The crypto challenge

Central banks will have to respond to Facebook's Libra

Just a few months ago, Augustín Carstens, general manager of the Bank for International Settlements (BIS), said his organisation saw no value in the potential of digital currencies issued by central banks. Mr Carstens seems to have just changed his opinion. In a recent interview, he said the BIS was working with many central banks that were developing digital currencies as there was a market. The announcement by Facebook of its intention to issue Libra, a crypto coin, may have been behind the new stand taken by the BIS and central banks. Cryptocurrency issued by central banks would turn the original concept of Bitcoin on its head while using similar technology. It would also lead to a new set of challenges in terms of regulation and accounting procedures. Bitcoin used a decentralised ledger, the blockchain, to verify and reconcile anonymous transactions in peer-to-peer fashion. The coin has a fixed money supply and is not tied to the value of any other asset. It sees huge volatility in value, and is difficult to use in a fractional banking system due to fixed money supply and high volatility.  

Any central bank issuing cryptocurrency would use some version of blockchain technology but it might be with restricted access. Money supply could be managed either by policy decisions, or by tying the coin to a fiat currency, or creating a currency board that ties it to a basket of underlying assets — as Facebook intends to do with Libra. In any of these situations, the digital currency would be seamlessly converted into fiat, and vice versa. Fractional reserve banking would be possible in such a system and the crypto would also not have exchange volatility that greatly exceeded normal fiat currencies. In theory, this could be an interest-bearing instrument. But, as the crypto would be borderless, such a currency would automatically lead to capital account convertibility. 

Such a coin could be large-denomination and used in high-value B2B transactions. Or, it could be low-denomination and suitable for retail use.  It would offer a degree of anonymity to the two parties in a transaction, but the issuer would have the ability to trace users. If this was for retail usage, it would almost be equivalent to allowing retail customers to open accounts directly with the central bank.  If it was for high-value customers, it might, for example, allow the central bank to directly service many businesses such as non-banking finance companies, securities trading outfits, exporters and so on.  

The advantage of such a digital system would be frictionless, borderless transactions, which could sharply reduce costs. However, if customers could directly transact in this fashion, they may also choose to disintermediate the commercial banks by converting fiat holdings into digital currency. That could lead to a drop in deposits in the conventional banking system.  It’s hard to assess such risks without a running system, however. In practical terms, the security and safeguards in a cryptocurrency system need to be very strong with multiple fail safes. Users could be vulnerable to identity theft, and the issuer would have to set up new protections against money laundering, given the borderless nature of transactions. Whatever the pros and cons, central banks will have to consider this option seriously. Otherwise, tech giants like Facebook would end up dominating the crypto currency space.