A child’s guide to cryptos, crypto mining, and blockchain: Part V

Aseni, whiz kid of economics, and her grandfather Sarath Mahatthaya who knows one or two things about economics, are in conversation on the latest hype in the money world known as cryptocurrencies, how they are mined and the technological innovation its pioneer, Bitcoin, has introduced to the global tech landscape called the Blockchain.

They had found that Bitcoin was introduced in 2009 as a protest payment method to the traditional payments done through banks by using currencies issued by sovereign governments because those payments were costly, and those issuers had disappointed the users by permitting their value to fall through overissue. But the initial success of Bitcoin had given birth to thousands of alternative cryptocurrencies called private cryptos that had begun to rule the financial world. This is decentralisation of finance, dubbed DeFi, that competes with sovereign fiat currencies which are issued from a centralised place and therefore called CeFi. 

The reaction of the sovereign governments has been mixed. Some governments have sought to regulate them, some outrightly banned them, some approved them as legal tender, and some emulated them by issuing their own fiat digital currencies. Aseni now wants to learn of how sovereign governments compete with private cryptos by issuing their own centralised digital fiat currencies. 

Today’s conversation is centred on this issue:

One of the main concerns at that time was when CBDCs are issued, whether it would cause a ‘large scale run’ on the deposits held by banks. Since the usefulness or utility of CBDCs is high and its use cost is low, naturally people may prefer them to traditional bank deposits. If they choose to convert all their bank deposits into CBDCs, banks will find it difficult to remain stable due to liquidity shortage and lack of funds for lending. It is a serious issue for a central bank

• Regulation of private cryptos to facilitate sovereign cryptos

Aseni: Grandpa, you said that governments are now looking into the possibility of issuing their own digital currencies called central bank digital currencies or CBDC for short. We hear that both Nigeria and China have issued the digital form of their physical currencies called e-Naira and e-Yuan, respectively. Is this the first time that a central bank has gone into digital form of payments?

Sarath: No. Central banks have been in the digital payments systems for some time now. In the good old days when everything was done manually, central banks provided services to their customers – commercial banks and governments – just like the way a current account department of a commercial bank had functioned those days. Physical currency was deposited and withdrawn, and payments out of accounts or into accounts were done through cheques, an outdated payments system by today’s advanced practices. 

In this system, when one commercial bank had to make a payment to another commercial bank, the authorisation was made by the paying bank by drawing a cheque on the account maintained in the central bank. The central bank, after verifying the genuineness of the cheque, debited the account of the paying bank in its ledgers, also maintained as physical ledgers, and crediting the receiving bank. They were all net settlements done at the end of the business day of central banks.

But after the payments systems were automated through systems like the Real Time Gross Settlement System or RTGS, the manual operations were converted to digital operations. Today, it is an authenticated digital signal that does the job. Therefore, the customer account and payments systems of central banks are digital operations today. 

The only distinguishing feature of these digital operations is that the balances in those accounts are convertible to physical currencies issued by central banks on a one for one basis. For instance, if a commercial bank wants to withdraw Rs. 100 from its account, it can get a Rs. 100 note from the Central Bank. Similarly, when it deposits a Rs. 100 note with the Central Bank, its account is credited by Rs. 100. 

Therefore, digital money is not a novelty for a central bank. 

Aseni: But when they issue these e-fiat currencies, is it the same as those digital operations or different from them?

Sarath: So far, there is no common platform agreed by central banks about this. It was the Bank of England that issued a working paper first on this issue in 2018. Anyone interested in knowing of details can download it from the link (https://www.bankofengland.co.uk/-/media/boe/files/working-paper/2018/central-bank-digital-currencies-design-principles-and-balance-sheet-implications.pdf?la=en&hash=11469281B32821BCFD85B4A5483AB3577E38B2DD). 

Since then, there have been several studies done by the Bank on the subject, but there is no finality in its approach to issuing an e-Pound Sterling. They expect to go live some time in 2024 because it is necessary to conduct wide consultations with all the stakeholders concerned and incorporate their views and concerns in the plan. These stakeholders are banks, financial institutions, government agencies, foreign governments that use the Pound Sterling as a reserve asset, and members of the public. England is still weighing the options available. A country like Britain cannot do it in isolation and as a shoddy job. 

Aseni: Is there any change in the approach of the Bank of England to e-fiat currencies since then?

Sarath: Yes, that is because the technology governing cryptocurrencies too has changed substantially during this short period. But the technology does not remain static. Therefore, when it goes live in 2024, it will face the same issue of being behind time. As a result, when the system is designed, it is necessary to go for a system that will be compatible with technology to be developed in the future too. 

One of the main concerns at that time was when CBDCs are issued, whether it would cause a ‘large scale run’ on the deposits held by banks. Since the usefulness or utility of CBDCs is high and its use cost is low, naturally people may prefer them to traditional bank deposits. If they choose to convert all their bank deposits into CBDCs, banks will find it difficult to remain stable due to liquidity shortage and lack of funds for lending. It is a serious issue for a central bank. 

In a discussion paper issued in 2020, the Bank of England has further probed into these issues. You can access this paper at: https://www.bankofengland.co.uk/paper/2020/central-bank-digital-currency-opportunities-challenges-and-design-discussion-paper. In this paper, the Bank says that the e-Pound should not be a replacement of the physical Pound it is issuing now but a supplement. Therefore, the Bank of England will issue both types of currencies. 

The public has the option of using the more convenient currency for payment purposes. The current e-Naira and e-Yuan are also issued by Nigeria and China, respectively, on the same basis. The reason for going for e-Pound is the gradual decline in the UK in the use of physical currencies for payments purposes. For instance, in 2006, about 63% of all payments in the UK had been done by using physical Pound notes. But this ratio had fallen to 28% by 2018. 

It is the debit card, a form of electronic money, that has taken its place. Its use has increased from 11% to 39% during this period. However, the use of cheques which had accounted for about 5% in 2006 has fallen to near zero level by 2018. Meanwhile, the use of credit cards had remained stagnant during this period. Hence, physical currencies have a problem, and that problem must be resolved by offering a more convenient mode of payments to people.

Sri Lanka cannot be aloof to what is happening outside. It is something which our Central Bank should look at as a matter of priority

Aseni: What it means is that central banks are fast becoming irrelevant as producers of the main form of payments. I therefore think that they want to show that they are still the boss by going for an e-fiat currency. Is it the only reason for going for an e-Pound by the Bank of England?

Sarath: When you say that they are fast becoming irrelevant in the field of payments, you are correct. But remaining relevant is not the only reason for going for an e-Pound. Several other objectives have been highlighted by the discussion paper mentioned above. 

Aseni: What are these other objectives?

Sarath: One is the need for being a catalyst in the development of a payment system which can withstand any unexpected shock and continue to serve the people after that disruption. We call this ability ‘resilience’ of the payment system. Then, there is the need for protecting the public from the potential risk of private parties issuing currencies. This comes within what we earlier discussed as ‘consumer protection’. A third objective is the need for giving a supporting hand to the ongoing innovations in the payment systems by promoting competition and through competition, the efficiency of the system. The fourth one relates to the need for meeting the future payment needs of a digital economy. What this means is that when the whole economic system has gone digital, you cannot have a non-digital payment mode. By issuing an e-Pound, the Bank of England wants to be the leading partner. It will also help the Bank to make available the means of payment in adequate amounts especially at a time when the use of currency has been declining. Such a digital currency is also useful for making foreign payments conveniently and at low costs. With one stone, the Bank of England wants to kill all these birds. 

Above all these objectives remain the most pressing one, namely, keeping the profits to be earned by issuing currency called seigniorage to themselves. With private cryptos, that is being shared with others. Central banks or sovereign governments do not want to lose this monopoly power.

Aseni: So, it is a centralised financing or CeFi. But how does it operate? In the same way as the physical currencies?

Sarath: No. There is a difference. In the case of physical currencies, the method of distribution and use is straightforward. The central bank prints currency notes and mints coins, keeps them securely in their vaults, and releases them to commercial banks for issue to their customers. Once they get into customers’ hand, they change from hand to hand until they become worn out and need be replaced. At that point, the central bank calls them back and destroys them. To take their place, new currency notes are issued. Hence, the central banks are eternally involved in printing currency notes and minting coins entailing a huge cost on them. 

But CBDCs are electronic signals and do not become unserviceable. Hence, there is no question of destroying and replacing them. Once issued, it will remain within the financial system forever. But the distribution and end-use of CBDCs by people are somewhat different. 

As proposed in the discussion paper which I have mentioned above, the central bank will have a main ledger to record the creation of e-Pounds and this ledger is distinguished from the other ledgers of the bank by designating it as a core ledger. E-Pounds are then distributed to Application Programming Interface or API suppliers. They are all regulated entities by the bank. Then, people are connected to these APIs through payment interface providers like the mobile phones, computer-based internet users and electronic card providers. 

Previously, it was thought that in the core ledger of the central bank, private individuals will maintain accounts and all payments into and out of those accounts will be made through electronic authorisations. API suppliers did not come into the picture at all. When a member of public goes to a shop, he accesses his account in the central bank through a mobile device like a smartphone, establishes his identity, and effects the payment. His account is debited, and the account of the shop is credited. 

This is a cumbersome procedure which requires the central bank to have a massive digital infrastructure for smooth operation. Hence, without charging, it is difficult for a central bank to run such a universal payment system. This goes against the first principle of central banking which says that central bankers should not be sellers of products in the market.

But the good side is that the recent developments have made the job of central banks as issuers of digital currencies easier. 

Aseni: What are those recent developments?

Sarath: With the springing-up of crypto exchanges, there is now an e-wallet to store and facilitate payments back and forth. Everybody who wants to trade in cryptocurrencies should have this e-wallet first. The Central Bank of Nigeria which has introduced the e-Naira has also introduced this e-wallet to operate the system. This e-wallet is presently maintained by the central bank. But in future when CBDCs are issued, API suppliers can be tasked to operate the e-wallet on behalf of the central bank concerned. 

But these API suppliers should be strictly regulated by the central bank as it does in the case of financial institutions which it regulates. They should have adequate capital, liquidity, and regular audit programs to remain in business as viable institutions. These API suppliers can be banks, other financial institutions, and non-financial technology companies. It is a fine combination of FinTech – financial institutions using technology – and TechFin – technology companies operating financial services.

Aseni: In neighbouring India, there is a plan to ban the use of cryptocurrencies except a few leading ones because of the superiority of the technology used and facilitate the issue of a fiat digital currency. A bill has already been presented for enactment in this Winter season of Lok Sabha. Does this mean that Sri Lanka should also follow this Indian plan?

Sarath: Yes, Sri Lanka cannot be aloof to what is happening outside. It is something which our Central Bank should look at as a matter of priority.

To be continued.

With the springing-up of crypto exchanges, there is now an e-wallet to store and facilitate payments back and forth. Everybody who wants to trade in cryptocurrencies should have this e-wallet first. The Central Bank of Nigeria which has introduced the e-Naira has also introduced this e-wallet to operate the system. This e-wallet is presently maintained by the central bank. But in future when CBDCs are issued, API suppliers can be tasked to operate the e-wallet on behalf of the central bank concerned

(The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected].)