The BoE on fundamental digital change in central banking

Izabella Kaminska

| Feb 25 13:20

 http://ftalphaville.ft.com/2015/02/25/2120122/the-boe-on-fundamental-digital-change-in-central-banking/

Here’s a comment to note in the Bank of England’s “fundamental change” section of its One Bank Research Agenda discussion paper:

Technology is potentially transforming the landscape for money and banking. New digital or e-monies and new methods of payment and financial intermediation raise fundamental questions for financial regulation, money demand generally and central bank money in particular. For example, might central banks issue digital currencies and what would be the impact on existing payment and settlement systems? Is the cryptographic technology behind Bitcoin transformational? How will financial regulation need to adapt if new non-bank credit intermediaries emerge in scale?

Talk of official digital money, of course, is not new to FT Alphaville readers. Nor, for that matter is talk of collaborative non-bank credit unions that mint their own currencies for their own network use. Or even talk of digital money solutions that open up the central bank’s balance sheet to more people in a way that eases the safe-asset shortage.

What is new is the sudden enthusiasm, given just a couple of years ago digital solutions to overcoming the Zero Lower Bound for interest rates and/or proposals to ban cash to better enforce negative rates — as originally proposed by the likes of Citi’s Willem Buiter as far back as May 2009 — were still met with raised eyebrows in central bank circles.
Mind you, not that we ever heard central banker-types say they were against the idea of official digital cash. More the social challenges associated with banning or making cash purely digital made an initiative of this sort impossible to implement without fear of a popular backlash. See here as to one example why.
The irony is, if we ever do get a cash ban and/or official digital money (you know, to better implement negative interest rates with, and to avoid cash vaulting), we may have to thank cryptocurrencies for paving the way, especially for much of the heavy lifting on public promotion and education which popularised the concept of digital-only cash.
The Bank’s own position on the potential usefulness of issuing digital currency is as follows:

The emergence of private digital currencies (such as Bitcoin) has shown that it is possible to transfer value securely without a trusted third party. While existing private digital currencies have economic flaws which make them volatile, the distributed ledger technology that their payment systems rely on may have considerable promise. This raises the question of whether central banks should themselves make use of such technology to issue digital currencies.

When it comes to lessons from the Bitcoin experiment the Bank, it seems, is mainly interested in potential for the distributed ledger technology known as the blockchain, which makes sense for the following reasons.

1) In previous conversations with Willem Buiter — a global expert in the field of digital currencies and central bank money issuance — the former MPC member has always stressed that we already have a plethora of private digital currencies in circulation. Nearly all of us (in the West anyway) have access to digital bank deposits and online payment services. What’s more, it’s become perfectly normal for society to treat private bank liabilities as money because the banking industry — motivated by free-market forces — has organised quite well to ensure all the respective private liabilities are mutually respected by the issuing network, in a way that guarantees their fungibility.

2) As a result of the above, the use of digital bank deposits over the course of the last 20-25 years has slowly and subtly transformed money into digital money without most of us even noticing.

3) If none of these currencies “feel” very private, it’s only because the system has organised throughout the centuries to peg the value of privately issued liabilities to the preferred social unit of account, which in most cases is state currency. This is why we don’t tend to notice that we’re using variable tokens with different underpinning value sets as money (unless there’s a bank crisis).

4) The bank industry uses many techniques to guarantee the pegged status of their units; everything from strict collateral regimes and cross-sector insurance schemes to, most important of all, the central bank’s lender of last resort facility — available to banks only if they comply with certain rules and regulations insisted upon by the Central Bank.

5) Sadly, the 2008 crisis proved these techniques may not be sufficient to guarantee stability and fungibility of private units in circulation. It turns out private issuers — even those supervised by a central bank — have an incentive to exploit their power as money issuers and act imprudently, undermining the quality of the units they put into circulation — threatening the fungibility of the money system.

Which brings us back to why the Bank might be interested in adopting a distributed ledger for money issuance.

At the moment, the central bank’s main concern is policing the legitimacy of physical banknote cash in circulation, as well as the number of digital claims held by licensed institutions to its reserves relative to how many there should be. When the latter don’t match up, there’s usually a liquidity problem which can only be fixed if the central bank feels inclined to transform failing private assets into public assets.
The central bank, in this way, outsources the job of managing and supervising the claims of society at large (you know, like for coffee payments) to private institutions. The more it has outsourced this digital job, the more it has de facto transferred seigniorage profits to private institutions, and the smaller its own requirement to issue physical banknote cash has become.
All well and good if you can trust the private system to manage and clear all those micro digital payments in a way that matches up with their ultimate claims on the central bank’s reserves.
But if you can’t, what is the central bank supposed to do when society begins to demand a digital and fungible currency that is publicly rather than privately issued?
The obvious option, of course, is to begin issuing digital central bank tokens of your own to the wider public.
The question is… does that really make sense for a national central bank? After all, not only would the cost of managing such a massive and dynamic dataset be hugely expensive, centralisation could undermine the overall system’s resilience.
One single database is much easier to hack than a complex web of databases defended and managed by private issuers.
Hence, the BoE’s interest in the distributed ledger technology. What’s appealing, no doubt, is the game theory embedded into the distributed clearing mechanism, which amplifies the mutual interest among member institutions to defend the validity and honesty of the claims within the system. Especially, if it incentivises private institutions to bear the costs of that clearing system in lieu of the central bank.
From the paper (our emphasis):

There are several different ways in which a central bank might make use of a digital currency. It could be used as a new way of undertaking interbank settlement, or it could be made available to a wider range of banks and NBFIs. In principle, it might also be made available to non-financial firms and individuals generally, as banknotes are today. The costs and benefits for monetary and financial stability would likely vary in the different cases, being more pronounced the more widely a digital currency is held. For example, making central bank money widely available could have an impact on deposits held at commercial banks and a knock-on effect on the banking system. Another relevant issue is the impact that offering a new method of settlement in central bank money would have on existing payment systems.
One important issue is the type of technology which could be deployed. There is more than one way in which a distributed ledger system can work, and remuneration would have to be designed in such a way as to incentivise honest participation in the system without leading to socially inefficient over-investment in transaction verification. Further research would also be required to devise a system which could utilise distributed ledger technology without compromising a central bank’s ability to control its currency and secure the system against systemic attack.

The central bank, in other words, isn’t so interested in issuing official digital money centrally as it is in finding superior techniques to keep bad incentives at bay when outsourcing management of the micro payments network to private entities.
The key challenge to overcome: persuade private entities the additional cost associated with cross-checking claims against each other in such an intensive manner would be worthwhile for participants.