The Digital Economist

• Has potential to grow rapidly in use for conventional dollar transactions, in contrast to its predecessors which were mainly used as a link to crypto
• Can be safer than predecessors and conventional bank deposits due to quality of asset-backing; is a competitive threat to banks which may respond with their own stablecoins
• Potentially provides an impetus to future demand for ETH
• By creating a strong bridge between traditional dollars and crypto, can facilitate development of decentralised finance and automated transactions on blockchains

Three ways this stablecoin is different

The new PayPal stablecoin (a digital token fixed to the value of the dollar) differs from its predecessors in three crucial ways.

First, it has been issued under the umbrella of a major global payments company.

Second, its issuer has undertaken to back it fully and transparently by high quality short term assets such as US Treasury Bills. The economics of this make sense now, because short term dollar interest rates are well above zero, so the earnings on the underlying assets will fund the operation and promotion of the stablecoin. The economics of earlier stablecoins, operating in an environment of near-zero Treasury Bill rates, made sense only if they were backed by assets that paid more but had significant credit exposure, making them inherently much riskier, with a tendency to move from par at times of stress.

Third, this is the first dollar stablecoin to be issued by a regulated entity: PayPal’s partner Paxos, a trust company regulated by the New York Department of Financial Services. Paxos states that this could provide a form of bankruptcy protection.

Potential for Widespread Use

These three features make the new PayPal stablecoin more likely than its predecessors to be widely adopted by general users for use in conventional dollar transactions. Its usage therefore has the potential to grow rapidly. By contrast, earlier stablecoins have been used mainly by crypto investors as a convenient way to hold a dollar-linked asset that could readily be switched into cryptocurrencies. The likely broader use of the PayPal stablecoin implies that the total funds held through it could fairly quickly exceed those held in earlier stablecoins by an order of magnitude.

Transactions in the PayPal stablecoin will be recorded on the Ethereum blockchain, and the fees for this will be paid in ETH, the native coin of that blockchain. This will increase demand for ETH (as well as curbing its supply, since a small amount is burned (destroyed) during each transaction). The detailed operation of the new stablecoin (not yet published) is likely to aim to minimise these fees, but it seems likely that there will be some net increase in demand and thus upward pressure on ETH prices over the medium term, other things equal.

100% backing: strengths and risks

A bank deposit is backed by diverse assets including risky loans to a range of undisclosed borrowers at varying maturities. By contrast, it is claimed that the PayPal stablecoin will be 100% backed by high-quality short-term assets, such as US Treasury Bills. In principle, this should make it significantly safer than a bank deposit. It should also in theory be largely immune to a bank run, since the assets backing it should be highly liquid and immediately saleable to meet any requests for withdrawals. This is not possible for the illiquid loans that are part of the asset pool supporting bank deposits.

It remains to be seen whether this will be correct in practice, because not only Treasury Bills but also assets such as high-quality commercial paper may be included in those backing the stablecoin. In normal times these are highly liquid and have near-zero risk of default, but in times of extreme stress this may change.

The PayPal stablecoin might over time become a major competitor against banks (and money market mutual funds), both on the “liabilities” side by attracting funds that would otherwise have gone to conventional deposits, and on the “assets” side, by buying Treasury Bills and commercial paper that would otherwise have been purchased by the banking system. These effects could be profound, forcing banks to search for other sources of liabilities, or to shrink their lending activities; and also affecting pricing in the short-term bill market.

The first of these effects is one of the reasons often cited by central banks for caution in creating Central Bank Digital Currencies (CBDCs) available to the general public. The PayPal stablecoin would not be as safe as a CBDC, but it should be safer than bank deposits while offering similar facilities, making it more convenient for day-to-day use than a money market mutual fund, although it will presumably pay no interest.

In short, this new stablecoing is reasonably likely to accelerate the move of mainstream dollar transactions onto the blockchain at the expense of traditional banks, some of which may respond by launching their own stablecoins.

Stablecoins, Crypto and CBDCs: the Harmonic Triangle

The above discussion focused on the use of the PayPal stablecoin for traditional dollar transactions, but it can also be a convenient vehicle for switching funds between dollars and cryptocurrencies. This second function has already been provided by existing stablecoins, but their scale and effectiveness has been affected by their inherent risks (see above) and small-scale use in traditional finance.

The PayPal stablecoin can thus provide a more powerful bridge between the traditional and crypto worlds than has been available until now.

I argued two years ago (“The Harmonic Triangle”, Blog, May 2021) that properly-regulated stablecoins, crypto, and CBDCs could operate together in a complementary way.

The stablecoins would be the day-to-day vehicle for mainstream transactions. Crypto would provide automated financial and real economy transactions including lending and derivatives that were faster, cheaper and more secure than existing banks and exchanges. CBDCs would anchor the system and would have limited functionality and very narrow connections to the rest of the digital world, to ensure absolute security and control.

The PayPal stablecoin can offer a major step forward to a world embodying that vision.

Spring is here: I don’t really see how else to describe what’s happened to the Bitcoin price. It has now virtually doubled from the lows reached in the immediate aftermath of the FTX collapse last November, and perhaps more relevant, it’s trading more than 50% up on the range either side of $20,000 that it held for nearly six months prior to that crash (briefly revisited this March).

This has happened despite everything that’s been thrown at crypto. An unrelenting upward trend in interest rates, with this week’s gathering of the world’s central bankers in Sintra, Portugal, delivering an unequivocal message: rates are going even higher, and the new normal is for them to stay up there. And SEC enforcement action against not only Binance but also Coinbase.

Of course, there’s been good news as well, with Blackrock announcing its application for a BTC spot ETF and Fidelity following suit by refreshing its own. In my view, these steps by the world’s leading asset managers are of vital importance. They symbolise how Tradfi is now embracing crypto. And, they provide a route for mainstream fund managers around the world to start buying Bitcoin as a core part of their portfolios. Imagine yourself as a portfolio manager almost anywhere approaching your investment committee to get permission to buy BTC. In the past, even if you could convince them that it made sense as an investment, your application would most likely fail as soon as they started asking about custody and even the apparently trivial question of whether performance data would have to be uploaded manually. Once the big-name ETFs become available, these problems will melt away into a simple ISIN that just gets loaded into the system like everything else.

Moreover, the last year has seen key developments within crypto itself, including of course the unlocking of staked ETH and steps forward in using BTC in simple smart transactions.

All this makes it likely that BTC will make its way into more and more institutional portfolios. As it does, watch for those old calculations comparing its market cap to gold to get dusted off — with corresponding price projections into the stratosphere.

But for the broader crypto world — and ultimately for BTC itself — the elephant in the room is the battle over whether it, or a series of closed private systems, will end up being the engine used to drive the use of blockchain by the broader conventional finance industry and other areas like logistics. For crypto to win this race, the central banks have to accept that their digital currencies, based on private chains, are allowed to interface securely with public blockchains built around ETH and other cryptos. Whether they are or not is likely to become clearer over the next year or so. BTC can perform well in its narrow role as a kind of digital gold even if that debate goes against the public route; but it (as well as ETH and parts of the broader crypto world) can go much, much further if the public route wins out.

POSTSCRIPT: The previous piece in this series was written just over a year ago. At first, I felt rather embarrassed to look back at that, since it argued that the crypto Spring was coming. Then I looked more closely at the timing: it was published when BTC was trading just above $20,000, so already in the range that was to mark the bottom, save for those dreadful two months after the FTX collapse. I still felt a bit embarrassed, but not so bad as at first.

As investors scramble for the exits and the “crypto has no value” doomsayers reappear, when better for reiterating the core role that crypto can play in future finance — in a Harmonic Triangle alongside CBDCs and (properly-reserved) stablecoins.

The stakes are high: the smart contracts operated on cryptocurrency blockchains have the potential to be a transformative enabling technology for both finance and the broader economy, but this is unlikely to happen until a stronger bridge is built to the familiar world of fiat currencies – and there is no consensus on how this can be done while maintaining the essential integrity of central bank money. This article addresses that question by setting out a vision for an imagined future digital architecture in which CBDC (Central Bank Digital Currencies), cryptocurrencies and stablecoins each play key, complementary roles. Even amidst the current market turmoil, the foundations are being laid, with legislation to foster constructive development of cryptocurrencies having been introduced in some countries, including Switzerland, and planning well advanced in the EU, though at earlier stages in the US and UK, and with many countries considering, or experimenting with, CBDC.

Defining the technology

CBDC (whether ‘retail’, available to all, or ‘wholesale’, open only to banks), cryptocurrencies and stablecoins all use the same core technology of a blockchain – which is nothing more than an electronic ledger in which transactions denominated in a unit of account are recorded, with a complete update (a new ‘block’) occurring every few seconds. The key differences relate to control of the updating process, access, and issuance of new units (or their destruction).

For CBDC, all three of these key processes are centrally controlled, by the central bank. For cryptocurrencies and stablecoins, a decentralised process (based either on ‘mining’ or on the more energy-efficient ‘staking’) is used to update the blocks, access is open to all, while unit issuance or destruction is rule-based; both allow limited technical changes, and in some cases adjustment to issuance rules, through largely decentralised governance processes. Stablecoins use a variety of rule-based mechanisms intended to maintain parity against a reference fiat currency, aided by a pool of reserves assets denominated in that currency; but historically, they trade in a band around par, usually narrow but occasionally wider. This is a key issue discussed further below.

All the familiar macro-economic aspects of monetary policy, such as targetting inflation, exchange rates or financial aggregates, can be applied with a CBDC, using the familiar instruments (though their impact might change, see below); and for a retail CBDC, there is the new possibility of direct “helicopter drops” of new money into the wallets of all holders, or equally, if more controversially, of direct removal of some holdings.

Crucially, blockchains can record not just debits and credits in their native unit of account, but also other items: information from outside (such as the scanning of the barcode from a package received in a warehouse); and contracts, which are written in computer code and can be automatically executed in response to a trigger, such as the receipt of that barcode or the achievement of a price target. The latter are known as ‘smart contracts’ and can take many forms.

Many cryptocurrency blockchains support this extra capability, the largest being Ethereum, and it is this which really marks the new technology out from the old world of banking. If we think of the clerks in a Victorian bank updating the ledgers with their quill pens, which is still essentially what modern banks do albeit with computers, it is as though the same office now also contains the agents from the back office of a shipping company or a corn-trading house, alongside lawyers writing and completing contracts, all at lightening speed. It is this integration across functions that are still separate even in today’s world, that really marks cryptocurrency blockchains out as a quantum leap in technology.

There is nothing technical that prevents a central bank including such functionality in the blockchain that it uses to operate its CBDC; but doing so in a way that realises its full potential would require the central bank to give almost anyone access, and permit them to incorporate computer code that could robotically execute transactions in CBDC. It seems most unlikely that any central bank would ever feel comfortable with allowing this. That is why this article talks of a harmonic triangle: if designed to inter-operate, CBDC, cryptocurrencies and stablecoins can act in a complementary way to give an overall financial system that can exploit the full possibilities of the new technology, while also maintaining the familiar characteristics of central bank fiat money.

A possible future digital architecture that does this is described below, but before that, further issues need to be discussed, starting with the question of whether there is some fundamental basis to the prices of cryptocurrencies, for without this, they would seem an unstable unit to have at the heart of the economy.

Do cryptocurrencies have ‘fundamental value’?

The transaction fees on smart contracts are paid in the cryptocurrency (such as Ether) native to the blockchain on which the contract operated (even though the contract itself could be denominated and settled in conventional fiat currency such as dollars). We could imagine a logistics company offering its clients a smart contract which ensured that the moment a package arrived at its destination and its barcode was scanned, the buyer’s funds would automatically be debited to pay the seller; this could go even further and include automated factoring in which a third party offered credit to allow the seller to receive instant payment even where the contract gave a grace period.

The fees on such contracts would create an underlying transactions demand for the cryptocurrency involved and thus provide an anchor for its value. Many commentators talk of cryptocurrencies as “having no fundamental value”. This assertion would be true if such fees were payments only for transactions within the cryptocurrency world itself, as was the case in the past. But once real economy transactions are handled on a cryptocurrency blockchain, an anchor for fundamental value is established, since the execution of each real economy smart contract creates a demand that has to be balanced against the rule-limited supply of the relevant unit.

This could be thought of as the price of a company’s shares being influenced by its discounted stream of net revenues, or as the price level being determined by the number of transactions (at given velocity and supply) in the quantity theory of money – noting that in the digital architecture envisaged here, contacts would be mainly denominated in fiat currency, while the fees would be paid in cryptocurrency.

Bitcoin, in contrast to Ether and some other newer units, operates on a blockchain with limited functionality, but its importance as the largest and best-known cryptocurrency is encouraging innovations that allow it to be used to support smart contracts, which could indirectly provide it with a fundamental value metric.

The vast price swings in cryptocurrencies seen in recent years have caught the public imagination, while also causing concern among regulators about the involvement of smaller investors. If a basis for fundamental value is established, this might help reduce the scale of such swings, as might the effective increase in free float as the concentration of ownership declines, and the development of derivatives that improve price discovery. Note that some commentators have argued that where such instruments allow leverage, using cryptocurrency as collateral, this could worsen the price swings, notably when automated margin calls force widespread liquidation, and especially in the absence of a central authority to control the leverage. Others argue that centralised regulation has often failed to prevent, or even exacerbated, asset price swings, and add that cryptocurrency derivatives can develop rapidly to incorporate automated, self-imposed limits to leverage based on the signals of an overheating market.

A changing role for banks

In imagining a future digital architecture, it is important to consider two radically different scenarios for the banks – noting that both are consistent with bringing the benefits of blockchain to the broader real economy.

Banks do three things that are not really compatible: they provide transactions services, they hold deposits as a store of value, and they also operate as highly leveraged institutions to provide credit. As limited-liability entities, there is no ultimate backstop to protect depositors once loan losses have burnt through their equity capital (and through any debt they have issued that stands below depositors in their capital structure). Moreover, even before loan losses reach this point, they may be sufficient to reduce a bank’s holdings of liquid assets below the level needed to meet normal day-to-day transactions flows. Because depositors are aware of these issues, if they sense that a bank is approaching such limits they will withdraw their funds – a ‘bank run’ – which can precipitate the very crisis that they fear.

This contradiction came starkly into public view during the 2007-9 financial crisis, and in response, regulators tightened their earlier range of rules requiring minimum levels of capital and liquid assets, as well as tightening supervision. While such measures should reduce the likelihood of a financial crisis, they do not eliminate it, because the underlying incompatibility of having highly leveraged institutions providing basic utility services to the financial system has not been removed. Moreover, it could be argued that concern over such risks imparts an inflationary bias to macro-monetary policy, since a modest inflation, with low or negative real interest rates, can help to mitigate the likelihood of bank collapses. Arguably, it is this bias that has driven the policy stance of the last decade, which may be providing one source for the chronic asset price inflation of recent years that is now being followed by inflation in goods and services prices.

Blockchain technology offers the opportunity to remove this problem, by moving the transactions and deposit-taking functions away from banks to a retail CBDC, leaving them a more limited role in credit provision funded only via liabilities that offer attractive interest and/or premium services, and with the resulting gap made up by forms of peer-to-peer lending on cryptocurrency blockchains, where they would be operated by smart contracts but denominated in fiat currency. This would not only remove the contradiction at the heart of banking; it should also cut costs to charge-paying users of banking services, due to the inherent efficiency of blockchains, and be inclusive, since anyone could hold and use CBDC.

However, this is, of course, a very radical vision, and the transition to it would be risky and so would likely need to take place over a number of years, in a carefully controlled way. Were a retail (open to all) CBDC to be introduced overnight, it would tend to attract funds away from bank deposits, because of superior credit quality and lower charges. This might not only starve banks of the funds they needed for lending, creating a deflationary credit implosion, but might also have a risk of causing the bank runs that in the longer term it is designed to eliminate.

To avoid this, a phased introduction of CBDC could start with a wholesale version (open only to banks themselves), followed by an opening up to the general public that initially capped holdings at a very low ceiling, that could be gradually raised over time and eventually eliminated. This would allow banks time to progressively find alternative sources of funding and/or shrink the size of their loan books, while meanwhile giving time for an efficient and effective market in decentralised (peer to peer) lending to develop on cryptocurrency blockchains. During this adjustment, the ways that monetary policy was transmitted would change, in ways that are difficult to predict – one possibility is that movements in longer-dated yields would increase in importance relative to shorter, as the banks lost their current ‘captive’ deposit bases, forcing them to compete more for funding with bond issuance by end-borrowers on capital markets.

As an alternative scenario, it would be possible to introduce only the first step of this process, the wholesale CBDC. Stopping there, and leaving the current role of banks largely unchanged, would avoid the risks of transition, at the cost of abandoning the potential gains to stability, inclusion and efficiency in the banking area.

For the broader real economy, and for financial markets outside banking, realising the benefits of blockchain technology depends not on whether a CBDC is wholesale or retail, but rather, on how it is allowed to interact with stablecoins and cryptocurrencies.

An Imagined Future Digital Architecture: The Harmonic Triangle

Smart contracts running on cryptocurrency blockchains offer functionality that can power big efficiency gains in the real economy; stablecoins offer the mechanism to allow those contracts to be settled in a unit that is pegged to the familiar fiat currency which that broader real economy uses; but a stablecoin is not the same as fiat currency, since the peg is not perfect. So the missing link, to allow the full power of the smart contracts to be applied, is for the stablecoins to be pegged firmly to the fiat currency – which requires creation of a CBDC designed to facilitate that.

The way this might work is as follows. 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. Such backing would ensure that there could never be a bank run. The need for such ironclad backing has been made abundantly clear in recent weeks with the collapse of Terra, which had no such reserves, relying instead on support from a cryptocurrency, Luna.

These Authorised Stablecoins would operate on a blockchain such as Ethereum 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 real economy and financial market contracts, buy securities, and all the other features that the Ethereum blockchain can 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 (deleted) 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 account.

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 outside 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 or other blockchains, the scale of Authorised Stablecoins outstanding and of transactions using them 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.

Conclusion: 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 the background: decentralised finance and real economy transactions on Ethereum and other smart blockchains, inter-operability between chains facilitated by units such as Polkadot, Bitcoin being used mainly as a longer-term store of value, and Authorised Stablecoins being used for a very large majority of day to day transactions.

In this sense, the Harmonic Triangle would bring out the best of each of its three elements. CBDC would provide the universal acceptance, familiarity and total security that comes from a unit operated by a central bank, while having the potential to be inflationary when needed, and yet for reasons of security offering very limited functionality. Cryptocurrencies would offer the capability for automated financial and real economy transactions on a secure network, and/or provide a deflationary (ie store of value) bias. Stablecoins, properly regulated, would 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.

Giles Keating

April 2022

Giles Keating is a Board Member of Bitcoin Suisse AG. A version of this article was shortlisted for the Rybczynski Prize in June 2022 and is an updated and extended version of articles that appeared in this blog in May 2021, for which Abdallah Mahdi provided valuable background research.

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.

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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.

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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.

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 https://digital-economist.com/2021/05/02/the-harmonic-triangle-cbdc-cryptos-stablecoins/

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.

https://www.coindesk.com/ex-head-of-chinas-digital-yuan-effort-says-cbdcs-could-operate-on-ethereum

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 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.

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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.

Introduction

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

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.

Conclusion

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.

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

Arguably the most important event in cryptocurrency history, since the launch of Bitcoin in 2009, is scheduled for 1^st 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 1^st December 2020 matters so much.

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.