Technological innovation is an important driver of productivity growth. Harnessing its potential lies at the heart of raising living standards. Nowhere does this apply more forcefully than in the financial sector.
Yet experience with financial innovation is mixed. Employing information technology within the financial system has supported reductions in transaction costs, improvements in capital allocation and upgrades in risk management. But that technology has also magnified the adverse consequences of mistakes and miscalculations. Mortgage securitisation that relied on overly optimistic statistical models of the US housing market—models that denied the possibility of a nationwide decline in house prices—is a case in point. The lasting macroeconomic costs of the ensuing financial crisis far outweigh the benefits offered by easier access to mortgage financing.
Capturing the (largely micro) benefits of financial innovation while containing their (largely macro) risks should guide public policy towards the financial sector. Managing this trade-off constitutes the decision framework for central bank and financial regulators, which, in turn, shapes the future environment, structure and prospects of banks and markets.
As reflected in a number of recent articles on these pages and elsewhere, the application of this trade-off to the retail-payments system has received renewed attention of late. Digital payments have become commonplace over recent years, with fintech (financial technology) innovation in this market segment continuing apace. Novel technologies, including but not exclusively applications of distributed ledgers (blockchains), have the potential to improve access, reduce cost, increase speed and strengthen the resilience of retail-payments systems. Why the current increase in activity and attention?
Evading existing regulation
A maligned view sees recent innovation as an attempt to evade regulation, such as that embedded in anti-money-laundering or terrorist-financing legislation. A case in this direction can certainly be made. Recent high-profile ransomware cyber-attacks have sought payments using crypto-assets such as bitcoin, while anecdotal reports of the use of crypto-assets for illicit activities are widespread. Either the underlying legislation is misplaced, or (much more plausibly) there is a strong case for more aggressive implementation of the underlying legislation in the digital sphere. Regulation needs to keep pace with technological change—if necessary, by outlawing some of the new platforms but preferably by adapting to the new environment. Ensuring that the benefits of digital technology can be reaped without undermining important payments regulations requires much more invasive supervision of emerging systems—and may offer one rationale for a publicly provided digital currency embodying credible checks against illicit use.
Viewed through this lens, many of the policy challenges raised by digital currencies prove less novel. In particular, we know that the anonymity offered by transacting in banknotes has led to their use in black markets, tax evasion and criminal activity; with regard to illicit transactions, they acted as the bitcoin of the pre-digital age. Central banks have acted to curtail such activity in the past; for example, in line with the recommendations of former IMF (International Monetary Fund) chief economist and Harvard professor Kenneth Rogoff, the ECB (European Central Bank) has announced the phasing out of its large denomination EUR 500 banknote on the grounds that it is especially suited to furnishing illicit transactions. Central banks, therefore, both recognise the risk that payments innovations may serve to undermine necessary regulation and have proved willing to act to contain those risks. I would anticipate that this approach will apply equally in the digital sphere.
Employing technological advances
A more benign interpretation of recent developments views digital innovation in retail payments as a reflection of technical advances in a market segment that was otherwise moribund and inefficient. Facilitating transactions entails having access to safe, capital-certain, secure, stable, simple and transferable assets—these are the characteristics required for such assets to be widely accepted as means of payment. The traditional view has been that preserving these characteristics requires an institutional regime with a high level of regulation that, in turn, is associated with high barriers to entry. But behind these barriers, incumbent providers of payments services—though safe—can stagnate. After all, the greatest of all monopoly profits is an easy life.
As has been the case in many other sectors across the economy, technological advances allow new and innovative entrants to contest moribund markets, creating scope for both greater efficiency and more competition. Life for incumbents is no longer so easy. For sure, technology-induced contestability in the market for payments will challenge the existing regulatory framework as well as the complacency of incumbents. But, as in other settings, it is precisely this disruptive process that drives change and ultimately improves performance. The onus is on regulators to keep pace.
How well do recent innovations match up to this benign ideal? So-called cryptocurrencies such as bitcoin fall well short. Cryptocurrencies fail to meet the criteria needed to serve as a means of payment: the speculative gyrations of bitcoin’s US dollar price hardly offer the stable purchasing power required. Such instruments are better understood as crypto-assets (or even crypto-commodities) than a currency or form of money. They are a vehicle for speculation rather than for transactions. As a large asset manager recently argued: Even if the intrinsic value of a crypto-asset is zero, it may nevertheless prove promising to trade.1
Much as a Millennial soccer enthusiast may prefer to play FIFA 2021 on his or her gaming console rather than kick a football around in the park, a Millennial speculator may prefer to trade a crypto-asset rather than a more tangible asset or commodity firmly grounded in the real economy (such as oil or gold). In this context, the key question is whether retail investors should be permitted to engage in such a volatile, speculative market, given their understanding of the potential risks involved. Existing securities laws and financial conduct rules provide a basis for governing such questions. The challenge is to apply these rules in a novel and evolving space rather than the underlying design of the rules themselves.
So-called stablecoins present other challenges. By contrast with crypto-assets such as bitcoin, stablecoins (as their name suggests) seek to maintain a predictable value in terms of existing currency. They do not seek to offer a new unit of account but rather to employ digital technology to offer a better means of payment for an existing unit of account (such as the dollar or euro). Convertibility of the stablecoin into central bank currency at par then becomes central to its credibility and effectiveness. As several central banks have recently highlighted,2 doubts about such convertibility will undermine the reliable value of the stablecoin and are thus likely to threaten financial stability and the integrity of the payments system by prompting runs from the stablecoin into central bank money.
In all these respects, stablecoins are similar to bank deposits. Much like stablecoins, retail bank deposits constitute a supposedly physically more secure and efficient instrument for making payments than exchanging wads of banknotes. But deposits must be readily convertible into banknotes at par if they are to have the secure and predictable value required to act as a medium of exchange. Over time, a panoply of interconnected instruments have evolved that define a complex web of obligations and responsibilities among central banks, governments, financial regulators and deposit-taking banks that seek to ensure such convertibility: lender-of-last-resort facilities, bank supervision, deposit-guarantee schemes, capital and liquidity requirements, and so on.
If it looks like a duck, walks like a duck and quacks like a duck, perhaps it really is a duck. Since, in many respects, stablecoins are essentially equivalent to bank deposits, the preservation of a level playing field among competing payments technologies would imply regulating the providers of stablecoins in broadly the same way as banks. There may be a case for a lighter regulatory regime to encourage new entry and support innovation; once stablecoin providers have achieved a certain level of maturity and scale, the machinery of bank regulation should then be applied. This is consistent with a “principle-based” approach to financial regulation—focused on economic outcomes—rather than a more legalistic approach. The latter can quickly become overly complex and legalistic and is more likely to become outdated as innovation occurs.
Wider (and newer) questions
The preceding considerations suggest that digital innovation in payments technology is to be welcomed. The challenge facing financial authorities is to ensure the existing monetary and regulatory regimes are applied to emerging institutions and technologies in timely and effective ways, rather than to introduce a wholly new framework.
Yet, the role of central banks (and other regulators) in the economy and financial markets is undergoing a wider transformation. The global financial crisis (GFC) revealed new weaknesses in the financial system, stemming from its greater size, interconnectivity and complexity; increasingly global character; and greater reliance on digital technologies. Management of these vulnerabilities thus far has largely adopted a patchwork approach: Problems are addressed “bottom-up” with measures designed to address specific issues. Little regard has been paid to the overall system-wide implications of individual measures. Unintended consequences of well-intentioned responses to one set of difficulties have created challenges elsewhere in the system. Viewing the challenge of managing emerging digital-payments technologies as one implementation of existing regulation is a continuation of this approach.
At some point, a more fundamental “top-down” rethink may be required, within which the treatment of new payments technology is one aspect that is addressed on the basis of consistent system-wide principles. Admittedly, undertaking such a rethink will be difficult when immediate challenges remain significant. But as a starting point, it may be useful to highlight two key questions that any such review would need to address, touching on how the emergence of new payments technology may both influence and be influenced by how these questions are addressed.
First, central banks need to review who should have access to their balance sheets and facilities, for what purpose and on what terms. The traditional answer to this question has been to limit such access to a privileged set of financial institutions (banks or a subset thereof), offering them central bank reserves that can be converted into banknotes on demand. In return for this privilege, banks assumed certain obligations and responsibilities, and the policy authorities relied on the banking sector to transmit monetary policy and distribute liquidity into the wider financial system and economy. The central bank stood behind the system by acting as a contingent lender of last resort (LOLR).
The evolution of the financial sector over recent decades brings into question the workability and reliability of the traditional framework, as the GFC demonstrated. In particular, central banks found a need to circumvent a malfunctioning banking sector by offering direct access to its operations to other actors while introducing access to other instruments via regular foreign exchange and securities-lending operations. Behind these policy innovations was the assumption of new responsibilities: central banks proved willing to become not just “lenders-of-last-resort” to a specific group of banks but also to act as “central-counterparties-of-last-resort”, “market-makers-of-last-resort” and even “risk-absorbers-of-last-resort” to a broader set of market participants.3 Such were the demands imposed on central banks if they were to maintain market functioning in a period of market stress.4
Treatment of new digital-payments technology needs to be seen in this light. Central banks should decide whether to force providers of digital payments to work through banks (or to become banks) in order to obtain access to central bank facilities or to offer access to them directly via a new regime that would place different obligations upon them. Establishing any such new regime entails defining the terms of access: Would providers simply obtain central bank reserves as banks do at present, or would they have to hold distinct instruments with different characteristics—such as central bank digital currency (CBDC)? And once such a CBDC exists (and assuming the technology exists), should individuals be able to hold this directly rather than through an intermediary stablecoin provider? Were that to be the case, what would be the implications for the character of the CBDC instrument as regards remuneration and so forth?
All these remain open questions. The key point is that questions about the treatment of digital payments and CBDCs cannot be answered in isolation from the broader issue of who can access the central bank’s balance sheet and on what terms. In the aftermath of the global financial crisis, this issue remains in flux. Central banks have recognised that the management of digital-payments technology needs to recognise its potential implications for monetary-policy transmission and financial stability. But these are governed by wider and as yet unresolved questions.
This leads to the second, wider question facing central banks: Should they focus on stabilising financial institutions or stabilising the financial instruments that they create and hold? Within the traditional framework, this question does not really emerge. The stability of key systemic instruments—bank deposits and bank loans—are inextricably linked to the stability of the institution that created them under a “relationship banking” regime. But financial innovations—such as the originate-to-distribute model of credit associated with securitisation – have introduced a distinction between institution and instrument. It is the need to support the integrity of the latter during the financial crisis that has prompted central banks to adopt a more active role in maintaining market functioning by acting as a market-maker-of-last-resort, since acting to support banks alone is no longer sufficient.
While the pursuit of financial stability entails supporting both institutions and instruments, different approaches are required. Institutions have a personality of their own: When they hit trouble, they will approach the authorities for support. Such is the basis of central banks’ lender-of-last-resort function. By contrast, instruments are impersonal. When an instrument encounters trouble, the central bank has to proactively act to address stress. Such is the nature of acting as a market-maker-of-last-resort: the authorities need to enter the market to establish a price for the instrument rather than passively wait for a bank to request emergency liquidity assistance. Grappling with how to act in this proactive manner has been at the heart of the controversies faced at central banks during and in the aftermath of the financial crisis.
Again, resolving this question has important implications for the treatment of innovative digital payments, in particular to the extent that new payments systems embody distributed ledger (blockchain) technology. Blockchains open up the possibility of so-called decentralised finance. The central promise of decentralised finance is that intermediaries become redundant: financial transactions are conducted through the disembodied medium of code rather than via an institution. Widespread adoption of decentralised finance would, therefore, imply a diminishing role for financial institutions and force authorities to focus on instruments. In turn, this would reinforce the ongoing trend at central banks towards a more proactive approach to financial stability embodied in their greater emphasis on maintaining market functioning.
Digital innovation in retail payments is an ongoing and dynamic trend. It promises much in terms of better access, lower costs and greater efficiency in retail transactions. But, as with any financial innovation, it entails risks, especially via its macro impact on financial stability and monetary-policy transmission.
Central banks are acting to capture and magnify the benefits while containing the risks. In doing so, they are adding to the patchwork of new regulation and supervision that has been built bottom-up since the onset of the global financial crisis. While this approach represents the likely path forward against the background of a rapidly evolving financial system, within which innovative payments technologies are merely one part, it would be preferable for central banks to step back and revisit more holistically to whom, how and what access they offer to their facilities and operations, as well as the nature of those operations. Policy treatment of digital-payments technology would fall out of a broader and more consistent overall central bank framework, avoiding the potential unintended adverse consequences of the more limited, piecemeal bottom-up approach.
Taking a more holistic, system-wide view is desirable but practically difficult at a time when monetary and financial policies face many other challenges. But only by doing so can a coherent framework for the governance of digital payments emerge.
1 “Crypto has ‘no inherent worth’ but is good to trade, says Man Group chief,” Financial Times 26 July 2021.
2 e.g. “Systemic stablecoins and financial stability,” ch. 5 in Bank of England Financial Stability Report December 2020.
3 Durré, A. and H. Pill (2012). “Central bank balance sheets as policy tools,” BIS Papers 66, pp. 193-213.
4 Lenza, M., et al (2010). “Monetary policy in exceptional times,” Economic Policy 62, pp. 295-339.