Bitcoin and cryptocurrencies in general have reclaimed the imagination of the investing public, especially as crypto has enjoyed another of its periodic spectacular runs since late last year. Belatedly, mainstream analysts are beginning to note what we told a crowd at the Las Vegas MoneyShow three years ago — digital currencies are a new asset class, alongside equities, bonds, real estate, and commodities. (That link is still a good introductory explainer if you need to get up to speed on how decentralized cryptocurrencies work.)
Individual and institutional investors are not the only ones who are noticing. Because digital assets have such huge disruptive potential, commercial banks, payment processors, securities exchanges, and other components of the mainstream financial markets have been working overtime for the past several years to understand the risks and opportunities posed to them by the rise of the “internet of money.” They understand that the central power of digital assets is “disintermediation,” which represents an existential challenge to financial-system incumbents and an opportunity to new non-bank financial institutions.
And of course, above and beyond these, central banks and governments are assessing the risks and opportunities of “digital money” from their own perspective and their own interests — which are not always parallel to those of the private sector.
Central Bank Digital Currencies
All the world’s central banks are on the bandwagon, planning, creating, and implementing their own digital currencies (“central bank digital currencies,” or CBDCs). Fed Chair Jerome Powell has indicated that it is a major priority for the Federal Reserve, although the U.S. is lagging other major central banks. China and Brazil are both in active development, with China having already initiated a digital yuan pilot program. Pilot programs are underway in Europe, Canada, Russia, South Korea, Sweden, and Singapore, and earlier-stage development in Japan, India, the UK, Australia, Switzerland, Norway, and Israel.
This rapid development means, as we have long said, that central banks around the world are very serious about creating their own digital assets. Below we will describe some of the risks and opportunities they perceive that are motivating them — and we will also reflect on some of the disruption that CBDCs may create for actors in the traditional financial system. Spoiler alert: the arrival of CBDCs poses significant challenges and risks to legacy commercial banks and payment systems. Depending on how the financial authorities structure their CBDCs, those challenges and risks will be more or less severe.
What Central Banks Are Afraid Of
The first wave of digital currencies, led by bitcoin, occurred in the private sector. These assets were “cryptocurrencies” properly speaking — decentralized, cryptographically secured, beholden to no authority, and in the beginning, completely unregulated.
Obviously, if cryptocurrencies were to succeed in displacing any significant part of government-backed fiat currencies, the result would be that governments and central banks would lose monetary sovereignty. Indeed, this was the explicit goal for which cryptocurrencies were created and embraced by their enthusiastic early adopters and evangelists.
Early on we came to believe that governments could not and would not permit this process to occur. Losing monetary sovereignty poses an existential threat to governments’ power to influence the economy via monetary policy, to deploy monetary policy as foreign policy, and even to tax citizens. The question was simply how governments would go about securing their prerogatives in what would unavoidably be an era of digital money. Particularly in more or less free-market economies, draconian measures such as outright bans of cryptocurrencies — cutting them off from the formal financial system — seemed unlikely, although India’s recent efforts suggest that some countries may still try. That route will probably fail, however.
“Digital Money” — An Older Trend Than Cryptos
Further, cryptocurrencies are merely the most recent and intensive threat posed by “monetary digitization” to the monetary sovereignty of governments. Monetary digitization has of course been gradually growing for decades; for many Gen Xers and millennials, cash, not gold, is the “barbarous relic.” Even the non-crypto digital monetary system poses monetary sovereignty risks. China is a case in point, where mobile payments systems have become so widespread that a form of “narrow money” exists and circulates within those networks perpetually, potentially threatening the state’s capacity to effect desired policy. China’s authoritarianism makes this less of a risk, since they can control the relevant companies, witness the recent crackdown on Alipay and other payments giants. But financial authorities everywhere are concerned.
Rather than outright bans, governments are adopting the philosophy of “if you can’t beat them, join them,” and they are creating their own digital currencies. None of these will be cryptocurrencies, properly speaking. They will not be decentralized in the way that bitcoin is, secured by the insurmountable computing-power demands of the network. Central bank digital currencies will “live” in a centralized ledger controlled by the central bank itself. They hope that their functionality, ease of use, and mainstream legitimacy will “steal the thunder” of the private-sector alternatives, and keep government-issued money at the heart of the financial system.
CBDCs and Central Banks’ Fears And Ambitions
Central banks need to make two fundamental choices about how to structure their digital money. It could be wholesale or retail — that is, direct holding might be restricted to banks, or might be permitted for all consumers. And it could be one-tier or two-tier — with consumers having their own accounts directly at the central bank, or with commercial banks intermediating those accounts for consumers.
Central banks, particularly in the new era in which “central bank independence” is increasingly a thing of the past, have two basic interests. They want to strengthen their management of domestic economic trends, and they want to strengthen the management of their country’s currency on a global stage — strengthening or weakening it as needed to effect their government’s policies.
Domestically, they have an interest in financial stability. Therefore we think that in the construction of their digital currencies, the major central banks will be at pains to minimize the immediate disruption to established financial actors, such as commercial banks and payment systems. No matter how they do it, however, there will be unintended disruptive side-effects for the incumbent financial system. Innovative non-bank financial companies will build on the platform provided by CBDCs to deliver new services and functionality to retail customers. Whether this is merely a problem for the legacy financial system — including the banks that have dominated the U.S. financial landscape since the 19th century — or a deeper challenge, will depend on the precise structure that CBDCs are given. We suggest that all of our readers keep up with what we share as we monitor these trends long-term.
In any event, it is a significant tail risk. For example, digital money has been a windfall to banks and payment processors who can acquire extremely granular consumer data through the transaction process, sell it on to a legion of marketing analysts, and use it for their own critical risk evaluation functions. CBDCs will certainly have significant privacy provisions; how will that affect private-sector data collection?
A New Global Conflict
Dollars are involved in 88% of global foreign exchange transfer volume. Beyond their own shores, governments and central banks are eager to seize on the potential for a digital currency to strengthen the standing of their domestic currency on the global stage. You can be absolutely certain that this idea is front and center for the Chinese government (leaders of the People’s Bank of China expressed this clearly at a recent conference of the Bank for International Settlements).
Cyberwarfare is one new global battlefield (as shown by recent Israeli cyberintelligence efforts to thwart Iran’s nuclear ambitions); digital currencies are another. Any country that can make a more friendly, more reliable, more secure digital currency will be able to move toward having a more important currency to transact global business. A country with a successful CBDC may become somewhat more immune to the sanctions pressure that the U.S. is able to exercise on its international adversaries through the global banking system. The Fed and the U.S. government surely understand this, and that explains their eagerness to ramp up development efforts.
Investment implications: The development of central bank digital currencies is an existential imperative for countries globally, for both domestic and foreign policy reasons. This development, while it will be conducted in developed economies with due care and diligence, will almost certainly have unintended consequences for the legacy financial system — potentially disrupting their ability to perform some of their most lucrative operations. In our view, these risks create a cloud over many financial system incumbents. In the financial sector, we prefer tech- and crypto-exposed innovators to banking and to some money transfer operators and middlemen.
