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By Arnoud W.A. Boot, Professor of Corporate Finance and Financial Markets, University of Amsterdam
Money is central to banking and finance. With information technology (IT) developing rapidly, digital variations of money are mushrooming. Cryptocurrencies (including bitcoin), stablecoins and CBDCs (central bank digital currencies) are very much in the news. Cash (coins and notes), on the other hand, is becoming less prevalent. In this bewildering environment, we need to go back to the basics and truly understand what money is, how it is created and what these modern names and acronyms have to do with it. Once we thoroughly understand the fundamentals, we can try to see the future.
This is very much an exercise in understanding the economics of money. How does it function and serve the economy at large? There is a difference between the perhaps technocratic focus on the economics of money and the political and societal sentiments that may also impact the future of money. Money is part of the fabric of society; it deserves more than a technocratic treatment. Some are deeply suspicious of any digital variation of it, fearing government control. The digitalization of society is something with which many still have to come to grips. To make matters worse, some want to control money for their own financial interests—after all, money is power. In any case, both the future of money and the control over it are highly uncertain.
Understanding money
Life was so easy. We all knew (or thought we knew) what money was. Banknotes and coins are clearly money. They are called cash—physical manifestations of money. We can use cash at any moment, and it is widely accepted. The same holds true for what we have in our bank accounts; this is called bank money, primarily the deposit balances that we hold at our banks. Unlike cash, it is digital, but it has the same value. We can use it to pay bills and even settle on-the-spot transactions via, for example, the use of debit cards. Hardly any of us doubt its genuineness—this is what money is and how it works.
Two things have changed. First, cash is becoming less important, while bank money is growing in importance. Second, all kinds of digital alternatives to bank money have emerged.
But lately, the situation has become more confusing. Two things have changed. First, cash is becoming less important, while bank money is growing in importance. Second, all kinds of digital alternatives to bank money have emerged.
As for the first change, cash versus bank money, note that virtually all money now comes in digital form, primarily as bank money. This change does not seem fundamentally threatening, but it has raised controversy, nevertheless. The key is that cash is issued by public authorities—the central bank, to be precise. Bank money (deposits) is managed by banks, and these institutions are typically private (often referred to as commercial banks). The question then is: Do we feel comfortable about the control of something as critically important for society’s functioning as money arguably is increasingly residing only with commercial banks? And for the skeptics of commercial banks’ key role, matters are even worse: Money is even created by these banks via their lending. That is, when a bank makes a loan, it ends up as money in a customer’s deposit account, thus enlarging the money supply. Banks don’t even have to look for the money to lend; bookkeeping entries alone suffice (the loan is reported as an asset on the bank’s balance sheet, and that money is credited to the customer’s account as a liability).
With cash disappearing, money is thus becoming more and more dependent on private banks. The question then is: Should public authorities, meaning central banks, offer a digital equivalent to cash to reduce this almost exclusive dependence on commercial banks? This is what a central bank digital currency is about: a digital cash equivalent provided by a central bank. However, some view the CBDC with suspicion. Would it not make central banks even more important? Is that desirable? Stability concerns are also raised: Depositors may flee to the safety of CBDCs in times of crisis, putting commercial banks at risk.
Now for the second change. With ongoing technological innovations, digital alternatives to bank money seem to be mushrooming. Thus, it is not just cash that is being replaced by bank money, but bank money itself is being subjected to competition from other digital alternatives. Cryptocurrencies, with bitcoin as the best-known manifestation, come to mind. But bitcoin violates the definition of money in at least two ways: It is not widely accepted as a medium of exchange, and it cannot easily function as a unit of account (there is no underlying bitcoin economy with prices in units of bitcoin). As a matter of fact, bitcoin is just too volatile to have money-like properties. However, technological innovation goes a step further. As we have already widely observed, cryptos can resemble money once they are made (more) stable. These are called stablecoins. Volatility is removed (or lessened) by pegging their value to “official” money and collateralizing them. Most stablecoins are backed by the US dollar, meaning that “real” dollars—or short-term U.S. Treasuries (“safe” obligations of the US government)—are supporting them. Stablecoins might come close to money, but these privately arranged constructs are not foolproof. In times of stress, distrust may undermine their values.
Innovations follow inefficiencies
Innovations often arise to address inefficiencies. An important inefficiency in the current system is the cross-border payment system, but it is most visible in the elaborate role that correspondent banking plays in international affairs. This is where stablecoins and CBDCs could offer benefits. They essentially provide peer-to-peer payment services that bypass commercial banks.
Facebook’s attempt several years ago to introduce Libra (also known as Diem) was in essence an effort to create a stablecoin. Since it was linked to a basket of currencies, one could not readily view it as a unit of account—prices would have to be expressed in Libras for that to be the case. This undoubtedly complicated matters, and the initiative was abandoned. But what if it had been linked to the US dollar exclusively, as most stablecoins are today? A platform-based stablecoin, as Libra was intended to be, would have become immediately accessible to the platform’s hundreds of millions of users. Inducements could have been offered to encourage its use, and it might have gained traction. The stablecoin’s issuer would have benefited as well; it could have received seigniorage (in other words, the collateral, typically U.S. Treasuries, earns interest; the stablecoin does not pay interest).
Central banks were put into overdrive to come up with their own equivalents, as Libra’s success might have uprooted the financial system and possibly control over money and the payment system. While the Libra initiative was abandoned, the recent proliferation of all kinds of other US-dollar-linked stablecoins has again led to discussions about the need for CBDCs. In particular, CBDCs could help ensure the “uniformity of money” and interchangeability in a world with many different private moneys (i.e., stablecoins). They could provide an anchor and reference for the value of money in whatever form it takes.
To complicate matters further, other innovations have been proposed. In its most recent annual economic report, the Bank for International Settlements (BIS) put forward proposals for the “tokenization” of deposits (see BOX). This would remove frictions in payments within the current banking system. It would (try to) keep commercial banks in the driving seat by modernizing their business. As stablecoins are not foolproof, tokenized deposits could offer benefits because they carry the safeguards that accompany banks, including credible regulation and insurance arrangements (lender of last resort and deposit insurance). But do we want to keep banks in the driving seat? Banks’ ability to move effectively in this direction is also an open question.
The BIS and the Tokenization of Deposits
The future is more uncertain than ever
“There are unknown unknowns.” When he made this statement in 2002, former United States Secretary of Defense Donald Rumsfeld was pointing to known and unknown unknowns. We are in the middle of ongoing developments without a real understanding of where all this will end. Few would have believed that cryptos (including bitcoins) would become “normalized” to the extent that they have, with well-known banks and brokers facilitating broad access to these innovations. Stablecoins are part of this development, but what will their role be in the future? In the spirit of Donald Rumsfeld, what more can we expect? What the future will bring is highly uncertain.
In the United States and Europe, the surges in stablecoins have led to new legislations (respectively, the US’ GENIUS Act [Guiding and Establishing National Innovation for U.S. Stablecoins Act] and the European Union’s (EU’s) MiCA regulation [Markets in Crypto-Assets regulation]), but so far, stablecoins are still marginal in the financial system at large. How this will develop is equally uncertain. Particularly among some US policymakers and politicians, stablecoins (and cryptos) are seen as worthy of being given a free hand to prosper without much interference. This may in part be anti-central bank rhetoric, but that possibly makes it an even bigger concern. If like our earlier discussion of Libra and Facebook, today’s Big Tech (say, Amazon) can issue its own stablecoins and declare them the main “currency” on its platforms, effectively creating its own money, what prevents Big Tech from not only being powerful from a commercial point of view (today’s main concern) but also from a financial-sector point of view? Big Tech’s money operation would arguably become more powerful than banks have ever been. With hundreds of millions, if not billions, of clients, it would even be too-big-to-fail, and its stablecoins would effectively have to be guaranteed by the government if problems were to emerge.
Society may not be well served
But what is optimal for society? Are stablecoins the future? What role should CBDCs play? And what about tokenized deposits, and whatever other innovations come along?
But what is optimal for society? Are stablecoins the future? What role should CBDCs play? And what about tokenized deposits, and whatever other innovations come along?
The political backlash against the US central bank (the Federal Reserve, or simply the Fed) does not help, as this undermines its system-wide supervisory powers that might be needed more than ever. It also does not help prudent decision-making that financial self-interest seems to play an important role. It sometimes resembles a gold rush. Some people see enormous possibilities for self-enrichment. Policymakers and politicians might not be immune to this. Also, in Europe, we see former government officials lobbying for crypto-firms.
Where money is, power is, and that may not serve society well.
ABOUT THE AUTHOR
Arnoud W.A. Boot is a Professor of Corporate Finance and Financial Markets at the University of Amsterdam, the Chairman of the European Finance Association (EFA) and a Research Fellow at the Center for Economic and Policy Research (CEPR). Previously, he was the Chairman of the Bank Council of the De Nederlandsche Bank (DNB), a Partner in the Finance and Strategy Practice at McKinsey & Company and on the faculty of the Kellogg School of Management at Northwestern University.
