This Sunday will see Switzerland’s famed direct democracy in action. People are heading to the polls to decide whether or not they back a referendum motion, known as the sovereign money (or “Vollgeld”/”Monnaie Pleine”) initiative. This motion proposes to do away with fractional banking and make the central bank the sole authority for creating money. It seems unlikely to pass — just 37% of Swiss people are in favour at present — but it is a very interesting proposal that, if enacted, would likely presage the future of banking in the event of national cryptocurrencies being introduced.
The sovereign money initiative
Notes and coins — currency — are created by the central bank, but they only represent a small part of money (roughly 8% in Switzerland). Instead, the majority of money is made up of electronic money, which is created by commercial banks when they lend to consumers and businesses. This process of money creation happens since when banks make loans, they create corresponding deposits — so-called “fountain pen money” since it is created figuratively at the stroke of a pen.
The amount that banks have to keep as reserves to meet depositors’ demands for cash and as a buffer against asset write-downs is very small in comparison to their assets, a fraction. In practice, banks keep about 5% of liabilities as reserves, meaning they are leveraged up to 20x.
The sovereign money initiative proposes that all sight deposits have to be kept as reserves (with the central bank). Since the deposits created when a commercial bank makes a loan are essentially IOUs, banks’ ability to create money through loans would disappear and, effectively, the central bank would be in sole charge of money supply. Any loans that commercial banks granted would have to be financed through savings deposits, debt certificates or equity.
What would be the benefit?
Proponents of the sovereign money initiative, which was tabled by the Monetary Modernisation Association, a Swiss non-profit organization, believe that it would strengthen the transmission of monetary policy changes to the real economy and — most importantly — make financial crises, like the one in 2007, much less likely.
At present, central banks can only influence — not control — the creation of money. They set interest rates in an effort to influence the extent to which economic actors borrow or save, which along with government fiscal policy, helps to ameliorate the excesses of the economic cycle. However, their role is indirect. When they lower or raise interest rates, there is no automatic mechanism for commercial banks to pass on these rate changes to their customers. As in the recent case of quantitative easing, there is little evidence that this led to an increase in bank lending, but more likely led to asset inflation. With sovereign money, the transmission mechanism would be direct. Since customer deposits are all central bank reserves, interest rate changes would be applied directly to these deposits. In the event of quantitative easing, consumers would see their deposits increase directly.
In terms of stability, the central bank cannot directly control how much money is lent, nor at what stage of the economic cycle. History shows that bank lending tends to be very pro-cyclical, leading to regular financial crises, which are very expensive both in terms of direct fiscal costs as well as the economic growth foregone.
Moreover, since consumer deposits are not risk-free (unlike central bank reserves) governments often insure savers’ deposits. This provides both an implicit subsidy to banks as well as, as Martin Wolf puts it, making banking crises “rarer but bigger”.
With sovereign money, it is argued, central banks would be able to control directly how much money was lent out, reigning in excesses and limiting the prospect of bubbles.
What would be the downside?
Critics of the sovereign money initiative — which is not a new initiative, it was first proposed by Irving Fisher in the 1930s in response to the Great Depression — argue that it would deprive the economy of the fuel for growth, see central banks become politicised, undermine the value of national currencies and is unlikely to work as desired.
Under the sovereign money proposal, the central bank would take on a much more important role in establishing the amount of money needed to meet growth and inflation targets (at present, it generally only targets inflation). This would extend the Central Bank’s role and, as the SNB notes, could “jeopardise monetary policy independence and the fulfilment of the SNB’s mandate”. Further, the central bank would issue “debt-free” cash without having corresponding assets, which it argues would erode its balance sheet and undermine confidence in the Swiss Franc. Lastly, there is no certainty that sovereign money would remove the risk of financial crises. As the Economist points out, Lehman Brothers was not a deposit-taking institution but its collapse very much precipitated the last financial crisis. Instead, its critics argue that the desire for stability would more easily be achieved within the existing system by continuing to increase capital adequacy ratios or, as the UK has done, by ringfencing deposit-taking divisions.
Why does this have relevance for the world of crypto?
The phenomenon of cryptocurrency also grew up very much in response to a banking crisis.
Bitcoin, the most important cryptocurrency, emerged as a result of a paper published by Satoshi Nakamoto on 31 October 2008, just a few weeks after the collapse of Lehman Brothers.
Bitcoin — cyptocurrency in general — is definitely a new form of money. As the below diagram, taken from an excellent post from the Federal Reserve Bank of St Louis, illustrates, its properties are unique. It is virtual like electronic money, competitive in that many actors can create it (miners as opposed to commercial bankers), but it is also decentralized.
And as its proponents point out, it is this last point that makes it special. Since, they argue, it is not centrally controlled (consensus is established cryptographically, hence the name), it cannot be created at the whim of central banks or governments — and in Bitcoin’s case, the number of coins is finite — making it a better store of value.
Nonetheless, it is not our purpose here to discuss the relative merits of Bitcoin vs fiat currencies, but instead to discuss what might happen to commercial banking in the event of national crptocurrencies being launched, which we believe would be very similar to the effects of sovereign money.
Central bank cyptocurrency would be a lot like sovereign money
The St Louis FRB paper highlighted above comes out in favour of sovereign money, but against central bank cryptocurrency on the grounds that the anonymity of the latter would be too problematic. “Think,” they say, “of a hypothetical “Fedcoin” used by a drug cartel to launder money or a terrorist organization to acquire weapons.”
While it is not our intention here to discuss in detail the feasibility of national cryptocurrencies, we would point out that there could be many ways in which to preserve the distributed aspect of national cryptocurrencies while mitigating problems of anonymity. These include using cryptographic obfuscation techniques (e.g “zero-knowledge” computing) to allow for, say, AML checks while keeping the data encrypted or a permissioned implementation of the cryptocurrency where users would be attributed a unique digital identity after a KYC-like check that would need to be used in certain circumstances to guard again fraud.
But, leaving aside for now the plausibility of using blockchain technology for national digital currencies — which several countries such as Sweden and Canada are exploring — their properties would probably lead to a 100% reserve system. The way this would likely play out is very well explained in an interesting blog from the Bank of England:
“If CBcoin were remunerated at the same rate as CB reserves, it would be interchangeable with reserves…. As a risk-free, interest-bearing asset, CBcoin would be preferable to bank deposits, encouraging households and firms to convert their bank deposits into CBcoin deposits.”
And, thus, a central bank cryptocurrency would first become equivalent to central bank reserves and then all depositors would rather hold deposits in this fiat cryptocurrency than as electronic money with their commercial bank.
Essentially, in a world of central bank cryptocurrencies, the role of central banks expands vis-à-vis commercial banks. Effectively, all deposits sit on the central bank’s ledger and the ability for commercial banks to create new deposits through lending becomes greatly diminished. We could argue that role of commercial banks would get squashed almost to the point where central banks could bypass them altogether, dealing instead directly with the fintechs arranging and distributing loans and originating payment transactions. However, this seems excessively pessimistic. Not only would many bank activities — private banking and investment banking in particular — be largely untouched, but likely banks would take on a different role with different activities, such as cryptocurrency custody services and providing settlement for a new payment scheme between consumers’ CBCoin wallets.
But it goes without saying that the introduction of national cryptocurrencies, like the sovereign money initiative, would be a radical experiment in the unknown which would introduce major changes in the banking sector.
A Swiss sovereign fund
Under the current system, the money that is created by the central bank in Switzerland is invested chiefly into foreign securities and foreign currencies. This enables the SNB to influence the CHF exchange rate vs other currencies and explains both why it holds such large foreign currency balances and why it makes such large profits (and losses), which get paid out as dividends to its shareholders, the Swiss cantons.
Under the proposed new system, the sovereign money system, the money created would not be used to buy foreign securities and currencies, but instead would be handed to the cantonal governments.
This creates a unique opportunity. Notwithstanding its wealth, Switzerland does not have a large amount of risk capital. And its banks, like banks in general, have struggled to make the transition to the new intangible economy, preferring instead to double-down on real estate lending.
So, there is a clear gap for risk funding to invest in new digital age businesses. A side effect of Vollgeld initiative is that it could create the means for a Swiss sovereign fund — one modelled on Softbank, making the big bets to build the next generation of national champions, the lions and aircraft carriers that Switzerland and Europe desperately need.
Switzerland’s system of direct democracy sees it hold many referenda. The motion on this weekend’s ballot paper seems particularly radical, especially for a country where banking represents 10% of GDP. The sovereign money initiative proposes to end fractional reserve banking and make the central bank the sole authority for money creation, which would have profound implications for the industry (similar although probably less dramatic than the introduction of a national cryptocurrency). It seems unlikely the Swiss will vote for the motion, but in the event that they do, the country should not miss a unique opportunity to create a giant sovereign fund to support the next generation of Swiss companies built for the digital age.
This article was written together with Adrien Treccani, CEO of Metaco, which provides a cryptocurrency custody platform for banks. I would ask like to thank my colleagues Dan Colceriu, John Schlesinger and Laura Kemp for their comments on the draft version.