The crypto market is a source of worry for regulators around the world. Their worries are due, not only to the speculative aspects, but also to the tracking of anonymous money transfers, opportunities for money laundering, and tax evasion. Even the most conservative regulators have begun to realise that they will be forced to deal with the financial revolution which, until now, they have chosen to ignore. Faster, more efficient and cheaper money transfers and payments are closer than ever to becoming mainstream, and under these circumstances, traditional fiat money could eventually become an ancient relic.

These changes are already evident in some countries. In August, China announced the launch of a yuan-based digital currency. Other countries are still being cautious, but are exploring the potential of Central Bank Digital Currency (CBDC).

Evidence of the growing awareness of governments and financial institutions of these changes, can be found in The Rise of Digital Money, a recent article by the International Monetary Fund (IMF), by Tobias Adrian, Director, and Tommaso Mancini-Griffoli, Deputy Division Chief, of the IMF’s Monetary and Capital Markets Department. The article offers insights into the ways these establishments might be able to adapt to the radical changes of the digital world.

The Money Tree

When considering the disruption to the financial world, the article presents the following intriguing questions: “How should we think of these new digital forms of money? Are they money at all, and does that matter?” They argue that cash and bank deposits — the two most common forms of money today — will face tough competition from different forms of e-money, and may even be overtaken. However, they encourage traditional institutions to learn about the new forms of money and to consider how to deal with them. In order to better analyse the money market, they present an original classification of various types, organised as a money tree.

The first attribute of the money tree is the money type:

Objects like such as cash, where the payment is executed immediately without any exchange of information.

like such as cash, where the payment is executed immediately without any exchange of information. Claims such as debit cards or payment applications, where the transfer is executed via a value that exists elsewhere. This is the common payment type today, and hides a complex hidden infrastructure.

The second attribute is value, which is relevant only to claim based money:

Fixed is a promise of redemption of a claim in a pre-established face value (of an agreed currency).

is a promise of redemption of a claim in a pre-established face value (of an agreed currency). Variable is an exchange at the going market value of the asset that backs the claim.

The third attribute is backstopped which is relevant only to claims in fixed value:

Government promises to back up the redemption.

to back up the redemption. Private in case the redemption relies only on business practices under legal structures.

The fourth attribute in the money tree is technology:

Centralised transactions controlled by a central server — such as debit cards, payment applications, and CBDCs.

transactions controlled by a central server — such as debit cards, payment applications, and CBDCs. Decentralised transactions making use of DLTs (Decentralised Ledger Technology) and Blockchains — either limited (“permissioned”) or public (“permissionless”) — such as cryptocurrencies, stablecoins and developing projects like Facebook’s Libra project. Cash also falls under this category.

One of the conclusions of the money tree is that while cash is a decentralised object, launching CBDC would transform national fiat money into a centralised object. This definition highlights the huge threat to users’ privacy as a result of such a governmental mechanism. The article suggests the option of protecting user data from third parties, but it is doubtful whether governments would desist from using such a powerful tool.

When it comes to cryptocurrencies, the difference is emphasized between variable object-based currencies, which are defined as public coins, such as Bitcoin or Ethereum, and fixed claim-based currencies, such as stablecoins, which are defined as managed coins. A cautious remark is added that these coins “use some variation of a simple system to stabilize value, which is not always credible.”

The crypto market has been waiting for the last couple of years for the general acceptance of “security tokens” — sometimes described as a powerful tool that can liquefy assets. The article defines such tools as asset-backed tokens — which may be relevant to Facebook’s Libra, since it is backed by a portfolio of assets, including bank deposits and government bonds.

To answer these questions, the article defines two main forms of money that are used today, which are both denominated in a specific currency and can be redeemed according to their face value:

b-money — mostly bank deposits, which the government has promised to insure;

— mostly bank deposits, which the government has promised to insure; e-money — digital payment instruments denominated in, and pegged to a common unit of account such as the euro, dollar, or renminbi, or a basket thereof.

E-money is managed by the private sector and does not enjoy deposit insurance by the government.

In addition to traditional e-money, and digitised e-money, the IMF article describes a new and controversial form of money, i-money. I-money is similar to e-money in many ways except for one crucial one: it is an equity-like instrument with variable value redemption. This fact raises a question: how can an equity-like instrument be considered money?

“If B owes A 10 euros, B could transfer 10 euros worth of a money market fund to A. To the extent that the fund is liquid, its market price should be known at any point in time. And to the extent the fund comprises very safe assets, A may agree to hold these with the expectation of using these to pay for future goods and services at approximately the same exchange rate with local currency. In other words, i-money could be sufficiently stable to serve as a widespread means of payment.”

Although e-money and i-money both suffer from higher instability risks, the article claims that they will be attractive to users, and may be faster and cheaper. Therefore, the adoption of these new forms of money could take place very quickly, with a growing network effect. In some countries, users trust e-money even more than they trust traditional banks.

The end of traditional banks?

If e-money has the potential for overwhelming success, will retail bank deposits migrate to it? There are three main scenarios suggested by the article regarding the potential effect of e-money on the banking sector.

Coexistence

Beginning the battle from a position of strength, banks will adapt themselves to the digital revolution and provide services that will attract customers, despite the competition. They will offer higher interest rates on deposits — even at the risk of lowering their profits; and they may be able to improve the quality of their services, making them faster and more efficient. At the same time, the e-money providers will probably use the banks to arrange their payments and exchanges. The key question is whether banks will adapt fast enough, and whether they will suffer from lack of liquidity during the transition period. In such a case, central banks might assist them.

Complementary

E-money providers will focus on poorer households, smaller businesses and weaker economies — enabling them to join the digital and global economy. They may be in a position to collect data about users and sell it to the banks. In this scenario, the banks and the e-money providers will share the market and each offer differentiated services.

Takeover

In the least likely scenario, the financial markets will go through a radical transformation in which the current model of the commercial banks will be split: deposits and payments will migrate to e-money, and private sector savings will be channelled through international capital markets. Traditional banks will focus mostly on funding the local wholesale sector. This shift will transform the banking model and limit fractional banking — in which banks hold only a fraction of their deposits in liquid assets. The article ponders whether this is a positive outcome: “How much liquidity would get locked up in e-money and no longer be available to extend loans to the private sector? Would credit to firms and households be limited or become more expensive as mutual and hedge funds are required to receive funding before they can extend a loan?” concluding that the answers to these questions are usually based on beliefs rather than on facts — and recommend further research on these issues.

The central bank of digital money

The article ends with an unprecedented suggestion — albeit somewhat centralised — that might boost the money revolution: a suggestion that central banks “level the playing field” for e-money providers, by protecting the public’s deposits, offering liquidity when needed, and settling payments between the commercial banks.

It also suggests that the new players in the financial field should have the opportunity to hold central bank reserves, if they agree to be supervised:

“The Reserve Bank of India, the Hong Kong Monetary Authority, and the Swiss National Bank already offer special purpose licenses that allow nonbank fintech firms to hold reserve balances, subject to an approval process. The Bank of England is discussing such prospects. The People’s Bank of China requires the country’s large payment providers, Alipay and WeChat Pay, to hold client funds at the central bank in the form of reserves. ”

If such methods are adopted, e-money providers will have more power to overcome market and liquidity risks and promise better stability for themselves and the entire market. In this way, they could transform into narrow banks, while covering 100% of their liabilities with central banks reserve, as opposed to the fractional banking used today.

Other advantages would include the creation of a regulatory framework that would protect consumers, avoid monetary risks and promote competition between the e-money providers and avoid the growth of e-money monopolies, especially global ones. This scenario is quite far from the decentralised crypto dream – but is it more realistic? Only time will tell.

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