“Flawed” Crypto Not the Future of Money: BIS
Posted by Colin Lambert. Last updated: June 21, 2023
With The Full FX View
A chapter in the 2023 Annual Report from the Bank for International Settlements (BIS) offers what the central banks’ central bank terms a “game-changing blueprint for the future” built around tokenisation, observing that “Crypto and decentralised finance (DeFi) have offered a glimpse of tokenisation’s promise, but crypto is a flawed system that cannot take on the mantle of the future of money.”
The chapter in the report notes that throughout history, developments in the monetary system and society at large have been closely interwoven with one side pulling the other, leading to dramatic leaps in economic activity over time. While the evolving needs and demands of society have spurred the monetary system to adapt, the report points out that key innovations in money and payments have unleashed latent demand for new types of economic activity that have led to dramatic spurts of economic growth and development.
“Today, the monetary system stands at the cusp of another major leap,” the report states. “Following dematerialisation and digitalisation, the key development is tokenisation – the process of representing claims digitally on a programmable platform.”
The BIS says tokenisation can be seen as the next logical step in digital recordkeeping and asset transfer, and could “dramatically enhance” the capabilities of the monetary and financial system by harnessing new ways for intermediaries to interact in serving end users, removing the traditional separation of messaging, reconciliation and settlement. “Tokenisation could unlock new types of economic arrangement that the frictions inherent in the current monetary system have hitherto made impractical,” it adds.
The reports characterises crypto as “self-referential, with little contact with the real world”. It adds it also lacks the anchor of the trust in money provided by the central bank. “While stablecoins have mushroomed to fill this vacuum by mimicking central bank money, the implosion of the crypto universe in the past year shows that there is no substitute for the real thing,” the report argues.
The Full FX View
Although the BIS’ views on crypto will undoubtedly attract some of the headlines, this approach is actually little new for the organisation, which has served as a cheerleader for central bank digital currencies at the expense of private cryptocurrencies for some time now.
The idea of a unified ledger is a natural progression from what has been going on in the private sector, it is notable that just last week R3 enhanced its Corda platform to be inter-operable, but there remains one big question around this blueprint – indeed around CBDCs generally – when will it happen?
The BIS report does observe that there are near-term gains possible from such an approach, but the reality is building anything in the central bank space is going to take time – will the world have the patience to wait for the central banks?
A crucial aspect of the BIS’ blueprint is the public/private approach, without this it is hard to see a unified ledger and CBDCs becoming reality for much of the world any time in the near future. The fact is though, things do need to happen fairly quickly, because the digital assets world is speeding over the horizon in terms of innovation and technology.
If this blueprint becomes reality, it will be interesting to see what happens to private cryptocurrencies, for one of the few remaining arguments left to support them is they offer a store of wealth. Being such a store, however, means having the opportunity to use that wealth, and if the world is run on a financial system predicated on CBDCs and a central bank-run unified ledger, you have to question what value there is in, for example, Bitcoin.
It would be an irony if the inspiration for this BIS blueprint – the crypto industry – is the one to suffer most from a successful project, but any success should not be taken for granted. One suspects there is a shadow race on now, and the result will be decided by how quickly, if quickly enough, the world’s central banks can execute on the BIS’ blueprint.
The report does acknowledge efforts by commercial banks and other private sector groups to explore the capabilities of tokenisation for real-world use cases, but argues these efforts have been hampered by the silos erected by each project and the resulting disconnect from other parts of the financial system. “These projects also lack integration with a tokenised version of the settlement asset in the form of a central bank digital currency (CBDC),” the BIS argues.
What the report cites as “the collapse of crypto” and the faltering progress of other tokenisation projects underlines a key lesson, it continues, stating, “The success of tokenisation rests on the foundation of trust provided by central bank money and its capacity to knit together key elements of the financial system. This capacity derives from the central bank’s role at the core of the monetary system.
“Among its many functions, the central bank issues the economy’s unit of account and ensures the finality of payments through settlement on its balance sheet,” it continues. “Building on the trust in central bank money, the private sector uses its creativity and ingenuity to serve customers. In particular, commercial banks issue deposits, the most common form of money held by the public. Supported by regulation and supervision, this two-tiered structure preserves the “singleness of money”: the property that payments denominated in the sovereign unit of account will be settled at par, even if they use different forms of privately and publicly issued monies.”
The report does acknowledge frictions in the current monetary system, and argues they result from the current design of the system where digital money and other claims reside in siloed proprietary databases, located at the edges of communication networks. “These databases must be connected through third-party messaging systems that send messages back and forth,” the BIS states. “As a result, transactions need to be reconciled separately before eventually being settled with finality. During this back-and-forth process, not only do participants have an incomplete view of actions and circumstances, but the uncertainties and misaligned incentives preclude some transactions that have clear economic rationale. “While workarounds such as collateral or escrow can mitigate such frictions, these solutions have their limits and create their own inefficiencies,” it adds. “Tokenisation is a more fundamental route towards addressing the shortcomings of the current system.”
Solution
The BIS’s “game-changing” solution involves the key elements of CBDCs, tokenised deposits and other tokenised claims on financial and real assets. The blueprint envisages these elements being brought together in a new type of financial market infrastructure (FMI) – a unified ledger. “The full benefits of tokenisation could be harnessed in a unified ledger due to the settlement finality that comes from central bank money residing in the same venue as other claims,” the BIS suggests. “Leveraging trust in the central bank, a shared venue of this kind has great potential to enhance the monetary and financial system.”
A unified ledger reduces the need for manual interventions and reconciliations that arise from the traditional separation of messaging, clearing and settlement, thereby eliminating delays and uncertainty, it further observes, explaining the ledger also supports simultaneous and instantaneous settlement, reducing settlement times and credit risks.
The eventual transformation of the financial system will be limited only by the imagination and ingenuity of developers that build on the system
The BIS also points out that by having “everything in one place”, a unified ledger provides a setting in which a broader array of contingent actions can be automatically executed to overcome information and incentive problems. “In this way, tokenisation could expand the universe of possible contracting outcomes,” it argues. “The unified ledger thus opens the way for entirely new types of economic arrangement that are impossible today due to incentive and informational frictions.
“The eventual transformation of the financial system will be limited only by the imagination and ingenuity of developers that build on the system, much as the ecosystem of smartphone apps has far exceeded the expectations of the platform builders themselves,” it adds.
The unified ledger concept can be broad or narrow, the report says, with the first instances likely to be application-specific in scope. For example, it says one ledger could aim at improving securities settlement, while another could facilitate trade finance in supply chains. Tokenised forms of money would figure in each ledger to provide the transaction medium. Each unified ledger would bring together only the intermediaries and assets required for each application. The scope of a ledger will also determine the relevant players that must be involved in the governance arrangements. Separate ledgers could be connected through application programming interfaces (APIs), or, as their scope expands over time, they could incorporate additional assets and entities, or merge together.
Some of the benefits envisaged from the unified ledger could be reaped by interlinking existing systems through APIs into a “network of networks”. While such a network of networks would still consist of separate systems and fall short of fully fledged programmability across systems, the worst drawbacks of siloed systems could be mitigated,” it explains.
The BIS does envisage a role for the private sector in the blueprint, observing this next stage in the financial system’s journey will be one that combines the best efforts of both the private and public sectors. Central banks could work with regulated private entities to develop technological solutions and standards to meet specific use cases, it explains, arguing, “With their public interest mandate, central banks are best placed to establish a common venue for each use case by interlinking with the monetary system. Proper oversight and supervision will be a prerequisite for this endeavour.”
