Crypto assets may one day reduce demand for central bank money Dong He
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he global financial crisis Crypto assets derive market value from their and the bailouts of major potential to be exchanged for other currencies, to financial institutions be used for payments, and to be used as a store of renewed skepticism in value. Unlike the value of fiat currencies, which is some quarters about cen- anchored by monetary policy and their status as legal tral banks’ monopoly on tender, the value of crypto assets rests solely on the the issuance of currency. expectation that others will also value and use them. Such skepticism fueled Since valuation is largely based on beliefs that are the creation of Bitcoin not well anchored, price volatility has been high. and other crypto assets, which challenged the para- digm of state-supported currencies and the dominant Deflation risk role of central banks and conventional institutions Some crypto assets, such as Bitcoin, in principle in the financial system (He and others, 2016). have limited inflation risk because supply is limited. Twenty years ago, when the Internet came of However, they lack three critical functions that stable age, a group of prominent economists and central monetary regimes are expected to fulfill: protection bankers wondered whether advances in information against the risk of structural deflation, the ability technology would render central banks obsolete to respond flexibly to temporary shocks to money (King 1999). While those predictions haven’t yet demand and thus smooth the business cycle, and come to pass, the rise of crypto assets has rekin- the capacity to function as a lender of last resort. dled the debate. These assets may one day serve as But will they be more widely used in the future? alternative means of payment and, possibly, units A longer track record may reduce volatility, boosting of account, which would reduce the demand for further adoption. And with better issuance rules— fiat currencies or central bank money. It’s time to perhaps, “smart” rules based on artificial intelligence— revisit the question, will monetary policy remain their valuation could become more stable. “Stable” effective in a world without central bank money coins are already appearing: some are pegged to (Woodford 2000)? existing fiat currencies, while others attempt issuance For the time being, crypto assets are too volatile rules that mimic inflation- or price-targeting policies and too risky to pose much of a threat to fiat cur- (“algorithmic central banking”). rencies. What is more, they do not enjoy the same As a medium of exchange, crypto assets have degree of trust that citizens have in fiat currencies: certain advantages. They offer much of the ano- they have been afflicted by notorious cases of fraud, nymity of cash while also allowing transactions security breaches, and operational failures and have at long distances, and the unit of transaction can been associated with illicit activities. potentially be more divisible. These properties make crypto assets especially attractive for micro Addressing deficiencies payments in the new sharing and service-based But continued technological innovation may be digital economy. able to address some of these deficiencies. To fend And unlike bank transfers, crypto asset transac- off potential competitive pressure from crypto tions can be cleared and settled quickly without an assets, central banks must continue to carry out intermediary. The advantages are especially appar- effective monetary policies. They can also learn ent in cross-border payments, which are costly, from the properties of crypto assets and the under- cumbersome, and opaque. New services using dis- lying technology and make fiat currencies more tributed ledger technology and crypto assets have attractive for the digital age. slashed the time it takes for cross-border payments What are crypto assets? They are digital repre- to reach their destination from days to seconds by sentations of value, made possible by advances bypassing correspondent banking networks. in cryptography and distributed ledger technol- So we cannot rule out the possibility that some ogy. They are denominated in their own units crypto assets will eventually be more widely of account and can be transferred peer to peer adopted and fulfill more of the functions of money without an intermediary. in some regions or private e-commerce networks.
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Payment shift Economists disagree about whether massive
More broadly, the rise of crypto assets and wider adjustments in central bank balance sheets would adoption of distributed ledger technologies may be necessary to move interest rates in a world where point to a shift from an account-based payment central bank liabilities ceased to perform any set- system to one that is value or token based (He tlement functions. Would the central bank need to and others 2017). In account-based systems the buy and sell a lot of crypto assets to move interest transfer of claims is recorded in an account with an rates in a crypto world? intermediary, such as a bank. In contrast, value- or Regardless of such disagreements, the ultimate token-based systems involve simply the transfer of concern is similar: “The only real question about a payment object such as a commodity or paper such a future is how much the central banks’ mon- currency. If the value or authenticity of the pay- etary policies would matter” (Woodford 2000). ment object can be verified, the transaction can To Benjamin Friedman, the real challenge is that go through, regardless of trust in the intermediary “the interest rates that the central bank can set . . . or the counterparty. become less closely—in the limit, not at all— Such a shift could also portend a change in the connected to the interest rates and other asset prices way money is created in the digital age: from credit money to commodity money, we may move full circle back to where we were in the Renaissance! In Central banks should strive to the 20th century, money was based predominantly on credit relationships: central bank money, or base make fiat currencies better and money, represents a credit relationship between the central bank and citizens (in the case of cash) and more stable units of account. between the central bank and commercial banks (in the case of reserves). Commercial bank money that matter for ordinary economic transactions” (demand deposits) represents a credit relationship (Friedman 2000). between the bank and its customers. Crypto assets, In other words, if central bank money no longer in contrast, are not based on any credit relationship, defines the unit of account for most economic are not liabilities of any entities, and are more like activities—and if those units of account are instead commodity money in nature. provided by crypto assets—then the central bank’s Economists continue to debate the origins of monetary policy becomes irrelevant. Dollarization money, and why monetary systems seem to have in some developing economies provides an analogy. alternated between commodity and credit money When a large part of the domestic financial system throughout history. If crypto assets indeed lead to operates with a foreign currency, monetary policy a more prominent role for commodity money in for the local currency becomes disconnected from the digital age, the demand for central bank money the local economy. is likely to decline. Competitive pressure Monopoly supplier How should central banks respond? How can they But would this shift matter for monetary policy? forestall the competitive pressure crypto assets may Would diminished demand for central bank exert on fiat currencies? money reduce the ability of central banks to First, they should continue to strive to make fiat control short-term interest rates? Central banks currencies better and more stable units of account. typically conduct monetary policy by setting As IMF Managing Director Christine Lagarde short-term interest rates in the interbank market noted in a speech at the Bank of England last year, for reserves (or clearing balances they keep with “The best response by central banks is to continue the central bank). According to King (1999), ceas- running effective monetary policy, while being ing to be the monopoly supplier of such reserves open to fresh ideas and new demands, as econo- would indeed deprive central banks of their ability mies evolve.” Modern monetary policy, based on to carry out monetary policy. the collective wisdom and knowledge of monetary
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Central banks must maintain the public’s trust in
fiat currencies and stay in the game in a digital, sharing, and decentralized service economy. policy committee members—and supported by market and developing economies, seigniorage central bank independence—offers the best hope is the main source of revenue and an important for maintaining stable units of account. Monetary safeguard of their independence. policymaking can also benefit from technology: To be sure, there are choices and policy trade-offs central banks will likely be able to improve their that would require careful consideration when it economic forecasts by making use of big data, comes to designing central bank digital currency, artificial intelligence, and machine learning. including how to avoid any additional risk of bank Second, government authorities should regulate runs brought about by the convenience of digital the use of crypto assets to prevent regulatory arbi- cash. More broadly, views on the balance of ben- trage and any unfair competitive advantage crypto efits and risks are likely to differ from country to assets may derive from lighter regulation. That country, depending on circumstances such as the means rigorously applying measures to prevent degree of financial and technological development. money laundering and the financing of terrorism, There are both challenges and opportunities strengthening consumer protection, and effectively for central banks in the digital age. Central banks taxing crypto transactions. must maintain the public’s trust in fiat currencies Third, central banks should continue to make and stay in the game in a digital, sharing, and their money attractive for use as a settlement vehi- decentralized service economy. They can remain cle. For example, they could make central bank relevant by providing more stable units of account money user-friendly in the digital world by issuing than crypto assets and by making central bank digital tokens of their own to supplement physical money attractive as a medium of exchange in the cash and bank reserves. Such central bank digital digital economy. currency could be exchanged, peer to peer in a decentralized manner, much as crypto assets are. DONG HE is deputy director of the IMF’s Monetary and Capital Markets Department. Safeguarding independence This article draws on “Virtual Currencies and Beyond: Initial Considerations,” January Central bank digital currency could help counter 2016 IMF Staff Discussion Note 16/03, by Dong He, Ross Leckow, Vikram Haksar, the monopoly power that strong network external- Tommaso Mancini Griffoli, Nigel Jenkinson, Mikari Kashima, Tanai Khiaonarong, Céline Rochon, and Hervé Tourpe. ities can confer on private payment networks. It could help reduce transaction costs for individuals References: and small businesses that have little or costly access to banking services, and enable long-distance trans- Friedman, Benjamin M. 2000. “Decoupling at the Margin: The Threat to Monetary Policy from the Electronic Revolution in Banking.” International Finance 3 (2): 261–72. actions. Unlike cash, a digital currency wouldn’t Goodhart, Charles. 2000. “Can Central Banking Survive the IT Revolution?” be limited in its number of denominations. International Finance 3 (2): 189–209. From a monetary policy perspective, interest- He, Dong, Ross Leckow, Vikram Haksar, Tommaso Mancini Griffoli, Nigel Jenkinson, carrying central bank digital currency would help Mikari Kashima, Tanai Khiaonarong, Céline Rochon, and Hervé Tourpe. 2017. “Fintech transmit the policy interest rate to the rest of the and Financial Services: Initial Considerations.” IMF Staff Discussion Note 17/05, economy when demand for reserves diminishes. International Monetary Fund, Washington, DC. The use of such currencies would also help central King, Mervyn. 1999. “Challenges for Monetary Policy: New and Old.” Speech delivered banks continue to earn income from currency at a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, issuance, which would allow them to continue to WY, August 27. finance their operations and distribute profits to Woodford, Michael. 2000. “Monetary Policy in a World without Money.” International governments. For central banks in many emerging Finance 3 (2): 229–60.
