Fraud Detection Using Machine Learning Amid Covid-19 crisis (as published in Business Times on July 21, 2020)
Fraud Detection Using Machine Learning Amid Covid-19 crisis
By Paul Condylis and Emir Hrnjic
Online shopping and the quest for ever-increasing convenience resulted in the scattering of our credit card details across various websites. Over time, we have become desensitised to providing our payment details and, effectively, passed the responsibilities of storing and protecting our personal and transaction details to e-commerce companies.
Unfortunately, many companies have failed to keep our data safe and secure. According to Statista, over 164 million sensitive records were exposed in 1,473 data breaches in the United States last year.
The exponential growth in e-commerce attracted even more aggressive growth in illicit activities. Southeast Asia’s e-commerce market will likely exceed Google’s prediction of US$200 billion, driven by a high mobile internet penetration rate, young consumers, and an increase in disposable income.
At the same time, fraud cost the world economy over US$5 trillion in 2019. According to AppsFlyer, APAC’s fraud is 60 per cent higher than the average global rate, while South East Asia is the heaviest hit region, especially Indonesia, Malaysia, Thailand, and Vietnam.
Recently, the international law enforcement agencies warned of a spike in fraud related to the COVID-19 pandemic, and The Straits Times reported that victims in Singapore have lost S$41.3 million in the first quarter of this year, nearly a 30 percent increase. Unfortunately, it seems that 2020 will turn out to be a bumper year for fraudsters around the world.
Fraud Detection and Machine Learning
In order to protect the customers, banks and retailers have deployed large-scale fraud detection pipelines that scan transactions in real-time. For a long time, fraud detection has relied upon rule-based expert systems to detect illicit activities. Traditional experts analysed transaction logs, identified fraudulent patterns, and implemented hand-coded rules to flag those activities. The rules were as simple as blocking the transactions from a compromised credit card number to more sophisticated rules such as flagging transactions that deviate from the credit card’s historical patterns.
Over time, as transaction volumes have exponentially grown, thousands of increasingly complicated fraud–detection rules emerged and this approach became intractable. Fortunately, machine learning can easily scan millions of transactions to enable real-time fraud detection. Machine learning is a procedure that enables a computer to learn from data how to perform a certain task. Once a computer learns the task to a sufficient level, human experts are no longer needed.
Indeed, fraud detection algorithms based on past purchase behaviour have matched accuracy of human performance at identifying anomalous transactions. Meanwhile, the experts’ role evolved to analyse and understand larger issues such as new global fraud trends.
But what happens when purchase behaviour suddenly changes? And therein lies the rub. If machine learning algorithms rely on learning from historical data, a rapidly changing environment and fast-evolving patterns will wreak havoc on the predictions and forecasts.
The world has drastically changed since COVID-19 wrecked the global economy. Predictably, fraudsters have taken advantage of the uncertainty in the rapidly evolving environment and changed the patterns and targets of attack. For instance, traditional strategies of ticket fraud (i.e. reselling tickets purchased with stolen card information) have migrated, and fraudsters are increasingly turning to well-orchestrated scams directly defrauding unwitting consumers.
In such an environment, machine learning algorithms must be retrained on new data and quickly redeployed. However, as changes are unfolding in real-time, algorithms have far less data to learn from and adapt to changing fraud attack vectors. Slow moving trends underpinning increasingly irrelevant historical data must be unlearnt and machine learning engines must accurately predict newly evolved tendencies using limited data. Moreover, the impact is compounded by having less validation data to judge the effectiveness of machine learning algorithms.
As fraudsters changed the patterns and targets of attack forcing experts to retrain and quickly redeploy machine learning algorithms in a rapidly evolving environment, automatic retraining of machine learning algorithms on new data and thwarting fraud attacks become paramount.
Only companies that have significantly invested in talent and robust big-data pipelines are well placed to cope with the current situation. Have the companies you have trusted with your data been so diligent? Maybe it is time to check your bank statement.
The future is digital
Digital currencies may one day challenge US dollar supremacy
Interest in digital currencies has been boosted by recent developments such as China’s pilot rollout of the digital yuan and a shift in Facebook’s plan for its Libra cryptocurrency.
While consumers may still associate blockchain technology closely with the speculative and volatile nature of bitcoin, significant advances in the use of distributed ledger point to a more promising outlook for digital currencies.
Dr. Emir Hrnjic, an adjunct assistant professor of finance at the National University of Singapore and a co-founder of Block’N’White Consulting, provides insight into central bank digital currencies and private cryptocurrencies and the potential impact on financial markets and investors in this question and answer with Asia Asset Management (AAM).
AAM: What do you see as the benefits and costs of central bank digital currency (CBDC)?
Hrnjic: The actual CBDC has yet to be properly launched. The People’s Bank of China (PBOC) achieved the first milestone by rolling out a pilot test of CBDC in four cities. We still do not know all the details.
Nevertheless, a CBDC needs to be properly designed and enable scalability, accessibility and privacy. The challenge is to design a CBDC with the convenience typically provided by financial intermediaries, not by central banks. PBOC tried to combine these by designing a two-tier system: the central bank will create the digital currency and then large financial institutions and the four largest state-owned banks will distribute it.
A properly designed CBDC will help target money supply and enable central banks’ access to money demand data. However, a CBDC will also enable central banks to trace individuals’ transactions. While this may help the battle against illicit transactions, it will also permit encroachment on consumers’ privacy.
The PBOC will probably institute limits on the frequency and amounts of anonymous transactions to try to strike a balance between preserving privacy and halting illicit transactions.
AAM: How do you see distributed ledger technologies being utilised by central banks in the next five to ten years, and what would the implications be for financial markets and investors?
Hrnjic: This is a million-dollar question. The future of blockchain technologies depends on many unknown variables and everyone is really making at best an educated guess at this point. A recent study by the Cambridge Centre for Alternative Finance prophesised that a third of central banks will have active applications within a decade.
Moreover, a study by the Bank of England in 2016 concluded that a properly designed CBDC may strengthen the transmission of monetary policy changes. However, the study also warned that any mismanagement of transition from physical to digital cash could pose a major threat to financial stability.
Despite many potential challenges, the Bank of England’s study concluded that CBDC issuance “could permanently raise GDP [gross domestic product] by as much as three percent and could substantially improve the central bank’s ability to stabilise the business cycle”.
AAM: Do you think the coronavirus pandemic may have helped push digital currency developments forward?
Hrnjic: Many changes across the world happened simultaneously as a consequence of Covid-19 [the disease caused by the coronavirus] and it is very hard to disentangle the impact of the pandemic versus numerous other seemingly related contemporaneous events.
Nevertheless, during the Covid-19 pandemic, communities socially distanced and observed strict hygiene measures. Since earlier research suggested that physical money carry up to 3,000 types of bacteria, money in a physical form became less desirable than digital money. Even the World Health Organisation warned that bank notes may carry the coronavirus for several days and advised the use of contactless payments.
While contactless payments and digital currencies are not the same, this is consistent with the notion that Covid-19 helped push digital currency developments forward.
Even the early versions of the US stimulus bill unexpectedly included the development of the digital US dollar to disburse stimulus payments. Eventually, the digital dollar did not make it to the stimulus bill, but the mere attempt seemed very intriguing. While a proposed digital dollar would have not used blockchain, it would have bypassed intermediaries by creating government-run digital wallets for all Americans.
AAM: Do you believe the digital yuan will have a significant impact on the dollar in coming years?
Hrnjic: One can argue that the launch of the digital yuan may pose a distant threat to the US dollar’s supremacy. Indeed, a recent Foreign Affairs article argued that the failure to “develop a competitive American alternative could significantly hinder the United States’ global influence” despite the fact that nearly 90% of international transactions were settled in US dollars, whereas RMB controlled only 2% of the market.
Nevertheless, China has worked on its CBDC since 2014 and its next emphasis will likely be on improving the domestic banking and payment system. While rolling out a pilot test of the digital yuan represents a major milestone, and China may have the ambition to unsettle the global monetary system in the distant future, it seems that this process will likely be slow and deliberate.
AAM: What can you tell us about Facebook’s recent pivot away from launching its Libra currency?
Hrnjic: Libra was initially designed as a stablecoin fully backed by a basket of bank deposits and treasuries denominated in five major international currencies. After strong pushback from regulators around the world, Libra was recently revamped.
Revamped Libra will comprise several stablecoins – each backed by a single currency such as the US dollar or British pound – separate from the Libra coin. Libra coin will simply be a digital composite of some of these coins.
In another major change, the Libra Association will vet any wallet launched on the network. While the first Libra White Paper vowed to transition Libra to a permissionless system, revamped Libra backed out of this promise.
Although Libra’s initial idea was to become a global digital currency with permissionless network and censorship resistance, revamped Libra significantly scaled back. While attempting to satisfy regulators, it seems that Libra has lost its soul.
AAM: What is your opinion about Libra’s potential to act as an alternative for currencies of countries with high inflation such as South Africa?
Hrnjic: Libra should have a stable exchange rate due to its backing by five major international currencies and thus it could be very useful in certain countries as well as in cross-border transactions. For example, populations in many developing nations have access to mobile networks and high mobile phone ownership rates, which offer potential for Libra to improve financial inclusion.
This could be especially useful in countries with high inflation or unstable banking systems as well as for cross-country remittances. Hence, Libra can expand access to capital and help people in developing countries get involved in the global economy.
This may be of great importance to countries such as India, Philippines and Indonesia with large remittances from their diaspora and a high fraction of underbanked people.
AAM: Do you believe private cryptocurrencies may pose a big risk to CBDCs?
Hrnjic: Despite the fact that private cryptocurrencies are facing intense regulatory scrutiny, especially in the US, Libra may eventually challenge the digital yuan’s global dominance.
Indeed, Libra could partially replace some sovereign currencies, especially in countries with high inflation, an unstable banking system and a large underbanked population.
Moreover, the potential dominance of any private cryptocurrency in a specific country would undermine the monetary policy of that country. If private cryptocurrency started replacing local currency, it would cause the local currency’s depreciation and thus higher inflation.
In this respect, the effect of cryptocurrencies would be analogous to dollarisation – the impact of the US dollar on local currencies in some developing countries. For example, the population in countries such as Zimbabwe or Cambodia use the US dollar due to a lack of trust in local currency.
AAM: What are the main takeaways regarding CBDCs and private cryptocurrencies.
Hrnjic: CBDCs and private cryptocurrencies may partially replace fiat currencies relatively soon, but not in the near future. If that happens, the impact on financial inclusion would likely be positive for both private and government-backed cryptocurrencies. That should be of enormous interest to policymakers in countries such as India, Philippines and Indonesia with large diaspora and tens, if not hundreds, of millions of underbanked people.
However, the impact of private and government-backed cryptocurrencies on monetary policy diametrically differs. CBDCs are likely to strengthen the transmission of monetary policy and help in targeting money supply.
On the other hand, dominant private cryptocurrencies would severely undermine the effect of monetary policy. Furthermore, they could also lead to diminishing the relevance of some fiat currencies, the loss of their value, and high inflation.
Did Islamic equity funds outperform?
By BEN CHAROENWONG and EMIR HRNJIC
decade long performance
AS the Covid-19 virus reached pandemic proportions, national borders closures and country lockdowns led to diminished consumer demand and a collapse of industrial production and service industries. The crisis led to financial distress among small and medium enterprises (SMEs) and sparked massive layoffs. In matter of weeks, unemployment rose to double digits.
Large companies were not immune to the pandemic either (no pun intended). While Boeing and major US airlines pleaded for more than US$100bil in federal funding to stay afloat, several well-known companies including Hertz, Thai Airways, and JCPenney filed for bankruptcy.
As the Covid-19 pandemic ground international trade almost to a halt and wreaked havoc on national economies, stock markets plummeted.
The S&P500 started dropping on February 19 and lost almost a third of its value in a month. Only after the Fed committed to lend trillions of dollars and US Congress allocated more than US$2 trillion in federal emergency assistance to American companies and financial institutions did the American stock market reverse the free fall and partially recover.
Almost simultaneously, dominos started falling in Asian markets. Along with the collapse in the US stock market, the Japanese Nikkei Index and Singapore’s Straits Times Index lost roughly 30% of their values, while Hong Kong’s Hang Seng Index dropped by almost 20%.
As the global economy reached the brink of total collapse, Morningstar Research reported that in March 2020 investors withdrew US$326bil from mutual funds across the world.
Islamic equity funds
In the midst of the unprecedented mayhem, an often-overlooked area of niche investing stands out – Islamic equity funds.
Islamic equity funds avoid non–halal activities such as conventional finance, alcohol, gambling, pork related products, and adult entertainment, as well as tobacco, weapons, arms, and defence manufacturing. Additionally, the screening criteria requires investing in companies with low debt ratio, low cash and interest-bearing items, low accounts receivable and cash, as well as low revenue from non-halal activities.
Originally targeted to Islamic investors, these funds appeal to non-religious investors as well. Notably, shunning sectors associated with weapons production would appeal to the broader investors’ base, especially with the general trend towards environmental, social, and governance (ESG) investing. Furthermore, their conservative nature may be attractive to long-term investors as well.
During the Covid-19-induced market panic through March, the MSCI World Index lost over 30%, while the MSCI World Islamic Index lost 20%, thus resulting in a relative outperformance of 10%. As the Islamic index fared better than the rest of the market during the crisis, one might argue that Islamic equity funds offered some protection from downside risk to investors.
Remarkably, while the pandemic triggered massive declines of assets under management (AUM) across the world, in-flow into Islamic funds in certain countries picked up. According to the Fitch ratings agency, Islamic funds in Saudi Arabia experienced an increase in AUM by 3%, thus surpassing Malaysia as the largest market for Islamic funds in the world.
Nevertheless, it is still too early for a victory lap since the Covid-19 crisis has been around for a relatively short time and thus corresponding outperformance of Islamic finance index provides relatively few data points to support meaningful conclusions.
Global financial crisis
Even though some analysts were quick to attribute the outperformance during Covid-19 to luck, we find a consistent pattern during another major market downturn – the Global Financial Crisis (GFC) from 2008 to 2009.
While outperformance of Islamic indices during the Covid-19 crisis could have been due to short-term fluctuations, longer data surrounding the GFC provides the ground for more robust experimentation to examine the relative performances of the Islamic versus conventional global indices.
In the six months around the failure of Lehman Brothers, the MSCI World Index lost 42.6%, while the MSCI World Islamic index lost only 12.4%, resulting in an outperformance of over 30%.
Another prominent measure of performance over a decade–long horizon around the GFC – from the Dow Jones Global index’s inception in October 2006 through December 2016 – indicates that a US$100 investment in the Dow Jones Global index would yield US$123.96 while an equivalent investment in the Dow Jones Global Islamic index would yield US$144.99, roughly a 20% improvement.
Part of the difference in the performance in the period surrounding the GFC stems from Islamic funds’ avoidance of conventional financial institutions and the embrace of Islamic financial institutions, making them inherently more defensive and better able to withstand adverse economic conditions.
Notoriously, Bear Stearns, Lehman Brothers, Merrill Lynch, and other behemoths of financial world either filed for bankruptcy or were acquired to escape insolvency.
Their shareholders lost hundreds of billions of dollars. None of these conventional financial institutions were syariah-compliant and thus were not included in Islamic funds.
An IMF study by Jemma Dridi and Maher Hasan suggests that Islamic banks outperformed conventional banks during GFC due to smaller investment portfolios, lower leverage, and avoidance of financing or investing in the innovative (and risky) instruments that wrecked conventional banks.
Surprisingly, Islamic AUM was only US$15bil in 2008. While it grew almost five-fold to US$70.8bil in 2017 according to the Malaysia International Islamic Financial Center, projections are even more optimistic going forward – to approximately US$216bil by 2024.
Islamic equity funds can provide some protection from downside risk as evidenced by their outperformance in two high-profile crises. This is partially due to a limited exposure to highly volatile stocks such as conventional financial institutions. These return characteristics should appeal not only to Islamic investors, but to the broader public as well.
Moreover, Moody’s 2020 Investors Service’s report predicted expansion of Islamic assets by 3% to 4% per annum in the short to medium term. The report states that the demand for Islamic asset management is rising due to “large Muslim populations, supportive legislation and growing investor demand for syariah-compliant products.”
We expect this wake-up call to further boost the development of the Islamic asset management industry and thus expand the existing investable universe.
Development of Facebook’s Libra expedited amid Covid-19
By Emir Hrnjic
Amid the COVID-19 pandemic, experts warned that the virus could spread via physical money as the monetary notes and coins may carry viruses and up to 3,000 types of bacteria. In March, the World Health Organisation confirmed that banknotes may carry the coronavirus for several days and recommended the use of e-payments to mitigate the risk of contagion.
Moreover, the widespread national lockdowns highlighted the need for people to transact from the comfort of their own home. Thus, a heightened virus awareness and a more urgent need for contactless payments might have expedited the development the digital currency of Facebook, Libra.
Libra’s development was further highlighted by the pilot launch of digital yuan in four cities across China. Even though digital yuan may not be a direct competitor to private digital currencies such as Libra, its upcoming rollout threatens to affect Libra’s potential market.
More recently, Libra made the headlines again as Singapore’s sovereign wealth fund Temasek joined Libra Association and became its first Asia-based member as well as the first member with state backing. After the departure of several prominent members such as Visa, MasterCard and PayPal, Temasek’s backing breathed new life into the digital currency.
On May 7, the Libra Association appointed Stuart Levey, former chief legal officer of HSBC, as its first CEO. The hiring of a legal expert to run the digital currency clearly signalled Libra’s priorities after intense regulatory scrutiny from US lawmakers triggered massive exodus from the Association last year.
While cryptocurrencies have great potential, they are notorious for widespread scams, frauds and hacks. Thus, scepticism towards Libra has been expected. US Congresswoman Maxine Waters went as far as to request a moratorium on the development of Libra, comparing it to “starting a bank without going through any [regulatory] steps”.
Regulatory response around the world will differ due to diverse regulatory philosophies. While China is expected to ban Libra, Singapore will likely have a much more accommodating approach. Even though Ravi Menon, Managing Director of Monetary Authority of Singapore, expressed concern that Libra raises global financial risk, Temasek’s involvement signals that the Singapore government has decided to focus on potential benefits.
Libra has the potential to be a game–changer in digital payments thanks to Facebook’s 2.5 billion active users. While one of the major problems with existing cryptocurrencies is slow and insufficient adoption, Libra wallets will likely ease and accelerate Libra’s adoption, thus creating an immediate advantage over existing cryptocurrencies.
One could argue that a single digital currency – or perhaps very few of them – will dominate the global market, while the overwhelming majority will fail. In this “winner-takes-all” market, contenders are incentivised to move early and aggressively, and Libra’s start seems like the step in the right direction.
Libra was initially designed as a stablecoin fully backed by a basket of bank deposits and treasuries denominated in stable international currencies, comprising the US dollar, euro, Japanese yen, pound sterling and Singapore dollar. This backing would ensure a stable exchange rate in contrast to the overwhelming majority of existing cryptocurrencies with extremely volatile prices.
After the strong pushback from the regulators around the world, Libra was recently revamped in the initiative allegedly aimed at minimising disruption to the global monetary system.
Libra 2.0 will comprise several stablecoins – each backed by a single currency such as the US dollar or Singapore dollar – separate from the Libra coin. The Libra White Paper added that “each single-currency stablecoin will be fully backed by… cash or cash equivalents and very short-term government securities denominated in that currency.”
Libra coin will be a “digital composite” of some of those coins – most likely the initial five currencies – and could potentially operate as a settlement coin in cross-border transactions as well as in countries without a single-currency stablecoin on the Libra network.
In a further attempt to satisfy regulators, Libra reemphasised its commitment to financial compliance, including strict enforcement of measures against money laundering, terrorism financing, sanctions compliance, and the prevention of illicit activities.
In the first stage of Libra rollout, Unhosted Wallets will not be allowed on the Libra network and their eventual inclusion will have limited balance and number of transactions. As Unhosted Wallets are, loosely speaking non-institutional developments and thus crucial for financial inclusion, crypto enthusiasts criticised this deferral.
In another major change, the Libra Association will vet any wallet launched on the network. While the first Libra White Paper vowed to transition Libra to a permissionless system, Libra 2.0 backed out of this promise. Hence, Libra 2.0 will lack censorship resistance, disappointing cryptocurrency devotees who consider the absence of censorship a very important feature of cryptocurrency.
While Libra’s initial idea was to become a global digital currency with permissionless network and censorship resistance that would have an easy adoption by Facebook’s massive user base, Libra 2.0 has significantly scaled back from its initial promise and made uneasy compromises to satisfy regulators. In an attempt to please both crypto enthusiasts and regulators, it seems that Libra 2.0 has not satisfied either side. Time will tell.
As China's digital currency moves ahead, can Facebook's Libra match up? (as published on ThinkChina.sg on June 2, 2020)
As China's digital currency moves ahead, can Facebook's Libra match up?
By Emir Hrnjic
The People’s Bank of China recently started pilot-testing a digital RMB in Shenzhen, Suzhou, Chengdu and Xiong’an New Area. Will this development threaten the US dollar’s role as the world’s reserve currency in the future? Meanwhile, Facebook and the non-profit Libra Association headquartered in Switzerland have been working towards launching a revolutionary cryptocurrency since June 2019. Although the shape of the project has changed, what will Libra be adding to the mix?
In late April, the People’s Bank of China (PBOC) started a pilot test of the digital RMB in Shenzhen, Suzhou, Chengdu and Xiong’an New Area, and thus China became the first major economy to roll out a central bank digital currency (CBDC).
Digital currency is money that exists in electronic form. While deposits in commercial banks are also digital, they are a liability of the bank. In contrast, China’s CBDC is a liability of the state.
China had already become a global leader in e-payments with its market surpassing those of the US, the UK, Japan, and Germany combined. Notably, the world’s largest FinTech company Ant Financial — the China-based company behind mobile payment app Alipay — is valued at US$150 billion. Remarkably, the capitalisation of this private company is roughly equal to those of Citigroup and Goldman Sachs combined. Additionally, the launch of the digital RMB aims to further cement China’s leadership in e-payments.
A recent report from the Bank for International Settlements mentioned “scalability, accessibility, convenience, resilience, and privacy” as desirable features that a CBDC needs. The challenge, the report argued, is to “design a CBDC that combines the virtues of a direct claim on the central bank with the convenience offered by intermediaries”.
Even though this may facilitate the fight against money laundering and terrorist financing, tracing may also enable the close surveillance of cash flow movements in the economy and invade people’s privacy.
Notably, the PBOC created a two-tier system whereby it creates the digital currency and passes it on to China’s large financial institutions and largest state-owned banks which are supposed to further distribute it to the retail population. As the digital RMB will be used for settlement of transactions, it may increase the transparency of the Chinese banking system and create more stability.
On the other hand, CBDC enables the PBOC to trace transactions. Even though this may facilitate the fight against money laundering and terrorist financing, tracing may also enable the close surveillance of cash flow movements in the economy and invade people’s privacy. While the PBOC has promised to balance concerns about privacy against the objective of halting illicit transactions, it remains unclear how it can achieve balance between these opposing objectives.
The launch of the digital RMB may signal China’s ambition to unsettle the global monetary system. China is already ahead of the US in the digital payments market and one can argue that digital RMB may pose a distant threat to the dollar’s supremacy as an international means of payment.
Even though nearly 90% of international transactions were settled in US dollars in 2019, whereas RMB controlled only 2% of the market, a Foreign Affairs article by the executive director and co-director of the Belfer Center, Harvard Kennedy School notes that “the failure to check the influence of China’s digital RMB and develop a competitive American alternative could significantly hinder the United States’ global influence in the information age”.
Current sentiment in China may give credence to this theory. Recently, a former Bank of China president, Li Lihui, delivered a talk, opining how China’s digital currency may restructure the global monetary system. Furthermore, a recent opinion piece in China Daily by Daryl Guppy, an equities and derivatives trader and columnist, said: “A sovereign digital currency provides a functional alternative to the dollar settlement system and blunts the impact of any sanctions or threats of exclusion both at a country and company level.”
Finally, most cross-border payments are facilitated by the Society for Worldwide Interbank Financial Telecommunication (S.W.I.F.T.) while a large fraction is routed through US banks. Even though S.W.I.F.T. is headquartered in Belgium, many argue that the US yields a disproportionate influence including the ability to exclude countries under sanctions from cross-border transactions. This implies that the digital RMB may weaken the power of US sanctions and its ability to track illicit financial flows.
How will the world react?
Intuitively, the best response to the digital RMB would be the digital dollar. In that spirit, the early versions of the US stimulus bill included the development of a digital US dollar to provide payments to people and businesses hit by the economic downturn. According to the reports, the Fed was supposed to offer bank accounts to all Americans — FedAccounts — which would bypass commercial banks.
The digital dollar would likely combine the economic strength of the US dollar with the convenience of digital technology. It was unlikely that a new digital dollar would use blockchain, but, nevertheless, the idea was scrapped and did not make it to the final version of the stimulus bill. Moreover, while more than 50 central banks around the globe have been experimenting and researching digital currency space for years, the US Fed is lagging behind the rest.
While Libra, the digital currency proposed by Facebook, is facing a regulatory pushback and scrutiny in the US and is being reconfigured, ironically, it may be America’s second-best response to potential challenge to its global monetary dominance. In his testimony to US Congress, Mark Zuckerberg, the Facebook CEO noted that increased regulatory scrutiny over Libra impedes its development, which would benefit China that was working on a similar project. While being grilled in Congress, Zuckerberg tried to convince US lawmakers that the choice is not Libra versus no Libra, but rather Libra versus digital RMB.
In fact, Li Lihui spent half of his talk discussing Libra and described it as a “supranational digital currency”. Even though the two currencies widely differ, Libra and CBDC may yet compete on the international scene.
Moreover, Mark Carney noted in a speech in August 2019 when he was still governor of the Bank of England that the US dollar has played a dominant role in the world order for much of the past century and discussed the need for a new international monetary and financial system.
While he opined that neither RMB nor Libra were in a position to take over from the dollar yet, Carney suggested several possible replacements to the dollar, including a digital currency supported by an international coalition of central banks co-insuring each other.
Carney added that a “SHC [synthetic hegemonic currency] could dampen the domineering influence of the US dollar on global trade. If the share of trade invoiced in SHC were to rise, shocks in the US would have less potent spillovers through exchange rates...”
Notwithstanding all of the above, we should keep in mind that the deliberate process of developing China’s CBDC lasted six years and its early focus will likely be on ironing out the wrinkles in the domestic banking system before it makes a leap on the international scene.
While digital RMB represents a major milestone and China may have the ambition to unsettle the global monetary system in the distant future, it seems that this process will be slow and deliberate. However, if digital RMB takes off sooner than expected, ironically, the best defence in preserving the dominance of the US dollar may be a dominant private cryptocurrency such as Libra as it was earlier envisioned or a multinational digital currency issued by a coalition of central banks.
Did Covid-19 spur digital currency development?
By Emir Hrnjic
With people observing social distancing measures during the COVID-19 pandemic, a serious concern has emerged. Can the virus spread via physical money? One research seems to suggest so – tests conducted found that some notes and coins may carry as much bacteria as those present on the soles of shoes or even toilet seats.
In March, the World Health Organization confirmed that banknotes may carry the coronavirus for several days and advised the use of contactless payments instead. Amid the heightened hygiene awareness, digital currencies came to focus Improbably, the Covid-19 crisis might have prompted central banks to expedite this development.
Recently, the head of the Bank of International Settlements (BIS) Innovation Hub Benoît Cœuré said “the [COVID-19] crisis has exposed the value of technologies which enable the economy to operate at arm’s length and partially overcome social distancing… The current discussion on central bank digital currency also comes into sharper focus.”
China leading the way
While the rest of the world has been discussing and analysing the benefits and costs of digital currency, China’s central bank—the People’s Bank of China (PBOC)— had seized the moment and started a pilot test of the digital yuan, the electronic form of the renminbi with value equivalent to the paper notes and coins in circulation. It has since become the first major economy to introduce a central bank digital currency (CBDC), rolling out the pilot test in three cities, including Shenzhen, Suzhou, and Chengdu, as well as in the Xiong’an New Area.
Also known as “DC/EP (Digital Currency/Electronic Payments),” the digital yuan transactions can be made through smartphone–based NFC technology (Near Field Communication). The technology enables the phones to interact with each other when in close proximity and, thus, allows the digital currency to be exchanged without the internet.
Mobile cashless payments – like Alipay or WeChat pay – have become a part of daily life in China. But the launch of digital yuan – coupled with a recent President Xi Jinping’s call for China to focus more on blockchain – exemplifies China’s continuous push to become the world’s leader in digital currency space. Moreover, digital yuan may even pose a threat to the dollar’s supremacy as an international means of payment. Mainland based English newspaper China Daily went as far as to claim that “[China’s] digital currency provides a functional alternative to the dollar settlement system and blunts the impact of any sanctions or threats of exclusion both at a country and company level… It may also facilitate integration into globally traded currency markets with a reduced risk of politically inspired disruption.”
Pros and cons
While it may be too early to evaluate China’s experiment, central banks around the world are paying great attention to this development while carefully observing pros and cons of digital currency.
The truth is, central banks have been studying the use of blockchain technologies for years. The Bank for International Settlements (BIS) views potential CBDCs favourably as they would be backed by the government, and the money supply would be controlled by the central bank. Furthermore, the early versions of the US stimulus bill flirted with the development of a digital US dollar to disburse economic stimulus payments, while The European Central Bank recently released a working paper analysing merits of its potential digital currency.
The pros are there. A Bank of England’s study in 2016 on the feasibility of digital currency pointed out that it could increase Growth Domestic Product (GDP) “by as much as three percent.” The usage could also “improve the central bank’s ability to stabilise the business cycle.”
Following the rise of cryptocurrencies such as bitcoin, the secure digital transfer of money has become paramount. While Bitcoin’s extreme volatility and low transaction processing capacity hinder its ambition to become a global medium of exchange, digital currency issued by a central bank has a far greater potential to become a trusted medium due to inherent low volatility as well as potential for greater efficiency, lower transaction costs, and large scale.
CBDCs would likely help monetary policy targeting money supply and enable access to real-time data regarding money demand. At the same time, blockchain could support faster, auditable, and in general more transparent interbank settlement systems at decreased settlement costs, while avoiding issues like single point of failure.
As societies become immersed in digital payment, central banks which roll out digital currency could gain the first-mover advantage. Any central bank ignoring the role of digital currency could risk losing relevance in the global economy.
Challenges to overcome
However, the transition to digital currency adoption needs to be carefully managed. One challenge to overcome is the potential shortfall in credit. As the head of Germany’s Bundesbank, Jens Weidmann once argued, in uncertain economic times, people may choose to put their money as digital currency in central banks, instead of deposits in commercial banks as the former is more secure and holds lesser risk. With reduced deposits also comes a severe contraction of consumer credit which would clearly harm the real economy. As central banks’ digital currency looks set to take on a bigger role in future, commercial banks would have to find alternative sources to replace the deposits.
The PBOC are aware of this shortcoming: They did not want digital yuan to become a threat to the retail banking system. For this reason they did not make it available directly to the public. Instead, the digital yuan will be used by the PBOC and commercial banks for settlement of transactions which may increase transparency of the Chinese banking system and create more stability.
PBOC’s playbook calls for implementation of a two-tier system – the central bank will create the digital currency and issue it only to large financial institutions and four largest state-owned banks that will further distribute it to China’s 1.4 billion citizens, just like the issuance of cash.
Another major challenge is privacy. Digital currency enables digital tracing of all digital cash in circulation and, thus, a person’s use of finances. While this considerably helps authorities to fight money laundering, terrorist financing, and even tax evasion, it also facilitates close surveillance and control of individuals’ transactions. In countries where privacy is a great concern, this may lead to serious public opposition.
Even though PBOC promised to keep the balance between privacy and supressing criminal transactions, it remains unclear how it can achieve balance between these diametrically opposite objectives. Early reports hint at limits in the frequency and amounts involved in anonymous transactions.
As an improbable consequence of COVID-19 crisis, CBDCs were brought in focus and governments might have been prompted to expedite their development. Seizing the moment, China’s central bank made major steps toward becoming the first major economy to issue a CBDC. How other central banks follow suit will be something that markets will play close attention to.
By Emir Hrnjic
The People’s Bank of China (PBOC) has reportedly begun a pilot test of the digital yuan in April, thus, becoming the first major economy to introduce a central bank digital currency (CBDC). The experimental trials started in three cities, including Shenzhen, Suzhou, and Chengdu, as well as in the Xiong’an New Area and digital yuan became part of the monetary system.
Together with President Xi Jinping’s recent appeal for greater urgency in the development of blockchain, the pilot launch of digital yuan epitomizes China’s ambition to become the digital currency leader. Moreover, state-media outlet China Daily claimed that “[China’s] digital currency provides a functional alternative to the dollar settlement system.”
While China was the only major economy that made a daring step toward a major milestone, governments and central banks around the world have been experimenting with blockchain and digital currencies for years. The early versions of the US stimulus bill included the development of a digital US dollar, while The European Central Bank recently released a working paper analyzing merits of its potential digital currency.
Indeed, as central bankers around the world are increasingly showing interest in blockchain technologies and the global adoption of digital currencies continue, they could eventually challenge and partially replace fiat currencies, thus, creating significant monetary policy implications.
In agreement, a recent report of G7 working group on as a subset of digital currencies known as stablecoins stated that “stablecoins that reach global scale could pose challenges and risks to monetary policy.”
THE IMPACT OF CENTRAL BANK DIGITAL CURRENCIES
CBDC would likely help monetary policy targeting money supply and enable access to real-time data regarding money demand. It would also likely be a direct liability of the central bank, while blockchain-based interbank settlement systems would be faster, auditable, and more transparent.
In general, central banks influence monetary policy by changing the short-term interest rate. Additionally, monetary authorities reduce long-term interest rates by buying long-term government bonds. This process, also known as quantitative easing, increases the money supply.
CBDC could help with targeting of money supply since citizens would have direct access to the central bank’s base money. It would also enable governments’ access to real-time data on money demand.
Indeed, a recent research study by the Bank of England concluded that a central bank digital currency might “strengthen the transmission of monetary policy changes to the real economy.”
Bitcoin supporters glorify its fixed issuance schedule with no discretionary influence of central banks or any other institution. They often present past evidence of central banks in several countries abusing their discretionary power and printing money for the benefit of various interest groups.
In the case of CBDC, the central bank’s commitment problem could be potentially solved by using smart contracts to predetermine the issuance rate of the currency when predefined conditions are met.
However, the pre-determined currency issuance implies that money supply would by default ignore future market factors and, hence, the future quantity of money would not be able to respond to future market conditions.
THE IMPACT OF PRIVATE CRYPTOCURRENCIES
When Facebook and its partners in Libra Association announced the development of cryptocurrency with a potential user base of 2.4 billion active users last June, the possibility of a private cryptocurrency replacing sovereign currency became a reality.
At the Congress Hearing organized a few weeks later, Facebook’s executive David Marcus stated that The Libra Association has “no intention of competing with any sovereign currencies or entering the monetary policy arena.” However, if Libra becomes a widely adopted private currency as its founders hope, it will inevitably have monetary policy implications regardless of the founders’ intentions.
Libra will be fully backed by the basket of currencies comprising the US dollar, euro, Japanese yen, pound sterling, and Singapore dollar, and, thus, it will effectively follow the monetary policies of the five central banks that issue these currencies. As regulators around the world expressed concerns that Libra could interfere with their national currencies and monetary policies, Libra was recently redesigned, and a new White Paper describes single-currency stablecoins separate from the Libra coin.
Notwithstanding these changes, Libra could eventually partially replace some sovereign currencies, especially in countries with high inflation and unstable banking system. According to BIS’ report, private cryptocurrencies backed by tech giants could “rapidly establish a dominant position in global finance and pose a potential threat to competition, stability and social welfare.”
Furthermore, the potential dominance of Libra or any other private cryptocurrency in a specific country would severely undermine the effects of monetary policy of that country and jeopardize its economy. If citizens start using cryptocurrency rather than local currency, weak demand would cause local currency’s depreciation. As inflation of local currency increases, it will affect even non-adopters of the cryptocurrency.
In this respect, the effect of cryptocurrencies would be analogous to the dollarization – the impact of the US dollar on local currencies in some developing countries. For example, demand for local currencies in countries such as Zimbabwe or Cambodia is affected by lack of trust in the currency and, thus, locals use the US dollar as a medium of exchange. This currency substitution causes local monetary authorities to lose a set of monetary policy tools that can affect macroeconomic outcomes.
On the other hand, libertarians and free market devotees claim that competition from private currencies may impose market discipline on central banks, which should improve the quality of sovereign money. Currency competition, they argue, can reduce inflation and prevent the central bank’s manipulation of interest rates.
Moreover, monetary policy typically affects the real economy via central banks’ short-term interest rate, which has an impact on the bank funding cost and, thus, bank lending rates. This monetary policy pass-through is limited by the relatively strong market power that banks have over depositors. In layman’s terms, deposit rates are not very responsive to policy rate changes.
However, an improved blockchain-based payment system would likely increase competition and, as a result, competitive pressures on depository system would increase the responsiveness of deposit rates to policy rates.
As global adoption of cryptocurrencies continues to accelerate, policy makers expect that they will challenge and even partially replace fiat currencies in future. Central banks’ digital currencies are likely to strengthen the transmission of monetary policy and help monetary policy targeting money supply.
Dominant private cryptocurrencies, on the other hand, would severely undermine the effect of monetary policy. Furthermore, they could also lead to diminishing relevance of some sovereign currencies, the loss of their value, and high inflation.
Prospect of Cryptocurrencies in Islamic Finance (as published in the Jakarta Post on February 24, 2020)
Prospect of Cryptocurrencies in Islamic Finance
By Emir Hrnjic and Nikodem Tomczak
In May of this year a mosque in London announced it would begin to accept donations in cryptocurrency form.
Although many were skeptical, the mosque received four times more donations in cryptocurrency during the month of Ramadan than in traditional cash.
Even before the mosque’s experiment, debate has been raging about the permissibility of cryptocurrencies under Islamic law as religious scholars deliberate the issue of sharia compliance.
Some religious scholars in Egypt, Turkey, and India for example have directly opposed the use of cryptocurrencies citing various issues such as their use in illegal activities, widespread speculation and price volatility. Others, however, have declared bitcoin sharia compliant, paving the way for Islamic institutions to start accepting cryptocurrencies.
Considering that the worldwide Islamic finance market recently surpassed U$2 trillion, the issue of sharia compliance has huge economic significance. Muslims make up almost a quarter of the world’s population and Muslim countries account for approximately 10 percent of global GDP.
To comply with sharia, financial products should avoid interest, speculation, and excessive uncertainty. They should also be ethical and underlying contracts should be transparent, whilst Islamic financial instruments should be backed by real economic activity or a physical asset.
Against these benchmarks, concerns have been raised about widespread speculation and the extreme price volatility of cryptocurrencies. Furthermore the majority of cryptocurrencies have no underlying economic activity or physical asset.
However, taken to an extreme, strict interpretations of Islamic finance disapprove even of traditional fiat currencies – especially so after the gold standard was abandoned in 1971 and money lost its “real” value.
As a solution, some have argued for the creation of Islamic gold dinar and Islamic silver dirham currencies, backed by gold and silver, saying that such a system would alleviate several problems of modern economies such as inflation and recurring financial crises.
Whilst the ambiguity about sharia compliance has kept many devout Muslims on the sidelines, companies across the Islamic world have started incorporating blockchain and cryptocurrencies into their business models.
Among ASEAN countries, Malaysian government formed partnership with Hong Kong’s iSunOne which specializes in digital banking services to develop the blockchain–based Islamic financial network and to establish a blockchain–based Islamic bank.
In Indonesia, Blossom Finance offers Smart Sukuk Tokens which represent an ownership in the sukuk used in funding microfinance projects. The platform is able to reduce the cost of sukuk issuance by automating much of the legal, accounting, and payment cost.
Meanwhile in the Middle East, a crypto token for money transfers received sharia certification from an advisory agency licensed by the Bahrain’s central bank, while Saudi Arabia’s monetary authority signed a partnership with blockchain firm Ripple to use the company’s platform for cross-border payment settlements. In April, Saudi British Bank (SABB) launched an instant cross-border transfer service based on Ripple’s blockchain technology.
One crypto solution that seems tailor-made for sharia compliance is stablecoin – a cryptocurrency backed by a stable commodity such as gold or silver.
Since the concepts of the Islamic gold dinar and Islamic silver dirham represent ideals of Islamic finance, a stablecoin backed by gold or silver provides an opportunity for an emergence of a “digital Islamic gold dinar” or “digital Islamic silver dirham.”
The market value of a stablecoin theoretically equals the value of its underlying collateral deposited in a crypto company’s bank account. Hence, a stablecoin should have a stable value regardless of the ups and downs of the rest of the crypto market. This should avoid excessive volatility fueled by speculation and market manipulation, although of course gold and silver are not completely immune from these.
Recently, a stablecoin issued by a Swiss firm and backed by a basket of eight fiat currencies and gold received sharia certification from a leading consultancy and audit firm in Bahrain.
However, a concern for collateralized coins is that they require intermediaries including the token issuer guaranteeing redeemability of the stablecoin and the banks safekeeping of the collateral. In this case credibility of an authenticator of the commodity held in reserves would be an issue. Furthermore, the presence of intermediaries renders such schemes effectively centralized, and as a result subject to a single point of failure.
Along with their impact on Islamic finance, truly resilient stablecoins would profoundly impact the cryptocurrency world in various ways. For example, enabling crypto-based loans with significantly reduced volatility risk would make a large impact on lending and borrowing markets. Moreover, stablecoins could be used for payments, remittances, salaries and many other purposes.
If stablecoins prove resilient, they will unlock the blockchain potential to its fullest with the potential to even rival bitcoin as they become a truly global medium of exchange.
Islamic investors and entrepreneurs are increasingly aware of the seemingly endless opportunities.
While the debate over the permissibility of cryptocurrencies is still ongoing among Muslim scholars, governments must decide whether to back cryptocurrencies or risk being ostracized from the new economies.
Furthermore, central banks in Muslim countries should embrace opportunities offered by the growing importance of cryptocurrencies.
In that spirit, development of stablecoins backed by gold or silver will revitalize a “digital Islamic gold dinar” or “digital Islamic silver dirham” providing a tailor-made solution for sharia compliant cryptocurrencies.
Marrying the cryptocurrencies with key principles of Islamic finance may finally bring the needed stability and scale to Islamic finance.
Beware of Risks in Blockchain–Based Smart Contracts (as published in South China Morning Post on November 16, 2019)
Beware of Risks in Blockchain–Based Smart Contracts
By Emir Hrnjic and Nikodem Tomczak
Among the many technological advances enabled by blockchain technology, such as the emergence of cryptocurrencies, smart contracts have attracted significant attention due to their potential transformative power in business and finance.
Digital contracts, much like traditional contracts, outline the terms of an agreement between two or more parties but the terms are in the form of computer code residing and executed on a blockchain. The “smart” aspect of these contracts comes supposedly from their ability to automatically enforce and execute the contract provisions on the blockchain when preset conditions are met.
The self-verifying, self-executing and self-enforcing nature of smart contracts removes the need for any central authority or intermediaries for the contract execution, drastically reducing the cost of doing business.
Transacting parties can easily audit the smart contract code, while the blockchain technology theoretically provides a tamper–proof record of the contract code and of every transaction executed by that code, minimizing risk and greatly improving transparency and accountability.
However, these contracts are arguably neither “smart” nor “contracts.”
The code describing the contract provisions is not necessarily legally binding.
For its obligations to be legally enforceable the transacting parties may also need real-world legal agreements to facilitate the resolution of potential disputes that would arise from human-made errors in the smart contract code.
Appropriate legislation needs to be passed to recognize the legal effect of smart contracts when conducting electronic business transactions. To this end, many jurisdictions have recently passed relevant bills recognizing the legal effects of smart contracts, helping to pave the way for their wider acceptance.
Smart contracts have widely proliferated on different blockchain platforms and currently underpin the emerging decentralized finance sector that facilitates funding and servicing of loans, digital securities trading, as well as initial coin offerings.
Furthermore, they are poised to transform businesses by drastically cutting overhead costs, increasing efficiency by automating many business tasks, and accelerating financial transactions by reducing the likelihood of disputes.
However, smart contracts are relatively new, and to achieve wider adoption, some key hurdles need to be overcome.
Since a smart contract is as good as the underlying computer code, vulnerabilities and hacking that would result in loss of funds are major concerns that may force potential adopters to stay on the sidelines.
In one infamous example of smart contract vulnerability, a weakness in the smart contracts code underpinning a blockchain-enabled venture capital fund, caused a loss of 3.6 million Ether (the equivalent of roughly US$50 million at the time) in 2016.
The recovery of the funds came at a major reputational cost to the blockchain security and governance.
Despite regulatory efforts around the world, unscrupulous developers remain a danger to the industry, while the legal uncertainties of conducting business on blockchain platforms across different jurisdiction significantly increase the risk.
Before smart contracts achieve wider adoption, the code vulnerabilities and the legal frameworks need to be properly addressed. In the meantime, entrepreneurs should figure out what role smart contracts can play in defining the future of their business and factor in the risks involved.
Blockchain path to more inclusive world