October 24, 2016    4 minute read

Are Central Banks Warming Up To Digital Currencies?

The New Era Of Finance    October 24, 2016    4 minute read

Are Central Banks Warming Up To Digital Currencies?

In August 2016, a consortium of five financial services firms – UBS, Banco Santander, Deutsche Bank, BNY Mellon and ICAP – announced the introduction of the Utility Settlement Coin (USC). While this is another variation of digital currency being introduced into the marketplace, like bitcoin, the project utilises blockchain technology.

Blockchain technology, it can be argued, has been the more sought after element of the bitcoin concept. However, as the head of FinTech innovation at UBS’s securities division Hyder Jaffrey states that financial services firms require a type of digital currency on the blockchain to get maximum benefits from this form of technology.

Cheaper Transactions

The purpose of the USC is to enable financial services to digitise assets to complete transactions without waiting for traditional fiat currency to be transferred. It has been designed to allow the digital currency to trade with cash at central banks. Therefore, this would be the development of a parallel system if central banks approve the project’s implementation.

The benefit of this project is the decline in transaction costs, the amount of time it takes to complete transactions and the freeing up of capital. According to business management consulting company Oliver Wyman, the costs associated with clearing and settling financial transactions in the industry can fetch up to $80bn annually. In addition to this, it can take a number of days before this process is completed thus tying up capital in the marketplace.

Historically speaking, financial services firms have been advocates for financial innovations that enable greater flexibility with capital to participate in market activities. For example, the credit default swap engineered by JP Morgan freed up regulatory capital in the 1990s in private transactions between parties. Whereas previous innovations like the credit default swap were opaque regarding the number of transactions involving the derivative in the build up to 2008. Blockchain has been widely embraced due to the real-time audit overview benefits and increased transparency.

Central Banks Responding

Although it is still early days for blockchain and digital currencies in the financial services industry, the central banks of the world will have a significant role to play. This can be viewed from a credibility standpoint and the selection of a digital currency model to carry forward and implement. Central banks such as the Federal Reserve and the Bank of England have seen their credibility critiqued for their roles in response to the economic downturn of 2008 by participating in a stagnant recovery. Nonetheless, in part due to their independence, by backing a new form of digital currency safeguards and confidence can be generated in the market.

Whether the Utility Settlement Coin will be fully adopted by a central bank such as the Federal Reserve remains to be seen. After all, the Federal Reserve Bank of St. Louis has mentioned the possibility of its type of digital currency for the central bank as a whole. However, the general increase in transparency is likely to be a welcome prospect for policymakers who potentially have three to five years to consider the technology’s wider implications before it is potentially scaled.

Is An Alternative To Paper Acceptable?

Another area to consider for digital currencies and blockchain technology would be central banking monetary policy. In particular, the zero-bound environment the global economy is effectively operating in. Andy Haldane, Chief Economist at the Bank of England, has suggested in the event of a negative rate environment cash could be abolished.

Alternatively, there could be the establishment of an exchange rate between fiat currency and digital currency where cash depreciates, so a negative interest rate on it occurs. Overall there remain a series of unanswered questions including whether this technology could support or generate increased efficiencies in central banking operations and whether society would accept an alternative to paper currency.

Would economies be prepared for the introduction of a cashless society? For the time being it is unlikely given the early stages of blockchain technology and digital currencies, but countries like Sweden can act as a potential model given the fact that cash transactions represented 2% of all transactions in 2015.

Central banks, if they embrace the USC, will have to conduct an extensive trial with the digital currency and distributed ledger before further advancements. If the efficiencies of this digital currency variation and distributed ledger promise are delivered in a market setting and banking stability is maintained, this will be another block for central banks to build on in the shift to a cashless society in the long-term.

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