ECON120: Monetary History

Alternative Cryptocurrencies

Bitcoin copycats were inevitable. Bitcoin is a free and open- source software, which means that the software is free to download and open to view by anybody. On multiple occasions, Bitcoin has resisted fundamental changes to its rulebook from developers that were out of consensus with the majority of Bitcoin users. Alternative versions of cryptocurrency to Bitcoin emerged, whether copied directly, tweaked, or reimagined. If ideas better than Bitcoin existed, capital would gravitate toward these alternatives and away from Bitcoin. So far, however, no cryptocurrency has challenged BTC over any sustained duration, measured in both market value and hashpower. Alternative cryptocurrencies exist on a lower layer within the BTC money pyramid due to a price relationship, much like national currencies existed on a layer below the dollar after the Bretton Woods agreement of 1944. Like the USD acts as the base price for currencies from around the world, BTC acts as a base price for all digital currencies.

BTC also acts as a monetary constraint on lower layers of its own pyramid because it's unforgeable, but this doesn't prevent the issuance of second-layer BTC or any other digital asset. Whether classified as copycats or money-grabs, a volcano of cryptocurrencies erupted after the early success of Bitcoin. Exchanges added cryptocurrencies to their plat- forms which notably traded against BTC, not USD, as their base currency. A new asset class of digital token-based cur- rencies is here, and BTC functions as the final form of settlement within that digital realm.

BTC will never be alone as a digital asset; it will always have both ancillary and auxiliary assets. But it is the one unit of account on which others in the digital universe can rely on for incorruptibility. The Bitcoin protocol's dominance as the primary value-transfer protocol of the Internet will likely endure for decades to come, much like how the Transmission Control Protocol, Internet Protocol, and Hypertext Transfer Protocol (TCP/IP/HTTP) dominate our digital interactions every day when we connect to the Internet or browse the web.

Stablecoins

A rapidly growing second layer within Bitcoin's monetary pyramid is a new type of digital asset called stablecoins. Stablecoins are liabilities issued in the form of digital tokens by private sector companies. These stablecoins are supposed to trade at a "stable" value relative to dollars, for example. The moniker of "stable" is a bit of an oxymoron in this case because as we've learned, monetary instruments on lower layers of money rarely possess enduring stability. Stablecoins: digital coins that are stable until they aren't.

Stablecoins were invented because exchanges needed an easier and quicker way for customers to convert between BTC and USD. In essence, exchanges create their own cryptocurrencies that represent USD in a bank account but are transacted with private keys and addresses just like Bitcoin.

The most famous stablecoin is one that has yet to launch: Facebook's Diem (originally called Libra). Its intent is to be backed by U.S. Treasury Bills and other dollar-denominated monetary instruments. Whether or not Diem launches, Facebook's announcement of a stablecoin in 2019 was a major landmark for digital money. The moment Facebook attempted to encroach upon the world of money was the moment central banks knew they needed a formal response to the merger of money and cryptography. Private sector banks are also looking to capitalize on the demand for dollar- pegged, ledger-based digital tokens: J.P. Morgan launched its own stablecoin, called JPM Coin, in 2020.

In January 2021, the U.S. Treasury issued a definitive guidance on the legality of cryptocurrencies and stable- coins in a report from the Office of the Comptroller of the Currency (OCC). The guidance names both cryptocurrencies and distributed ledgers independent node verification net- works (INVNs), formally defines the word "stablecoin" exactly as we have in this section, and approves both of them for use by banks to digitally transact value as long as banking laws are followed. The ruling was proof that the future monetary rails would be built with the backbone of cryptography:

Commodity Futures

Though New York is the banking capital of the United States, Chicago has always been its commodity hedging capital. During the nineteenth century, Chicago standardized the world of forward and futures contracts, allowing farmers to contractually sell their crop before it harvested. In 1898, standardization of butter and egg futures contracts led to the formation of the Chicago Butter and Egg Board, the predecessor to the Chicago Mercantile Exchange (CME), which today is the world's largest derivatives exchange. The CME would add practically every commodity imaginable to its range of futures products over the years, from live cattle futures in 1964, to silver futures in 1969, to Bitcoin futures in 2017.

In 2016, when the CME announced plans to publish Bitcoin price data in preparation for a launch of Bitcoin futures the following year, the weight of Chicago as the worldwide authority on commodities was thrown behind Bitcoin and significantly added to its legitimacy. CME Bitcoin futures help financial market participants translate between BTC and USD, which will directly contribute to Bitcoin's adoption. Businesses can engage in BTC-denominated activity knowing that they can actively manage away unwanted exchange rate risk. Additionally, Bitcoin futures off er a second-layer BTC to participants that operate only within the dollar pyramid and simply want exposure to changes in the price of BTC, not possession of Bitcoin private keys. CME's product brought Bitcoin forward on its path to full integration with the traditional financial system.

Layered Bitcoin

As worldwide adoption of Bitcoin as a currency and as a monetary mindset continue, Bitcoin's second layer is blossoming with a variety of BTC-based promises, alternative cryptocurrencies, and stablecoins. Figure 16 shows that Bitcoin is at the top of its own novel monetary pyramid, with some second- layer monies stemming from balance sheets and others from price relationships.

Figure 16

CENTRAL BANK DIGITAL CURRENCIES

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

Source: Nik Bhatia: Layered Money
This work is licensed under a Creative Commons Attribution-ShareAlike 4.0 License.