When an organization as august as the International Monetary Fund (IMF) provides its view on the future of ‘digital money’ and cryptocurrency, people sit up and take notice.
It is clearly further evidence – in my view at least – that a world of fungible, cross-border, digital assets that are used and accepted en masse, is closer than we think.
No doubt the IMF has in part been spurred on by the announcement of the Libra project, however, its paper entitled: ‘The Rise of Digital Money’ makes for compelling reading. It lays out a number of real scenarios, where digital assets and the distributed ledger technology (DLT) underpinning them, are integral to a more inclusive and efficient future.
Think about that for a moment. This is the organization, often billed as the ‘lender of last resort’, and seen as the steward of the global monetary system, demonstrating that the subject of cryptocurrencies and ‘digital assets’ is worth our attention, and essentially can no longer be ignored. It is telling its readers – which are the world’s Central Banks and economic policymakers – that they need to be ready for this phenomenon and that regulation is required to put protection mechanisms in place, while also encouraging innovation.
Making sense of digital money
In a typically rigorous IMF way, the paper first seeks to categorize the various forms of digital money, each with its own set of advantages and challenges.
It makes a distinction between claim and object-based money, where the former is essentially an IOU, and the latter is ascribed intrinsic value. Both lend themselves well to cryptocurrencies, including stablecoins, to be used as a store-of-value or as payment, it says.
The paper is quite clear about its conclusion: digital money and stablecoins like Libra will transform the landscape of banking and money as we know it (p.15). In addition to convenience, lower costs, and speed, it also stresses that adoption on a major scale could be so much easier than it has been for fiat monetary systems because digital money integrates well with our mobile, socially digital lives (p.8).
Risks and Regulatory Considerations
Of course, there are risks.
First, the interplay between crypto and new forms of money, and the banks who issue fiat currency clearly awakens concerns about financial stability and consumer protection. But in addition to this, it also warns about the impact alternative forms of exchange, finance and value could have on financial integrity, monetary policy, and capital flows.
Consumer protection & financial stability
A key observation is that in contrast to commercial banks, which are closely regulated, offer insurance, and rely on Central Banks for liquidity in times of systemic stress, a private issuer of a stablecoin cannot guarantee redemption to the same degree if that currency comes under pressure. Put simply: if there is suddenly a collapse in the value of a stablecoin, the issuer cannot fall back on a Central Bank or established deposit guarantee schemes to try to bring back stability. In particular, the IMF highlights four risks:
- Liquidity risk, meaning there may be a delay before consumers can exchange their tokens for fiat;
- Default risk, capturing the scenario in which the issuer goes bankrupt, leaving client funds at risk;
- Market risk, potentially emerging from the specific assets held by the issuer as collateral;
- Foreign exchange rate risk, which only applies if the stablecoin in question is collateralized by a currency other than the domestic unit of account.
The IMF acknowledges that stablecoin issuers could mitigate these risks by:
- Investing in safe and liquid assets;
- Making sure that the amount issued never exceeds their reserves;
- Organizing some form of insurance for clients’ deposits;
- Ensuring that assets held are never encumbered (i.e. rendered unavailable through loans to third parties).
However, this is where the paper sees Central Banks step in. By having the collateral for stablecoins backed by Central Bank reserves, liquidity, market, and default risk can all be eliminated.
The paper also points to the risk of monopolization, which it says may come naturally to big technology companies due to their sheer size and the access they have to huge amounts of user data (p.9). But again, the IMF thinks that Central banks could prevent this from happening.
One option would be to give preference to domestic issuers, operating under the direct supervision of the Central Bank. A recent example of this comes from the Philippines, where UnionBank will be issuing a stablecoin, pegged to the Philippine Peso and endorsed by the country’s Central Bank. Another option would be for a Central Bank to issue its own government-sanctioned digital currency. This has already happened in Venezuela, and is currently being considered in China, in part as a response to the proposed launch of Libra.
By officially sanctioning the issue of stablecoins, Central Banks could then take the driver’s seat for ensuring set standards are met for customer due diligence, vetting wallets, developing the underlying technology, monitoring transactions, and providing customer service.
Of course, that would also make them responsible if there are cyberattacks or a loss of assets and so instead it suggests for effective regulation there could be a ‘public-private partnership’ where responsibility primarily lies with private firms to the exclusion of providing access to Central Bank reserves. Such a partnership would pose less risk to the Central Bank’s reputation and would drive innovation in the private sector.
Monetary policy, financial integrity & capital flows
The paper deals with other risks as well that are posed by both object-based crypto and claim-based stablecoins.
Cryptocurrencies such as Bitcoin and Ethereum, which have historically seen significant volatility, could potentially impact monetary policy. There is already evidence that cryptocurrencies become attractive amidst macro uncertainty, due to their uncorrelated nature, and are used as a hedge against recession as seen during the Greek Debt Crisis or more recently in Venezuela.
Central Banks in countries with weak currencies and high inflation, lose control over their policies due to capital flight into new forms of money. Partnering with domestic issuers of stablecoins could mitigate these risks.
Financial integrity also poses a concern with the rise of Libra and other digital assets. It makes clear that anti-money laundering (AML) and counter-terrorism financing (CTF) obligations should essentially be non-negotiable and must include customer identity verification, monitoring transactions, reporting suspicious transactions, and taking sanctions lists into account.
Fortunately, international bodies such as the Financial Action Task Force have been taking steps to develop a global set of rules that would apply to issuers of cryptocurrencies and stablecoins to combat AML and CTF concerns.
Further, the IMF suggests, Central Banks are in a position to grant licenses to digital asset service providers based on clear conditions, including supervision.
The paper does stress, however, that regulation in this space ought to be applied in proportion to the risks and types of services offered, meaning that issuers that operate as banks should be regulated as banks, while firms that offer services akin to investment funds, or broker dealer services, need to be regulated differently.
Currently, there are still more questions than answers, and much more needs to be clarified before concrete policies can be designed. But as the paper clearly states, regulators cannot remain bystanders. Even more importantly, I would add, the problems that are identified are now being presented with possible solutions.
That can only be positive in fostering a future world of diversified digital assets.
About the author
Thor Chan is the Chief Operating Officer at AAX.