Challenges of Digital Currencies

When Facebook announced its intentions last June to issue a digital currency, to be called the Libra, the official sector was muted in its initial response.  As we observed at the time (see “Facebook enters the digital currency world”, 30.06.19), central banks could not be seen to be too overtly unwelcoming to innovation and new ideas, but equally, the concept struck fairly directly at the sovereign privilege of issuing currency, and they were also privately concerned at the possible consequences for their conduct of monetary policy.

Since then, central banks have been largely silent;  indeed, the main news on Libra has been of resignations from the consortium, as Visa, Mastercard, eBay and PayPal among others have terminated their involvement.  This has denuded the project of much payments systems expertise, and although Calibra, the consortium which will run Libra, have found other companies to take their place, the consortium is now less balanced and much more clearly a Facebook-dominated operation. 

But silence from the authorities does not mean they have ignored the subject or overcome their initial wariness.  Much research into digital currencies continues to be done by the central banking fraternity, and two issues in particular are coming to the fore.

The first of these is the effect on the orthodox banking system, and in particular its role in the creation of money.  Under a fractional banking system, banks are able to make loans (ie, create money) that are a multiple of their deposits, keeping only a small part of their balance sheet in liquid assets such as central bank reserves.  This process enables the money supply to expand, and in any modern economy is an essential contributor to economic activity and growth.

But if digital currencies become a significant part of the economy, this creation of money will be interrupted.  Calibra have made clear that they do not intend to offer loans or overdrafts, as to do so would immediately make them a bank and so subject to banking regulations, which is not their intention.  Instead they will use the cash they receive from the general public as they buy Libra coins to hold “safe assets”, for example government bonds.  But this means that any cash that customers take out of the banks to put into their Libra accounts will be removed not only from banks’ balance sheets but also from the money creation process[1]

In effect, the introduction of Libra threatens to split the banking sector’s currently unified balance sheet, by moving a significant proportion of customer deposits (that is, the banking system’s liabilities) to the digital currency issuers while leaving customer loans and overdrafts (the banking system’s assets) with the banks.  The inevitable result of this would be to force the banks to reduce the asset side of their balance sheet to match the reduced liability side – in other words reduce their loans. 

This would almost certainly lead to a major credit squeeze, which would be highly damaging to economic activity.  Indeed, the threat that digital “narrow-bank” (ie non-loan making) institutions might reduce or even replace the role of existing commercial banks has central bankers deeply concerned:  there is no precedent for a modern economy thriving without commercial banks and their role in money creation.

Unfortunately, central banks have no easy answer to this.  Relaxing the reserve requirements on the banks and allowing banks to offer more loans per unit of deposit would allow them to maintain the same volume of loans despite their reduced deposits, but would weaken the banks and risk bank insolvencies in any economic downturn.  Alternatively, central banks could issue loans directly themselves (or guarantee banks’ loans, which would have a similar effect in removing the need for reserves to be held against them) – but this direct involvement in the private sector economy is even less attractive for them.  Not only would such a move be running counter to all existing central banking theory, but in pure practical terms it would open the central bank to far more direct contact with the general public and thus, almost inevitably, far more political oversight.

The second issue that arises from the introduction of private sector digital money is the one of cost.  Libra and any other digital currency rival will require a revenue stream to pay their costs (and provide a return to the consortium partners).   How will they raise this revenue?

We suspect that Calibra, with its Facebook heritage, will aim to monetise all the extra data on spending habits that users of Libra will give them for free in the same way that Facebook have monetised social media – that is, with a mixture of advertising and, where they can, direct sales of the personal data they garner to those wishing to make use of it. 

We have our doubts that this will raise the sort of sums required to run a payments system, including building the necessary liquidity float and contingency buffer that such a system requires, and pay the Calibra participants a return.  And we also think there is a risk that monetising yet more data through yet more advertising will eventually run into the problem of limited spend by the advertisers, and Facebook might find that they are cannibalising their other advertising revenue streams.  Any advertiser given a choice between paying for adverts on Facebook, where one knows what users are vaguely interested in, and on Calibra, where one has the much harder data of what they are spending money on, is likely to prioritise the latter. 

If Calibra cannot generate enough revenue from advertising and data sales, and since they have eschewed a revenue stream from interest-bearing loans and overdrafts, the shortfall will have to come from usage charges.  In principle these will be levied on the commercial service provider not the retail consumer, but in practice they will inevitably be paid for by the consumer in the end. 

This raises important questions of efficiency and value for money.  It is by no means clear that such a private sector payment system would be cheaper to operate than the existing bank-based system even on the narrow point of cost per transaction, particularly if, as seems likely, one digital currency soon becomes dominant to the exclusion of competitors.  But in addition, there is the wider issue of whether society is advantaged by Big Tech creaming off yet more money from the economy into an unaccountable, untaxable and often overseas behemoth.

Libra’s current trials may mean that its introduction will be delayed; indeed many consider that it is by no means guaranteed to operate at all.  And there is little doubt that the official sector will not be sorry if Facebook do not manage to bring their project to fruition;   their  view of Libra is well summed up in the comment “Libra is a slippery project, known to change shape in pace with its critics. If criticised on the payment front, it’s a currency. If questioned on the monetary front, it’s a payment system” (Francesco Papadia, “Libra vs TIPS”, 3.02.20).  And it is no secret that privately, the authorities consider Zuckerberg with some distaste and he might have some difficulty receiving their blessing as “fit and proper person” to run a payments system.

But central banks are well aware that even if Libra never happens, sooner or later someone will succeed in introducing a private sector digital payment system.   And the issues and implications for central banking, the commercial banking system and the wider economy that their current research has highlighted will not go away.

A shorter version of this article has also been published by OMFIF as one of their Daily Commentaries.

[1]              The process will be slightly more complex than this statement implies, as if Calibra buy the bonds in the secondary market, then the cash ends up with the bond seller and will still be in the banking system.  But even if Libra make all their purchases in the secondary market, eventually governments will we think issue new debt to replace the debt that Libra has in effect taken out of the market, in order to keep their bond markets liquid and functioning and to allow other bond holders to maintain their preferred level of holdings.  Which will drain the banking system as described.  The alternative would be to see their markets go illiquid at best, and might even allow Calibra to control the government bond markets through owning a major proportion of them, and we cannot see any government being sanguine about that.