The Fed just became much more expansionary

Is it real or nominal short-term interest rates that matter?

Rising nominal rates matter when they cause financial stress – borrowers who can’t service debt, loans called in because collateral values have fallen, lenders facing loan losses that erode their capital, etc.

Right now, that’s not happening – so it’s real rates that matter. Real rates have fallen very, very sharply across the yield curve in recent months. That’s true whether you use actual or expected inflation to calculate real rates – because inflation has been much faster than people thought it would be. Even if the Fed now accelerates to a 50 basis point hike every meeting, by year-end it’s likely to have done no more than partially nibble away at the recent collapse of real short rates into deeply negative territory.

Currently, it makes enormous sense to go out and spend, spend, spend, whether you are a consumer, a company building inventories, or even in many cases someone looking at physical investment. Whatever you are buying is set to get much more expensive in coming months, and you are so far from being compensated for that on your savings, or even your borrowing costs, that you better get out and spend before cash gets devalued.

Of course, the surge in energy and commodity prices that is starting to percolate into retail prices implies a squeeze on real incomes for many people. But for any consumers who’ve got savings, or access to credit, that doesn’t invalidate the argument that anything you can buy now will be cheaper than if they delay. Moreover, for energy-exporting countries like the US, this is essentially a distributional shock rather than a deflationary one. The Biden Administration already announced penal charges on energy companies with unexploited assets, and if enough policy signals of this type are given, the shock is spending-shifting, not spending-reducing. There is also scope for some direct help to consumers. Countries that are net energy importers can achieve similar results through government borrowing – EU plans to finance new energy infrastructure are an example.

The bottom line of the above is that the Fed is way behind the curve (and most other central banks even further). Unless they catch up, spending will be strong and inflation will stay high – until the monetary system crashes into major stress points.

But stress of that kind could be a long, long way ahead – after all, the entire structural reaction to the financial crisis of 2008-9 was to build in massive buffers to bank capital and elsewhere, and this regulatory sea-change has the effect of greatly diluting the relevance of nominal interest rates as compared to real ones.


So what about that yield curve? The combination of long years of central bank asset purchases, together with those regulatory changes, play a major role in distorting the signals from yields across the curve. No-one –let’s be honest about this – can really estimate how important these two effects are, because there just aren’t many data points. You can’t use daily, or monthly, or even annual data to gauge their importance, because bond markets are forward looking. All that’s really relevant are the small number of occasions on which a change to quantitative policies or regulations have been made, and there aren’t enough of those (especially since actions by different central banks and regulators are not truly independent).

So the inverting curves may signal recession, or they may reflect distortions, we don’t know (for what it’s worth, my personal view blames the distortion). But what we can be sure of is that they remain ultra-low against likely trend nominal GDP growth, and have recently fallen steeply relative to current inflation. So they remain highly stimulatory – supporting the major positive monetary stimulus coming from the fall in real short-term interest rates.

Quantitative Tightening, of course, will exert upward pressure on longer yields and gradually reduce this distortion. But gradually is the key word here. Moreover, since we can’t truly disentangle the effect of central bank asset transactions from the regulatory-induced demand for bonds, it’s very possible that the latter is by far the more potent force (noting that demand for shorter-dated bonds has ramifications right up the curve), and there are no plans whatsoever to dial that back.


The major decline in real interest rates is clearly a substantial buttress across the spectrum of risk assets, from equities to crypto. Of course, it cannot provide those assets with immunity from the effect of new adverse shocks as they unfold, but absent a drastic change of policy from central banks, it can provide an underlying bedrock of support.

China Embraces Ethereum

CBDC running smart contracts on Ethereum! That idea has now been proposed semi-officially in China, by Yao Qian, former head of the digital currency initiative at China’s central bank (see link below). The proposal is important both by showing how central bank thinking is advancing rapidly to embrace the idea of CBDC and cryptocurrencies operating in harmony rather than opposition, and also by raising the stakes for western countries concerned about being left behind by China.

Yao Qian’s describes a “layering” of access to CBDC, with banks at one level and the general public at a lesser level. Many details of his outline proposal remain to be filled in, but it seems unlikely that he is proposing that the public Ethereum chain should be used to operate CBDC itself — surely, central banks will want to retain full control of the network on which their own currency operates! So that leaves two likely possibilities.

A cloned private version or the real thing?

The first possibility is to clone Ethereum and operate a version of it as a private network for CBDC with smart contract capabilities, under full control of the authorities, rather like the Ubin proposal in Singapore. The second is to create coins that operate on the public Ethereum chain but are 100% backed by CBDC on the central bank’s private network.

The first of these may initially appear attractive, but arguably it offers the worst of all worlds. Having private sector agents operating all manner of smart contracts on the native network of CBDC is asking for trouble. Moreover, such a network would have to be updated like any software, either by continuing patches from the public Ethereum chain, or by expensive in-house development. And biggest of all, it would either have to have a fixed schedule of fees for transactions, which is uncompetitive and inappropriate in a world of fast-evolving new smart contracts; or, it would have to have its own internal shadow pricing. The public Ethereum chain, of course, is designed to do all of this — and one of the main purposes of its native coin, Ether, via purchases of gas, is precisely to provide that internal pricing for running smart contracts whose use of computing power varies quite enormously.

In short, the public Ethereum chain, as it develops, can do exactly the job that Yao Qian envisages, provided a form of CBDC backed coin can be developed to operate on it. See my earlier blog

What’s in a name: CBDC Mirror Units? Or CBDC-backed stablecoins?

The coins fully backed by CBDC could be called anything, but for most people in the crypto world, they would probably best be described as stablecoins fully backed by CBDC. However, central bankers have seen that current (not fully backed) stablecoins don’t regularly trade exactly at par, and they will rightly be concerned that this gap could very rapidly become far wider if the public lost faith – a kind of “bank run” on not-fully-backed stablecoins. So they may prefer a different name: “mirror CBDC unit”, for example (perhaps especially in China, which has banned stablecoins.)

Towards a Valuation for Ethereum

If Ether does come to play the role of providing the internal pricing for smart contract transactions in CBDC, there will be a natural demand for it linked to the volume of smart contracts and their complexity, because anyone executing such contracts has to buy a small amount of Ether to be converted to gas, and then burnt, to reflect the cost of the contract. Just as shares in a company that owns a stock market can be valued based on the current and expected volume of fees it earns from transactions, this would provide a way to work out a “fair valuation” for the market capitalisation of Ether. As with any kind of asset, being able to compute some kind of valuation metric does not eliminate price volatility – but it would probably make wild swings less likely.

And while it’s far to early to carry out any formal calculation of such metrics, the current valuation of about $300million (price of $2,600) does look intuitively low for a system that’s may before too long be providing the operating system for smart contracts using CBDC from many of the world’s major central banks.

We’ve got Ethereum. Why do we need banks?

When HRH Queen Elizabeth famously said during the height of the financial crisis in 2008 “If these things were so large, how come everyone missed them?”, an honest reply would have been “because banks have been around for so long that we see them as the inviolable heart of the financial system — even though it’s crazy for money, and the payments system, to be provided by highly leveraged institutions, whose weaknesses are simply patched up each time there’s a new crisis!”  If HRH asked the same question today, she could be told that blockchain technology has now developed to the point where we can still have pounds and dollars and euros, but no longer need them to be built on the shaky foundation of multiple credit expansion by banks.

Early banks operated with what in modern parlance would be called a 100% ratio of (largely unsubscribed) capital to deposits. In other words, the shareholders had an unlimited liability to protect depositors. If bad loans on the asset side of a bank’s balance sheets were so large as to swamp the subscribed equity and thus threaten to make it unable to repay their depositors, then the poor shareholders were on the hook to put in sufficient extra capital to make sure that the depositors were whole. The classic example was Sir Walter Scott, the Scottish novelist, who held bank shares (as a trustee for someone else) and had to write many extra books to pay the money owed to depositors when the bank’s loans went bad.

This arrangement was marvellous for protecting depositors, but didn’t exactly encourage people to subscribe for equity capital in banks, nor did it inspire bank mangers to take too many risks in the loans that they made. In short, it wasn’t a good arrangement for providing the growth in money and credit needed as the UK moved into an accelerating industrial revolution in the second half of the nineteenth century, with the US, Germany and others keen to follow. That was when limited liability companies were introduced, both for industrial entities and for banks.

Limited liability is often seen as one of, if not the, crucial building blocks that allowed the explosion of capitalist development in the western world. So far as industrial and commercial companies are concerned that seems fair, but for banks, it was just a patch-up. How on earth could limited liability for a bank be reconciled with the idea that bank deposits were money — by far the largest class of money in the whole economy — a money that could just get wiped out if domino bankruptcies in real-economy companies caused catastrophic losses to banks?

The solution, of course, was another patch-up: the invention of modern central banks. They took on a trio of responsibilities to make the patch up work: first, imposing rules about the minimum capital banks had to hold; second, trying to smooth out the credit cycle so that loan losses didn’t get bad enough to exhaust that capital buffer; and third, acting as a lender of last resort if it did get used up. It was a kind of public-private partnership, the central banks not providing an explicit full underwriting of potential losses, but nevertheless taking responsibility for any that might become systemic.

The 2008-9 financial crisis reminded us just how unstable this system was, and it could be argued that the jury is still out on whether we have really escaped from that. The central banks did indeed underwrite the banks, and did indeed stimulate the credit cycle, and tightened up the capital rules.

But tightening capital rules is just another patch-up that brings its own problems. The UK has ring-fenced the domestic operations of its banks into retail units that hold low-risk assets and high capital. Inevitably, this low-profitability model chokes off competition, often hitting smaller businesses and troubled individuals with high charges. New “challenger banks” were meant to address this but their failure to gain much traction in such an unattractive business area is hardly surprising. Australia has entrenched much the same model. None of this should be surprising: when you have a system that is fundamentally unfit for purpose, each regulatory or structural change that addresses one problem simply throws up another.

And now, we have a new technology that offers an escape. The functions of money creation, payments systems and major credit provider, currently bundled together in the banks, can now be separated. The patch-up can be replaced with a brand new system that is designed from bottom up to fulfil the functions needed for a modern economy. Stablecoins fully backed by CBDC will take over the role of money currently played by bank deposits. Public blockchains like Ethereum will take over the payments systems currently operated by banks — and throw in automated stock, derivatives and commodities markets, and much else. And the credit provision function of banks can be partly left with them (funded by bond issues rather than deposits) and partly migrated to carefully regulated decentralised loan markets on public blockchains. The muddled conflation of functions in highly leveraged entities that led to HRH’s question will be eliminated.

All this is great. There is just one problem: how do we get there from here? Orchestrating a stable transition that sees bank deposits and loans being run down, at least in relative terms, while stablecoins and decentralised lending grow, will be difficult. So much so that until recently, central bankers have shied away from contemplating it.

But as the new technology has gathered momentum, and started to take on a life of its own, not just with cryptocurrencies but now also with rapid growth in stablecoins, the decision point has suddenly become much nearer. Central banks and governments have to decide whether they are going to embrace the new technology, with its promise of a new system that is not only much cheaper, quicker and more secure than the present, but also eliminates the inherent instability of a system built on money that sits on the liability side of highly leveraged bank balance sheets — and accept the challenge of making that very difficult transition. Or, they have to try to freeze it out and stop it — a task that itself brings deep inherent risks, as the public becomes more familiar with the new technology and starts to find ways round any barriers to its use.

The Harmonic Triangle: CBDC, Cryptos, Stablecoins

The Harmonic Triangle of Cryptocurrencies, Central Bank Digital Currencies (CBDCs), and Stablecoins is slowly starting to emerge as the digital future.

CBDC, Cryptos and Stablecoins are complements, not rivals

Far from being rivals, these three have the potential to be highly complementary. Look at what each of the three does best:

– CBDC: The universal acceptance, familiarity and total security that comes from a unit operated by a central bank and the potential to be inflationary when needed; but with very limited functionality.

– Cryptos: A deflationary (ie store of value) bias if designed that way (eg Bitcoin), and/or the ability to offer extraordinary functionality for financial and real economy transactions on a secure network (eg Ethereum).

– Stablecoins: If properly regulated, the potential in the digital future to take on much of the role in linking CBDCs to the financial and real economy that bank deposits currently perform for conventional central bank money, but without the risk of bank runs.

An imagined future architecture for digital money

I’ve imagined a future digital architecture that illustrates how The Harmonic Triangle can work in practice, drawing off recent research by Abdallah Mahdi. His excellent paper is attached below.

The role of the banks in this architecture is worthy of a separate article. For now I’ve assumed a controlled transition in which they gradually replace their deposits with other financing while losing some share of the loans market to decentralised credit — managing this would be a significant challenge for central banks.

To explain this architecture, I look at each of the three components in turn, beginning with CBDC.

CBDC’s role in The Triangle: total security; central bank control; functionality limited to payments; expandable

First, CBDC. Each country would operate its own CBDC on a highly secure, centralised ledger, possibly a blockchain, over which it retained total control. If access was granted only to authorised financial intermediaries – call them banks – this would be a so-called “wholesale” CBDC and would offer little more functionality than current gross real-time settlement systems, but with significant improvements in speed and security of operation. If access was also granted to individuals and companies with a low limit on the size of any individual holding, this would be a “retail” CBDC and would immediately bring the benefit of digital payments to the unbanked. For example, the “Sand Dollar” currently operating in the Bahamas allows each person living on outlying islands (where there are no banks) to hold a couple of hundred dollars or so of CBDC.

If this holding limit was progressively raised, businesses could begin to make widespread use of the CBDC to make and receive payments at ultra-low transaction costs and high security. Alternatively, in the wholesale model, there could be gradual growth in Authorised Stablecoins fully backed by CBDC (see below) which would bring similar benefits. In particular, there would be gradual downward pressure on current high domestic transaction costs. (I operate a small business in the UK and am not unusual in being charged 1.5% for all transactions, which with a profit margin of 15% on sales means that I pay 10% of my profit to process payments.)

The key to a successful transition from the old to the new architecture is for there to be a progressive and controlled growth in holdings of CBDC, whether direct as in the retail model or indirect via Authorised Stablecoins, to ensure that funds do not move rapidly out of (risky) bank deposits into (secure) CBDC – which could cause the greatest credit implosion and depression ever seen. To avoid this, as the banks lost deposits due to growth in directly or indirectly held CBDC, they would need to grow their other sources of funding such as bond issues, and meanwhile their need for funds would likely decline as the asset side of their balance sheets — their lending — tended to lose market share to decentralised credit on the Ethereum blockchain.

This vision is a middle way between two extreme models for the banks. One of those would see them left roughly as they are now, but that would rule out substantial direct or indirect emission of CBDC to the public and thus make banks the effective gatekeepers into the public blockchain, potentially damaging competition and innovation. The opposite extreme would be to allow them to contract and disappear, but managing that smoothly would be highly challenging and positive aspects of their expertise and structure would be lost.

Despite its potential advantages in improving payments, the functionality of CBDC as described here barely even begins to climb the foothills of what digital money is capable of. But there’s a good reason for that: trying to use the central bank’s secure ledger to operate smart contracts that can automatically close out derivative trades and instantly settle invoices on delivery just doesn’t seem a good idea. It does not seem appropriate to try and combine the absolute security required for central bank money with the full range of financial market and real economy transactions – it would be a bit like trying to settle expiring future contracts or Amazon logistics payments on the current central bank gross real time settlement systems.

But there’s one bit of functionality that CBDC could potentially offer, which is to impose negative interest rates or to allow a universal “helicopter drop” of money to everyone. I personally think the first of these has reputational risk for a retail CBDC, it’s somehow difficult to reconcile the narrative of total security that goes with central bank money with negative rates, which could be regarded as a form of confiscation. But the helicopter drop is very appealing as a way of giving extra cash to everyone and I can see it becoming popular as a macroeconomic tool – longer term it’s inflationary, but that’s the whole point, because sometimes a controlled inflation is needed to prevent a credit collapse. The ability to do this and the very limited functionality are arguably the two things that make CBDC so different from cryptos (the other big difference is the centralised versus decentralised ledger – the debate over which of these is most secure is more a matter of religious faith than absolute truth).

Crypto’s role in The Triangle: non-inflatable (Bitcoin); platform for all financial/real transactions (Ethereum etc)

Turning to cryptos. The strictly limited supply of Bitcoin means it’s inherently deflationary, which makes it a respectable candidate to have a long term uptrend against inflatable central bank moneys. But that’s not quite the same as saying it will trend up from here, for two reasons. First, because we can only guess at the starting price for this uptrend by (for example) comparing its market capitalisation to that of gold – is it $150,000, or more, or just $1? Second, because it’s not certain that its first-mover brand recognition and sheer proven brute resilience trump the ability of anyone to set up an alternative that could cannibalise investors’ portfolio allocation to such assets. These issues aren’t going to get resolved soon, if ever, but the real point is that Bitcoin is genuinely different from CBDCs and complementary to them: it has aspects of in-built deflation that a CBDC can never have, because there are moments when a central bank has to be inflationary to save the economy.

Staying with cryptos but moving on to Ethereum and other coins that support real functionality (eg Polkadot with its ability to facilitate interoperability), there is a very different kind of complementarity to CBDCs. The Ethereum blockchain can in principle do (more or less) all the decentralised finance that the controlled, centralised central bank ledger can never be allowed to do: peer to peer loans that embed the borrower’s credit history and genuinely syndicate the risk; derivative contracts that settle instantly; logistics processes with automated factoring, etc etc. But, that’s not much use if the two ledgers can’t inter-operate with one another without compromising the security and central control of the central bank’s, and that’s where stablecoins come in, as the third point of the Harmonic Triangle.

Stablecoins’ role in The Triangle: Allowing fiat transactions on public blockchains while protecting the integrity of CBDC

Let’s suppose that in our imagined future digital architecture there are Authorised Stablecoins, privately operated but approved and regulated by the central bank of the country in whose fiat currency they are denominated, that are 100% backed by CBDC in real time. These would operate on the Ethereum blockchain and would interact with all of its functionality – so a holder of an Authorised Stablecoin could use it not only to make payments, but also to settle derivative contracts, buy securities, and all the other features that the Ethereum blockchain will in future offer. Crucially, at the same time, the Authorised Stablecoins would also interact with the CBDC ledger. This would allow them to act as a bridge between the new world of digital money and decentralised finance on one hand, and CBDC and the old world of banking on the other.

A technology such as an upgraded version of the Baseline Protocol could be used for the link between the Authorised Stablecoins and the CBDC ledger; critically, this technology would allow the central bank to maintain total control over its own ledger. Each Authorised Stablecoin would hold a CBDC balance on the central bank’s ledger which would be updated in real time to maintain the 100% backing. To illustrate this: under a wholesale CBDC, when an individual switched funds from their conventional bank deposit into an Authorised Stablecoin, the latter’s balance on the central bank ledger would be increased by a transfer from the individual’s bank; simultaneously a message would be sent to the Ethereum blockchain causing creation of the same amount of new Authorised Stablecoin in the name of that individual. A transaction the other way round would see Authorised Stablecoin burnt on the Ethereum chain while on the central bank ledger, CBDC was transferred to the individual’s bank account. Under a retail CBDC, much the same would apply but without the need for a bank deposit.

All this sounds quite fussy but the point is to eliminate the risk that the central bank’s ledger can ever be compromised. Nothing ever actually moves between it and the big bad world of open blockchains. All that comes in from outside are instructions to move CBDC from one holder to another. There is always some risk that these instructions are fraudulent, just as currently fraudsters cause money to be moved between beneficial owners at banks, although the audit trail of events leading up to a fraud will generally be much better in the digital world. But such frauds would not pervert the integrity of central bank money itself.

Over time, as the system grew more familiar to users and more functionality became available on the Ethereum blockchain, the scale of Authorised Stablecoins outstanding and of transactions using them on the Ethereum chain would likely come to dwarf activity on the central bank ledger. Why would one want to keep switching from an Authorised Stablecoin, which was 100% backed by CBDC and allowed full access to the digital finance world, and take funds back into an old-fashioned bank which was slower and ultimately offered less functionality? The central bank’s ledger might almost drop into the background, rather as the current real time gross settlement systems sit in the background, yet still provide an absolutely crucial anchor to the whole system.

An irony of The Triangle: cryptos play a crucial, central role, but almost all transactions are denominated in fiat

Note that in this imagined future, it’s likely that a large majority, perhaps almost all, transactions in the real economy, and most financial transactions, would be denominated in conventional fiat – the currency issued by the central bank. And yet, crypto would be playing a large and crucial role, in a different background way: Ethereum driving all of the decentralised finance and real economy transactions on its blockchain, Polkadot ensuring inter-operability between chains, Bitcoin being used as a longer-term store of value, and Authorised Stablecoins being used for a very large majority of day to day transactions. We could even imagine the price of Bitcoin being used as part of a monetary conditions index by central banks: falling means conditions are tight, rising means they are easy.

In this sense, the Harmonic Triangle brings out the best of each of its three elements: the pivotal short to medium term stability and accounting role of CBDC; the longer term store of value and the incredible functionality of the cryptos; and the day to day payments functions of stablecoins. Conventional roles of banks would likely have shrunk, but as noted above the relative decline in their balance sheets would need to be handled very carefully, and the best among them would adapt their operations to play a leading role in the new world. And economists would need to update the traditional three functions of money (medium of exchange, store of value, unit of account). Those three functions would be split among different parts of this digital system, just as they are currently split between central bank money and bank deposits, but a fourth would be added: the ability to execute contracts automatically.

Moving closer towards The Harmonic Triangle — at least in the US

A divide seems to be opening up in approaches around the world. The common strand is that almost everywhere, central banks have now either actively introduced a CBDC or are at some stage in starting to talk about it, even if it is only preliminary.

But there the common strand ends. Possibly the biggest divide is between China and the US in their approach to stablecoins. China has banned them in Renminbi, even as it pushes ahead rapidly with its CBDC rollout. By contrast in the US, Fed Chair Jerome Powell has given a cautious signal that properly regulated stablecoins may have a role to play in the broader system, just as he has indicated that there needs to be public debate and the passage of a new law before the US issues its own CBDC.

Attitudes to cryptos vary in a similar way. At one extreme, India and Turkey have now moved to more or less ban their use/holding. At the opposite, other countries, notably Switzerland and Singapore, have signalled an openness to the new digital world, under recent laws that have been passed to facilitate it.

Crucially the US, while embarking on a tight enforcement of existing laws where they apply to the crypto world, has signalled the potential enactment of suitable new statutes to facilitate development of the technology. The future legislation on CBDC mooted by Jerome Powell would be one key building block for this. Although it has not been stated explicitly, the clear logic would be to include a structure for regulation of stablecoins within this legislation and, possibly, clarification of the legal framework for cryptocurrencies. Creation of constructive legislation in this area will clearly be facilitated by the depth of knowledge on cryptocurrencies of the new SEC Chair, Gary Gensler.

The Harmonic Triangle is still a work in progress, but the momentum towards it is rising fast, at least in the US.


Central Bank Digital Currencies and their relationship to Stablecoins and the Crypto ecosystem

By Abdallah Mahdi

  • CBDCs are a new form of digital central bank money that can be used by households and businesses to make payments and store value and settlement balances held by commercial banks at central banks.
  • When building their CBDC, central banks can opt for either a private, public blockchain or not even use a blockchain, and naturally conservative central banks would want to conserve control that comes with a private ledger.
  • Stablecoins are a type of cryptocurrency that are designed to maintain a stable market price and are often pegged to fiat currencies
  • Baseline protocol is a form of hybrid chain, that works by anonymising public blockchain transactions by using zero-knowledge proofs, meaning no enterprise data gets stored on-chain.
  • Using stablecoins, a central bank can transact on a public ledger without distributing CBDC onto the public ledger.
  • The Polkadot network could interact with a CBDC ledger in much the same way that the parachains interact with other blockchains, through a bridge.
  • Currently, the Bahamas, China, Sweden, Thailand and Ukraine have launched a pilot/trail CBDC, many more countries are in the research phase, and excitingly Brazil has launched the world’s first CBDC network, Pix.
  • HTLC uses hash locks and time locks to ensure the atomicity of transactions across two DLT platforms.


With the rise of cryptocurrencies and stable coins in the past year, many central banks have engaged in CBDC projects, which include: China’s digital Yuan, Singapore’s UBIN project, Canada’s Project Jasper, and Bahamas’ Sand Dollar and many others. In this digital ecosystem, all these different currencies will have to interact and operate with each other. It is important to remember that central banks would not want to cede control of their currency, whether paper or digital, to a third party outside their control. Therefore, a CBDC ledger would be controlled by the central bank. Furthermore, although controversial, the rise of stablecoins in the past year, most notably USDT, which claims to back all digital tokens with fiat currency, has shown a need for digital fiat currencies on public blockchains. With this in mind, there are many possibilities to achieve interoperability: technologies such as baseline protocol; stablecoins; cryptocurrencies such as Ethereum and Polkadot; and CBDC projects designed to interact with other ledgers. This paper will try to answer how CBDCs will operate with each other and other cryptocurrencies.

What are CBDCs?

CBDCs are a new form of digital central bank money that can be used by households and businesses to make payments and store value and settlement balances held by commercial banks at central banks. CBDCs are denominated in the national unit of account and are a direct liability of the central bank. There are various ways for central banks to design their CBDC, including: limiting access (by type of user or what can be held), ranging degrees of anonymity,imposing caps on holdings, and accruing or charging interest. The two main CBDC variants are wholesale CBDC, where access is limited to a group of commercial banks and clearing institutions, and general-purpose/retail CBDC, which would widen access to central bank money across the economy.

Although the term CBDC includes the words ‘digital currency’, CBDC would be something fundamentally different to cryptocurrencies such as Bitcoin. Many cryptocurrencies are privately issued and not backed by any central party. They are not considered a currency because they do not perform the essential functions of money: they are too volatile to be a reliable store of value, they are not widely accepted as a means of exchange, and they are not used as a unit of account. Stablecoins aim to overcome these shortcomings and provide stability of value via some form of backing. In contrast, a CBDC would be a new form of digital currency issued by the central bank and would therefore perform all the essential functions of money. CBDCs can increase financial inclusion in countries where many residents are unbanked or do not have ready access to banks. CBDCs can also speed up the introduction of technologies, such as smart contracts and DLT.

Adversely, unrestricted CBDCs can hollow out the banking system. As CBDCs open up payments to non-banks, commercial banks would see their payment-related income streams eroded by increased competition. Further, a larger central bank balance sheet could lead to a large-scale withdrawal of funds from commercial banks. Commercial banks could try to prevent a loss of deposits by raising interest rates or seek funding. This could lead some banks to raise spreads and increase transaction fees in order to maintain profitability. Depending on existing market structures, banks might have to shrink their balance sheets. In the long term this may indeed be the way of the future; however, in the short term this disintermediation will have to be carefully controlled to avoid a credit crunch.

The Blockchain

When building their CBDC, central banks can opt for either a private, public blockchain or not even use a blockchain. In public blockchains all historic transactions can be found on block explorer, by anyone, anywhere. Further all users have the ability to trade, interact, and participate on the blockchain without any permissions needed, this is why they are also called permissionless blockchains. As a result, they are transparent, decentralized, and immutable—they are a very secure way to log transactions, but not very private. Further, public chains, like Ethereum, have a host of decentralized applications. These applications can be used for different types of complex transactions and smart contracts. Public blockchains can be considered the most secure chain because the network is maintained by millions of users globally in exchange for rewards or ‘gas.’ In order to ‘hack’ the network, you would need to control 51% of the entire network. As a result, it is basically impossible to input a false transaction on a public blockchain. Most cryptocurrencies are built on public blockchains. Although naturally conservative central banks would want to conserve control that comes with a private ledger.

On the other hand, private blockchains allow for a higher level of privacy by using Zero-knowledge proofs and permissioned access granted through certificates to various data points, which can be monitored. Further, a private blockchain allows central banks to ensure that they are the only party capable of issuing or recording transactions on the ledger, meaning all transactions using CBDC would naturally be verified by the central bank. Private chains are secure for a central bank that has hundreds of employees who can maintain the network. However, private chains are costly and difficult to set up and maintain; they have to be built from the ground up, and importantly, they do not come with any public chain applications, meaning all applications would have to be set up by the central bank. Further, transactions can only be verified by permissioned parties, meaning central banks can give certain levels of access to their network to other commercial banks, thus allowing them to customise a range of services.

Private permissioned chains are an incremental improvement over currently available structures because they may lead to faster settlement times and better security, while maintaining many of the same characteristics of our current system. However, public chains can bring a paradigm shift in the way we conduct business. In the past year we have seen tremendous growth in public chains including Bitcoin and Ethereum; and if enough value is generated by users, private ledgers will be forced to connect with these public ledgers. As witnessed in many CBDC projects, central banks ledgers are likely to be on private permissioned blockchains.


Stablecoins are a type of cryptocurrency that are designed to maintain a stable market price and are often pegged to fiat currencies. Unlike other cryptos, stablecoins are designed to be resistant to market volatility. Therefore, stablecoins are very useful in the operation of CBDC because they are tethered to the value of a fiat currency and operate on a public blockchain. The idea behind stablecoins is to provide some of the advantages of fiat currency and cryptocurrencies. Currently, they are predominantly used as a hedge against the volatility of cryptocurrencies, but they can also be used as a stable currency that provides greater transparency and decentralisation. Further, they have faster transaction times and lower fees than fiat currencies, making them useful for everyday payments and international transfers. Both USDT and USDC claim to be backed 1:1 with USD. However, in the case of Tether, a court ruled not all tokens were backed by dollars, ultimately undermining people’s confidence in USDT. Therefore, in order for stablecoins to be widely accepted, there needs to be increased oversight and strong regulation.

Moreover, Central banks are anxious about stablecoins. There are dramatically different approaches; China and Thailand even went so far as to ban any local currency stablecoins. However, not all central banks share this attitude. The US Fed have acknowledged the risks of CBDCs, especially concerning the need for regulation; however, they have not made any comments against stablecoins. Excitingly, the past month has seen the Fed, under the guidance of Jerome Powell, effectively endorse stablecoins. Powell acknowledged the need for greater and more robust regulation of stablecoins, but he also opened the possibility of a stablecoin ‘bridge’ between a CBDC ledger and public blockchains. However, despite this positive development for stablecoins, there remains mixed attitudes towards them for the following reasons: people get muddled between stablecoins and local currency (USDT vs USD), they do not always maintain a 1-1 parity, and most importantly they could completely crash. This last point is the biggest worry for central banks. If a stablecoin crashed, the private sector would not be able to turn to the Fed for assistance because it is not central bank money. This could potentially result in a loss of credibility in fiat currency from a stablecoin. Regular bank deposits are also not central bank money; however, they are covered by a bank deposit guarantee. A potential workaround could be a deposit guarantee for stablecoins; however, this is not as clear cut; what event triggers the guarantee? Stablecoins are certainly an exciting addition to the crypto landscape; however, is the current hype merely a result of people using stablecoins as a means to trade other cryptocurrencies?

How can ledgers interact?

There are many technologies proposing various approaches for interoperability. This paper will look specifically at using Baseline protocol, stablecoins, and Polkadot to enable CBDC ledger interaction.

Baseline protocol is a form of hybrid chain, that works by anonymising public blockchain transactions by using zero-knowledge proofs, meaning no enterprise data gets stored on-chain. This protocol offers central banks a more private and secure alternative to public chain transactions, while still maintaining the natural benefits of a public chain. Baseline protocol runs on the public Ethereum chain. Although baseline protocol does bring public chain technology more in line with the current regulatory requirements around data residency and privacy protection, it does not yet meet current standards. In addition, current performance requirements are higher than any public ledger is currently capable of supporting. However, this does not mean that baseline protocol is not useful. Central banks could use a variety of public and private chain options in order to meet the regulatory and performance requirements and provide increased interoperability. Central banks could use a private ledger that interacts with a permissioned node on a public chain: the ledger would be completely private but would interact with a public chain through a permissioned system, i.e an application that has permission to interact with the private ledger. This hybrid system would allow central banks the autonomy of their own private chain, while allowing them access to the public chain ecosystem. This system could work through stablecoins.

Using stablecoins, a central bank can transact on a public ledger without distributing CBDC onto the public ledger. This works by creating a ‘bridge’ between the private bank ledger and the public ledger whereby banks can interact with a smart contract on the public chain for minting and redemption of stablecoin versus CBDC on the central bank ledger and adjust their balances on the two ledgers as per their needs. In this way, the banks would retain complete control and independence of their private ledger, while being to transact on a public ledger using essentially a like-for-like currency. This relationship would operate by burning stablecoin on the public ledger in order to redeem the same amount on the private ledger and vice versa. It is important to note that this bridge is a single point of failure; the security of the bridge would be less robust than a blockchain ledger. However, the security of these bridges would be akin to security of bank balances currently, so it is possible to mitigate those issues.

Polkadot and Ethereum have created digital ecosystems that prioritise interoperability in the hopes that these blockchains will be able to communicate with one another. Polkadot, specifically, is a cryptocurrency that uses ‘parachains,’ which are sovereign blockchains that can have their own tokens, that connect to the central relay chain, and can also connect and communicate with other blockchains like Bitcoin using bridges. Parachain technology is unique to Polkadot, therefore making it a potentially vital tool in the quest for interoperability. Parachains will have specialised characteristics for their use cases and the ability to control their own governance. Interactions on parachains are processed in parallel, ensuring a scalable system. Therefore, transactions can be spread out across the chains, allowing many more transactions to be processed at one time. The Polkadot network could interact with a CBDC ledger in much the same way that the parachains interact with other blockchains, through a bridge. This would allow the central banks access to the whole array of applications offered on the Polkadot network, while also maintaining an independent and wholly private ledger. A central bank could launch a parachain that connects to their CBDC network through a bridge. This parachain would share in the security of the Polkadot system, and be connected to the larger Polkadot ecosystem, giving the CBDC access to more applications. Further, the parachain does not even have to be a blockchain, allowing the central bank to design the interaction between their CBDC and their parachain to their specifications. Adversely, the central bank would not have complete control over the parachain, with certain operations left to the validator and collator of the Polkadot network. The Polkadot system in many ways mirrors what many CBDC projects are trying to achieve on their own; the value of a CBDC does not solely rest in the token, but rather the network is the most important part. Therefore, the network must not only be robust and secure, but also have utility.

Real world CBDCs

Over the last year, central banks all of the world, and indeed most large central banks, have completed CBDC projects with the goal of potentially building a CBDC network designed for their specific needs. For example, the Bahamas’ CBDC project, Project Sand Dollar, is in the pilot phase and is primarily designed to increase financial inclusion and strengthen security against money laundering. Another example, Switzerland’s CBDC project, Project Helvetia is mainly concerned with designing a CBDC network that can handle multicurrency transactions and is interoperable with other cryptocurrencies and CBDC networks. Currently, the Bahamas, China, Sweden, Thailand and Ukraine have launched a pilot/trail CBDC, many more countries are in the research phase, and excitingly Brazil has launched the world’s first CBDC network, Pix.

Singapore is a good example of a country that has done more than preliminary research into a CBDC. Singapore’s goal with Project Ubin is primarily to create a common payment platform for both domestic payments and cross border payments. This hypothetical international network would consist of central banks and banks from different countries transacting in multiple different currencies on a common platform. The Ubin network provides connectivity to currency issuers for the issuance or distribution of digital currency on the network.  This function can be performed by trusted parties such as central banks and commercial banks. The architecture of the network would be flexible where services and roles would be unbundled and modularised. This would be achieved by segregating control and imposing limits on control. For example, for a specific digital currency only the appointed issuer has the ability to issue digital currency, and no single party is able to exert control over an area outside of their designated scope.  Blockchain technology would allow the network to operate in a decentralised manner while providing sufficient trust between participants to transact on the platform. The intention is to enable interoperable wallets that can connect to Ubin, as well as other platforms. For example, a multinational corporation will likely connect to Ubin for payments specifically in Singapore, separate payments networks for payments in other countries, and other blockchain applications for different use cases. The use cases are blockchain applications that could benefit from integrating with the Ubin network.

In the Jasper-Ubin project, a joint project undertaken by the Central Banks of Canada and Singapore, the central banks proved the benefits of their networks for cross-border payments. Project Jasper and Project Ubin were launched respectively by the Bank of Canada and the Monetary Authority of Singapore with the goal of exploring the use of DLT for clearing and settlement of payments and securities. Although these prototype networks were built on different blockchain platforms (Corda in Canada and Quorum in Singapore), they were able to interoperate, allowing for cross-border payments to be settled on CBDC ledgers. This collaboration successfully demonstrated a cross-border, cross-currency, cross-platform atomic transaction without the need for a third party. The joint project identified three possible options for cross-border transactions: the first option involved using intermediaries, and the second and third involved granting transacting parties access to the central bank’s liabilities. Access to the central bank’s liabilities can be achieved through two different designs. The first design achieves direct access by granting transacting parties direct access to accounts or wallets on the network, i.e., allowing a financial institution to hold foreign currency issued by the central bank even if it is not a financial institution in that particular jurisdiction. The second design allows local currency to flow into foreign currency networks where it can be transacted directly. This can also be viewed as a multi-currency settlement system. Through all these approaches, HTLC protocol was used.

HTLC was originally designed for public blockchain networks, where there is no trusted central authority and transacting parties are possibly adversarial. Therefore, it works well in facilitating atomic transactions between DLT networks while minimizing risk to transacting parties. HTLC uses hash locks and time locks to ensure the atomicity of transactions across two DLT platforms. Importantly, because of HTLC no action would proceed if any action failed, ensuring end-to-end consistency of the transaction. The receiver of the payment must acknowledge receiving the payment prior to a timeout deadline by generating a cryptographic proof of payment, or hash lock. Otherwise, the receiver forfeits the ability to claim the payment, which results in the payment being returned to the payer. HTLC has no need for a trusted third-party. Rather, the intermediate escrow account is operated autonomously as a smart contract with predefined rules. A DLT platform must support locking, secret disclosure and timeout to successfully build HTLC functionality. However, there are no standards to govern how HTLC is implemented on each of the platforms; therefore, HTLC implementation may differ from one platform to another.


CBDCs are an exciting new payment method, which can potentially improve cross-border transactions, provide better digital security, prevent money laundering, increase financial inclusion, reduce transfer fees, speed up transactions, access to new technologies, and so much more. It is no surprise that nearly all central banks are looking into building a CBDC payments network; a CBDC network might increase the confidence in a currency. Nevertheless, all CBDC projects will have to be designed with their specific needs in mind. Further, a CBDC payment network that is designed to be interoperable with other cryptocurrencies, stablecoins, and other CBDC networks will be well placed to take advantage of the latest technologies. On the other hand, CBDCs can have unintended consequences on the banking sector, potentially driving bank deposits into central banks. In order to avoid CBDCs from working within the dodgy world of commercial banks, stablecoins potentially provide a way of working together, while still maintaining the total integrity of the CBDC. As described above, stablecoins can bridge the central bank ledger with the larger financial world, therefore there would be no interaction of CBDC with commercial banks, rather, the only link is that the central banks provide some sort of deposit guarantee for the stablecoins. How central banks approach this dilemma will be very important for the future of CBDCs.

Valuing Cryptos: Market cap or DCF?

Yes, a DCF (Discounted Cash Flow) valuation for cryptos is possible! At least in principle.

Market Cap approach: Nice and simple, but what compares with what?

There’s currently a fair amount of writing around about Cryptocurrency valuations. It ranges from :

  1. the “it may be worth nothing’ school (which could be said about pretty well anything, by the way); through to
  2. calculations based on comparing the market capitalisations of Bitcoin to gold or similar; and then
  3. you also hear people say “of course, one can’t do a conventional DCF valuation’.

The market cap approach is perfectly reasonable, not least because it is quick, simple and easily understandable, though there are so many uncertainties (do we look at the ratio of the Bitcoin market cap to that of gold; do we bring in other cryptocurrencies on the numerator or a broader range of established assets to the denominator; do we adjust for whatever…) that it obviously gives an enormous range of possible answers.

But while a case can be made for comparing Bitcoin and gold, it’s less clear what coins like ETH and DOT, with their potential to take over most functions of global finance and a fair part of global logistics, might be compared to. A starting point might be the global financial sector plus all logistics companies, but that’s probably too broad in some ways and too narrow in others. Still, to give you an idea where it might lead, the market cap of global banks is around USD 6 trillion, while that of ETH and DOT combined is somewhat below USD 200 billion (end-Jan 2021).

A DCF would be much better defined, if it could be done.

There are income streams

So is a DCF possible? It’s clearly wrong to say that one “can’t” do a DCF, because all cryptos offer at least the potential for an income stream. There are a vast number of issues to be addressed in doing a DCF for crypto, but then that’s also true for almost every asset under the sun.

So, let’s look at some of the income streams that accrue, or may in future accrue, to cryptocurrencies.

Staking Rewards

The easiest and most obvious are staking rewards. These currently run at around 15% on DOT and 10% on ETH. If it was as simple as that, then we could do our DCF in seconds and given where fiat yields are, it would give an astronomical price.

But it’s not as simple as that: partly because staking rewards are calculated in various ways, so for example we know that the return on ETH will go down by about a third as more and more of the outstanding coins are staked; partly because if you are unlucky enough to validate a duff block, your holding could be slashed; but most fundamentally, because you are paid in the same coin that you have staked.

Fixed income investors will immediately think of PIK (payment in kind) bonds, which pay their coupon in more of the same, and which tend to have a bad name because they are, sometimes, issued by companies that don’t have any actual cash to pay out. A kinder, and perhaps more appropriate, analogy is with a scrip dividend, where a company pays dividends in its own shares, which might be good if the stock has growth potential.

In short, a DCF calculation based on staking rewards begs the question of what the coin will be worth in the long run, which is kind of what we wanted to know in the first place.

Supply-Chain and DeFi earnings as an anchor for DCF

Another approach could be based on DeFi (Decentralised Finance) earnings or, perhaps even better, earnings for operating real economy stuff like supply chains. Suppose there’s a smart contract that is used to power switches between a USD stablecoin and a Swiss France stablecoin. Or to trigger a payment from one company to another, in USD stablecoin, as soon as someone in a warehouse scans the barcode on an incoming delivery.

Whoever is doing the forex transaction, or the supply chain transaction, has to pay a fee. The fee will actually be paid in the cryptocurrency native to the blockchain, or chains, being used, so the transactor has to buy some of it to pay their fee. (Hopefully not very much – one of the points of doing all this is that ultimately, it’s meant to bring costs down, as well as improving security, transparency etc.)

Now, we could just wave our hands in the air and say that this “increases demand” for said native coin, and that’s already an interesting result, not least because that demand is linked to the volume of fiat-related transactions using the crypto world, implying that this is a source of demand that will rise over time.

But what’s also interesting is that the fee being paid is an income stream to the holders of crypto, that (unlike staking rewards) is linked to the value of the underlying fiat-denominated transactions. This allows, in principle, the calculation of DCF that will actually give a valuation measured in fiat for the relevant cryptocurrency.

I think that’s rather exciting. The trouble, of course, is that these kind of transactions haven’t started yet, or only in small quantities. So we can’t even begin to start doing the actual calculations, but knowing that they are in principle possible seems to me a fairly big step forward.

And like so much in the crypto world, it may well take only a short space of time before a theoretical idea like this becomes easily applicable.

An income for Bitcoin?

And what about Bitcoin? In itself, it has no smart contract capability so it can’t directly generate income of any kind, fiat-linked or otherwise. But as more links across different blockchains are built under the Polkadot system, it’s not too fanciful to imagine Bitcoin being used as collateral or in some other way on a different chain, and that might in some sense provide an income stream that can be assigned to it. (Note that as a conventional accounting matter, investors rarely assign any part of the return on a leveraged investment to the collateral used for the loan, but they ought to, because you couldn’t do the deal without the collateral.)

Bottom line: DCF is coming

DCF valuations are on their way! As the DeFi market develops even more (and despite recent stellar growth, it’s probably barely started) and as supply-chain applications appear, it will be possible to do DCF calculations. And these may help more investors to become comfortable with the concept of cryptocurrencies and start adding them to their portfolios.

1st Dec: The most important crypto date since the launch of Bitcoin

1st Dec: The most important crypto date since the launch of Bitcoin

Arguably the most important event in cryptocurrency history, since the launch of Bitcoin in 2009, is scheduled for 1st December 2020: launch of the Ethereum Beacon Chain.

Earning 15% on a currency?

The Beacon Chain sounds technical, but in practical terms, it means that any of the holders of the second-largest cryptocurrency (around $40 billion is held, about a fifth of Bitcoin’s figure) will now be able to earn perhaps as much as, initially, 15% per annum, by staking their holdings. Staking may sound technical, but for many investors, there is nothing technical about 15%.

Staking can be thought of as a contract with three parts. First, you promise to honestly choose the correct entries to go into the distributed ledgers that record cryptocurrency transactions. Second, you put your holding into an escrow account, where it is held as surety for your honesty (hence the term “staking”). Third, you are paid a fee, unless you are dishonest, in which case you are subject to loss.

Bye Bye Banks

In the old-fashioned world, the core function of banks is remarkably similar to what staking achieves. Banks record transactions in a ledger (previously using quill pens, nowadays on a computer). They receive fees for this, either directly, by charging their clients for debits and/or credits, or indirectly, by levying monthly fees and charging a high interest rate on overdrafts, and through numerous other routes. They use this income to pay their costs, including wages, and the remainder is profit that goes to the shareholders.

So staking puts holders of a cryptocurrency in a position similar to the employees and shareholders in a bank. They are paid to ensure that transactions are correctly recorded.

When you make a payment, you may think in terms of money moving out of your account into someone else’s, but of course, nothing is physically moving; all that happens is a debit entry in the ledger against your account, and a credit entry in the other person’s. This principle is just the same in both the old world and the crypto world.

The fourth function of money

Up to now, the two largest crypto units, Bitcoin and Ethereum, looked very snazzy but were really rather old-fashioned, in the sense that all they could do were the three things that currencies have done down the ages: store of value, medium of exchange, and unit of account. With staking, a fourth thing is added: the currency becomes the bank.

I’ve recently watched some videos on crypto by respected academic commentators. One of their themes is that cryptocurrencies don’t fulfil all of those three old functions very well, implying that they aren’t very good currencies, maybe not even currencies at all. But that’s like saying the internet isn’t a good source of news, because you can’t fold it up and use it to make paper darts or wrap fish and chips in, like you can with old-fashioned newspapers. Cryptocurrencies, like the internet, do things that could never have been conceived of with the old medium.

Bitcoin can’t be staked, but can still benefit

Three more points to finish with. First, staking is not new, you can already do it with recently-launched Polkadot and some other small cryptocurrencies. One or more of these may yet become successful but currently they are small; it’s the sheer size of Ethereum that makes staking of it so important. Second, transactions in Bitcoin are recorded by “miners” who use large-scale computing power to solve puzzles, most likely that will never change. But Bitcoin is at the heart of the cryptocurrency ecosystem, its ubiquity and tested robustness make it unique, so for investors it’s a natural complement to hold in a crypto portfolio alongside stakable units. Thus, the value of Bitcoin can still be underpinned by the rewards earned from staking holdings of other cryptocurrencies. Third, staking is really only the start of what cryptocurrencies can eventually do, they can be used to drive futures and derivatives contracts, embedded in the heart of physical supply chains for goods, and more.

Summary: 1st Dec is the big one

In short, cryptocurrencies can take over most of the current functions of banks, and logistics, and accounting, and stock exchanges and so on. Cryptocurrencies can still do all this even if most people never hold them directly, because they can link with future digital currencies issued by the central banks and operate in the background, rather as many people drive a car without ever looking at the engine.

The start of staking in the second largest crypto unit is a crucial step down the route to this new future, and the prospect of getting good single digit, or even double-digit, yields will draw many new investors in. That’s why 1st December 2020 matters so much.

How to break up Google, without breaking up Alphabet

When the anti-trust case against Google was announced this week, the share price of its parent, Alphabet, went up. Suggesting that investors expect that either the case won’t stick, or that if it does, the remedy won’t be effective.

And indeed, although the authorities have said that all possibilities are open, the remedies mentioned so far look weak. Giving users of Apple or Android devices a choice of search engines on first set-up might reduce Google’s market share, but probably only slightly, given its strong name recognition. As for a forced break-up of business divisions, while it could be powerful to force Facebook to divest Instagram and What’s App, there is no equivalent for Alphabet – splitting off a cloud computing business, for example, won’t do much to a search monopoly.

It’s the advertising, stupid

The real heart of Google’s business model is advertising. Google has a dominant share of search-related ads. It operates an auction system for those ads, based on keyword searches. As I’ve written previously, charges can typically be $40 per click or more for some keywords like “car insurance”. Auction theory says that the value (monetary or emotional) to the winner of the item purchased, net of the price paid, can be next-to-nothing. Google auctions set the price at the second-highest bid, which ensures that some value is always left for the winner, though it still may not be much.

So, the emergence over the last two decades of search ads has been double-edged: it has allowed businesses of almost every type to target customers in a way that was never before possible, generating greater efficiency and profit, but Google’s auction system is set up to be able to capture the lion’s share of that profit.

The best anti-trust remedy

The best way for regulators to address monopoly power in advertising, is to directly introduce competition into the ad-auction process. Competition, that is, among sellers of ad space. Designing auction systems for regulators is a job for people who know more about it than I do, but here’s a straw man to get the debate going.

In this straw man, the regulators require Google to have a preliminary auction, every week, for all of the keywords across its entire US search universe, divided into seven equal parts, each of which has to go to a different bidder. Google can bid for one of the parts, and gets to keep all the proceeds of the auction.

The seven winners, call them ad wholesalers, then on-sell keyword searches to advertisers, either using exactly the system Google now does, or any other method, no collusion allowed.

So, if ninety-eight people search for “car insurance” on Google, fourteen of them (allocated randomly or sequentially) will see an ad from the advertiser who transacted with the first wholesaler, another fourteen the ad (which may or may not be different) from whoever transacted with the second wholesaler, and so on.

Giving market power back to advertisers

What will this do to the prices that advertisers are prepared to pay? (And hence, to the prices that the wholesalers pay to Google?) One simple answer is that advertisers now face seven different vendors of an identical product, so there is competition where there was none before, and the price will come down.

That’s probably the right answer, though there is something else going on here as well. Under the current system, an advertiser is actually buying two things: clicks that may lead to sales; and the diversion of clicks away from competitors. Under this straw man proposal, an advertiser can still get both those things, by bidding high enough to transact with all seven wholesalers. But, many advertisers may be happy to simply get the first, by transacting with one or two wholesalers only. The existence of this second kind of advertiser will tend to bring the price down.

The old-fashioned ad world was like this straw man: some advertisers might have bought up all the prime-time TV slots and best billboard slots to keep out competitors, but for many, the aim was merely to buy up enough to get their message out.

How to break up Google, without breaking up Alphabet

In summary, the issue is Google’s monopoly power over search ads; its dominant position in search is just a means to that end.

So the way to regulate the market is not to focus on Google’s dominant position in search, which is a difficult thing to change. Much better to directly address the market for search-based ads, possibly by requiring a two-stage auction like the straw man described here. Advertisers would get some market power back from the search engine, and those who don’t want to pay to squeeze out their competitors, but simply want to pay a lesser amount to get their product out there, could do so.

Tobin’s Q, QE, Canal Barges, and Tech stocks

I’m not sure that equity market investors have fully taken on board the full implications of the policy change that Jerome Powell at the US Federal Reserve announced recently. A couple of canal barges, the narrow ones that go through the eighteenth century locks on Britain’s oldest canals, can help explain why.

Canal Barges and Tobin’s Q

As an undergraduate at Oxford in the early 1970s (yes, a while back!), I was wandering along one of the canal towpaths in a bit of displacement activity to avoid actually writing my essays, when I saw a couple of those narrow boats up for sale. They looked in great condition, almost new, but the price, I can’t remember but say £100 or so, seemed absurdly low compared to what it would surely cost to build a brand-new one. Now, maybe there was something horribly wrong with them (though they seemed to float just fine), but the stock market, along with house prices, were in a deep slump at the time, so it made sense that second-hand boat prices would also be rock-bottom. It suddenly struck me: why would anyone buy a new one, when a good used one was a fraction of the price? Not just the sort of discount that gets measured as a percentage, as there always is on things like slightly-used cars, but a reduction measured in multiples, one-quarter of the brand-new price, or something like that.

J M Keynes and Tobin’s Q

That really brought Tobin’s Q alive for me. This jargon term, coined by the great James Tobin, is the ratio of the market price of an asset, to the cost of making a new one. It’s sometimes used to try and evaluate stock markets, but its real power comes when applied much more broadly. The canal boats instantly showed me that the economy was going to stay in a slump, so long as asset prices were crazily low. Why would anyone buy a new boat, when they could get a good slightly-used one for vastly less money? Same for a company thinking of building a new factory, a person buying a house, etc.

I did go to the library after that, and I found that the (then) recent re-interpretation of Keynes by people like Axel Leijonhufvud and Bertie Hines put Tobin’s Q at its heart. Their re-reading of Keynes was that he saw asset prices as central to economic slumps: when they were (far) below replacement value, no-one would want to invest in new stuff since they could buy old stuff cheaper, and the lack of investment would create a downward multiplier that would drive the slump even deeper. Later on, I wrote a rather technical article about all this, somewhere in Oxford Economic Papers in the unlikely event that you’re interested.

Boosting asset prices was central to breaking this vicious circle. And how did you do that? Cut interest rates, of course, but there came a limit for that process, once they got to around zero. So in Keynes’ world, that left only fiscal expansion as the way out, but note the re-interpretation: the key objective of that was to boost asset prices.

QE and Tobin’s Q

Fast-forward to the 21st century, and this kind of thinking now underlies much of the new conventional wisdom, even though it’s been modified a bit, re-branded and doesn’t acknowledge those antecedents very explicitly. Quantitative Easing (QE), where central banks buy lots and lots of assets (government bonds, privately-issued bonds, even equities in some countries) is one key strand of this. Buying assets directly is almost certain to push up their prices, especially when combined with zero-ish interest rates. And chuck in a bit of fiscal expansion as part of the mix. Of course, neither central banks nor governments buy canal barges directly, but a rise in the price of one kind of asset sooner or later percolates through to other types, and that supports capital investment, lifting the economy out of a slump, or stopping it going into one.

Now, central bank policy is still officially focussed on consumer prices, it has never been explicitly about asset prices. There are all sorts of reasons for that, partly because the central banks don’t like to confuse people by changing headline targets, so they’ve still got the 2% consumer price inflation target dating back to Bank of Canada work in the early 1980s. Partly because asset prices are slippery beasts that can move around far too much to be useful for policy-making, and anyway can be impacted in crazy ways by the merest hint that the authorities are even thinking about them. Despite all this, asset prices have clearly been utterly crucial for central bank policy for at least the last decade.

The Fed and Tobin’s Q

And that brings us to Jerome Powell’s recent policy shift. Having spent the last ten years, on and off, buying bonds so as to get their prices up (which mechanically means that their yields go down), a lot of investors were thinking that he would support the recovery from Covid by shifting to a new policy that included an explicit, very low target for bond yields. Especially since the Bank of Japan has been doing just that for some time. No-one expected the target to be as low as in Japan (where it’s zero), but any figure significantly below current levels would set financial markets on fire, since bond yields help determine today’s value for an expected future stream of corporate profits. The lower that bond yields are, the more those future profits are worth, and stock market prices are likely to rise to reflect this. That in turn should stimulate the economy, partly via the Tobin’s Q effect.

But, Mr Powell, in two or three recent speeches, has made very clear that the Fed has considered targetting bond yields, and explicitly rejected the idea. Instead, they’ve in effect announced that they will be keeping short-term interest rates at around zero for the next three years or so, more or less regardless of what happens to inflation. That’s a very strong commitment. But they’ve also made clear that they won’t be targetting longer term bond yields, whether for ten-year bonds, or 30-year, or whatever. That’s also a strong statement, compared to what investors had started to think.

Now, that set of policy statements didn’t cause bond yields to shoot upwards, for two very good reasons. Partly because the Fed, alongside other central banks, is still buying a lot of bonds through its QE programme. And partly, because the yield on a ten-year bond can be thought of as the weighted average of the current yield on a three-year bond, and the expected yield on a seven year bond issued in three years time. Since the Fed’s promise anchors the first of those firmly at zero, and there was no particular reason to revise up expectations for the second, ten-year bond yields didn’t shoot up.

Nevertheless, there is a kind of wake-up call here. The Fed is telling us that longer-dated yields are being held down for the moment, but they are also warning that if inflation starts to rise too much, or the economy recovers rapidly, then they will be allowed to rise in future. That’s quite a change from where investors were beginning to think we were.

Tech stocks and Tobin’s Q

The stock market has kind of started to take this on board. Arguably, it’s no coincidence that the technology stocks that had been making so much of the running, have lost their seemingly unbreakable upward momentum and become very volatile, on some days leading the broader market down. The income from those stocks is far in the future, so even the possibility that bond yields may rise later on, means that the very high valuations they enjoyed are that little bit more difficult to justify.

So has the Fed implicitly abandoned efforts to use Tobin’s Q to stimulate the economy? Not at all. By sitting hard on short rates for the next three years, they are keeping asset prices high for now, and that ought to allow Q to do its magic, persuading investors to build new stuff rather than buying old stuff cheap. But by giving the hint about future longer-dated bond yields, the Fed is taking a bit of froth out of some of those technology stocks. Other stocks, where it’s the next few years of expected earnings that are more relevant than the distant future of the tech stocks, are better protected by this configuration of bond yields, and the price action has tentatively started to reflect this. I think this is a new trend that could go a quite a bit further.

Sean Shepley kindly made valuable comments on an earlier version of this draft. All remaining errors and problems remain my responsibility.

Google Amazon Facebook: Ad-Boom Ends

Marketing is so central to economic life that if you suggested otherwise to anyone who’s ever run a business, they’d think you were having a bad hair day. But someone forgot to tell economists. I did two economics degrees and it was barely mentioned (OK, that was a fair few years ago). Even nowadays, the extensive literature on advertising is a more or less self-contained area of economics. And, though entire universities are devoted to marketing, that discipline is mainly about how to do it, not what it does to the general economy.

GAF rules the world

So the economists’ toolbox didn’t help me much when I started trying to understand how Google affects the macro economy, which it must do, because it’s so vast. Google’s business model was founded on advertising revenues (even though parent Alphabet has since diversified), with Facebook and Amazon following.

A Faustian Bargain: You make more profits, We take them away

The impact of these online giants is often seen in terms of taking ad revenue away from old-fashioned media like newspapers, as well as privacy issues. But their effect is far wider, on almost every business in the whole economy, in a kind of Faustian bargain.

Onine adverts have revolutionised marketing, with vastly improved targeting, immediacy and feedback. That tends to boost profits and business efficiency throughout the economy. But the other side of the bargain is that those ads are priced by online auctions at a level that identifies those extra profits and transfers most of them away from the businesses actually selling stuff, and into the bottom line of the GAF.

The Prices of Online Ads

To understand this, look at how (some) online ads can be priced. Let’s say you are an insurance company, and you want people who type “car insurance” into a search engine to go to your website. “Car insurance” is an example of an ad-search “keyword”, which could be almost anything, such as “muesli” or “flight to New York”. You want your ad displayed prominently in the search results, so you place a bid in an online auction.

The system can then work as follows. Your website is checked and deemed relevant, and you are the highest bidder, so your ad is displayed in the most prominent place in the results. Every time someone clicks on it, you pay the amount bid by the second-highest bidder. Suppose you bid $45 per click, and the next highest bid is $40. Then, for the next 24 hours (or other agreed period), if 1,000 people click on your ad, you pay $40,000.

Studies suggest this hypothetical $40, though it may intuitively seem high, is the right ball-park for some of the most sought-after keywords in areas like insurance and autos. How do these prices come about? Of course, online search is dominated by one big player, Google. Advertisers who go to other search engines, like Microsoft’s Bing, reach only a tiny fraction of consumers. When there is one dominant seller, theory suggests that it can charge a monopoly price (or close to it), which will be higher than the competitive price, perhaps much higher.

$40 a Click?

But, why would anyone want to pay $40 for a click? Suppose that 5% of those 1,000 clicks (ie 50) lead to someone taking out an insurance policy, which they renew several times, and let’s say the total expected future profits are $1000 per policy. That’s a total of $50,000, which is $10,000 more than was paid for the clicks. So the insurance company is happy, sort of, since they made some money. Their marketing campaign got a shot of accurately targeted adrenaline.

But from a more macro view, things don’t look quite so rosy. The search engine got four-fifths of the profit from those insurance policies, the insurer kept one-fifth. OK, this is a made-up example, but it captures the essence of an auction: the value (monetary or emotional) that the winner gets from the thing they buy can be next-to-nothing, once the price paid is deducted. Auctions where the price is set at the second-highest bid, like this example, ensure that some value is always left for the winner, though it still may not be much.

Why the Tech Boom Happened

The results of all this, of course, have driven a multi-year trend in stock markets. The GAF have dominated more and more, alongside a handful of other tech giants their share prices have outperformed almost everything else as they take a larger and larger share of total profits in the economy. The Covid lockdown gave this long-term process another big push forward (though the prices stumbled in early September).

Monopoly Good, Monopoly Bad

It’s been a great run for investors. But it’s difficult to see that this is good for the overall economy. And, capitalism has a way of eventually squeezing out things that get in its way.

Of course, monopoly profits, for a while, are an essential and healthy part of the capitalist process, to reward innovative companies for their risk-taking and investment. But it becomes unhealthy when those profits persist long after that reward has been paid, and especially when their impact is felt not just in one narrow sector of the economy, but across the whole of it. This example feels especially unhealthy because it affects marketing, which is itself such a core part of capitalism.

Governments don’t look set to address this anytime soon. Even the countries that have started to regulate the tech giants, notably the European Union, India and Australia, have not focused on advertising. So, will the capitalist system itself start to erode the monopoly profits, via increased competition?

Competition: A Slow Start, but it’s Coming….

Fifteen or so years ago, online advertising more or less meant Google. As Facebook developed ads on its social media channels and then Amazon expanded its marketing offering, and as a plethora of smaller online choices emerged, a form of competition has developed, moderating Google’s earlier exponential growth in ad revenue.

But this competition is still limited. One reason is that the three big channels are complementary rather than alternatives: a search engine does not compete directly with social media. The other reason is that the GAF control many of the brokers that give access to “independent” channels such as banner ads or in-game ads.

Nor have China’s own tech giants provided head-to-head competition, with Baidu’s search engine focussed on China and Alibaba focussed on wholesaling. The one exception is TikTok’s video-sharing platform, which has seen rapid growth in the US and elsewhere with online ads that offer clear competition to Facebook. Far from welcoming this competition, the Trump Administration has challenged TikTok’s US operations, so it has started discussions for a possible sale, with the leading (joint) bidders being Microsoft and Walmart; Beijing is not pleased.

Walmart in 2020: Three’s Company, Four’s a Crowd

Meanwhile, Walmart’s promotion of third-party ads on its US website has seen it emerge as a significant challenger to the big three (especially Amazon). This challenge would be given an enormous boost if it were able to buy TikTok’s US operations, potentially leapfrogging this fourth platform to a serious position of strength. And, when measuring market power, to paraphrase a well-known saying: three’s company, four’s a crowd.

This acquisition may or may not happen, but that’s not really the point. The Walmart strategy, with or without TikTok, demonstrates what ought by now to be blindingly obvious to any company with a reasonable online presence: why stop at selling your own products?

I’m based in the UK and when I go on a website like John Lewis, it seems crazy that this venerable but struggling department store is not selling space on its site for third-party products that complement its own offerings. Same for Galleries Lafayette in France, Co-op in Switzerland or whatever. Some sites, notably some airlines (remember those?) are doing this, but overall the eyeballs visiting many sites are a grossly under-monetised resource.

In the aftermath of Covid, with online traffic so greatly increased, all this may change rather rapidly. Many companies with a strong eyeball count can start to offer ad space and cross-sell products. This won’t change the big picture much, if they sell ad space through brokers controlled by the big three. But as they grow, and deal directly with advertisers, or use independent brokers, they will start to make the online ad market much more competitive.

A Whole Family of Amazons

In effect, the web can start to look like a whole family of Amazons, each with their own ads and cross-sales, and their own internal search engines. As the choice of targeted ad channels widens, prices for those ads will come down. Walmart is moving along this road; watch for European retailers going the same way.

Google, Amazon, Facebook: End of the Ad-Boom

Ad profits are big for the GAF, even with their other large revenues like cloud services and logistics. So, the accelerated shift to online business during Covid may turn out a double-edged sword for them: great for their profits in the short-term, but so profound that it will shock older players into changing business models faster than otherwise, bringing new competition to the online ad world. As ad rates come down, it’s difficult to see the GAF’s incredible share price run continuing.

And, some of the profits that they have been earning from those ads can flow back to the companies that generated them in the first place.

Does Bitcoin have fundamental value?

With Covid sending debt levels soaring and pushing central banks to slash interest rates towards zero or further below, the price of Bitcoin has been buoyant, breaching levels not seen since the “ICO bubble” three years ago. Some mainstream investors, spooked by the risks of a post-Covid inflation as governments monetise the debt, are starting to consider Bitcoin and other crypto (digital) currencies as a serious alternative asset, alongside precious metals such as gold and silver, whose prices have also been strong. The recent launch of a Bitcoin fund by fund managers Fidelity is just one example of this mainstream interest. But while the enthusiasm for cryptocurrencies is palpable, is there any fundamental underpinning to give confidence in their long-term value?

Three sources of value

The most obvious source of fundamental value comes from the use of Bitcoin and other cryptos for transactions. I’ve eaten a couple of excellent meals in Zug that were paid for in Bitcoin, and some Swiss Cantons will now accept it for tax payments. In July of this year Worldline, in collaboration with Bitcoin Suisse, started piloting a system that allows its 400,000+ merchants across Europe to accept Bitcoin and other cryptocurrencies from their clients and be paid in Euros, Pounds etc. The number of transactions is small but can be expected to rise as the infrastructure rolls out. Cryptocurrencies are also used for cross-border payments between individuals, where costs can fall far below those in expensive traditional channels as volumes rise and technology improves, including the increasing replacement of power-hungry “proof-of-work” methods for validating transactions with the cheaper (and more environmentally friendly) “proof-of stake” systems.

A second source of value comes from the potential to link company supply chains, payments and credit seamlessly together using one of the public blockchains, the decentralised systems that record cryptocurrency transactions. The barcode for a product could be scanned when it left the manufacturer’s factory and scanned again on arrival in the buying company’s warehouse. Those barcode scans could cause the delivery to be recorded in both company’s stock ledgers, source a third-party loan to the seller at a competitive price that reflected the credit history of the two parties, and at a later date, trigger an automated repayment of the loan by the buyer. Second-generation cryptocurrencies such as Ether incorporate the “smart contracts” needed to do all this.

The third source of fundamental value for cryptocurrencies comes from their use in finance. They can be used to provide automated hedging between fiat currencies (like Dollars and Euros) for companies or individuals making cross-border payments or investments. They can facilitate equity and debt capital-raising for companies, as in 2017 when around $6bn was raised in “Initial Coin Offerings”, and though that was an unregulated era and some of the investments were lost, part ended up with thriving companies, demonstrating the potential. Smart contracts could potentially take over many of the functions of fund managers, to provide investment funds that invest in the stock market. In short, much of the current financial services industry could eventually migrate to the crypto world.

Programmable Money: Life, the universe, and everything

Taken together, these three sources offer enormous potential underlying value for cryptocurrencies. They can become the heart of both the real economy, operating and recording logistics and production, and of financial services, making payments, loans, share transactions, capital-raising, and operating investment funds. Indeed, the very word “currency” in “cryptocurrency” is misleadingly narrow for something that is better described as “Programmable Money” and can potentially operate, in Douglas Adams’ phrase, “life, the universe, and everything”.

Crypto owners get the banks’ profits

All this means that the profits from activities that currently go to shareholders of banks and payments providers, logistics providers, fund managers, and so on, can in future be earned instead by the holders of cryptocurrencies, or other participants in the crypto universe.

While some of this can happen through explicit receipt of fees, notably the “staking” fees paid to holders of newer cryptocurrencies for validating transactions, or the “gas” payment to those operating the computers that calculate the outcome of a smart contract, there is a broader supply/demand effect that can potentially benefit all holders. As more and more activity takes place using a cryptocurrency whose supply is limited, then demand rises relative to supply, which tends to raise its fundamental value over time. And a rise in fundamental value is likely to be reflected in a price that trends upwards.

Operation of this supply/demand balance varies among different cryptocurrencies, but in general the design is, or is planned to be, such that supply will be limited. Looking at just the two largest cryptocurrencies, new Bitcoin is created every time a new block of transactions is validated, but at a rate that is predetermined to decline to zero over time, via the “halvings” that occur roughly every four years. For Ether, revisions are proposed that would “burn” (ie destroy) fees paid by those making a transaction, thus reducing supply as activity increases.

The two things needed to let crypto grow up

This helps to explain why crypto-enthusiasts are so excited. However, some words of warning are needed. Much of the potential just described above is still just that – potential. The number of transactions related to the real economy is still tiny compared to conventional channels. Companies have been looking hard at the use of the public blockchain in their supply chains, but there is reluctance to take the plunge in a big way. And with little action in those key real-economy areas, most of the financial transactions on the blockchain are adding only relatively limited value to the real economy. However, at less than 12 years old, the crypto world is not yet even into adolescence, so it’s reasonable to ask what is needed to help fulfil its amazing potential as it gradually matures towards adulthood.

The first key thing is for it to be properly regulated – without destroying its innovative spirit. Progress has been made. For example, major players such as Coinbase in the US and Bitcoin Suisse in Europe are now fully regulated by their national authorities, and Know-Your-Customer rules affecting most switches between crypto and fiat currencies mean that anyone trying to use Bitcoin for money laundering now in effect faces similar hurdles to those in conventional banking.

Second is to address the problems caused by volatility in the exchange rate between cryptocurrencies and conventional currencies. No-one wants to pay EUR500 for some Bitcoin at the start of their holiday, and find it’s only worth EUR400 when they come to settle their hotel bill. “Stablecoins” are a possible solution, these are cryptocurrencies linked to one of the conventional currencies, such as USDC or Tether for the US Dollar, or Facebook’s proposed Libra (likely to be offered in several versions each linked to a different major currency like Dollars or Euros). The problem is that despite their name, so far none of these has been completely stable, often fluctuating a couple of a percent or so relative to the underlying traditional currency, sometimes by much more. If Facebook’s Libra is successful, it may operate on scale so large that it can be kept truly stable, but as yet that lies in the future.

Another possibility, which I personally like, is simply for any unwanted currency risk to get hedged out. So a holidaymaker can exchange EUR500 into Bitcoin and also pay a small amount extra for an automated hedge, which will ensure they still have EUR500 available when they pay for that hotel. This sounds complicated but it will all happen behind the scenes, so to the users just see a simple payment in Euros. The big advantage is that in future, blockchains can be a very cheap way to process transactions, so the fees can be much less than currently charged on credit cards or banknote exchange.

In a parallel development, a CBDC (Central Bank Digital Currency) trial has started in China, with the Bank of England and Fed exploring the idea. These official currencies will be stable, and can play a crucial and valuable role in the future digital financial world. They will likely operate on a tightly controlled blockchain, making them safe and secure but also making it difficult if not impossible to develop and operate the smart contracts offered by cryptocurrencies on public blockchains. Linking the central bank world to the crypto world may potentially give the best of both. So in the company supply chain example discussed above, records for the dispatch and delivery of goods, and the corresponding financial transactions, would operate via smart contracts using a cryptocurrency like Ether, but the companies would receive or pay in Dollar-CBDC issued by the Fed. In short, CBDCs are likely to be complements to the cryptocurrencies, not competitors.

The road to long term value is opening

With better regulation, and a route emerging for stable links to conventional currencies, the road to realising crypto’s long-term value looks to be starting to open wider. However, in the short to medium term there are numerous influences that can push prices in both directions. Current ultra-low interest rates and the risk of rising inflation have supported the price of gold and Bitcoin, but if economic recovery starts to look more assured, investors will perceive that interest rates can’t stay low for ever, and that goes the other way. And, looking at a crypto-specific effect, the recent boom in issuance of “governance tokens” has helped to boost prices of Ether, but it’s possible that the short-term effect has been overdone.

Further ahead, the long-term value drivers described here may benefit different cryptos in different ways: among the younger generation, Ether still has the lead by size, but others are vying with promise of even better smart functionality and governance; while Bitcoin, though lacking the functionality of its younger siblings, still benefits from having an absolutely clear predetermined supply, as well as being the oldest, largest and best known.

Many thanks to Raffael Huber, Head of Research at Bitcoin Suisse, for invaluable input; all errors and omissions remain my responsibility. Raffael’s latest research in the Decrypt series can be found at