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Whether or not the purported explanation that the plot and characters of Wizard of Oz being an allegory for the Federal Reserve and the Gold Standard is correct, for anyone in finance the notion that central banks operate on a basis of smoke and mirrors certainly rings true. It’s not only that it’s all smoke and mirrors with the central banks. It’s that behind the smoke and mirrors, there’s just more smoke and mirrors. Usually, clues surface when central banks start opining on something that is so fundamentally a bad idea that it really ought to be left to shuffle off into a dark corner and die a quiet, unmourned, death. Something like sovereign digital currencies, for example.
The FT has been trying (more on this later) to work out what central bank governors, like the Bank of England’s Mark Carney, meant when he came down from Mount Parnassus, to tell us all how central banks and governments will increasingly be required to consider the move to a digital reserve currency in a “multi polar world”. Carney was, here, entirely correct in principle. The US manages the US dollar primarily for the US’ interests. Certainly in terms of interest rates, the US Federal Reserve takes the needs of the US economy — as it perceives them — as the basis for how it operates monetary policy and who can use the US dollar, for what purposes. Reading between Carney’s lines, you can also intuit a political frustration that, on more than one occasion, the US will also operate the US dollar in pursuit of US geopolitical policy objectives. Even at some economic cost — and not just to the rest of the world, but potentially to the US itself, too. Carney didn’t mention in his speech about another problem, which is how central banks end up having to step in to support the commercial banks in times of financial stress — the FT spotted this angle, we’ll return to this more fully below.
But firstly – and most importantly – whether a sovereign digital currency ever gets implemented is ultimately going to be a political choice. It is a political – not something that is subject to any economic or technical constraints or influences – decision, if The Powers That Be did decide to introduce a sovereign digital currency. We would have to ask ourselves why it was they made that choice to solve the problems they are confronted with, rather than an equally valid (and considerably simpler) alternative, which was nationalisation of the existing system.
Apart from hard-line free-market ideology, there is another, more subtle, impediment to any ideas about the implicit nationalisation of the payment system through a government-backed digital currency, which the banks could only access through an interface the central banks would have to provide to the currency’s (presumable) distributed ledger. Note that this is a key element of the digital sovereign currency idea – and why a digital sovereign currency would be defacto nationalisation of the payment system. Today, it is the commercial banks which control their individual ledgers which when taken in aggregate form what is in effect a single distributed ledger. They – and add-on’s like the credit card schemes and interlopers such as PayPal – then create bespoke competing and overlapping interfaces. A digital sovereign currency could only have one distributed ledger (which the central bank would maintain) and one interface to it (which again, the central bank would specify and control).
But given that this would entail the central banks and governments taking a far more hands-on role in the provision of what are currently operated solely on a strictly private-sector commercial basis, like money transmission services – a role they are determinedly eschewing — how will the cakeism inherent in what is being mooted be resolved? If central banks — and, by proxy, governments – want to be in control, they’ll need to be willing to to shoulder responsibilities of operating, monitoring and controlling any digital sovereign currency. Responsibilities which they can presently and often conveniently shirk through a “because markets” shrug of the shoulder.
If the system were to be in effect nationalised by migration to a digital sovereign currency, then governments would provide – in response to public, or consumer, demand — the services which societies needed. This would be on a utility basis — there’d be no drive for marketing and adding special bells and whistles onto what would be a generic, core, product of sending money from person (or business) A to person (or business) B. But much of the complexity in the current payments ecosystem is artificial, driven by needless product differentiation. Bank accounts which will clear checks for value on paying-in (rather than having to wait for them to pass to the issuer bank and get a confirmation that the check wasn’t bad). “Instant” transmission of funds whereby there’s no time-lag between, say, using your Debit card in a store and the store getting your money into its account. Some of this was driven by a call, legitimate at the time, to avoid banks being able to profit on the funds held up while payments were being cleared.
But that was only a true statement in the days of high positive returns on cash (or positive liquidity). Now holding cash – having a positive balance in funds awaiting release through clearing — can be a cost to the banks.
And for consumers, just how useful is this incessant demand that all payments must be settled instantly? Gone are the days where you could issue a check, but get a cooling-off period through the ability to stop it, should you find that there was some (valid) reason why you no longer wished to have the recipient get their hands on your money. Or that you could instruct your bank to make a wire transfer, but then realise momentarily later that you’d specified the wrong amount or had the payee’s details incorrect. Too late, in the world of instant money transmission – it’s your liability and it’s your problem to get the money back from whoever you (possibly inadvertently) sent it to.
In a nationalised payment system, governments would be forced to determine what, on a social utility basis was the most appropriate feature-set for money transmission services, at what costs to system users and with what benefits. And once that line is crossed – governments taking ownership of the money transmission services – they won’t be able to avoid all the associated baggage that comes with it, like dispute resolution, fraud and money-laundering countermeasures and Know Your Customer verification. And it gets even worse from there. Once those functions are, unavoidably, subsumed into a nationalised payment services system, what, exactly, would the commercial banks — certainly at a retail level — be for? Apart from possibly gaudy branding and gruesomely sentimentalising marketing.
Moreover, while at a retail level simple checking accounts and card payments are easily-understandable and worthwhile services for consumers, at the margins – such as for large corporate customers – it’s not nearly so clear-cut what is socially useful and what is inherently full of hard-to-determine compromises. For example, the commercial banks and their large corporate customers utilise netting and pooling arrangements to minimise transactions volumes and thus costs. The banks often sell pooling services to their large customers manage complex accounting needs, so it’s also a valuable revenue stream for the banks. But in a Central Bank-managed digital sovereign currency, this could no longer happen because any pooling or netting run by the commercial banks (and their customers) presents credit risk as counter parties’ positions are not instantaneously settled. “Someone” would have to decide whether netting and pooling arrangement would be permissible, if so to what extent and available to which types of customers on what basis.
In our prevailing small-state cultures, it’s perhaps no wonder governments would rather not have to do the hard work of making those sorts of choices and explaining to their electorates what the trade-offs are which are available to them. “Conventional” nationalisation of the existing system and its key players would be too overt and their newly-acquired responsibilities too obvious and traceable. Perhaps something a little more opaque is needed? Hence the sudden appearance of a new-fangled technology-based sleight-of-hand in the form of the sovereign digital currency.
We can forgive, then, the Financial Times for doing its part in keeping a flame burning under the meagre gruel being cooked up by purveyors of digital currencies, such as Facebook’s Libra, because the central banks have not stopped muttering on about it for months. The FT does its best in their article to puzzle out why central banks are even entertaining the possibility of implementing a digital currency. To be fair, if you read the piece closely, you can see that it expands on a key difference between something like, say, Libra – which is entirely a private sector owned and operated system – and a sovereign digital currency which would be, notionally, run in the public interest by governments.
You have to wade through the entire thing, though, before you get to the real explanation for why this concept is being given the trial-balloon treatment by the central banks. To save readers’ patience’s, I’ll cut to the chase for you:
The picture that is emerging is one in which private institutions are licensed to issue digital currencies either through accounts or “wallet” applications that are fully backed by central bank reserves, which are already electronic.
The BoE’s [Bank of England] recent consideration to giving non-bank fintech companies access to its reserves was intended to encourage this type of system.
To consumers it would feel very much like the electronic payment and transfer solutions that are already available today through their banking apps or a service such as PayPal. The difference would be that both the safety of the intangible cash and the reliability of the transfers would be fully secured by the sovereign provider of money: the central bank.
I think the FT’s writer stumbled across the truth of the matter, but didn’t realise it. Certainly, they could have simply printed their last paragraph and be done with it. It’s the only thing that tells us what’s going on here, in the entire article. Because the FT stopped at that point – just where it was getting interesting — rather than using that as their introduction, we’ll need to pick up that baton from there and explain what’s really afoot.
To understand what’s piqued central banks’ interest in digital currencies, we need to remind ourselves about a feature of the banking system which is hidden in plain sight. If, as a suggestion, you decide to make a donation to the Naked Capitalism fundraiser and you, wisely, don’t want to risk putting cash in the mail, you can use the PayPal option or post a check. These are money transmission, or remittance, products. They move money from the sender of the funds to the recipient of them.
But what happens in the – highly likely – event that several different financial institutions are involved in the flow-of-funds chain? To return to the fundraiser donation example, unless you and Yves have the same bank, there’s your bank (the one which maintains your account) and Yves bank (where her account is held). And that’s just the most straightforward of scenarios. If I send a donation, there’s my bank in London (HSBC in my case), HSBC’s office overseas (in NY), a currency conversion from £ to $ (potentially done via HSBC’s NY branch and the NY Fed, should HSBC need to access a fresh supply of dollars for the dollar clearing) then finally Yves’ bank as she doesn’t have a bank account with HSBC.
In normal circumstances, none of this is a problem. The central bank which looks after UK banks (the Bank of England) is happy to provide HSBC in London with whatever GBP (£) liquidity it needs to send the money to its NY branch, the NY Fed is happy to let HSBC’s NY branch have whatever USD ($) liquidity it needs to convert the GBPs to USDs and then the regional fed which supervises Yves bank is happy to let Yves have her money knowing that it can get it back from HSBC in NY.
But in times of financial stress, especially systemic ones like those which occurred in the Global Financial Crisis (GFC) 10 years ago? It was in those circumstances where the (unwitting) generosity of the central banks to support all that nice “provision of industry and payment services” came back to bite them on the bum. By making all those $’s and £’s (and other currencies, like ¥ from the Bank of Japan, or € from the European Central Bank) available on demand (subject to the proffering of high quality collateral, or what was supposed to be high quality), the central banks prop up the whole show. This is known in the industry as intraday liquidity.
To say that the central banks are vexed by this shotgun marriage between public funds and private capital is an understatement. Since the GFC — so we are talking a decade or more now — central banks have been ruminating over how to extricate themselves from this role — while at the same time save the money transmission system from complete collapse in times of upheaval. Take the Bank of England:
5.1 This chapter provides a definition of intraday liquidity risk and outlines the PRA’s [Prudential Regulatory Authority] approach to assessing and calibrating intraday liquidity risk under Pillar 2.
5.2 The PRA defines intraday liquidity risk as ‘the risk that a firm is unable to meet its daily settlement obligations, for example, as a result of timing mismatches arising from direct and indirect membership of relevant payments or securities settlements systems’.
5.3 The PRA considers that all firms connected to payment or securities settlement systems, either directly or indirectly, are exposed to intraday liquidity risk.
I’ll leave interested readers to digest all 18 pages of the Bank of England’s report, in all its wonderful wonkery, at their leisure, should they so wish. Suffice to say that the initiative referenced (“Pillar 2 liquidity”) is, as the name implies, just the latest in a long line of other initiatives. And the report linked to is a summary of a much more detailed policy statement on how the bank of England wishes to lessen the money centre banks’ reliance on its involuntary largess.
Somewhere, though, a light seems to have gone on in the central bank governors’ minds that they will never be able to truly square this circle – guaranteeing the functional stability of the banking system, certainly for money transmission, but avoiding being on the hook for losses if the central banks have to step in and act as the liquidity providers of last resort.
Readers of sites like Naked Capitalism would be shouting at their screens “But why not rely on a Post Office bank?!” – or, in more technical terms, a nationalised provider of banking and money transmission services. A simple and technically proven ready-made solution. Unfortunately, its politically and culturally impossible. Instead, we have yet more of the smoke and mirrors which get brought in to try to disguise how the central and the commercial banks are inseparably joined in a push-me pull-me connivance of mutual dependency and loathing.
By adopting a digital currency – which is also sovereign – the central banks could rip out the current money transmission plumbing and allow the commercial banks to create payment services products which look and feel much like the ones we know and use today but which remove all counterparty risk (because there are no counter-parties any more — everything is done on the the central banks’ digital sovereign currency’s distributed ledger and the services are accessed via an interface available to all authorised system participants). It would achieve the same thing as nationalisation of the payment services system. And the best part is, if you’re a central bank trying to sell the idea of nationalising the payment system to governments incurably beholden to free market dogma, it all looks like a refreshingly familiar and unquestioned standard-issue tech unicorn. You have to look really – really — closely at its teeth to see the inherent slippery slope to full nationalisation it is carrying with it.
The “only” downside, for the rest of us, is the inevitable overbearing monitoring and surveillance.