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The Good, the Bad and the Ugly of Central Bank Digital Coins (CBDCs)

Paul Schulte | Schulte Research | Dec 21, 2020

CBDCs Good Bad and Ugly - The Good, the Bad and the Ugly of Central Bank Digital Coins (CBDCs)

The good: inclusion, provenance and bank cleanup  

It is becoming clear to anyone with a window in their office that blockchain is now (finally!) emerging as a viable and pivotal technology. It was a long time coming and, as with all new technologies, the actual use case is far different from anything envisaged during its inception. The main drivers in the development of distributed ledger technology are central banks. And they do, in fact, see great benefits to Blockchain technology.

See:  Should the U.S. Government Create a Token-Based Digital Dollar?

These benefits include...

  • Independent identification and verification. The establishment of an identity confers ownership. Shockingly still, more than 1 billion people in the world do not have a conferred legal identity and about 2 billion have no financial history.
  • This creates provenance for everything: ideas, people’s bodies, property, data, relationships, and so much more we cannot conceptualize now.
  • The provenance constructs a whole new understanding of collateral and establishes the capacity to borrow against assets which, heretofore, were an uncounted part of human experience. This includes millions of hectares of agricultural land, millions of homes, and 2 billion people who are not in the banking system.
  • Blockchain, thus, guarantees mass inclusion — once provenance is established, everyone’s land, ideas, and homes become protected assets that can be borrowed against.
  • Finally, once newly empowered and financially integrated people start businesses, blockchain technology offers them smart and cheap contracts; expensive and business-killing middlemen are eliminated.
  • Whole new types of financial opportunities emerge and a new class of entrepreneurs is born, creating prosperity for millions of families and their communities.

There is another more subtle and complex — yet utterly simple — dynamic at play here. I have heard it from too many separate and independent corners of the investment community for it to be hearsay. The banks in the US, Europe, Middle East, and China are a mess. They need to be cleaned up after a 20-year Supercycle of mad lending. What if there is a plan afoot to roll out a new form of M1 in the form of digital coins from The Central Bank directly to the e-wallets of accredited entities or directly to people’s accounts so as to bypass banks altogether?  What purpose does this serve? It redirects the deposit liabilities of banks directly into people’s accounts in order to give those same banks time to deal with their bad debt.

In effect, digital coins will act as a “ring-fence,” turning banks into a large scale “asset management company” to clean up balance sheets. Incidentally, don’t expect the banks to sit by idly as they will want a piece of the “central bank crypto action.”

See:  Better to get it right than to be first with CBDC, says US Fed chair

In the meantime, the economy can function with digital money distributed directly to citizens.  Digital coins, in effect, become a substitute bank credit. Easing the pressure on bad debt and ensuring that bad banks can’t paralyze national economies. Ideally, it is done slow enough so as not to put too much pressure on asset prices.  We need to pay attention to how central bank coins (let’s call it  M1-b money) replace paper money and what financial applications (the new rails) are used to distribute M1-b directly to consumers. I contend that the chatter distinguishing wholesale and retail distribution will become irrelevant as the global banking system morphs from a fractional reserve system run by banks to a full reserve system run by a group of tech companies who manage the ‘electronic rails’ and ‘train stations’ by which the money flows from the government to the citizen.

 

The Bad: conflicts of interest and political blocs  

Now we get to the bad stuff. What I see playing out before my eyes is a general rebellion against the dollar. There is a growing global perception that the US hegemony has morphed from an enlightened Pax Americana to a hypocritical bully-ana; DC has been weaponizing sanctions (or outright invasion) “willy nilly” to punish countries who dare to question the dollar’s supremacy. I attended a European Central Bank Zoom conference last week and was alarmed to hear that CBDC now carries intellectual baggage of regionalism and “currency bloc” thinking. There is certainly a sense of FOMO (fear of missing out) as the Eurozone confronts its lack of an alternative to Libra and BSN. That’s fair. But the optimistic tenor of the discussion belies a confused attempt to create a CDBC Frankenstein’s monster to satisfy 18-19 countries (is it “Euro-first” or “Euro, first”). I heard a “don’t call us — we’ll call you” attitude when it comes to the creation.

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At the same time, I was alarmed to hear about BUNA, the newest FOMO iteration of a CBDC in the Gulf States.  When pressed by interlocutors about why the Gulf States needed their own CBDC, the argument boiled down to sanctions. I am getting the sense that the CBDC’s elephant in the room is that each national bloc wants to be able to impose its OWN sanctions on its OWN perceived adversaries.  They do not want someone else to impose sanctions on them, ie Uncle Sam.  So, we have a world which is morphing into four blocks: Libra in the US; a many-headed-hydra in Euroland; BUNA in the Gulf countries; and BSN in Asia. Incidentally, there was a massive pushback to Libra among the European central bank folks. A representative from the Deutsche Bundesbank was especially unflattering about Libra: “We might give it a look sometime in 2025.” OUCH!

Second, the “bad” part of CBDC is the practical realization that central banks are, by nature, very conservative organizations. The joke goes that if you need a heart transplant, get one from a central banker because it has never been used. The slowness and institutional absence of imagination, technological or otherwise, means that a private sector partner is vital. Public-private partnerships are crucial to kickstart the process. Someone has to build the new digital rails! In the US, it seems that Libra has been tapped on the shoulder. In China, it is Red Date.

The Eurozone has the European Payments Initiative which will use the existing technology of 14 banks in 5 countries to build a private rail system (what could possibly go wrong?). For better or worse, the private sector is vital to work alongside central banks in order to create a speedy, flexible, and interoperable system of payments. So far, Red Date is further ahead than anyone. While Libra can rapidly create a system, there is still massive resistance to Facebook operating inside other countries as an “honest broker.” A company like Master Card might be a better candidate, but it seems that the political Rubicon has been crossed and Libra has been tapped.

See:  China’s digital currency app looks like Alipay and WeChat Pay

Lastly, there was a terrific presentation by a very senior member of the Banque de France on the politics of a digital coin. There is now yet another elephant in the living room (it seems that a herd of elephants is squeezing CBDC from all sides).  He was very clear about the priorities of central banks when it comes to new initiatives of any kind. ‘What is the order of priorities?”, he asked? “First is politics. Second is policy. Third is regulation. And fourth is the functional solution.” I think this explains why the evolution of agreed-upon terminology is so problematic. It explains why the functionality of the CBDC’s “rails and train stations” is too elusive.

The reality is that politics and national policy are far more important than the creation of clever solutions to glaring problems.  I have learned that money and power are always at the heart of fixing national problems. Find out whose money and whose power is working the levers behind the scenes and you will find the solution. The regulators will also slavishly follow this trend. For instance, all of Libra’s senior leadership will be in Washington DC. It will likely be located in Lafayette Square across from the White House. The new spokesperson has been hired from the FDIC. The new CEO came from HSBC and has a history as an undersecretary in the US Government.

Follow these breadcrumbs. It’s a matter of form over function. Investing with an eye toward finding companies with the best solutions rather than companies with the best political instincts or connections might lead one to pick the wrong horse.   This is why people may be grossly underestimating Libra.

 

The Ugly: Each CBDC bloc wants to decide who is a terrorist & who is a money launderer.

Now we get back to the point I made earlier about The Euro Central bank conference last week (Incidentally, not a single Asian central banker was invited, even though it had delegates from Canada, Mexico, Libra, Bahamas, Sweden, Finland, and Middle East. I have to add that the smartest guy in the room was, I thought, Tim Lane from the Bank of Canada). There was frequent discussion of the need to regain control over a sovereign state’s ability to impose sanctions.  Countries no longer want to play the game of guessing who will be the new best friend or enemy of the United States. And they certainly do not want to find themselves on the sanctions list.

See:  Fintech experts divided on form for U.S. central digital currency

If a country does land in the sanctions swamp, it is essentially barred from SWIFT and cannot transact in dollars. SWIFT is NOT a ‘society’ in Belgium. It is controlled by Politicians in DC and is executed through 5 banks in New York. The world has become increasingly wary of this arrangement and is seeking an alternative. Representatives from BUNA, ECB, and BSN have all made this same point loud and clear.

Second, countries also want to decide who is a terrorist and who is a patriot. It is easy to forget that the 56 “terrorists” who signed the Declaration of Independence in 1776 were ordered to be hanged by Great Britain. By 1781, they were hailed as patriots who created a new country.  (The US was not a country until 1789 — it took 13 years to get from rebellion to nationhood!). They say that the difference between a patriot and a traitor is a matter of timing.

Here we see the problem with dollar sanctions. At any time given time, the US gets to decide who is a terrorist and who is a patriot. Many countries are still very young and are in the painful and tawdry process of nation-building and establishing a national consensus. There is growing resentment about the US’ ability to take a snapshot of history and decide when nation-building must cease and restart again. The US’ gross history of international abuse ought not to be forgotten either. The 20th century is filled with the US overthrowing rightfully elected Democrats and replacing them with tyrants: Pinochet in Chile, the Shah in Iran, Arbenz in Guatemala, and so many more.

Third, countries want to have the freedom to decide who is a money launderer and who is a tax evader. This sounds absurd. Hear me out. Much of the clandestine activity of intel agencies are very often carried out with laundered money. Countries deem the activities of their intel agencies as essential to survival. If these activities are caught in a trap of “laundering,” the funds can be frozen by the US. Furthermore, some countries reserve the right for political or national security reasons to let some elites off the hook when it comes to tax evasion, money laundering, or hidden financial identities. Why should politicians in DC get to decide matters of sensitive national security of other nations in a simplistic “good versus evil” view of the world, especially when recent history has shown these judgment calls to be smeared with hypocrisy?

See:  Top US Banking Regulator Reveals Positive Cryptocurrency Regulation Coming in Weeks

So, the CBDC debate rages on. Let’s not think that it is solely about functionality or the issues being addressed. Power, money, and nation-building are first and foremost. Regulation comes a distant second.  And problems being solved are, unfortunately, last. The reason why the debate over CBDC has the hallmarks of the fog-of-war is because, as always, we’re having the discussion upside down: the solutions come last, politics come first. Welcome to the world of financial realpolitik.  It’s form over function — political form trumps practical function as these new digital rails are being built.

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