Claude Brown of law firm Reed Smith looks at how the combined pressures from social media, central banks and sanctions are driving hitherto unenthusiastic banks towards devising or adopting digital currencies.

On the face of it, social media companies, central bank reserves and sanctions would appear to be odd bedfellows; looking at the Libra Association backing Facebook’s proposed new digital currency, the absence of banks is notable. Yet several commercial banks, including JPMorgan, have announced plans for their own digital coins, notwithstanding a declared scepticism about Bitcoin. 

In 2019, a dozen banks and assorted financial institutions injected $50m into Fnality International, with a brief for it to develop a network of distributed financial market infrastructures to support the Utility Settlement Coin (USC), an institutional streamlined payment medium.

At first sight, a bank’s own digital coin using a private distributed ledger has clear advantages for both the bank and its customers. Payments would settle faster, transaction costs would be reduced, intermediaries would be squeezed out and customers would be immune from currency fluctuations (provided they remained within the bank’s own digital coin environment). The bank could benefit from reduced processing costs and simplified accounting and regulatory reporting. For a consortium there is the additional benefit of wider interoperability and acceptance. 

Freeing dead pools

No one wants to invent the crypto equivalent of Betamax, however, and for both individual banks and consortiums, there is a bigger prize. At the moment, commercial banks are required to deposit a proportion of their reserves with central banks. Each central bank wants to ensure the banks it regulates have something put away for a financial crisis; for international banks, this means maintaining deposits with many central banks. Not only do these deposits produce little return, they are ‘dead’ pools of money that the banks cannot deploy for profit. 

However, with a distributed ledger-based digital currency, a bank could say to its central banks: “At any given moment, we know where our reserves are across the world. What is more, we can move those reserves instantaneously to any national banking system where they are needed. If you don’t trust us, the distributed ledger will not only keep us honest but also you will all be part of the distributed ledger so you see what is going on with our reserves. In exchange, can you please give us our central bank deposits back?” While a consortium approach, such as the USC, is more likely to find favour, the competitive advantage for an individual bank would be significant. 

The logical response would be for central banks to come up with a universal digital coin of their own. However, this would be less attractive for  commercial banks as they would not be able to use this central bank digital coin (CBDC) for their commercial activities. Also, central banks have shown little desire to develop a common CBDC. Until Facebook announced its plans for Libra, central bank orthodoxy was that cryptocurrencies were too small to worry about.

Their reaction to Libra has been different. They have warned that it needs to comply with banking regulation. At the same time, they have rushed to develop their own versions of stablecoins. Yet having as many CBDCs as there are fiat currencies would seem to be a missed opportunity for the global financial system. 

Dollar dominance

Since the collapse of Bretton Woods, the US dollar has been the world’s reserve currency, which has resulted in central banks stockpiling dollars. As Bank of England governor Mark Carney mooted in his speech to the Economic Policy Symposium in August, a new digital currency – a “synthetic hegemonic currency”, backed by a coalition of central banks – could depose the US dollar. Sanctions may prove to be the catalyst for that change. 

The differing views of the US and the EU over the application of sanctions against Iran has reinvigorated the EU’s 1996 blocking statute, which seeks to protect EU persons from the effects of extra-territorial sanctions imposed by non-EU countries. Given the choice of complying with US sanctions or the blocking regulation, EU companies are faced with the reality that the US sanctions have daily implications for as long as the US dollar retains its hegemony and clears through US-based banks. 

A synthetic hegemonic currency, operating on a pan-central bank distributed ledger, could change all that, reduce US dollar dominance and provide a counter to the global aspirations of Facebook and the commercial banks.

Claude Brown is a partner at law firm Reed Smith.


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