Central banks are starting to explore a digital money future.
Hey friends -
This week's letter wraps up our dive into money! While the most recent letters dove into novel privately issued monies including digital almost-dollars and cryptocurrencies, we're actually returning to government-issued money.
Central banks have not been content to sit on the sidelines as the private sector experiments with new monies. They're getting in on the action. This week is all about central bank digital currencies (CBDCs).
In this week's letter:
Total read time: 10 minutes, 37 seconds.
We're in the very, very early days of what digital money can be. There's perhaps nothing more exciting happening than the reinvention of government-issued cash as a digital currency. The industry's landed on central bank digital currency as the formal term, or CBDC for short.
We're in the early days of discovery. Central banks, industry groups, think tanks, and all varieties of academics are actively publishing papers with possible models. Let's start with physical cash today before jumping into the proposed models for CBDCs.
By design, the bill tells us most of what we want to know. At the upper left, it tells us that is a "Federal Reserve Note" - cash is a direct claim on a central bank's balance sheet where it is accounted for as a liability. Below the text, there is a serial number that enables us to track the bill. Below that there is a two-character alphanumeric code that denotes which of the 12 banks that make up the central bank issued the currency (G7 is Chicago).
The attributes of cash are also important. It is a highly accessible, physical, anonymous, bearer asset, where bearer means that whoever has control of the asset owns it. Because of its physical nature, cash also moves slowly - imagine the chaos if foreign exchange markets tried to settle the $6.6 trillion of daily currency trades in physical cash.
At first glance, we'd likely expect a proposed CBDC to be similar to cash in all respects except that it is digital instead of physical. The reality turns out to be more complicated.
In a retail CBDC model, the new digital money continues to be a direct claim on the central bank's balance sheet just like cash. This immediately differentiates it from the digital monies we explored in previous letters, all of which were claims on either private entities or entries on a shared ledger. It is similarly differentiated from checking accounts, Venmo, and the like.
A major challenge with such a model is that it could undermine the very foundation of how banking works. Banks take in money as deposits and then make loans. Like the cash on the central bank's balance sheet, deposits are a liability on a bank's balance sheet. A bank's ability to make loans is directly dependent on deposits - fewer deposits, fewer loans.
A retail CBDC is stored on a digital ledger maintained by the central bank - there’s no need for a bank to keep your money safe as a “deposit.” Your money is already risk-free, why bother involving a bank at all? This could easily spiral into a crisis as banks make fewer loans because they lack deposits, access to capital dries up for mortgages and businesses... it could be a serious mess.
There's a second major challenge - central banks are not well suited to operate the systems required to support a payment network used by individuals. The beating heart of the system will be a digital ledger that tracks who owns how many CBDCs. Like public blockchains, these systems need to support basic financial operations like transferring money between accounts, but also evolve over time to support more interesting and complex operations. The track record of government organizations building innovative technology platforms and encouraging private enterprises to build atop the platforms to further innovate is abysmal.
A third major challenge is the traditional activities performed by intermediaries during payments. Among the most important are anti-fraud and anti-money laundering, both of which aim to prevent money from landing in the hands of bad guys or being used to fund illicit activities. Central banks are not set up to perform such activities, nor from a principled standpoint does the idea of a governmental organization directly determining who can and cannot hold money on a case-by-case fit well with our principles of freedom.
Even assuming we could solve all three challenges, likely by involving the private sector to take on responsibility for parts of the system, we still would need to design a business model whereby those financial institutions could make money. That money will likely be paid for by CBDC holders, making the new digital money less and less attractive with each penny of cost.
These challenges are not insurmountable, but it's also not necessary that we tackle them. These challenges stem from having individuals hold CBDCs that are claims on the central bank. What if we move further away from thinking about this as cash? What if we create a CBDC that, like cash, is a claim on the central bank balance sheet but is instead only owned by banks?
In a wholesale CBDC model, banks hold CBDCs that are direct claims on the balance sheet and in turn issue another digital currency that is backed 1-for-1 by the wholesale CBDC. We as individuals could own the bank-issued currencies.
We already have a name for these - they're stablecoins, the very same blockchain-based digital assets we covered last week. Specifically, they are CBDC-backed stablecoins and would likely rapidly displace cash-backed stablecoins.
In this model, banks and other private financial intermediaries would continue to facilitate everyday payments among individuals and businesses like they do today. The central bank would facilitate wholesale payments among financial services companies, again like they do today. That helps keep private enterprises and government in their respective swim lanes and solves the three challenges highlighted with retail CBDCs.
The model does raise a new concern - stablecoin competition among the issuing banks. Since the stablecoins would be claims on the banks, consumers may trust stablecoins from Bank A more than they do stablecoins from Bank B. Even with a requirement that the stablecoins be fully backed, an FDIC insurance-like safety net for stablecoins would go a long way towards instilling a minimum level of trust in all issuing banks.
While elegant, a wholesale CBDC doesn't solve all of our challenges. We've ignored that cash is both highly accessible and anonymous. Nothing in our retail or wholesale CBDC models supports those two attributes.
This is one of those times where the differences between physical and digital goods become painfully apparent. Physical goods, by their very nature, are by default accessible and anonymous. They're accessible in that anyone who can pick them up can use them. They're anonymous in that they have no built-in history or tracker, no one knows who used to own them or who owns them today.
Digital is the opposite. Digital is only accessible via devices that may not be intuitive, especially to older generations, and may require internet connectivity to work. Digital almost always leaves a trail that tells you where it came from and who owns it now. Blockchain has taken history and ownership to an extreme.
We can design digital money to be accessible and anonymous, but that is a choice. From many of the designs put forth by governments around the world, it's a choice that many seem unwilling to make.
While we're in the early days of CBDCs and continue to be for some years to come, there is real momentum at central banks around the globe to design and test potential models. R. Auer, G. Cornelli, and J. Frost put together a great summary of the work underway.
Look closely and you'll notice something very exciting - the Bahamas is live!
The Bahamas piloted their CBDC, the Sand Dollar, in December 2019. In October 2020, the Sand Dollar was rolled out nationwide.
The Sand Dollar is a retail CBDC model wherein the digital currency is a direct claim on the central bank. Bahamian citizens, and it's currently only Bahamian citizens allowed to hold Sand Dollars, can convert cash to digital at authorized financial institutions.
The Central Bank of the Bahamas instituted several practices to address the challenges highlighted with retail CBDCs. Citizens are limited to holding no more than B$8,000 of digital currency and transacting no more than B$10,000 per month. While the central bank maintains the ledger that tracks CBDC ownership, retail transactions are processed by private financial institutions. Time will tell if the model is successful.
The Bahamas prioritized accessibility and anonymity (up to a point) with an eye towards financial inclusion. The Sand Dollar is hosted on a network that can be accessed and used without internet connectivity or data usage, a real triumph for a country where service may be spotty.
Anonymity is more of a mixed bag. Whereas the above-mentioned limits are for those individuals who show a government ID and link a bank account to their Sand Dollar account, individuals who choose not to do so may still open a Sand Dollar account without any identification or bank account but are limited to holding no more than B$500 and transacting no more than $1,500 per month. In effect, if you want to hold more than $500 digitally then the government's going to know about it.
It's on this last point that I'll wrap our look to the future of digital government-issued money. I'm incredibly bullish on the potential for CBDCs but painfully aware of the potential for abuse. Government-issued money that by its very design can be tracked and traced will be abused by government actors given enough time.
We don't need much of an imagination to concoct an Orwellian future, we need only look to the ongoings in China. The country declared cryptocurrency illegal concurrent with early research into government-issued CBDC. China doesn't have anything against digital money - they have something against digital money they don't control.
When China links its now-ubiquitous social credit score with digital money, it'll have direct tabs on the wealth and purchasing decisions made by all of its citizens, all the time. Not only will individuals be disappeared and be erased from public records, but their wealth will also be confiscated without due process. Seizing wealth, or even just the threat, will become a highly effective tool in the arsenal of a country committed to subjugating its peoples.
We in the US are not immune from such concerns. Financial institutions are required to file Suspicious Activity Reports when more than $10,000 is deposited or withdrawn by an individual in a day. That amount was set in 1970. If adjusted for inflation, only amounts over $70,000 would be reported. Many other similar regulations have also been passed, almost always in the name of anti-fraud, anti-terrorist financing, or ensuring taxes are paid.
This isn't a rant against the laws - the laws are well-intentioned. It's an acknowledgment that we've legislated into existence the very infrastructure necessary to clamp down on a nation's retail financial sector in the name of making the system safer. CBDCs will be no different. They offer tremendous potential for financial inclusion, lower costs of transacting, and many other admiral benefits with the tradeoff of a system that can be abused in ways we're only beginning to understand.
Getting good people involved today, right at the beginnings, as we're designing these new monies is critical. It is they who hold tremendous power to change the world for the better and build in those safeguards that'll protect the system as it comes under attack in the decades to come.
The last six letters have been a whirlwind tour of money. We started at the very beginning understanding what money is, built our way up through the rapidly growing government money supply, and then dove into the future of money with the very active innovations happening across cryptocurrencies, stablecoins, and now central bank digital currencies.
From the archives:
This has been an awesome journey for me. I've found it incredible the diversity of assets that serve as a store of value, unit of account, and medium of exchange. If you had asked me just a few years ago what money was, my answer would have been limited to what we're all most familiar with - cash and its close cousins. Today, with the cryptocurrency boom and central banks starting to even redefine what government money is, I feel far less confident in my answer. What serves as money is changing day by day.
We're living through The Great Money Experiment. Only time will tell what money is tomorrow. It's a tremendously exciting time to be alive.
Another riff on a classic! Just in time for the cold.
2.0oz Bourbon
0.25oz Maple Syrup
2 dashes Orange Bitters
2 dashes Bitter Queens Chocolate Walnut Bitters
Orange peel for garnish
Pour all of the ingredients into a mixing glass. Add ice until it comes up over the top of the liquid. Stir for 20 seconds (~50 stirs) until the outside of the glass is frosted. Fill a rocks glass with ice. Strain the cocktail into the glass. Squeeze the orange peel over the top of the glass to express the oils and drop it in. Enjoy!
Who doesn't like an Old Fashioned? It's a wildly popular drink for good reason, but I've often found them to be a bit too sweet for the moment. By swapping out the sugar for maple syrup and the Angostura bitters for chocolate walnut bitters, you get a drink where the sweetness is tamed and the flavors far deeper. The bitters really make this cocktail. It's like the crunchy bits of a chocolate orange walnut cookie, the ones that got caramelized around the edges. The only thing that's missing is an evening cold enough to light a fire.
Cheers,
Jared
