The International Monetary Fund (IMF) in July 2019 published ‘Fintech Notes – The Rise of Digital Money’, with credits to Tobias Adrian and Tommaso Mancini-Griffoli. The publication attempts to offer a conceptual framework to categorise new digital monies, identify some of their risks, think through the implications, and offer some policy options for central banks to consider. This script, for its informative purpose, largely identifies itself with the 20-page report and the highpoints therein.
New Digital-Money Categories
Central bank money in the form of cash (the traditional notes and coins) is the most recognisable. Cash is an object-based means of payment. It is denominated in the local unit of account, issued by the central bank, settled in a decentralised fashion among transacting parties, and obviously has a physical appearance.
The other object-based means of payment that has been categorised in the report is crypto-currency. It is denominated in its own unit of account, it is created (or ‘minted’) by non-banks, and issued on a block-chain – commonly of the permissionless type.
The report also says: “The most widespread use of claim-based money is b-money, which typically covers commercial bank deposits. In many countries, most payments entail the transfer of funds from one bank account to another; often from one bank to another, and possibly across borders. We associate b-money with debt-like instruments denominated in a unit of account, redeemable upon demand at face value. Transfers are most commonly carried out through centralised technologies, as in the case of debit cards, wire transfers, and cheques”.
Fourth, it states: “E-money is emerging as a prominent new player in the payments landscape. Its single-most important innovation relative to crypto-currencies is to issue claims that can be redeemed in currency at face value upon demand. It is a debt-like instrument and redemption guarantees are not backstopped by governments. They merely rest on prudent management and legal protection of assets available for redemption. Transfers can be centralised, as in the case of many of the popular payment solutions in Asia and Africa – including Alipay and WeChat Pay in China, Paytm in India, and M-Pesa in East Africa (also called ‘stored value facilities’).
Fifth, it reveals that “I-money is a potential new means of payment, though one which may or may not take off. I-money is equivalent to e-money, except for a very important feature — it offers variable value redemptions into currency; it is thus an equity-like instrument. I-money entails a claim on assets, typically a commodity such as gold or shares of a portfolio. Examples of gold-backed i-money are Digital Swiss Gold (DSG) and Novem”.
Adoption of e-money could be rapid
Regarding the adoption e-money, the report in part states:” If a means of payment—either claim or object—has stable value in the unit of account most relevant to users, it is much more likely to be widely adopted. For one, parties will agree to hold it at least for the time it takes to complete the transaction. In addition, they will more easily agree on its value relative to the contracted transaction price, usually expressed in a common unit of account. Stable value is thus a necessary condition for an object or claim to be widely used as a means of payment”.
Effects of E-money on the Banking Sector
In the highlights: “If e-monies took off because of their attractiveness as means of payment, backed by large big-tech firms with large existing user bases — or nimble fintech start-ups — will that spell the demise of b-money and the banks behind them? Will retail bank deposits migrate to e-money providers in large amounts?” The report identifies these three (3) scenarios:
E-money and b-money will coexist – but associated with what the report describes as the “battle”, wherein banks are often in a position of strength. “They have captive users—though potentially much smaller user bases than large big-tech firms — and strong distribution networks. They can cross-sell other financial services to customers, including means to overcome cash-in-advance constraints by offering overdraft protection or credit lines.
“Moreover, e-money providers might recycle many of their client funds back to banks, as certificates of deposit or other forms of short-term funding. Clearly, from the banks’ standpoint, the outcome is not optimal. First, they would swap cheap and stable retail funding for expensive and runnable wholesale funding. Second, they could be cut off from client relationships, and third, they could lose access to valuable data on customer transactions.
“In addition, funding from e-money providers might be concentrated in a few large banks (though it would eventually trickle down to other banks). So, smaller banks might feel greater funding strains or, at least, experience greater volatility in funding.”
It further states: “Banks have leeway to raise interest on deposits. Since banks make profits from maturity transformation (holding assets of longer-term than deposit liabilities), they may be able to offer higher interest than e-money providers, even than conservative i-money providers (note, Libra has announced that it will not offer any interest to users). E-money providers must hold very liquid assets, and thus could offer approximately overnight money market rates. Higher rates on deposits could be met with greater operational efficiency, lower profits, and potentially slightly higher lending rates”.
Andolfatto (2018) argues that if banks start from a position of market power, there is leeway to increase rates on deposits without significant macroeconomic consequences. Drechsler, Savov, and Schnabl (2018) point to banks’ market power as a prime explanation for the low and stable rates they tend to pay on deposits across countries. However, banks must cover distinct costs such as deposit insurance fees, regulatory costs, and branch networks.
“Banks could also rival the quality of payment services in e-money, at least domestically, though not necessarily across borders. In fact, b-money has grown increasingly convenient thanks to payment innovations such as touchless cards and phone-based apps that facilitate payments by debit cards—such as Venmo, Zelle, or Apple Pay Cash in the United States.”
Again, the insightful report identifies the fact that “more fundamental change is also possible through “fast payment’ systems rolled out by central banks in many countries (as TIPS—TARGET instant payment settlement—in the euro area), allowing banks to settle retail transactions in near real-time at negligible cost. A related example, though developed by a consortium of banks, is Swish in Sweden. Even JPM Coin is a prominent example of how banks are fighting back by entering the e-money space.
But will banks adapt fast enough? Can they live and breathe online customer satisfaction, user-centred design, and integration with social media the way big-techs do? Are they sufficiently agile to change business models? Some will no doubt be left behind. Others will evolve, but must do so quickly”.
It continues: “In the transition, central banks can help. They can provide temporary liquidity if banks lose deposits rapidly. But central banks will be reluctant to offer this crutch for too long, as their balance sheets might grow and they could become embroiled in difficult lending decisions. Short of this, banks can also find alternative forms of funding by issuing longer-term debt or equity”.
In the second scenario, “e-money providers could complement commercial banks. This outcome is already visible in some low-income and emerging market economies. E-money can draw poorer households and small businesses into the formal economy, familiarise them with new technologies and encourage them to migrate from making payments to seeking credit; more complex saving instruments; accounting services, and financial advice provided by commercial banks. In Kenya, for example, credit growth increased steadily for several years as e-money was being rapidly adopted after 2008”.
“But even in advanced economies, a partnership can be envisioned. E-money providers could leverage their data to estimate customers’ creditworthiness and sell their findings to banks or intermediate bank funding for a more efficient allocation of credit. Moreover, it is perfectly possible that some of the larger e-money providers will eventually migrate to the banking business – bolstered by the data they have accumulated and their scale, and attracted by the margins from maturity transformation. Thus, while today’s brands could disappear, the banking model is unlikely to be forgotten.”
Thirdly, “a radical transformation of the banking model whereby banks mostly rely on wholesale funding, and credit is increasingly intermediated. Commercial banks’ deposit-taking and credit functions could be split. The deposits we hold for payment purposes could migrate to e-money, and in turn could be held abroad in government bonds, or in central bank money. And those we hold as savings could be channeled to mutual funds, hedge funds, and capital markets for the allocation of credit”.
Alternatively, they could remain in banks – which would themselves mostly rely on wholesale funding. The result would be a very different world and a very different banking model. It would greatly limit fractional banking. Fractional banks take deposits but only hold a fraction of them in liquid assets such as central bank reserves and government bonds; the rest is lent to households and firms and thus helps the economy grow.
The IMF ‘Fintech Notes’ confirm the traditional role of central banks and other regulators. Thus, they help ensure the safety of our deposits by supervising banks and offering liquidity when needed. They also settle payments between banks since banks hold accounts at the central bank, and a payment from one to the other is settled by transferring perfectly safe funds (called central bank reserves) from one account to another. The question for tomorrow’s world is: what If E-money providers could hold central bank reserves?
Concise and interesting responses to this question and other implications of e-money are contained in the full report via:
https://www.imf.org/en/Publications/fintech-notes/Issues/2019/07/12/The-Rise-of-Digital-Money-47097 Thank you for reading! God Bless You!
This script was written by a Chartered Banker with a flair for feature writing. He works for a company which provides financial services. Apart from his work schedules, he edits or proof-reads corporate material for his colleagues, executive managers – including distinguished professionals working in various fields outside Banking. Through this column, his articles feature on third-party online media platforms in Ghana and outside. Email: Kwaku.Anumu@gmail.com