A Central Bank “cryptocurrency”? An interesting idea, but maybe not for the reason we think

The retail use-cases get all the press… but the killer-app for digital central bank money might be smart contracts

This post on a concept called “FedCoin” by David Andolfatto of the St Louis Fed raises the really interesting possibility of a world with central-bank-issued digital assets which can be held by a broad range of people.


Andolfatto’s FedCoin post

The core idea is essentially a variation on the digital cash theme: a digital bearer asset that is redeemable for dollars. So, on the surface, just like m-pesa but for dollars, right?

Not quite. Because Andolfatto’s FedCoin idea has two important differences.

  • First, FedCoin would be issued by the central bank. That contrasts with most other digital cash systems, where the holder has a claim against a telecoms firm or a commercial bank. In those systems, you have to trust the central bank not to inflate away the currency (as you do here) but you also have to trust the commercial issuer not to go bust – or any deposit insurance scheme to bail you out if they do. A central bank digital asset doesn’t have that second issue.
  • Secondly, Aldolfatto suggests this currency could be issued on a distributed ledger. As he writes in an update to that post, many people have questioned why that might be necessary. Surely if you trust the fed enough to hold its currency, you trust it to run an accounting system!   However, I wouldn’t dismiss this suggestion just yet, as I’ll argue below.

Robert Sams has an intelligent and thoughtful analysis of the overall idea.

So why am I writing about it now?

It’s not just the US: what about the Bank of England?

No sooner had the FedCoin idea been discussed and dissected, the Bank of England published its 2015 “Research Agenda”: a paper summarizing all the questions they plan to examine this year.

Turn to page 31 and guess what… there’s a section on Digital Currencies. If you haven’t read it, I urge you to do so. Because it doesn’t say what one might expect it to. Most official papers on “digital currencies” are influenced by Bitcoin and talk about volatility, monetary questions, the tedious question of whether cryptocurrencies pass the “money test”, regulation and so forth.

This paper doesn’t. Instead, it follows the same line of reasoning as Andolfatto and focuses directly on the question of what a central bank-issued digital currency might mean. And the paper does something really valuable: it lists a set of questions that anybody planning to do something in this space would have to answer.

Bank of England

The Bank of England’s Research Questions for a Central-Bank-issued digital currency

And these are important questions. Imagine something like FedCoin was built and you were able to hold a digital asset that represented a claim on the Bank of England or the Federal Reserve. The implications for commercial banks could be huge: why would you lend your money to (aka “deposit with”) a retail bank if you could hold the same money in a counterparty-risk-free form?

So the commercial banks would probably have to compete for your deposits with higher interest rates. But wouldn’t that make them more risky and more likely to fail?   So perhaps the central bank would have to charge you to hold their digital asset (a negative interest rate?) to encourage you not to hold too much of it and lend the rest to the commercial banks. But now the digital “cash” isn’t the same as physical cash…

And there’s another question. If everybody has access to central bank money, then why do we need payment systems? I wrote a simplified explanation of how money moves around the banking system a while back – and the noteworthy thing about it is that pretty much all of the payment infrastructure in the world exists because most money isn’t central bank money. If you imagine a world where everybody holds central bank money, suddenly the picture begins to look a lot simpler…

Central Bank Money for all

Do you need need most payment systems in a world with only FedCoin…?

There’s more… Do we really want people having access to unlimited amounts of digital bearer assets denominated in GBP or USD? Do central banks have the culture, systems and experience to oversee such a scheme and spot misuse, fraud and crime?

So perhaps a hybrid implementation, would emerge where consumers have to nominate a “sponsoring” commercial bank, which provides safekeeping services, has oversight responsibilities and, perhaps, has the ability to block suspicious transactions?

Who knows.   And I should stress that I don’t think anybody is proposing a system like this in any case…. These are research questions.   But it suggests that the BOE questions are a very good starting point for thinking about these issues.

A solution looking for a problem?

But there’s a small issue: this intellectual exercise is fascinating but is a central bank digital currency actually needed?   With a few notable exceptions, depositors don’t tend to lose their deposits when commercial banks fail. (But businesses and other large depositors often do…) And aren’t capital rules and prudential supervision designed to solve that problem in any case?

Remember I said the “distributed ledger” aspect of FedCoin was interesting…

Think back to the Andolfatto piece. He mused about building “FedCoin” on a distributed ledger.   On its face, that doesn’t seem to make much sense.

But if we open the topic of distributed ledgers, it also brings Smart Contracts into play. In my recent piece on the topic, I suggested a definition for a smart contract as follows:

“A smart-contract is an event-driven program, with state, which runs on a replicated, shared ledger and which can take custody over assets on that ledger.”

Implicit in my definition was that these “assets” could be native assets to the ledger (e.g. Bitcoin). But , more likely, they would be representations of real-world assets: GBP tokens issued by Barclays or HSBC or Coop, say.

For example, you could imagine consumers paying £50 a month into a “mobile phone insurance smart contract” and, if they can provide proof that they’ve lost their mobile phone, the smart contract will pay out enough money to replace the phone, using the funds that have been paid in by all the policyholders.

Perhaps the “proof” would be in the form of a “proof of purchase”, signed by a retailer and an “attestation of loss”, cosigned by the policy holder and a police officer. The details here don’t matter too much.

But what does matter is the payment.

How would you write a contract like this so that it could be sold to as many consumers as possible?  They probably have accounts with different banks and, if we imagine a world of distributed ledgers, they’d all be holding different tokens: GBP-Barclays, GBP-Coop and so on.

Which tokens should an insurance contract accept from its customers?   Only tokens issued by “safe” banks? Which ones? Who controls the list?   What about a £1000 IOU from me? Would the smart contract accept that?   What about a £1000 IOU from a billionaire?

What happens when the contract pays out?  If you had paid in GBP-Barclays, how would you feel about receiving an arbitrary mix of GBP assets when you made a claim, based on whatever happened to be in the pool at the time?

Too many issuers

Writing a smart contract that deals with GBP issued by multiple issuers gets complicated very quickly…

Systems like Ripple solve this problem by explicitly modeling the idea of an asset and its issuer. 50 GBP-Barclays is different to 50 GBP-HSBC and Ripple is built on that insight.   So you could certainly configure the contract to trust some issuers but not others.

But it gets complicated. What happens if one of those issuers gets taken over? Goes bust? Who updates the list of “trusted” issuers in the smart contract?

And now, scale the problem up to the institutional side of the world, where the sums involved in derivatives contracts are enormous. Suddenly the identity of the issuer really matters.

And this is where I think a central bank digital currency could make sense on a distributed ledger. It would clear away all that complexity.

You could simply write the contract to demand payment in the central bank token.   Policyholders would have the responsibility of converting other GBP assets into the central bank issued asset.

Now, perhaps this wouldn’t be a problem in real life – maybe you could just write the smart contract to only accept GBP-Barclays, say, and insist customers of other banks convert into Barclays tokens in order to use the contract.   But having a counterparty-risk-free representation of fiat currencies on these smart contract systems feels like it could be extremely useful.

But time will tell, as always.

26 thoughts on “A Central Bank “cryptocurrency”? An interesting idea, but maybe not for the reason we think

  1. Calling the separation of issuer from issuance an ‘insight’ is perhaps a bit rich. I think rather the reverse is true: we knew we had to describe and allocate these things, but this was hard. Following on from many partially described experiments, Satoshi Nakamoto discovered that if he only had one issuance in his system he did not need to describe anything; thus simplifying his system dramatically. But it was always a kludge to claim that all the peoples of the world could have consensus over one unit, and the altcoins world is a costly reminder to the Bitcoin core that we need to more fully identify the nature of the issuer, the issuance, the redemption, the units, etc. In short, the classical textual contract.

    Does a central bank need to describe its issue to any such similar degree? Could it get away with the Nakamoto simplification? Well, technically it could, and nobody’s seen the contract behind the English pound in a while! But it won’t, there will be lawyers all over such a thing as a Fedcoin before it ever gets off the ground.

  2. On the question of whether a smart contract, as a state machine with money as I describe it, needs to run on a blockchain: I think at the conceptual level the answer is no. The blockchain is one invention for a group to share trust in a smart contract, but there are other inventions with different performance points: single servers, replicated servers, HSMs, clouds, etc.

    I do agree that a smart contract would like to deal in one cash, and indeed this is a frequent claim of the benefit of the CB-issued unit. It is ‘the one’ and there is a benefit to all of society not to question it in any one trade, delivering certainty and cost savings to all. But this doesn’t mean that ‘the one’ CB unit has to be issued on a blockchain, just that the smart contract needs to be able to mediate its value. As fuller smart contract implementations are going to need Oracles in some form or other (e.g., somewhere between sidechain proofs or Ethereum Turing machines), it isn’t that much of a stretch for them to also remit payments and handle receipts from external value systems.

    Of course, this would be a lot easier if all could on an interchangeable identifier for the user accounts, a similar interchangeable identifier for the unit of issuance, and similar acceptability for signed instructions. You know where I’m going with this😉

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  4. I don’t think the article identifies the real driver for commercial bank currencies such as GBP-Barclays. One of the benefits of a distributed ledger is that it is open for all to see, so I can nominate whoever I want to do safekeeping, fraud checking etc. of my assets on a single ledger, managing a single Central Bank-issued currency. No need for that entity to issue its own digital currency.

    The real driver comes from fractional banking, which is one of the ‘evils’ that Bitcoin was meant to eliminate. Dominic Frisby points out that 97% of the money in the UK and US is created digitally (on their own books) by commercial banks, mainly by making loans. If the Central Bank were the only entity allowed to create money, and that money was all represented as digital bearer assets, bank lending could simply not operate the way it does today. Creation of commercial bank currencies such as GBP-Barclays would indeed be a possible solution to that problem, where the commercial currency issued would have to be backed by an agreed fraction of GBP-BOE held on deposit.

    Whatever the driver for issuing commercial bank currencies, the problems that it would create in the real world, with or without Smart Contracts, would be enormous. Fungibility of commercial currencies would vary, so very quickly the conversion rate between GBP-Coop, GBP-Barclays etc. would drift away from each other, and from GBP-BOE. Domestic transactions would suddenly become like FX transactions requiring currency conversions. That way lies madness!

    So even though I disagree with the route by which you got there, I fully support your conclusion, that a central bank digital currency makes sense and would be useful, but commercial bank digital currencies don’t and wouldn’t.

  5. Tom: One thing to bear in mind is that we may already be there. And nobody’s noticed? It’s a matter of secret fact that governments around the world have unwound the deposit guarantee. Cypress is now the precedent not the exception.

    In such a world, Barclays deposits are different to HSBC deposits. Barclays will need to maintain a market maker to bring their GBP-Barclays into line with GBP-Coop. As we come into the next crisis — remember 12/10/08 — those market makers are going to tremble and some will be pulled.

    Depositors are going to be faced with varying valuations … which means madness, granted, but it wasn’t us who decided, the governments / CBs already snipped that rug out from under us.

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  19. @iang, tom: thanks for the comment and discussion. On the question of different commercial bank issuances trading at different prices, I mentioned this to a guy with more familiarity with trading than me. He said he thought it would be a situation that didn’t last for long… traders would either bet that the government would stand behind the banks (and arbitrage the prices back to parity) or bet that the government wouldn’t (and force a run)… either way, he didn’t think “fractionally different prices” would be a stable situation.

  20. Hi gendal.
    Yes, what tends to happen in these scenarios is that different banks start by trying out their competing units in the marketplace. And they compete.

    When they figure out that the competition is damaging them all, they get together and figure out a solution that smooths out the rough edges for them. In today’s world this would be a negotiated solution with the CB, and the question could be resolved as easily with the CB issuing a single unit or the banks owning a single purpose issuer, jointly.

    The process is also known as cartelisation, which is a bit of a dirty word, so it will be done without the likes of us actually participating or having input. Click below to read Dowd on this, a very nice introduction to competitive note issuance.

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