A Composite Digital Currency Is a Non-Starter
The prospect of digital money replacing cash, checks, and credit cards around the world is both tantalizing and scary to many experts and policymakers. Law enforcement authorities worry about money laundering. Monetary policymakers worry about losing control of the tools to steer their economies. Some would be concerned, and some would applaud, if a digital alternative overthrew the dollar as the world’s dominant currency. For these reasons, Facebook’s Libra project to create a global cryptocurrency is embraced by some but also faces challenges from regulators and possible boycotts by potential partners.
At least some of these concerns seem overblown, however. A nondollar cryptocurrency, for all the hype, is unlikely to replace the dollar in its central role in the international financial system.
Of course, the union of finance and technology, or fintech, is hardly new as a phenomenon. The invention of the pantelegraph, a device used to verify signatures in telegraph cables, transformed transactions in the middle of the 19th century. A decade ago, the cryptocurrency bitcoin made its debut. Today, the financial innovation fixation is digital money, which may be issued by the private sector, like bitcoin or ethereum, or potentially by the public sector as a central bank digital currency (CBDC). A digital currency’s redemption value may be fixed, for example, in US dollars, or market-determined, again like the well-known bitcoin. It might be backed by a basket of currencies, such as proposed by Facebook in its private-sector initiative, or the synthetic hegemonic currency (SHC), sponsored by governments, as proposed by Mark Carney, governor of the Bank of England. He favors the SHC approach because he sees it reducing the dominant international financial role of the US dollar and the influence of the Federal Reserve on the monetary policies of other countries.
A single-unit digital currency issued by a major central bank with a fixed nominal redemption value in its unit of account may have a future. It should reduce transaction costs for users, who would be more likely to trust it compared with a private-sector alternative. Its introduction could build on existing official payment infrastructures. A composite digital currency, such as the SHC, would not have these advantages.
A Composite Digital Currency Would Be Inferior to a Single-Unit Digital Currency
A CBDC issued by a single central bank would be superior to a digital currency combining several currencies, such as the SHC, in all three traditional dimensions of money: unit of account, store of value, and means of payment. Unless the SHC becomes the dominant vehicle for international transactions, the relevant markets would be smaller and, therefore, less liquid and more expensive in which to transact. Moreover, at least two markets would be involved in any actual or contemplated transaction, cumulating expenses.
As a unit of account, the SHC would be unstable relative to a national currency, which is inconsistent with the principal anchoring role of a unit of account in financial systems. Users would have to translate the value of a unit of SHC into units of their home or base currency.
As a store of value, assets denominated in the SHC would fluctuate relative to the preferred numeraire of the investor or issuer, perhaps less than assets denominated in the currency of another individual country but involving exchange rate risks that would be expensive to hedge unless the SHC became the dominant international currency.
As a means of payment, the SHC would involve double-sided risks and costs for users. They would have to convert transactions from their home currencies into the SHC and then into another national currency and vice versa.
Tobias Adrian and Tommaso Mancini Griffoli; Markus Brunnermeier, Harold James, and Jean-Pierre Landau; and Barry Eichengreen are more positive about the stablecoin model of a digital currency that is designed to hold a relatively stable value, for example, a digital currency linked to the US dollar. However, these authors point to potential risks associated with this model: disintermediation of banks, private monopolization of issuance, fostering of illicit activities, concerns about consumer protection and privacy, financial instability, loss of seigniorage, and threats to weaker currencies. These risks lead them to favor a CBDC type of stablecoin.
If a major central bank began to issue digital currency, it is likely to gain an increase in net profit, or seigniorage. For the central bank, the cost of producing its currency would go down and demand for it would rise. Costs would decline relative to printing paper currency or managing electronic transactions, in particular if the system now services individuals. Lower production costs for the services provided by the currency would lead to a lower price for those services paid by the consumer. In the US case, the demand for the US dollar for use in legal transactions would rise, and seigniorage earned by the Federal Reserve would increase. This competitive advantage would be the counterpart to the threat of stablecoins to the use of weaker currencies. Seigniorage associated with illicit transactions might decline if the CBDC is better protected from such use and as demand for dollars in paper currency form declines because use of paper currency declines or is discontinued. On balance, the US dollar would likely increase its dominance in legitimate international finance.
Carney and others, such as Joseph Gagnon and Gonzalo Huertas, hold positive views of the prospects for SHCs. But their analyses discount the role of demand, which is necessary for the success of a digital currency. Demand, in turn, is a function of the price of the product.
Comparison with the IMF’s Special Drawing Right
For more than four decades, the International Monetary Fund has issued an official international asset, the special drawing right (SDR), whose value is based on a basket of five currencies (US dollar, euro, Japanese yen, pound sterling, and renminbi). The SDR has not developed into the principal reserve asset in the international monetary system as called for in Article VIII, section 7 of the Fund’s charter. The SDR is not a currency nor is it widely used to denominate private assets and liabilities. It faces many hurdles before it could gain widespread acceptance even in that limited role. The most recent (2018) comprehensive study of the potential role for the SDR in the international monetary system concluded: “The M-SDR [an SDR-denominated financial instrument] would have to overcome market infrastructure, settlement, and revision risk challenges.” Because the demand would not be spontaneous, the official sector would have to provide incentives or inducements for private users of instruments denominated in SDR. The M-SDR also would be disadvantaged, as would any SHC, because its currency composition would not match the portfolio preferences of potential issuers or investors in the private or public sector, requiring hedging to match those preferences.
An SHC is likely to experience a similar lack of demand unless its initial use is heavily subsidized by the issuers of the major currencies. That is unlikely. The Chinese authorities have already expressed their opposition to the Libra, reportedly because they want to protect Chinese leadership in fintech.
This skeptical view of prospects for an SHC should be qualified in two respects. First, as advocated by Claudia Biancotti and Riccardo Cristadoro, central banks and regulators must be proactive in promoting CBDCs. The private-sector alternatives would unleash a 21st century version of the wildcat free banking of the 19th century described by Eichengreen. Second, if US authorities excessively weaponize the US dollar to enforce controversial foreign policies, such as sanctions on Iran, China, or Turkey, other countries may decide to subsidize the establishment of a digital alternative. However, that official alternative is more likely to be linked to a single national currency than to a basket of currencies, even, and maybe especially, if it were to exclude the US dollar.