The brave new world of digital currencies

The Straits Times by VIKRAM KHANNA

Imagine this: One day, the Monetary Authority of Singapore (MAS) decides to issue its own digital currency for use by residents. High-denomination currency notes (S$50 notes and above) are abolished.

You are invited to open a bank account at the MAS. You are offered a rate of interest slightly higher than those available at commercial banks because the MAS saves a lot of money by no longer having to print, store and transport so much cash - it decides to share these savings with its depositors.

Having opened your digital currency account at MAS, you can make payments in real time to any party directly, via phone or computer for free, without having to go through commercial banks, which deduct a charge. You don't need credit cards or Nets either - which makes merchants happy as well because they no longer need to pay commissions to banks.

The digital currency makes it easier for the MAS to conduct monetary policy. For instance, when the economy is weak and the Government wants to increase liquidity, the MAS simply creates extra digital currency with a few keystrokes on a computer, which goes directly into everybody's MAS bank accounts.

In extreme circumstances, when there is a serious recession, it can decree a negative interest rate - which means you pay a charge to keep your money with MAS. This induces you to spend more of your money and help boost the economy instead of leaving it on deposit. If the MAS had tried to do this before cash was abolished, you would simply have withdrawn your cash and kept it at home to avoid the negative interest charge.

If you keep your account with the MAS, tax compliance becomes easy. There is no need for you to file your tax returns because the MAS has a record of all your income and your spending - your tax gets automatically deducted when it is due.

With cash eliminated and most transactions digital and verifiable by the MAS, suspicious activities such as money laundering and financing of illegal businesses decline dramatically.

Since there is no chance of the MAS getting into financial trouble (unlike commercial banks), deposit insurance is withdrawn.


There is a mass exodus of deposits from commercial banks to the MAS. The commercial banks are forced to compete with each other to raise their interest rates to levels above what the MAS is offering, but they still have a tough time attracting deposits.

This stylised and oversimplified scenario is not about to happen any time soon, at least not in Singapore. However, given some clear advantages of central bank digital currencies (CBDCs), central banks around the world are exploring the possibility of issuing their own. A few are even launching pilot projects.

At the Singapore FinTech Festival last week, IMF managing director Christine Lagarde urged central banks to investigate the possibility of introducing digital currencies "seriously, carefully, and creatively".

At the end of the festival, the MAS organised a two-day workshop on digital currencies together with the Asian Bureau of Finance and Economic Research and NUS Business School, where some of the world's leading experts discussed the implications of central bank digital currencies.

One of the forces driving central banks' interest in digital currencies has been innovations in payment technologies and the emergence of virtual currencies like bitcoin, Ethereum and Ripple. Given their proliferation, some economists believe that if central banks continue to be passive spectators, virtual currencies and other private payment providers will make inroads into payments systems and erode central banks' ability to control monetary policy - which could pose dangers to the economy, for instance during economic downturns.

Some central banks - including the MAS - are also intrigued by the possibilities created by blockchain (the distributed-ledger technology that underlies many virtual private currencies) for certain types of transactions, such as interbank payments.


The overwhelming majority of experts at the MAS workshop believed that despite the hype they have generated, private virtual currencies such as bitcoin - which is the most popular - pose no threat to central banks. They are paper tigers.

Harvard Professor Kenneth Rogoff (who has predicted that bitcoin will decline in value by 98 per cent in 10 years' time, to around US$100), suggested that it is "stupefyingly naive" to think that private virtual currencies will replace government-issued fiat currencies.

Just because technology makes virtual currencies possible does not mean they will win. "The private sector innovates, but in due time, the government regulates and appropriates,'' he said. "This is a game in which governments make the rules, and change them."

He predicted that the anonymity that private virtual currencies claim to offer will also be stripped away because, among other reasons, their holders will want to convert them into fiat currencies, in which goods and services are priced. "You might say 'I can pay a hitman in bitcoins' but the hitman would want to spend them - he would also have his needs," said Prof Rogoff. The moment bitcoins and their ilk get converted into real money, anonymity would disappear.

Some virtual currencies may survive, he suggested, partly because they have many followers and because they enable people in countries with badly managed or sanction-hit economies such as Venezuela, Zimbabwe and Somalia to work around dysfunctional payments systems.

But private virtual currencies are slow and inefficient and will eventually be displaced.

Professor Andrew Roseof the University of California at Berkeley pointed out that such currencies should not be considered money at all because they do not satisfy any of the conditions that money is supposed to have. They are not a unit of account (nothing is priced in virtual currencies). They are a cumbersome medium of exchange - barely five transactions in bitcoin can be processed every second, compared with 20,000 transactions per second by Visa. And given their highly unstable valuations, they are a terrible store of value.

They are also minuscule in size and reach. The total value of all private virtual currencies is about US$200 billion (S$274 billion) - though this fluctuates wildly on a daily basis - about half of which is in bitcoin. This is less than 4 per cent of daily global turnover of foreign exchange markets.


But even if private virtual currencies did have the characteristics of money, they would be unlikely to displace government-backed money.

Tracing the history of money, Berkeley professor Barry Eichengreen pointed out that up to the early 20th century, multiple currency issuers were common in many countries, including the United States; many privately owned banks issued their own currencies.

People then had to figure out the creditworthiness of the issuing banks. Their currencies were, in other words, "information sensitive" and therefore unstable. Over time, in every case, national governments took over currency issuance. People trusted government-issued money because there was no need to fathom the creditworthiness of the issuer. Such money was "information insensitive".

Many private virtual currencies (although not bitcoin, which is issued by algorithm) also require information about the issuer and will face the same problems as private bank currencies, and fall out of favour.

"The only reliable way to have stable-value digital currencies is for central banks to create them," Prof Eichengreen said.

Besides, governments need to control currency creation because they sometimes need to mobilise exceptional amounts of resources - for instance, during a war or an economic crisis, like the global financial crisis of 2008. Private currency issuers, or algorithms, cannot be counted on to do this.

So even if private virtual currencies pose no threat to central banks and even if CBDCs offer some advantages, should central banks start issuing them?

One question here is whether the current currency and payments system is problematic. Most economists think that at the retail level at least, it is not. In most countries, fiat currencies are relatively stable, thanks to inflation-targeting by central banks.

When it comes to retail payments, the existing real-time gross settlement system - through which payments are transferred from one bank to another - is fast and efficient, although it can involve some cost.

So if the current system works well, the case to replace it with a CBDC-based system is weak.


Moreover, a CBDC-based system would also have disadvantages.

One, commonly mentioned by economists, is that it would hurt commercial banks. Being 100 per cent safe, free and easy to use, CBDC accounts will be more attractive to depositors than deposit accounts at commercial banks, which would then be deprived of their main source of funding.

They would be forced to raise their deposit rates, but that would mean their lending rates would go up as well, which would be bad for investment and for home owners.

If banks are hurt by CBDCs, their lending function would also be impaired.

"This would open a whole new can of worms,'' said Mr Augustin Carstens, general manager of the Bank of International Settlements, which fosters cooperation among central banks and acts as their counterparty for some transactions.

"Central banks are not created to intermediate financial resources," he noted.

Another problem with CBDCs, highlighted by Dr Eichengreen, is that they would be a rich target for hackers and terrorists. While commercial bank systems can also be hacked, there are many of them. But if the CBDC system, which holds the majority of deposit accounts, is hacked, the entire national payments system would be paralysed.

In short, a CBDC, while conferring some advantages, would also introduce new fragilities and risks into the economy.

So, will we see CBDCs?

For wholesale payments - that is, payments between financial institutions - the chances are good. For instance, the MAS is already experimenting with using blockchain technology for interbank payments in trade finance and plans to explore its feasibility for cross-border payments, which would cut out middlemen and reduce costs.

But it is not looking to create a CBDC for retail use. Nor are most other central banks.

The IMF also urges caution. Despite Ms Lagarde's apparent enthusiasm for central banks to explore CBDCs, the institution's staff are more circumspect.

In a study released during the Singapore FinTech Festival, they advised: "Overall, it is too early to draw firm conclusions on the net benefits of CBDC. Central banks should consider their specific country circumstances, paying careful attention to the risks and relative merits of alternative solutions."