Notes, railways and bitcoins

Is it only a matter of time before central banks nationalise cryptocurrency?

I ask the question because if you look back through history it feels like one plausible chain of events. And for a long time when people asked me about the long term fate of things like Bitcoin I’d mumble something about how it might end up looking a bit like the railways.

Most of the railways were built in the 19th century by private companies. Eventually governments in most countries realised the importance of public transport to their economies and began gradually to bring them into public ownership. Sometimes this happened as a matter of policy, sometimes it happened when those rail companies went bust, something they had a habit of doing quite frequently. And sometimes, as happened here in the UK more recently, they’d later be privatised again, with questionable results.

Now, the analogy isn’t perfect, but the overarching point is quite important: that governments tend to be intensely relaxed about new disruptive technologies and markets until they realise those technologies are getting in the way of them doing their work – which in this case mostly means raising taxes and maintaining order.

It’s helpful to remember this when considering Bitcoin and cryptocurrencies. The main precept of the Bank of England’s remit is that it should use monetary policy, in other words interest rates, to help the government ensure “strong, sustainable and balanced growth” and (this is the key bit here) “price and financial stability are essential pre-requisites to achieve this objective”.

I’ve always assumed that the government would only really start paying close attention to Bitcoin and crypto when they began to pose a threat to this second bit of the remit – for instance triggering a financial crisis or getting in the way of the Bank’s ability to set interest rates. That, in a sense, is what the history of banknotes tells us. Remember that up until the middle of the 19th century private banks in most countries were allowed to issue their own banknotes.

In the US there were at one point more than 1,500 banks all printing their own banknotes, each of which claimed to be worth a dollar. The problem was that not only did each of those banks have a different credit profile, but the creditworthiness of the states which backed those notes also fluctuated. The upshot was that a ten dollar banknote in one state could be worth $9.90 in another state and $9.40 in another one. More worryingly, given the regularity with which these banks went bust, you wouldn’t ever be quite sure whether the currency in your pocket would still be legal tender the following day. That’s no way to run a financial system or a developed economy. The Civil War proved the main catalyst to unifying the monetary system, though the real underlying reason for nationalisation were these long-run problems with the existing hodge-podge of monetary systems.

In the UK the situation was not dissimilar, with private banks gradually elbowed out by the Bank of England from the mid-19th century onwards amid a series of financial crises that raised questions about the reliability of individual banks’ notes and enforced faith in the central bank. This was a slow and drawn out process which took three quarters of a century. While the Bank was granted a monopoly on issuance in 1844, the note-printing banks in existence were allowed to carry on until they were shut down or taken over by others. It wasn’t until 1921 that the last local private note issuer, Fox, Fowler & Co. of Somerset was taken over by Lloyds Bank and the era of private English banknotes came to an end.¹

That many of these central banks took decades, in some cases centuries, to get a monopoly on the issue of paper currency – at that stage the great technical innovation in money – is worth noting. Because they seem to be moving in similarly glacial fashion towards digital currencies today.

Today we learnt that the Bank of England is launching a “Taskforce” on creating its own digital currency. A Taskforce is not the same as action, or even an action plan. Indeed, the Bank has been thinking out loud about digital currencies for ages, for instance in this discussion paper last year and in any number of speeches.

On the other side of the Channel, the European Central Bank is in a more or less similar holding pattern, albeit slightly more advanced, with an expectation that it announces whether it will launch its ECBC this year. The Federal Reserve, meanwhile, seems even less enthusiastic than its European counterparts, for the time being at least.

It’s hard to make out what these central banks are really up to, in part because they are always Sphinx-like in their approach and, even more so I suspect, because they genuinely haven’t made up their minds themselves. On the one hand, they are all becoming increasingly fidgety about the prospect of cryptocurrencies providing a financial shock – something that would cause them to flex their regulatory muscles (remember the financial stability bit of the remit above).

Then there’s the defensive aspect to it. As ECB Executive Board member Fabio Panetta said in a recent speech: “We are working to safeguard the role of sovereign money in the digital era: we want to be ready to introduce a digital euro, if needed.”

Put these two together and you might find yourself returning to the assumption with which I began this blog: that central banks and their Treasury paymasters are preparing the turf so that they could, if need be, step in to nationalise or replace cryptocurrencies in the coming years or decades – say, if they became too big or too disruptive to their work. But while the railways thesis might have some plausibility to it, it turns out this is possibly the least interesting thing about Central Bank Digital Currencies (CBDCs for short).

Let’s start by forgetting about cryptocurrencies altogether and thinking about the digitisation of money. Consider the extent to which cashless payments are being used in various countries, as a percentage of GDP. The common wisdom is that China leads the world in electronic payments. Anyone who’s spent a bit of time there will know the extent to which it’s becoming nearly impossible to buy anything without using your smartphone. This is part of the explanation for why Beijing is being far more proactive about creating a CBDC than its counterparts in Europe or the US.

But actually when you look purely at cashless transactions it’s actually not China but the UK that leads the world.

Now, in practice here in Britain “cashless” mostly means credit and debit card transactions whereas in China it mostly means smartphone and other technology-based transactions. In one sense these are quite different things. But from the perspective of a central bank there are some similarities, which in this case rather matter.

To see what I mean it helps to go back to first principles. In this and most countries the most “reliable” form of money is the money issued by the central bank². We could have a long conversation in this case about what “reliable” means, but in this case let’s take it to mean money that you and the person you’re transacting with will know is likely to be accepted by anyone else they then want to transact or bank with.

The only form of central bank money you and I can use are physical banknotes. When we transact in the other ways we mostly do these days – so via our cards or direct debits or electronic money or pretty much anything save for cryptocurrencies – we are typically using commercial bank money. This is money “created” by commercial banks. Those commercial banks use central bank reserves to settle their accounts with each other at the end of the day.

Let’s say you buy something at a shop. If you use cash the process is pretty straightforward: you had the money, now they have the money. If you use a debit card then the money goes from your account into theirs (minus a transaction fee which goes to Visa or another such company) in the form of commercial bank money. At the end of the day your bank looks through its accounts and, theoretically at least, sends some central bank reserves to the main account of the shop’s bank (or, if you both bank with the same banking group, they don’t need to do anything).

Now, this is a massively oversimplified example (and no doubt I’ve committed some technical howlers banking purists will be screaming at) but it underlines a crucial point: there is already such a thing as central bank digital money. But not a kind that you or I can use: it’s just used by banks to settle their accounts with each other.

This model is in many ways the foundation of modern finance. The central bank sits atop a financial system, which in turn sits atop customer accounts. When the Bank of England changes interest rates what it’s really doing is changing the rate it charges and pays on reserves, with the expectation that those changes are in turn passed onto customers. You get the idea: you and I can’t have a bank account at the Bank of England, but these commercial banks do.

But what if you or I could have an account at the central bank? Or failing that, what if we could specify that we wanted the money in our accounts to be backed by the central bank rather than HSBC or RBS or whoever? It’s quite likely this kind of money would be incredibly popular; after all, you’d no longer have to worry about whether your bank might be about to go bust and you’d only have to worry about the extent to which your country was going to go bust, or inflate away the currency.

And that, in a sense, is the point behind central bank digital currencies: that you and I would suddenly have access to that digital money that up until now only private banks have been able to access.

At this stage you’re probably cottoning on that this isn’t really just a story about Bitcoin and other cryptocurrencies but about the nature of money and, more immediately, about banking systems. Or to put it another way, the institution most under threat from CBDC might not be cryptocurrencies but the banking and financial system itself.

This might also ring some bells from the financial crisis. Remember how people discussed the idea of “narrow banking” whereby the existing banking system should be replaced by one with utility banks which offered safe, reliable access to money and then more risky bank accounts? It’s possible CBDC may revive those conversations (which kind of tailed off as the financial crisis became more of a memory).

Perhaps this is why the Bank of England is at pains to emphasise in most of the material it’s been producing around digital currencies that this “would be introduced alongside – rather than replacing – cash and bank deposits.” Even so, in its discussion paper, the Bank points out one area where it looks to some extent like CBDC could disrupt some of the work done by commercial banks:

One of the most interesting features that has emerged through developments in DLT is the potential to create ‘programmable money’. This can be implemented via the use of ‘smart contracts’ — pieces of code which are able to self‐execute payments based on some pre‐defined criteria. In simple terms, these contracts are statements that say ‘If X happens, then pay Y to Z’. An example would be a forward‐dated payment: ‘If today’s date is X, then transfer £100 from account Y to account Z’. More advanced smart contracts could be used (for example) to automatically initiate payments on the confirmed receipt of goods, or routing tax payments directly to the tax authorities at point of sale. Transactions could also be integrated with physical devices, or the ‘Internet of Things’, for example code could be written to say ‘when £X is transferred to account Y, switch on device Z’.

Nor is this the only intriguing possibility raised by CBDCs. Remember one of the big debates in UK monetary policy right now is whether it might be practicable for the Bank to cut interest rates below zero. There’s a pragmatic reason for this: many banks, and especially building societies, have business models which are quite reliant on rates being above zero.

Now consider: if you have an account denominated in UK central bank money, it would have interest paid at precisely the Bank of England interest rate, but it could also plausibly impose negative interest rates without causing the kinds of financial ripples which might happen if it relied on the existing financial system.

You get the idea: this could have enormous consequences on the transmission mechanism of monetary policy, which up until now has involved a chain reaction that wasn’t always entirely predictable. Not to mention helping to combat the use of money in the black market.

Or here’s another prospect, raised recently by analysts at Bank of America:

Depending on how a digital currency is designed, governments could credit funds to a broad set of recipients, or potentially, credit accounts which transact in targeted industries. In principle, the stimulus can be tailored to provide additional ‘cash back’ if funds are spent on targeted businesses, allowing government to design more carefully tailored stimulus than currently possible.

This is, in other words, a genuinely intriguing new frontier, which raises all sorts of prospects – not to mention questions – about the role of state in our finances.

Now, back to that question at the start: yes, perhaps some of this is aimed at providing an alternative to cryptocurrencies. Have no doubt about it, central bankers don’t much like Bitcoin, an attitude best summed up by ECB president Christine Lagarde in a recent interview: “Ce n’est pas une monnaie. Les cryptoactifs, ce n’est pas une monnaie. C’est un actif hautement spéculatif”. Not a currency, then, but a “highly speculative asset”. The fact that Bitcoin and other cryptos, which rely on “proof of work” and are held together not by trust but by technology and energy, have serious problems with emissions doesn’t help.

It might seem odd, given the staggering amount of money having been put into cryptocurrencies, that central bankers still sincerely don’t believe they are competing with crypto. But they really don’t seem to.

However, they do seem to be using crypto’s rise as an opportunity to flex their muscles and explore a new frontier. In time this might not just be seen as the moment when central banks sought a foothold in a sphere where cryptocurrencies had already established themselves, but something else. It might be seen as the second chapter in a digital revolution which has enormous consequences for the way we transact with each other.

For centuries, central banks have sought to control the payments process at arm’s length, relying on the financial system to do much of the work. The advent of digital currencies may involve these institutions extending their reach far further into the financial world, and into our everyday lives, than ever before. A nationalisation – not of cryptocurrencies but of vast swathes of the financial system.

1. (If you’re interested in this here’s a working paper about all this by the Swedish central bank, the Riksbank, from which I stole some of this history; it’s well worth a read.) ↩
2. clearly this doesn’t go for some developing countries with histories of default and hyperinflation ↩