Crypto fiat coin confusion

A thing that can often be heard said these days is that central banks should tap blockchain technology to launch their own crypto coins.

But there are many reasons why such talk is misleading and distracts from the key issues at hand.

In its simplest interpretation, talk of crypto fiat issuance is almost certainly a euphemism for something else: the expansion of a central bank’s digital balance sheet to every single person. Yes, really.
If, however, central banks really wanted to provide digital access to their balance sheets to every single person they could have done so years ago using existing technologies. Blockchain, whatever flavour it comes in, is entirely unnecessary for accomplishing this objective.
In general, as centralised issuers of cash liabilities, there is little need for central banks to adopt much more expensive blockchain or distributed tech technology beyond the role such technology might play in backing up their core systems. Yet, even here, there are alternatives that don’t compromise system control the way blockchain does.
If for some reason central banks did decide to open their balance sheets to Joe Public, they would have zero interest in doing it in a pseudonymous or anonymous manner. Physical cash transactions are drawing greater scrutiny not less, and the move is clearly towards greater traceability not anonymity. And yet, assuring privacy is the only other possible justification for using blockchain in the process.
Even in a scenario where digital anonymous fiat was launched to replace physical cash entirely (say to make negative interest-rate policy easier to implement), this would not go down well if the cost of the move was less traceability of illicit funds through the system.
All of this implies that the reason central banks have not yet extended their balance sheets to everyone universally is not due to technological limitations as much as socio-economic and structural factors.
Given the above, why in all the talk of crypto dollars, roubles and yens are none of the socio-economic and structural limitations ever being discussed?

Something else is clearly afoot.

What’s crypto fiat issuance got to do with full-reserve banking?

What crypto fiat issuance talk really constitutes (and we’re sure central bankers are aware of this) is the popularisation of an agenda to wean the world off fractional reserve banking, albeit without full consideration of the negative externalities that come along with doing so.

We operate a fractional reserve banking system for two key reasons: First, because doing so is cost-efficient (it allows for financial economies of scale) and second, because it provides the central bank with control over financial conditions.

In a fractional reserve system there is by design never enough “full reserve” capital available to satisfy all the liquidity claims of the system simultaneously.

There is logic to this. The financial system is a merry-go-round which has no interest in encouraging capital to stand about stagnant and idle. It is economically inefficient to assume everyone with a liquidity claim on the economy will redeem it at the same time. Redundant or spare capital can be put to better put to use elsewhere in the interim.

Nonetheless, it is true, a fractional reserve system is not a free lunch. The cost efficiencies are to a greater or lesser degree always offset by the risk too many people will try to redeem their liquidity claims against real physical goods and services at the same time.

In that context it is the job of the central bank to monitor inflationary conditions and indicators such as consumer demand and industrial purchasing trends to ensure unexpected inflationary runs can be pre-empted by the early adjustment of liquidity supply. It is also the job of the central bank to supervise private banks so that they do not over-extend themselves by issuing too many unbacked liabilities.

One way the central bank takes pre-emptive action, as we all know, is via an interest rate mechanism. This has the effect of making liquidity more or less expensive, rationing it or releasing it in response to inflationary conditions.

Sometimes, however, it’s not as easy as just raising the cost of bank funding to achieve an inflation target.

Often the central bank must intervene in the market directly by borrowing or lending its own liabilities against physical assets (or in the QE world, buying or selling reserves in exchange for financial assets) at a specific discount or premium to ensure its policy aims are fully transmitted to the broader financial system.

Either way, the fractional nature of the system is essential for the central bank to influence liquidity conditions in a way that can keep inflation rates stable and trade/commerce functioning smoothly and dependably.

Some historical context

The modern fractional reserve financial system must be understood in the context of the digital-deposit revolution which occurred over the last couple of decades. This had a profound effect on central-bank liability issuance and liquidity, not least because of how it came to blur central-bank cash liabilities with private-bank liabilities.

From the perspective of the public, bank deposits were for the longest time almost indistinguishable from central-bank-issued cash. This confusion greatly decreased the demand for (effectively fully reserved) central-bank cash liabilities, saving costs for the system at large.

The global financial crisis, however, changed everything. In one fell swoop, people began to realise digital bank deposits — deposit guarantee or no deposit guarantee — were something very different to cash.

As this speech from Simon Potter at the New York Fed highlights, these sudden revelations matter when it comes to the stability of the digital bank deposit system (aka private money-like assets):

Thus, although in normal times investors may perceive these privately produced assets as safe and liquid, a sudden shift in investor perceptions can amplify instability in periods of market stress. To the extent that the private sector does not incorporate the social cost of runs on private callable liabilities, too much private money can be created in normal times, generating a role for public sector intervention.

What has subsequently become clear is that the public would really like to have its cake and eat it in terms of the convenience of privately-issued digital cash-like liabilities but the safety that comes from using publicly-issued liabilities.

Indeed, there is an assumption on the public’s part that Joe Public is “entitled” to a digital equivalent of fiat cash.

That is rational desire but it ignores one vital thing: the issuance of public cash liabilities is not cost free. As the work of Jeffrey Lacker has long argued, although it is common to think of government money as virtually costless to produce, the real resource costs are substantial whether that’s digital or paper cash.

Hence the longstanding arrangement between central banks and the private sector with respect to digital cash-like issuance. Bluntly put, it suits central banks to outsource the cost and operational responsibility of digital liability issuance to the private sector. What central authorities lose in terms of seigniorage revenue by doing so, they gain in cost savings. What’s more, in a fractional reserve system, they still retain control with respect to how far banks can extend themselves on that front.

If central banks took on the role unilaterally, it would be they who would have to absorb the costs. It would also be they, in an attempt to reduce costs, who would be tempted to redeploy immobile funds via a lending or risk-bearing investment channel to subsidise some of that cost. This, however, would emulate the mistakes of entirely centralised banking systems past, such as Gosbank, while undermining the full-reserve nature of the liabilities because of how centralised the risk had become.

Those advocating expansion of the central bank balance sheet to Joe Public (and de facto full-reservation of the system), of course, might argue that it is the current fractional reserve system which is the anomaly.

In the days of It’s a Wonderful Life, cash was king and bank deposits were clearly defined as risky, i.e. not cash. If you wanted the peace of mind of keeping savings in liquid “full reserve” cash mode you had to be your own bank, storing banknotes under your mattress or in secured vaults at personal cost.

In reality, the economic cost of doing so was substantial due to the risk of funds being stolen, burnt down or lost.

There was thus always an incentive to deposit cash into a professional banking system, even back in the days when deposits were known to be risky. Customers knew the banks would lend money against their deposits but hoped the banks would do this responsibly and pay enough interest in exchange. Depositors understood their assets (the banks’ liabilities) were much less liquid than cash but the terms the banks offered them (which often included the promise of short notice redemption) generally made it worth their while.

In this way the fractional reserve system could still be maintained and influenced by a central bank. What’s more, there was a general expectation in society that once cash was deposited in a bank, access to it was never going to be immediate.

Withdrawals took time, simply due to the manual way in which they were processed. It was perfectly normal to have to order in cash for redemption days in advance (when it came to large sums). Bank runs only became a problem when even small sums could not be honoured immediately.

(These, ironically, are the sort of practices the likes of Coinbase are now reintroducing to slow down bank-run risk).

So why couldn’t this work today?

When digital banking became commonplace, the system freed itself of many of these constraints.

From a consumer’s perspective, as soon as merchants became happy to accept banks’ fractional liabilities or credit in lieu of cash for final settlement of purchases, the liquidity advantage of operating in cash alone was diminished greatly.

As far as the consumer was concerned bank deposits really were as good as cash, hence entirely substitutable. The only advantage of holding cash was the ability to (privately) make purchases in the dark, grey, tax-dodging or micro-merchant economies.

From the banks’ perspective, the more fractional units were accepted for final settlement, the cheaper their funding costs would be, and the greater the amount of underlying capital they could reinvest elsewhere.

In that context — a.k.a one where fractional bank liabilities are already highly substitutable for cash if not considered to be much more liquid due to the instantaneous processes that govern them — what does the issuance of a crypto fiat coin really bring to the table?

Only two things:

1) The revival of excessive competition between bank liabilities and public liabilities (cash), to the disadvantage of cheap bank funding costs. (As the relative burdens of cash management are extinguished, banks would be forced to compete ever more aggressively for funding access, leading to spiraling interest rates and/or a dearth of capital provision for the real economy).

2) The unscaling of the economic system as unused liquidity is transferred away from financing global trade, commerce and cross-border investment towards financing public cash deposits.

Which is to say, be careful what you wish for. There are many externalities associated with issuing fiat crypto, the most grievous of which is the likely increase in costs for both the public and private sector.

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