The future is digital (as published in Asia Asset Management, July 2020)

The future is digital 
Digital currencies may one day challenge US dollar supremacy
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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.
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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.