Why central banks are key to electronic money

Speaker A: We've talked from time to time on this show about the debates about digital money in the past. I've been a bit reluctant to give them too much oxygen because it seems to me there's an awful lot of hype and hot air for what is still relatively little actual activity. But two things have changed. The first is that the US has passed legislation, the Genius act, which authorizes companies to issue stakeholders stablecoins, which are tokens backed by, um, a dollar. And it's debating another law known as the Clarity act, which could make those stablecoins more appealing to users. So this is no longer a mostly theoretical discussion. The second thing that's changed is that central banks are spending a lot of time debating this topic. Central bankers are making speeches and publishing papers about blockchain, about stablecoins, about tokenized deposits, and about the impact of all of this change and innovation on the financial system. So this week on the Big for you, we're going to talk about digital innovation in money in all its forms. It's what we do at Reuters. Breaking Views. We tap our best sources around the world for fresh insights into the biggest stories in finance, business and economics. I'm your host, Peter Thalassen. Uh, and we've got the ideal guest to guide us through this topic. His name is Gaston Gelos and he's the deputy head of the Monetary and Economic department at the bank for International Settlements in Basel. It's kind of the central bankers central bank, as it's known, uh, in the shorthand. He's, uh, also head of financial Stability policy at the BIS. He joined the BIS in 2023 from the international Monetary Fund where he served in very senior roles. And his research has focused mainly on financial stability, monetary policy and capital flows. The PIs has played a very active role in the debate about innovations in finance and particularly stablecoins and the application of blockchain technology. Last week it devoted a chapter of its annual report to the topic called Anchoring Trust in Innovation beyond stablecoins. There's a link to that paper in the show notes. Gaston Jelos. Welcome to the Big View.

Speaker B: Thank you. Thanks for having me here, uh, Peter.

Speaker A: Yeah, well, there's a lot for us to talk about. I thought I would start with a, uh, sort of somewhat practical question, um, which is really why the bank for International Settlements and all these other central banks are devoting so much attention to this question of, of digital money. Um, I mean, I think the global market for stablecoins, I believe you have a number in the report is about $320 billion, which sounds like a lot, but you know, there's $19 trillion on deposit at U.S. commercial banks. Uh, the bank of England last week published a paper about sterling denominated stablecoins. I think that market is $32 million out of the 320 billion. So there's an element of this which is sort of why are we all spending so much time talking about this technology when the sums of money at the moment are so small.

Speaker B: Thank you. Well, I would say that first we are not only or not primarily um, talking about specific forms of money, particular stablecoins. We are really interested in how the developments in technology, uh, that ah, can improve finance, how they can be made uh, uh, useful for everyday people, uh, so that we can improve our financial system, uh, in ways um, that uh, takes advantage of the possibilities that these technologies bring, uh, while kind of at the same time uh, not introducing new risks and not throwing away the baby with a bathwater so not to do away with all the good things that our current system has and which has been evolved over many centuries.

Speaker A: Mhm.

Speaker B: Now it's true that uh, some of these uh, stable coins, the market uh, has uh, stagnated somewhat after initial growth. Um, but of course there are people that predict future growth and faster growth. So we also have to, you know, we have to prepare for what could come and think about possibilities ahead and um, conceptually think through what could happen if.

Speaker A: Yeah, if that sort of takes off. I guess it's better to have that conversation now than in 10 years time if it's grown very large. Um, one of the things that's helpful I think about this discussion is and the technology is that it sort of forces us to really think through what is money. Right. Um, I think we sort of all. We've had this system where we sort of took money for granted, which I guess is kind of the whole point. But um, I guess it sort of forced everyone to really boil down what is the essence of money and what defines money and how do we sort of um, uh, and how do we organize it? I mean you have some helpful concepts in the report about how to think about that. In a nutshell, how would you say what's the essence of money?

Speaker B: Well, trust is really key for money. And how do you establish, how do you develop that trust? Ah, as you say, we take many things for granted, but they have evolved after many uh, attempts in history of experimenting with different forms of money. For example, uh, if I pay you with a pound or a euro or a dollar you don't ask me is that a dollar from bank X or Y. Uh, a euro is a euro, a dollar is a dollar, no matter exactly what type of bank I have, what type of money I use. And that's very important. That's the fundamental uh, uh, attribute of money, what we call no questions asked. And how is that achieved? Well it's ultimately achieved in our system because we have the central banks that do the settlement in the end. So um, they guarantee, they're the backbone and they guarantee that every pound or every dollar that I give you gets through one to one, um, to your account. And that's a fundamental uh, uh, dimension that we need to preserve. Also money serves as a unit of account, right? We have the convention or the coordination that we express prices in that unit of, of account. Um, and in our system money is also elastic. That's more of uh, a foundational aspect of how uh, the system works. The payments can be made elastically, liquidity can be supplied elastically depending on how conditions change. So the central bank can do that, it can provide uh, liquidity to the banking system as needed. But also banks can do that, they can uh, create money out of nothing quickly. And so we have an elastic system and that's also important. And lastly uh, we have elements in the financial system that help mitigate problems related to uh, illicit activities, uh, such as uh, measures to limit uh, uh, activities related to money laundering, financing of terrorism and so forth. Uh, and those are uh, also uh, that integrity part of the financial system that's also worth preserving.

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Speaker A: Yeah, just sort of picking up on that, that, that point about you know, you offer me a euro and I, I won't ask which bank is that coming from and stuff. I mean that's obviously true on a, sort of a, on a retail level, but I mean that's in part because most countries in the developed world have a system of deposit insurance. And so I can be confident that the euro in my bank uh, will be a euro and will be available to me even if that bank gets into trouble. But we have seen obviously in living memory in 2008 and in the eurozone more recently, that the euro in the bank is not necessarily completely secure, um, or predictable. So I guess, uh, how do you think about that? I think you call it in the report a two tier system. There's the central banks and then there's the commercial banks. But the commercial banks can, they're not in all states of the world completely stable.

Speaker B: No, that's true. But I think one has to conceptually separate here between the credit worthiness of an institution and the settlement. So even in its last moments of existence, every payment that Lehman Brothers made went through at par, the dollar at the settlement was a dollar. Now yes, institutions, uh, can go bankrupt and so forth. Uh, and for that, as you correctly point out, we have other types of safeguards and we have other types of mechanisms that help mitigate that risk. We have deposit insurance, we have strict regulations on the banking system precisely because the banks have those special advantages in a way that I was describing earlier, they have access to the central bank liquidity, they can create money. So we have a whole system that in addition, uh, to these other elements, helps provide the trust that is needed for financial transactions.

Speaker A: Yeah. So then, so let's talk a bit about this technology that the famous distributed ledger technology, uh, blockchain, uh, also gets known as. I mean there are a lot of people, and there have been a lot of people who make very grand claims for this technology.

Speaker B: Right.

Speaker A: It removes the needs for banks and for central banks, doesn't require any kind of central authority to guarantee it. Um, uh, it's a completely new form of money. I think my impression is that the BIS and other central banks think about this more as an evolution rather than a revolution in money. But what do you think is what is different about this from existing forms of money? And how does that then require a change of response or a different framework?

Speaker B: Right. So, um, the way, let's take stable coins. Yeah, stablecoins, the way they operate these days, they borrow in a way, uh, they piggyback on the trust in traditional money. So um, they circulate, uh, on blockchains. And um, so there are some elements that can be. Let me talk through this. So on a technical level, um, since blockchains operate as a system without a central coordinator, there needs to be a consensus mechanism, uh, to establish trust among the network participants. Right. Uh, and that is achieved by paying fees to validators. Now, uh, uh, if the number of transactions rises, uh, updates in the blockchain, uh, they become more computational and expensive, intensive and that leads to higher fees and to, to longer confirmation time. So you have congestion effects and those are a feature of the system. Right. And what does it mean? Well that means that scaling up uh, uh, stablecoins is difficult. Another technical aspect is that uh, you have these, because of these congestion features, you have uh, uh, uh, them residing on different layers, different part, different blockchains which are not necessarily uh, uh, linked perfectly to each other. So the same stablecoin may reside on different chains which limits singleness and also uh, network effects. Right. You know the money works because many people accept it. I know that you're going to accept it because you know the next person or the next company you interact with is going to accept it. So um, that these are kind of technological impediments. But then we have also more different shortcomings of stablecoins, at least the way that currently uh, they exist currently, uh, and these relate to the singleness that I was stressing earlier. So although stablecoins claim that they guarantee that they are stable vis a vis a certain currency, typically the US dollar, in fact their value fluctuates. So the exchange rate fluctuates. Now you could say, well these are usually small fluctuations, they don't matter so much. And that may be true for small transactions between uh, if you want to share a meal with a colleague and then split the bill. Uh, but no, if it comes to real, I mean to big wholesale transactions, if you want to have them play the role of money in the financial system on a big scale that doesn't work right. You have to be sure that €1 is exactly €1 and no matter what the state of the world particularly not become nervous, ah, in times of stress that maybe it's not quite €1 if I transfer it uh, to Peter. Uh, so this is really fundamental and that hasn't been achieved yet. Now could it be achieved? Perhaps. Um, that would require of course very strong mechanisms, uh, to guarantee that redeemability at par. It would require very uh, safe assets, uh, it would require perhaps even backstops, central bank backstops. So to have the certainty that in case of stress, it's back. Um, so this is important, something that hasn't been achieved yet. And lastly I was alluding to the importance of integrity and integrity, meaning the mechanisms imperfect, but mechanisms that help mitigate the risk of crime of illicit activities. With stablecoins, they can be hosted, uh, they can be on unhosted wallets, so they can be uh, uh, accessed in an uncontrolled way without being able to apply the, the Usual mechanisms that we have for know your customer, right in banking, uh, you, you, you're not able at this stage to, to, to really implement the type of, of mitigants uh to reduce illicit activities uh with stablecoins. So these are the shortcomings uh that we now see.

Speaker A: Well as some people would say uh, the kind of the illicit activity maybe that may be a big part of the appeal. That's why stablecoins have evolved, um, um although we're now trying to sort of trying to force them into a bit more of um a ah, kind of a uh legal straitjacket. But just so that's a very comprehensive sort of description of some of the shortcomings of the use of this technology, at least in the sort of stablecoin realm. But assuming that it's possible to address some of these issues, I still come back to this question which is like what are the benefits? What will we get from this new money technology that we don't already have?

Speaker B: Well I mean tokenization and tokenization combined with DLT distributed ledger technology does offer new possibilities, right? It does um, allow to have um, so called atomistic um, uh settlements where you say only execute a payment when you get an asset in return for example. Uh, it can allow to automate uh complicated workflows in one mechanism. It allows UM 247 operations. Tokenization allows for fractionalized uh holdings of assets. So it does offer uh, many benefits, programmability, um, reducing reconciliation needs and so forth. So we believe that we should think about how to use uh these possibilities. So uh, the question is then how to do so uh while preserving uh the good features of the old system so to speak. Um, and here there are possibilities, right? I mean we have been ah working with the private sector, with other central banks. We have an exploratory project with uh, over private uh banks and central banks where we look at how can these technologies be used for cross border payment. These days the correspondent banking system is quite complicated. If you want to make a payment, the remittance payment, uh from one country to another, it has to go often through multiple banks. It goes through different layers of confirmation, the time zone differences and so forth and so on. It's very costly and it takes time. And the new technologies, they can speed that up. They can also make those um, AML CFT controls um, more easy. And this um, pilot project that we have, this prototype that uh, was developed uh, with all these participants shows that this is possible in principle. So here's a way of showing how to integrate or how to make use of these new uh, possibilities that technology brings while preserving uh, uh, the good aspects, the bad. The central banks. In the back as the cornerstone of the financial system and preserving ah, financial integrity and so forth.

Speaker A: Yeah, I mean it's the point about central banks is one that sort of keeps coming back. And um, I think it sort of seems like um, clearly central banks are a very important, crucial, uh, sort of feature of kind of modern monetary systems. But central banks haven't been around forever and uh, I guess maybe it almost. It seems, I think you allude to this a bit in the report is this idea of sort of. Well, what we want to try and avoid is a situation where we have to learn the difficult and painful lessons that we learned in the past before there were central banks about why you need central banks and why the system is structured in this way. But maybe it might just be helpful just to talk a little bit about uh. What would uh, a monetary system, a decentralized monetary system like the one you're describing look like if you didn't have that central bank backstop?

Speaker B: Well, for example, um, I mean there have been cases where major economies have functioned without central banks for a period. For example in the U.S. uh, in the late uh, 18th, early 19th century, uh, and then late in the 19th century, uh there was no central bank. Uh, there was free entry for banks that would issue uh, then notes under certain requirements. And uh, so you had a proliferation of private banknotes. Uh, but then that became quite complicated because then you had to keep track of different quality of banks and somewhere further away. And uh, so at some point there was a node clearing system, ah, for example the Suffolk bank in Boston. Ah, uh, so over time you develop mechanisms to make sure that you could clear uh, a node from bank A, uh versus bank C. Right. And um, ultimately these functions were taken over by the Federal Reserve System because of the many problems that that system had created. It was just much more efficient and much more uh, conducive to a smooth operation of the financial system to have a central bank that conducts this clearing and uh, that's in the background to do settlement.

Speaker A: And the Fed was set up in response to periodic crises.

Speaker B: So you had runs, systemic ah, shocks. And you didn't really have this network effect that you want to have with money right where you were, uh, you accept my money because you know others will accept it and so forth. And if you're not sure, um, then uh, that limits the network effect. And those were not so present obviously with what this proliferation in private monies. Um, so over the past two centuries really, then we saw that central banks have really moved from becoming something novel to something widely established and key, uh, institutions to be charged with, uh, ensuring the stability of the currency and the financial system.

Speaker A: Yeah, so just to come back to stablecoins briefly, because I think it seems like this, My impression is that this has, um, uh, sort of added a sense of urgency to a lot of these discussions, which previously were really quite theoretical discussions about technology and money. But obviously the US has passed one bit of legislation, the Genius act, which authorized stablecoins. It's discussing another bill which would sort of allow some companies to offer rewards, a form of interest on stablecoins which would stimulate their use. And so to what extent is there a sense here that like you can see there's a sort of, you know, there's a real life example of kind of the way this technology is moving. And um, you know, this is an intervention to try to sort of steer the, steer that development or steer that industry onto what you think is a more stable track.

Speaker B: I think we believe that, um,

Speaker A: um,

Speaker B: clearly the future is very uncertain. Uh, we don't know whether stablecoins will grow, how much, how they will be used. But it's important to be prepared and it's also important to think conceptually through what would you want to achieve, what you want to preserve, what would you want to avoid. And here, um, one key distinction that we make, which I think is conceptually, uh, very important, uh, is to think, uh, okay, if you want to have stablecoins as a kind of investment vehicle, as some kind of assets, like a money market, mutual fund, that's one thing. And then you design the regulations accordingly. Uh, if you really want them to be used as money, that's another. Because then you go back to all these fundamental qualities that I was listing earlier. Then you need different type of regulation and you need all this very stringent backing and so forth. Okay, so that's one aspect that, that we stress just to have this conceptual clarity. Um, and then we go further. Okay, what if, what if, um, despite the shortcomings that stable coins currently have, what if they became really accepted or widely used as means of payment as money? Um, and then, uh, we go through various, uh, scenarios depending on how they are regulated in the sense of what type of assets they use as reserves, uh, and we go through the potential implications for the macro economy for credit, um, for ah, financial stability. And uh, we believe that that's a very useful exercise to do, uh, because While we don't know how likely such scenarios are, it's very good to be prepared and to think through the consequences and to prepare accordingly.

Speaker A: Um, to quick things, I just wanted to just uh, ask you about the. The first is you talk in the paper about something called a unified ledger as a possible solution, uh, for the laymen out there. Um, can you sort of describe in words of one syllable what a unified ledger is?

Speaker B: It's not a monolithic, uh, platform where everything is, but it's kind of a, a set of interoperable, um, uh, networks on which tokenized, uh, transactions can occur. And in particular what we have been. A vision that we have been putting um, forward is that if we want to make use of the advantages of tokenization that I was just mentioning earlier, um, what you really want to have is ah, ah, um, a shared platform where you have tokenized central bank money, where you have tokenized commercial bank deposits and then other digital assets, in particular, uh, sovereign bonds, but possibly also other uh, assets, private money. And that could really, um, give a boost, so to speak, uh, to integrating these technologies into the financial system while preserving the ah, central banks as the backbone.

Speaker A: Yeah, I see. Okay. Um, maybe just we're almost out of time, but I just want to come back to sort of where we started, which is kind of how much does this matter? I mean, the history of money. Uh, there's a long history of money and obviously there have been many different things that have been tried. Um, some things that were tried that worked better than others, some that quite spectacularly failed, I guess. I wonder how you think about the merits or demerits of experimentation in this area. Would it be helpful to have, um, things that are tried that go wrong as a reminder to everybody of kind of what the benefits are of having a properly regulated system? Or do you think actually that's something we need to avoid because it would undermine faith in the broader concept?

Speaker B: Uh, well, certainly I believe that it's better to. If we can avoid uh, any major crisis. Um, and so, uh, that's our mission as well, to support central banks in uh, fostering ah, financial stability. And so we want to be helpful in thinking about the possibilities, uh, being technology neutral. Right. Uh, but think through what new technologies mean and, and be clear about uh, what consequences that they could have, what could be done to ensure stability, what mitigants can be put in place to reduce risk and so forth. And that's uh, how we see our contribution.

Speaker A: Okay, good. Well, um, Gaston, that was terrific. We have to leave it there. Unfortunately. Um, sure this discussion will continue in many different forms for a long time and maybe we'll come back to it in the future. Uh, but for now, thank you very much.

Speaker B: Thank you for this opportunity.

Speaker A: That's all we have time for. Thanks to Gaston for taking the time to join us. And as always, thanks to you for tuning in. This podcast was produced by Oliver Tasich with the help of Mike Copeland and John Hodge. Here in the studio in London, you can check out a new episode of the Big View every Tuesday. Don't forget to tune into our sister show Views Room every Thursday, as well as all the other great podcasts from the Reuters team. To get in touch with feedback and suggestions for future shows, please email us on Breakingviews podcastr uh.com that's breakingviews podcastr.com if you liked what you heard, please rate the show and leave us a review. Breaking Views subscribers can read all our views on big global stories as they break apart. Breakingviews.com or you could read a sample of some of our columnists work every day@reuters.com.