central bank digital currency is likely to arrive in the coming years. The question of whether or not CBDCs are coming is moot.

The current reality is that there are more questions than answers surrounding central bank digital currencies and the path they will follow. Will they be retail second-layer money to which the entire public has access? If that is the case, what happens to banks and their issuance of third-layer money to the public? After all, the public uses third-layer bank deposits as its primary form of money, and a retail CBDC has the potential to supplant third-layer deposits as the preferred money-type for citizens. And from a societal standpoint, how will central banks use the new powers of surveillance and monetary policy that would emanate from the issuance of publicly accessible digital currencies? Central banks around the world are consulting industry and society on how to answer these questions about the world of digital money.

CBDC Design

Without any official characteristics yet, CBDCs are unchartered monetary territory. From a layered-money perspective however, CBDCs are more defined. When issued by a central bank, digital currency will be a second-layer money, a liability on the central bank's balance sheet alongside cash notes and reserves. The world is looking for a new multipolar game to play as Mark Carney said, and nations that want to participate in the overhaul must build their digital currencies with specific characteristics.

Central banks first have to decide which liability they want their digital currencies to emulate more: wholesale reserves or retail cash. The conversation demands a layered-money context in order to achieve clarity around this important and foundational decision for digital currency issuance.

When people use cash, they are using second-layer money and avoiding the banking layer altogether. But most people don't use cash anymore. They use bank deposits and payment platforms linked to bank accounts for their daily interaction with money, which occurs on the third and lower layers. Central banks are wary of the effects on the banking industry of launching digital currencies. With this new technology, they have the opportunity to actively reduce the role of banks in the issuance of money; if CBDCs are accessible to the entire populace, people might reduce their reliance on bank accounts to receive direct deposits and pay bills.

Alternatively, central banks could issue a digital currency in the form of wholesale reserves, which would only be accessible to banks. The digital reserves option has the potential to modernize financial infrastructure for the banking system, but it won't impact how society interacts with money.

Will central banks issue a retail CBDC or a wholesale CBDC? We'll see some attempt one or the other, and some attempt both. A wholesale CBDC doesn't bring into question the displacement of banks. It's also probably the best way for central banks to test new technology in a live environment with select banks as users instead of with millions of people. A retail CBDC has the potential to change the concept of monetary policy itself by giving central banks the ability to interact with people directly instead of only with other banks. Different central banks will choose different paths

China

Geopolitical tensions between China and the United States have risen over the past several years and will continue to do so as China fosters its desire to be the world's superpower. Th rough its Belt and Road initiative, a worldwide trade infra- structure network with over one hundred nations participating, China is spreading its influence and its currency denomination across the globe.

But China's rise is unquestionably missing a corresponding deep and liquid capital market for its currency denomination, especially when it comes to a risk-free asset. China's government bond market is but a blip on the international radar of liquid and safe securities, but more importantly, China's currency denomination renminbi (RMB, "people's currency") which began with the founding of the People's Bank of China in 1948, is not a freely traded currency. Trade between RMB and other currencies is largely restricted by the Chinese government, exchange rates are managed instead of market-driven, and convertibility between RMB and the world's reserve currency, USD, is far from seamless. The renminbi, despite all recent attempts by China at internationalizing the currency, remains a closed capital account. This means that companies and banks can't freely move renminbi in and out of the country, negating any demand for RMB as a world reserve currency. Nevertheless, China is preparing for a post-dollar world. During the few years after the 2008 financial crisis, China instituted direct cross-currency relationships with some of its allies in order to reduce its dependence on using the USD as a clearing mechanism for international trade. This started with China's 2011 agreement with Russia and continued as it looked for alternatives to the global dollar standard.

The People's Bank of China is already live-testing a digital renminbi system called Digital Currency Electronic Payment (DCEP) in select cities with a limited number of citizens and businesses participating in the first stage of the rollout. China is moving forward with an entire legal frame- work for DCEP as it looks to jump out ahead in the global CBDC race that is only just beginning. China will likely use its digital RMB as a tool to grow its global influence and spread the adoption of its denomination. When fully implemented, DCEP carries the potential to be the largest financial surveillance operation in the world, especially if it forces its major trading partners into using DCEP to trans- act with Chinese entities. One of the most important details of China's legal framework interestingly forbids the issuance of RMB-backed digital tokens by private sector banks, or RMB stablecoins. This will be a distinguishing trait of China's CBDC, as China might be transitioning to a financial system without third-layer bank deposits and drive all of its citizens into its second-layer retail CBDC instead.

 

Digital Euro

The European Central Bank published a "Report on a Digital Euro" in October 2020 and demonstrated full intent to take its currency denomination digital. The report concluded that a "digital euro may even become essential in a number of possible scenarios," an admission that the merger of the monetary and cryptography sciences is official and fundamentally changing the world's monetary order. The report is filled with more questions than answers about the digital euro, like how a CBDC would impact the second- and third-layer relationship between the ECB and European private sector banks, whether it would coexist with paper currency or replace it altogether, and what it would mean for monetary policy itself. Private sector banks are threatened by CBDCs because of their potential to displace the demand for bank deposits, and the ECB appears eager to strike the right balance. According to the report, the ECB seems ready to launch a digital euro project and full technical exploration phase in 2021.

Fedcoin

Current Federal Reserve chair Jerome Powell addressed a possible Fedcoin, a nickname given to the Federal Reserve's prospective digital currency, during an International Monetary Fund conference in 2020:

Although no concrete plans exist for Fedcoin, the Federal Reserve is clearly on track to create one in due course, if not because of the continued success of Bitcoin, then due to the sudden realization that it might be the last major central bank in the world to release one. The Fed, based on indications from China and Europe, is already going to be late to the CBDC party. It is unlikely to issue a retail CBDC that could be used by the public as a form of digital notes right away; instead, it will conceivably create a form of digital bank reserves in order to test the technology before eventually launching a publicly available, retail-facing Fedcoin. Figure 17 shows how a Fedcoin would be a second-layer money alongside reserves and cash.

Figure 17

BTC and CBDC Price Relationship

The underlying thesis of this book is that BTC will stand alone on the first-layer of money in the future. If only one word about Bitcoin could be used to describe why, we'd have to choose one coined only a few years ago in 2014 by author and seminal economic thinker Nassim Nicholas Taleb: anti- fragile. Here is how Taleb defined it:

Bitcoin is antifragile because it thrives off global monetary disorder within the dollar pyramid and is resilient to the threats, slander, and legislation from dismissive bureaucratic entities. The plain truth about Bitcoin is that nobody controls it. It has become the first-ever government-free, universally accessible digital currency. And for these reasons, all currencies in the purely digital realm will face price discovery in BTC terms. This means that all digital currencies, from cryptocurrencies to CBDCs, will be measured in BTC, just like the Bretton Woods agreement in 1944 mandated all currencies be measured in USD. Figure 18 elucidates a future in which BTC is the world reserve currency and only first-layer money.

In order for this type of BTC-denominated layered money system to evolve, a few technological details need to fall into place that might sound far-fetched but are already in development within central banks today. The last piece of the puzzle on the path to BTC becoming world reserve currency will be the atomic swap.

Figure 18

Atomic Swaps

Understanding the atomic swap and its role in the future of money requires the amalgamation of three elements discussed in this book: Lightning Network, Hashed TimeLock Contracts (HTLCs), and Distributed Ledger Technology (DLT). We'll quickly review the key aspects of each, and then show how they all fit together. Lightning Network is a net- work of BTC users that can transact instantly with each other instead of having to wait ten minutes for the next block to be mined. This is possible thanks to smart contracts called HTLCs. Separately, Distributed Ledger Technology (DLT) is a term that mainstream academia and central bank research departments use to describe Bitcoin-inspired software.

Now here's how all the terms are bound together. DLT software equipped with HTLCs that are compatible with Bitcoin's Lightning Network will be used by central banks to launch their CBDCs. If the smart contracts are compatible across digital assets, it would enable a world of atomic swaps.

An atomic swap is, at its core, a trade. It's a smart contract that allows for the trade between digital currencies without using a third-party exchange. This is absolutely revolutionary in the world of finance and trading, and let's use an example of buying shares of Apple to illustrate why. Say you want to purchase 100 shares of Apple at $100 each. You deposit $10,000 into a stock exchange. Those wanting to sell their shares will deposit them as well. The exchange is required in this situation to ensure that both the buyer and the seller have the money and assets necessary to complete the trade. Without a third party, traders would have to trust each other every time they traded. But with an exchange, that is not the case.

Atomic swaps fundamentally change these basic ideas of trading. They are programmed to execute the trade for both parties or for neither, eliminating counterparty risk, exchange risk, and default risk altogether. It's important to understand that atomic swaps will only work on central bank digital currencies that are built using DLT software outfitted with the same type of smart contracts present in Bitcoin's Lightning Network. However, this doesn't necessarily mean that a central bank issuing a CBDC on a distributed ledger would cede any control over the underlying currency.

Several implementations of DLT already allow for atomic swaps. Here is a real-life example of the work being done on atomically swappable central bank digital currencies. In 2019, the Monetary Authority of Singapore, the Bank of Canada, JP Morgan, and Accenture announced a successful atomic swap between Canadian dollars (CAD) and Singapore dollars (SGD) across two separate DLT platforms using HTLCs "without the need for a third party that is trusted by both jurisdictions". The transaction's setup was incredibly complicated from a software programming and computer science standpoint and took much time and care to execute, but this is the type of research monetary authorities around the world are conducting right now to explore the future of money. The Canadian central bank used a DLT called Corda, and Singapore's central bank used a DLT called Quorum, both solutions offered as products by private enterprises. The two DLTs have several fundamental diff erences but are compatible where it counts: they allow for HTLCs with each other. Central banks will need an increasingly large applied- cryptography contingent amongst their senior ranks in order to iron out all the technical details to CBDC implementation. Whether they decide to use a banking software solution, an alternative cryptocurrency, or Bitcoin itself, central banks have an array of options when it comes to their ultimate launch of digital currencies. If central banks want their digital currencies to thrive in the Bitcoin era, they will issue CBDCs that use DLT software with HTLC capabilities in order to join the atomic swap club. With BTC as the only first-layer digital currency, every other digital currency, no matter how powerful the issuer, will ultimately be measured against BTC.