There goes the dream of decentralization.
Bitcoin enthusiasts have railed against central banks since the cryptocurrency was introduced to the world in the aftermath of a global financial crisis, widely blamed on central bank policymaking.
But digital currencies issued by central banks, also known as Central Bank Digital Currencies (CBDCs), are at the center of a future monetary system in a report released by the Bank of International Settlements (BIS) yesterday.
The BIS report reimagines the monetary system as a tree with a central bank serving as its trunk and many private and public financial services as branches. Their services will be fed by the central bank’s settlement liquidity roots.
“CBDCs will enable most of the functionality that crypto enables today,” said Hyung Song Shin, the report’s lead author. “Anything cryptocurrencies can do, CBDCs can do better.” Many countries have already started experiments using CBDCs or released them. But it might take another two to three years before CBDCs will make an impact on monetary systems, he said.
The Problems with Cryptocurrencies
While it discusses numerous flaws in the crypto ecosystem as it exists today, the report also details two main problems that prevent it from becoming the basis of a future monetary system.
The first one is its tendency towards fragmentation. There is no authority or intermediary for final settlement in crypto today. Recent events have demonstrated that this can lead to all sorts of problems, from bank runs to liquidity issues. Thinly traded cryptocurrencies with volatile prices cannot function as a unit of account for a sound monetary system, according to the report.
The second problem are the high fees associated with cryptocurrency transactions. The high fees prevent them from becoming a medium for daily transactions. Greater usage or network effects of standard currencies can bring down transaction costs and make them accessible to a wider swath of the population. But the opposite is true for cryptocurrencies, where transaction fees become inflated as their numbers increase.
The report refers to such high fees as “economic rents” charged by node operators and validators to recoup the costs of confirming transactions on a blockchain. Previous instances of an increase in the number of transactions have caused blockchain congestion. The resulting delays in confirming transactions are a feature [that provide income to miners], according to Shin, and not a bug.
Unstable Stablecoins
The report also criticizes stablecoins – cryptocurrencies that aspire to stabilize the price volatility of crypto markets by backing themselves with a basket of reserve assets. The contents of those baskets are increasingly being questioned by crypto critics. Tether, the world’s biggest stablecoin, has refused to agree to regulatory scrutiny or an audit of its reserves. An algorithmic stablecoin UST imploded spectacularly last month and spread panic in crypto markets. Even Treasury Secretary Janet Yellen has weighed in and called for stablecoin regulation by the end of this year.
The report refers to stablecoins as “a nominal anchor” that imports the credibility of central bank-issued currencies to crypto. “…But they benefit neither from the regulatory requirements and protections of bank deposits and e-money, nor from the central bank as a lender of last resort,” the report states.
What Role Will CBDCs Play in the Future Monetary System?
The report outlines three roles for CBDCs. As a unit of account, CBDCs will ensure “ultimate finality” of payments using the central bank’s balance sheet. In practice, this means that the central bank will credit and debit accounts of the final payers and payees. It will also ensure remove the liquidity risk from settlements by using its mandates to print additional money, as and when required. Finally, central banks will ensure integrity of CBDC payment systems through regulation, supervision, and oversight.
A system underpinned by digital currencies would also increase the number of intermediaries able to access central bank reserves. That facility is currently available only to commercial banks. “New protocols built on wholesale CBDCs could be open source, making the source code freely available for a community of developers to develop and scrutinize,” the report states. Developers could develop new products and services using these open protocols.
A Role for Stablecoins
Stablecoins will have a limited role in the monetary system proposed by BIS. Only stablecoins that are big enough to be considered systemically important will come under the regulatory umbrella and have “robust oversight.” “Where stablecoins are issued by large entities with extensive networks and user data, entity-based requirements will be needed,” the report states.
Money transfers and cross border payments using CBDCs are one of the more interesting use cases suggested by the report. Shin said the current system of funding correspondent banks across geographies was “incredibly intensive in terms of liquidity and operational changes.” The use of CBDCs could make the process simpler by requiring fewer (or just one) deposits and the use of tokens to accomplish remaining legs of the transaction.
The Privacy Question
One of the biggest concerns about CBDC implementation is related to privacy. Allowing governments or regulators access to citizen’s private data can have far-reaching consequences and enable selective targeting of individuals. The report suggests several solutions to this problem.
Permissioned systems accessible only to select users are one. New data architectures to preserve anonymity and the use of zero-knowledge proofs, that allow confirmation of transactions without revealing usernames or posting entire ledgers publicly (as happens in the case of most cryptocurrencies), are another. Shin said subjecting central banks to the same of regulatory oversight as commercial banks might also prevent misuse of CBDC systems.