This is the second post of a two-part blog that distills the conversation from our last webinar, on digital money, with FAI’s Tim Ogden and financial policy expert Jesse McWaters, Head of Global Digital Public Policy at Mastercard. The first part covered some basic frameworks for thinking about these concepts. This one covers the regulatory environment around digital systems.
Tim Ogden: Let’s talk about how various governments are regulating digital money systems. Countries like Nigeria and the Bahamas have introduced a Central Bank Digital Currency (CBDC). What is the use case for countries to do this? What problems might that solve?
Jesse McWaters: First, we can go back to the earlier framework of a store of value versus payment network. A CBDC doesn’t need to use a blockchain system—it’s just a digital form of a currency. It could be run on the back of an existing or new real-time payments system. So there’s a network technology perspective, versus store of value.
How can a CBDC create value? There are three categories at the highest levels of central bank projects.
To start, there are projects that say we need to build CBDC to preserve the role of central banks in a changing world. For example, Sweden developed a CBCD because they’re almost an entirely cashless society. They were uncomfortable with what would happen if people couldn’t directly access central bank currency. So if people don’t like the old product—central bank notes—here’s a new product. Similarly in Canada— they are building a CBDC and have no plans to launch it yet, but they want to be ready to launch if it becomes necessary to protect the role of the central bank.
The second category is seen in the Bahamas, and in Nigeria with the e-Naira. They are building a new piece of financial infrastructure from the ground up, and which lets you focus on new policy goals. These goals could include financial inclusion, digitization, new ways to deliver government payments, etc. Now, none of that really requires the central bank to be the actor that guarantees the money, but depending on the circumstances they might be the best player in the market to deliver that sort of system. There are exciting opportunities there.
Finally, some folks do this because they have a set of disparate policy goals to drive. They have sovereignty and independence goals, don’t want to be vulnerable to foreign sanctions, and want a greater degree of retail payments to be driven at home. One way to accomplish this wide set of policy goals is to have the central bank build a CBCD.
On the other hand, China has banned cryptocurrencies and India is considering doing so as well*. Why would a government, beyond pseudonymity, want to ban crypto?
There are a few reasons. For one, a fear of currency competition. As a central banker I could be concerned that my currency could be supplanted by a foreign currency, like Bitcoin. Central bankers think the central bank should control the primary store of money.
Second, central banks may have capital controls in place, and Bitcoin could allow people to move money out of the country and circumvent those controls.
Third, there are concerns about consumer protection. There are regulatory protections that don’t currently exist in the crypto market. So, we see market manipulation, pump and dump schemes, wash trading, and money laundering. All of that happens in conventional markets as well, but there are fewer protections and fewer regulations in crypto markets.
How realistic is it that we’ll get to a place where people will understand and have the confidence to transact and use crypto? From a financial inclusion perspective, what about those people who currently don’t even trust banks?
Regulation is very important in trust building. I think of buying Ethereum less like buying a foreign currency, but more like buying stock (in AWS for instance). It’s like a claim on the company, its work and profits. An asset like ETH or stock isn’t stable value as a currency.
Once you have a stable value, you need to wrap it in regulation and strong compliance practices. There need to be standards in terms of the legal treatment of a stablecoin, what it is, how it can be traded, what happens if the system breaks down. Compliance is required to hold all players in the system to the same standards, to ensure trust and buy-in.
In banks for example, it is not enough for there to just be rules—they need to be built for customers, and customers need to be educated in them.
There is a genuine problem for smallholding customers who don’t have that much money: How do you serve them? Digitization is a good way to serve them because it brings down the cost, but we need to understand what more can be done.
Shamika Ravi** (audience member): I doubt that India is going to ban crypto. There is a genuine apprehension in doing that. China has banned it several times—that should tell us it isn’t that easy to ban it. There is also a genuine effort to understand this space before coming out with something specific. What are the common regulatory tools being used by governments here?
Jesse McWaters: We've seen an ongoing evolution of the Reserve Bank of India directive around crypto assets; the blanket ban was walked back. In China we’ve seen multiple bans, on exchanges function, then on mining, then restrictions on ability to transact.
In most advanced economies, the focus isn’t so much on banning, but on establishing controls that do these things:
A focus on anti-money laundering and counter terrorist financing—how do we figure out where the money that’s flying around is coming from, where is it going? We’ve seen some regulators establishing clear guidance on what you can do, and your obligations as a virtual asset service provider. We’ve also seen governments beefing up their capabilities to do enforcement in this space, and service providers doing the same.
Consumer protection—in the world of investable assets, you see consumer protection being thought through to protect those investing. If you think back to the US in the late 20s, there were a bunch of messes going on with wash trading, frontrunning, and insider trading that undermined trust in the market, so we decided to put in protections for the little guy to be treated fairly in this space—that’s how the SEC came into existence.
Stablecoin—what is it, what is an appropriate structure reserve for it, what are the legal protections, how do the various players enable the stablecoin, could be wallet provider or a notary, how do they run the system properly so individuals trust it?
On an international level, there’s serious regulatory questions about what systemic risk in this space looks like? It’s about things being large, interconnected, having a lot of leverage. Today crypto is getting pretty large. DeFi is introducing more leverage in the system and is getting connected with other traditional financial systems. Now we have to think about what a “living will” for a DeFi platform looks like, what does safety, stability and soundness of a financial system with crypto playing a bigger role in it, actually look like? Those are really exciting but hairy questions to deal with.
Tim Ogden: You mentioned in the beginning that you can only pay US government taxes in USD, so anyone who wants to do business with the US government has to get into dollars. From a global perspective, any government's ability to regulate is dependent on the need to transfer into the thing the central bank controls. If people start to be able to make payments where they never have to leave a crypto asset world, then why should they pay taxes if all their transactions are on the DeFi outside the purview of the government?
Broadly speaking, most economists agree that dollarization or a foreign currency becoming your country’s currency is a “break glass” measure (something that is undertaken in an emergency where a more conventional solution may not be equal to the task). Sometimes it’s the best way to fix a bad situation; you might have runaway inflation, and then it could make sense and work. But most of the time you want the central bank to be able to control its own currency so that it has the policy levers to control monetary policy domestically, in a way that is designed to deal with your economic conditions, not of another country and their currency.
Now the problem with CBDC is that, if I’m in a smaller country, is there a risk that my neighboring country could have their CBDC flow into my economy, and I’d find myself de facto dollarized or euroized (or something else depending on who your neighbor is) because I happen to be in the neighborhood. There are policy interventions you can take to prevent this, and big central banks generally want to design their CBDCs so that they don’t have that kind of impact on their neighbors. But it shows you how these kinds of new monetary innovations can have unintentional detrimental effects. Once countries lose control of their monetary policy, it can lead to more debt (due to a reliance on fiscal stimulus), and that’s a very sticky place to be.
In Venezuela for example, the government lost control of monetary policy, and Axie Infinity is practically becoming legitimate currency. Regulation comes from setting standards. Do we see big, decentralized players like Coinbase becoming de facto regulators since they can set the rules of how they interact with governments, and do we see that becoming a global standard?
It’s really important to distinguish investment in crypto-assets as speculative vehicles of capital appreciation, and payments. I am seeing that there is very little activity currently happening when retail payment flows are denominated in crypto-assets. Where stablecoins are being used it is mostly to buy and sell other forms of crypto—not as a currency to buy a chicken at the market. Remittance flows in this space are also limited, but it’s an area where there’s long term potential. However, one of the problems with cross-border transacting is that it’s legacy systems, and highly fragmented. It’s really important to not see technology as a silver bullet. There are many other problems like regulation, the interaction between money laundering rules and data protection, there’s a whole bunch of challenges in making the system work. We also have to think of the cost of each step of the transaction (currency to crypto to transferring crypto back to currency).
I don’t think we’re at a significant risk of seeing the incumbents of this space like Coinbase, who have driven some really exciting innovation, becoming de facto regulators. We’re seeing them learn the regulators’ language over time. We’re seeing processes happen whereby payment infrastructure standards setters (like the Bank for International Settlements) are thinking about regulations, and they’re being handed down to the IMF and World Bank, who are thinking about what that means for developing economies. I think they will start to have training programs for emerging countries to align themselves with global standards. It’s not going to be easy or happen overnight, but we are seeing more and more public sector engagement with the potential for crypto-assets and that’s exciting.
*Since this webinar aired, the government of India has chosen not to ban crypto, but is instead taxing it heavily.
**Shamika Ravi is Vice President at ORF, and Senior Non-Resident Fellow at Brookings.