There is a stimulating article released by the IMF staff on current state of digital and paper money which identifies conceptual features of all payment types and based on that categorizes them into 5 types. From the paper, I took away three main insights -first that traditional forms of payment transactions by banks (referred to as B-Money and comprising deposits, cheques, wires and debit cards) will face intense competition from electronic money (or E-Money) in coming years; this will obviously hurt the profitability of the banks given that banks rely heavily on deposits for their funding and to large extent their profits. Second insight is that in order to compete with digital money, banks will be eventually forced to offer electronic money or similar products and we can see this happening already with JP Morgan offering JPM Coin by end of 2019. Third insight is that the role of the central banks will be pivotal as they have two roles to play – one of referee and other of player i.e. they could jump in and offer central bank digital currency (being explored by Sweden, Uruguay, China, Thailand, Japan and South Korea) and they will play a prominent role in shaping the environment and the pace of innovation for digital money.
Type of Payments and Money
The article is thought-provoking and you can get a sense of the insights through the excellent visualization copied below (courtesy IMF Staff) which helps to make sense of the plethora of digital currencies ranging from stable coins, managed coins and all kinds of cryptocurrencies and even Libra.The picture shows the 4 inherent attributes of all payment transactions on the Y-axis on left-hand side – Type (Claim-based or Object-based); Value (Fixed value vs Variable Value); Backstop (guaranteed by Government or Private Agency) and Technology (Centralized vs De-centralized). Based on these 4 attributes all current and future payment transactions are grouped into 5 types shown on the X-axis and listed below.
(1) Central Bank Currency (right now just Cash and in future could be Central Bank Digital Currency)
(2) Cryptocurrency (Bitcoin, Ethereum and Managed Coins)
(3) B-Money or money created by bank instruments (Debit Card, Cheque and Wires)
(4) E-Money or Electronic Money offered by private sector (Alipay, WeChat Pay, M-Pesa and USD-Coin, TrueUSD)
(5) I-Money or Investment Money issued by private funds/companies (Gold-coins, Libra)
Some important take-aways that struck a light bulb in my head after seeing this and reading the article;
- E-Money (Electronic or Digital Money payments) has all of the features of B-Money (Bank money transactions) except it is not backstopped by the Government. Backstopping by the Government is allowed for B-Money since banks are closely regulated by the Government and if the regulation is effectively executed then the banks cannot take excessive risk and have liquidity to support these transactions.
- E-Money could be centralized as in case of Alipay or could be de-centralized as in case of USD-Coin. Blockchain based forms of electronic money such as those offered by Gemini and Coinbase also fall in this category as they share all characteristics of E-Money. The paper draws the analogy of floating rate exchange for centralized E-Money like Alipay and pegged currency exchange for managed E-Money like TrueUSD and gives a warning that just like central banks of pegged currencies can run out of assets to support the value of the currency so can issuers of the stable and managed coins.
- I-Money is different from E-Money since the value of the redemption or claim is not fixed and can vary based on the value of the assets backing up the I-Money (e.g. Libra reserves).
- I-Money is also different from cryptocurrency since they represent a claim and do not offer instant payment using an ‘object’ like Bitcoin. Also, since I-Money represents a claim it could be viewed as a security and could be subject to regulatory scrutiny as we are witnessing happening for Libra.
Insight # 1 – Growth of E-Money
The paper puts forward six reasons which will lead to rapid adoption of E-Money and the three that I found most compelling are Convenience; Costs and Network Effects. In these factors, the Big Tech companies have an inherent advantage over banks as noted in a previous post since they have figured out the most effective way to design products that are uncomplicated; have the infrastructure to harness the network effects and can compress the per unit transaction costs to be minimal or free. The effect of these factors is already seen in countries like China and Kenya where use of electronic money is now more ubiquitous than that of bank transactions. All of us are aware through our daily interactions of the convenience and ease of electronic payments (think Venmo or Zelle) which happens immediately compared to eons for bank to bank transactions and the added advantage is that these happen at a fraction of the cost or even free. The Network effect is particularly compelling since as more of your friends, colleagues and service providers (plumber, electrician)/vendors start using one of these forms of money there will be more reasons for you to start using it yourself.
Insight # 2 – Impact on Banks and Consequences
So, if E-Money takes off then what will happen to the Banking Industry? Like the Good, The Bad and the Ugly there are 3 likely scenarios hypothesized by the paper and all of them result in disruption to current status quo for Banks. But to be fair, there are extensive regulatory and legal issues to be addressed before that to ensure the safety and stability of the monetary system as well as to provide for customer protection, safety, data privacy, AML controls.
(1) Coexistence of Digital Money and B-Money – this is the most likely scenario but will still not be optimal for banks as they will lose some deposits to E-Money and also lose client facing transactions and data. Banks would have to compete for deposits and customer interaction/data by creating more value or offering similar products.
(2) Complementary existence – this is the middle road where E-Money providers (and cryptocurrencies and I-Money if it takes off) complement traditional banks by going after the unbanked products or population as is happening in some emerging market countries (Kenya with M-Pesa) or partner with banks in developed countries. This scenario is the least impactful to the banks.
(3) Takeover of E-Money – this scenario envisions a revolutionary re-make of the banking industry whereby banks are marginalized and reduced to using wholesale funding and majority of the deposits are captured by E-Money and other Digital Money providers. This scenario is most impactful to the Banks and will be death toll.
In my view, these scenarios are not mutually exclusive and we could have all three happening in varying degrees in different areas of financial sector/products.
Insight # 3 – Role of Central Banks
A challenging but not entirely unforeseeable scenario posed by the authors is where central banks allow E-Money providers to hold reserves at central banks such that central banks can use those reserves to facilitate settlements between E-Money providers similar to how they do now for banks. This will of course give a tremendous boost to the E-Money providers since it will offer stability and interoperability for payment settlements and will additionally add safety to monetary system but will come at the cost of oversight and scrutiny of them by the regulators and governments. The second role of the central banks in future could be to offer a central bank digital currency (CDBC) which can be done in partnership with E-Money providers or by the central bank itself. This will of course will be transformative and shake up the entire ecosystem but again is not outside the realm of possibility.
This scenarios are going to play out in the coming years and we will be in for an exciting ride and so stay tuned.