The world of finance is changing and the rise of cryptocurrencies are our most obvious indicator. Companies are now making strategic decisions to include some form of blockchain technology into their everyday operations. Innovative tech giants, such as Facebook and Google, are experimenting more and more with blockchain technology. We’ve even started to see investment banks, such as Goldman Sachs, enter the space by investing into blockchain technology.
That said, there are some traditional institutions, such as the central banks, that are slow to make changes, but technology and the modern world may well be forcing them to make that move.
What’s a central bank?
“A central bank, reserve bank, or monetary authority is an institution that manages a state’s currency, money supply, and interest rates.”
Nearly every country will have a central bank that will act as a “guardian” over the economy.
The main responsibilities of a central bank include:
- Implementing monetary policies
- Setting the official interest rate — used to manage both inflation and the country’s exchange rate
- Controlling the nation’s entire money supply
- The Government’s banker and the bankers’ bank (“lender of last resort”)
- Managing the country’s foreign exchange and gold reserves and the Government’s stock register
- Regulating and supervising the banking industry
Being a “lender of last resort” stands out as one of the most important jobs of a central bank. This means that during times of financial crisis, a central bank will leap into action with their regulatory and supervisory powers. Using these powers, it will prop up the private banks if their situation becomes critical.
During a recession, a central bank’s main reflex will be to lower interest rates to encourage the continuation of lending. But what if those interest rates are already close to zero, like they are now?
The central bank calls for purchases of newly created government bonds or Quantitative Easing (QE).
QE in effect gives free money to the private banks. So how does this happen?
Firstly, we need to know that central banks deal with two sorts of currency:
- Cash — anyone can hold
- Digital currency — only financial institutions can hold through their accounts at a central bank
Central banks are very different to private banks. At a central bank not everyone can open a bank account with them. Only the private banks can have a bank account with them. When QE takes place, the central bank, in effect, fills their accounts with new currency (Digital currency).
Normal individuals who wish to spend “digital currency” must use bank cards, transfers, mobile payment or cryptocurrencies.
Imagine instead that individuals also kept accounts at the central bank. New money could be added to their accounts which would provide a direct boost to spending. This would be a totally different form of “QE”. Rather than new currency going through the commercial banks before getting to the people, the people will directly receive the new currency.
This concept sounds pretty radical as it would require a overhaul of the entire monetary system. Radical as it may be, the emergence of discussions around this topic is on the rise.
Switzerland recently held a referendum which could change the country’s banking system. This was to decide on big monetary reforms, the reforms were called “Vollgeld”.
The heart of the argument was:
Should private sector banks be able to create money?
In modern economics, most currency is in the form of deposits at banks rather than cash in circulation. The deposits at the bank are then used in fractional reserve banking which creates more currency in the form of debt. This, in effect, allows the private sector banks to create currency.
Pro Vollgeld activists argue that bank deposits are not as safe. If a bank collapses, all uninsured funds will disappear. Instead, the public could hold current accounts directly with the Swiss National Bank (the Swiss central bank). This would follow that private bank’s lending will be entirely funded by deposits or by borrowing on their own. Therefore, no more fractional reserve banking. People in favour of the reforms claim that bank runs will be much less likely and there would be no more taxpayer bailout for banks.
Opponents claim that this scheme will incur large costs for little gain. The transition to Vollgeld would be expensive and banks would have to reorganise their structures to accommodate it. Furthermore, this is no guarantee to stop future financial crises. This could also complicate monetary policy as the Swiss National Bank would have to control inflation by regulating the amount of cash in circulation rather than adjusting interest rates.
Although Vollgeld was eventually defeated in the vote, this shows that monetary experiments are on the way and central banks are looking at new ways to manage the economy. Blockchain technology may just facilitate this change.
Cryptocurrencies and blockchain technology, could be a solution to allow individual accounts at a central bank and avoid fractional reserve banking. This is due to the fact that they can track transactions on a distributed ledger. In theory, this could give a central bank more control of the monetary system.
Individual accounts could help with monetary policy. At the moment, when interest rates are changed, the central bank manages the rates indirectly on the economy by adjusting the rates that banks earn on their reserves. But these are passed on imperfectly to the consumers. For example, banks in America can earn about 1.75% on their accounts’ interest rates at the central bank. While the consumer, with an account at a private bank, can earn next to nothing on a savings account.
If individual accounts at central banks were allowed, the interest rates will be directly paid to individuals, rather than through the private banking system. This could become an exceptional policy tool. Rate changes would have a direct transparent effect on depositors. Furthermore, if a central bank’s “digital currency” was to account for a larger amount of transactions, they could see swings in spending data in real time. This would be a good way to fine tune policy.
If used well, individual accounts could improve consumer welfare and macroeconomic policy.
However, central banks being integral to a country’s economy and politics are very risk-averse and slow to change. Central banks mainly worry about security risks and technical challenges that individual accounts would pose. They also worry about the fact that a lot of cryptocurrencies allow the user to operate anonymously.
Central bank backing for anonymous transactions would be awkward at best, considering their responsibilities previously mentioned. Especially when they face demands to crack down on money laundering and tax evasion.
Although, many cryptocurrencies have anonymous features, a central bank could design their system so that there would be transparency and a way to monitor money laundering etc. There are so many cryptocurrency projects out there now.
Some are great projects and some not so great, but the point is that they demonstrate all types of possibilities and permutations that blockchain technology can be used for. From public to private chains, permissioned to permissionless, blockchain to DAG, the list goes on. Not to mention, the wide range of network servicing protocols to choose from too. If a central bank wished to design its own cryptocurrency to facilitate a new monetary policy, it has a wide range of resources to choose from.
Cryptocurrencies may be a way to facilitate fundamental monetary change in central banks that have been so stuck in their traditional ways.The fact is, developed countries are now going “cashless” and turning to digital currencies — the amount of digital payments across these developed societies is increasing compared to cash transactions.
This has lead to some central banks considering making their own digital currencies, such as Sweden’s’ Riksbank, exploring the idea of an “e-krona”. If they were to explore this route they must also seriously consider the current monetary system and how to upgrade it to fit in with the changing times.
As we can see, the discussion about monetary policy and digital currencies is already underway in many countries. Although there are many challenges and concerns with overhauling the system, cryptocurrencies and blockchain technology are the obvious answers to facilitate this change.