Fortune: Central banks explore blockchain - why a digital dollar, pound or yuan could be a reality within five years

Rage Comment : The 2008 financial crisis brought a huge impact on the financial system, causing a lot of economists to reflect. In order to make the financial system more stable, Chain's CEO Adam Ludwin gave a speech on "Digital Asset Economy". He hopes that policymakers will use blockchain as a tool to prevent or manage other crises. He believes that within five years, central banks will issue digital currencies, and some banks are already preparing for this. However, the biggest problem with putting data on a shared ledger is privacy. Fortunately, several companies have invented zero-knowledge proofs to solve the problem of where to put it, and can selectively disclose information.

Translation: Nicole

Last Wednesday, about 150 central bankers from 60 countries around the world gathered at the Federal Reserve Bank of New York for the 40th annual Central Bank Symposium, a private event titled "Policy Implications of Persistent Low Inflation and Interest Rates."

Economic and financial experts such as economist and Harvard economist Lawrence Summers, Ray Dalio of Bridgewater, the world's largest hedge fund, and Yi Gang, deputy governor of the People's Bank of China, discussed the low interest rate, low growth environment and monetary policy around the world.

Then there was a talk titled “The Digital Asset Economy” by financial operator Adam Ludwin, CEO of Chain, a San Francisco-based startup that helps Visa, Citi, Nasdaq and other financial giants leverage blockchain, the technology that underlies bitcoin.

Like other speakers, Ludwin was looking for ways to make a financial system that has been through a financial crisis more stable, but he offered policymakers not a new regulatory idea but an entirely different tool to help prevent or manage other crises: technology in the form of blockchain.

“Initially this looks similar to Bitcoin, and it has nothing to do with the world of the traditional financial system and financial crises, but it’s slowly but surely working toward the same goal, which is to maintain the stability of the financial system,” Ludwin said in a treehouse-shaped conference room that floats in Chain’s Hayes Valley high-rise offices. In particular, blockchain networks increase transparency — giving policymakers real-time visibility into transactions — improving payments, capital markets, and more.

Blockchain distributes encrypted ledgers across multiple computers, allowing participants to reach a consensus on who owns what. Encryption and the lack of a single point of failure ensure security, and the presence of many copies of the ledger not only ensures transparency, but also prevents tampering of the record. It is also faster and cheaper than using multiple ledgers and intermediaries. For example, a traditional bank domestic transfer may take three days, and an international transfer may take a week or more, while sending Bitcoin to the other side of the world can be completed in 10 minutes. The technology was first seen as a breakthrough in payment forms (in the form of Bitcoin), but now also finds corresponding applications in many other financial services and products, such as self-executing contracts, micropayments or tracking the provenance of luxury goods, as well as applications in healthcare, government and digital rights management for artists (musicians and writers, etc.).

The idea of ​​putting people’s everyday fiat money income and spending on a blockchain has permeated the minds of central bankers from China to the U.K. Blockchain technology was discussed at the Blockchain and Financial Technology Forum co-hosted by the Federal Reserve, the World Bank and the International Monetary Fund in June, with central banks from more than 90 countries in attendance. Last week, in a speech at the Annual Symposium on International Finance, Federal Reserve Governor Lael Brainard said the board would issue a report on the application of blockchain technology in the financial sector, and that blockchain “may be the most important development in payments, clearing and settlement in many years.” Central banks in countries such as the U.K. and China have talked about issuing currencies on the new medium, while Canada is testing the so-called CAD-Coin.

Bitcoin has also suffered a major blow to its reputation as the currency of choice for criminals. Enterprise companies from Microsoft to IBM to JPMorgan Chase to Visa to Nasdaq have begun to adopt blockchain technology to make financial services processes more efficient and provide products that were not available before. But while many believe that this revolution will be in the future with central bank-issued currencies, Ludwin corrected that it is already happening.

He said:

“A lot of times you hear, ‘In 10 years, maybe there will be a government that issues their currency on a blockchain.’ I don’t think it’s going to take 10 years. I think it could be done in five years.”

His firm has formed partnerships with Visa, Citi, Nasdaq, Fiserv, Capital One, Fidelity and State Street, among others, driven in part by enthusiasm in the private sector.

Ludwin said,

“The private sector projects we are working on anticipate and aspire to feature central bank money in the long term.”

Since Ludwin’s speech at the Fed meeting in June, Chain has spoken to about a dozen monetary authorities around the world. He said policymakers are “prioritizing the next financial infrastructure system, so they’re not rehashing the old stuff as they usually do, they’re being forward-looking in this regard.” In fact, Lael Brainard is now talking about blockchain

Technology — they see this technology coming, they want to have a seat at the table, they want to observe these networks, and they want to make sure these networks are built in a way that benefits the economy from the outset.”

The New York Fed declined to comment on private events, but Ludwin, who once shared an equal passion for prestigious financial institutions and is now a partner at Chain, offered his thoughts on why central banks are so forward-thinking, how blockchain-based fiat currencies could improve our economy, and what these trends mean for everyday consumers.

How can blockchain help central banks?

As Dalio noted in his presentation, economies around the world, from Japan to Europe to the United States, are pushing the limits of traditional monetary policy. Traditionally, central banks can, for example, increase the money supply to reduce unemployment or stimulate consumer spending, or, on the other hand, tighten the money supply to control inflation by buying or selling government bonds, or raising or lowering interest rates. But, he said, some governments are already pushing these techniques as far as they can go. For example, interest rates are already close to their maximum point.

Ludwin also noted that central banks are becoming increasingly limited in their ability to influence bank lending, as much of this activity has moved to the so-called "shadow" banking system - financial service providers that provide credit and products that are not regulated by regulators, such as hedge funds or credit default swaps. In its 2015 report, the Financial Stability Board explored jurisdictions covering 90% of the assets of the global financial system, predicting that the shadow banking system accounted for more than 40% of total financial system assets in 20 jurisdictions and has been increasing over the past few years.

Therefore, blockchain technology is attractive. In times of financial crisis, everyone withdraws money at the same time, causing a credit crunch. However, what exacerbated the 2007-2008 financial crisis was complex financial instruments such as credit default swaps, Ludwin said:

“It’s made it impossible to know who owes whom what, and there are these fundamental problems — we have these toxic collateral assets. But where are they? On whose balance sheet? How do we know how much of these assets there are?”

But because blockchains provide real-time insights into how credit is created, what assets are in circulation and where they are, and how much they have been loaned out, they can help policymakers prevent another crisis rather than respond to it. The technology will also reduce overall transaction times for more complex financial instruments, some of which are so complex that they can take weeks to process. Interestingly, during the financial crisis, these instruments took longer to process, which undoubtedly made the financial crisis worse.

In the long term, central bank digital currencies could even enable more unconventional strategies for monetary policy, such as “helicopter money,” a way to put more cash in consumers’ hands by printing more and distributing it (the name comes from the metaphor of a helicopter from its creator, Milton Friedman, dropping cash from the sky into neighborhoods). Ludwin said:

“Right now, in order for the Fed to give you money, it has to go through the banking system, but now you can go to a website and sign up and say, ‘I want to get my helicopter money,’ and create a wallet, whether it’s Facebook, Google or your bank. Funds can be sent directly to individuals and businesses.”

What does a world of central bank digital currencies look like?

In a blockchain system, funds are stored in addresses and users have keys to access those addresses, giving them control over those funds.

He said:

“Every transaction on our protocol is a program, so if I’m sending you money over the network, I’ll write a transaction that says only Laura’s key can withdraw this money from here… or only Laura’s key can spend this money next Wednesday.”

He pointed to the protocol that Chain developed with partners like Visa, Citi, Fidelity and Capital One and launched in May.

These keys can be used to replicate the current process of handling cash. For example, when the central bank takes cash out of circulation, it is actually shredded paper (Ludwin said he had shredded money in his gift bag last Wednesday). The blockchain can do the same thing. With Chain's protocol, people can write a program that can send funds to an address without using a key.

As for who owns the network, in the current system, if you go to Chase to deposit $50 in cash, Chase will put that money (issued by the Federal Reserve) on its network. But Ludwin said, you can imagine not having banks run the network Fedwire, but by taking the current system for electronic settlement of payment transactions between member banks and building it on a blockchain, the banks hold the keys and can transfer money.

This could lead to non-financial institutions becoming custodians of this currency.

Ludwin said:

“If it’s a small enough amount of money, you don’t need a bank. Could Google, Apple, Facebook hold small amounts of digital cash? Would that change the paradigm of who the custodian is or could be? The answer is yes.”

This could also open up more channels for peer-to-peer lending and reduce consumers’ reliance on bank loans.

Over time, smartphones will be able to manage identities (satisfying banks’ KYC and AML regulations) and therefore keys.

Ludwin said:

"Smartphones are getting smarter when it comes to managing cryptographic material. The latest iPhones are very good at this. We can trust the secure element held in the iPhone not as a key, but as one of many. Or it can support small amounts of cash or loyalty points. The owner's identity can be verified with a fingerprint."

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Adam Ludwin

One of the biggest issues will be privacy, as data is kept on a shared ledger. Ludwin said:

“Previously, regulators would always chase reports and try to get data and find out the origin of assets, and these issues may become a reality in the future. In fact, if regulators want to adopt central bank digital currencies, we want regulators to self-regulate while ensuring the privacy of participants on the network.”

Noting there is a concern about such a system because it could force them to give up the privacy of cash, he said whether such a system would become a reality depends on how the new system is implemented.

One technological solution that a handful of companies are working on so far, called zero-knowledge proofs, would enable selective disclosure of information, with only the relevant regulators and counterparties to a transaction having access to that data.

“It’s like a computer that can tell you that some numbers in this black box add up to some other numbers in that black box, without knowing that one person said 2 + 2 and another said 4. It’s a way of blinding the computer so people can read the underlying data, but at the same time enabling the computer to verify the transactions that are required for the shared network to function.”

How will central bank digital currencies emerge?

He noted that the private sector started making requests for blockchain prototypes about a year and a half ago, but soon, these projects will be rolled out to customers.

Ludwin said:

“I find that policymakers and central bankers are very interested in this topic of the private sector, and while their understanding of the private sector is about 12 months behind what is happening in the private sector, they are very smart and are thinking very carefully about the impacts and how to engage with it.”

He believes that this cycle will start with a pilot program and the central bank will begin implementing digital currency in 2017.

He sees the two types of governments he’s interested in are what he calls “challengers and incumbents” — those emerging economies like in Asia, and then giants like the U.S., U.K. and Canada that are figuring out how to upgrade old systems. Some are exploring it because they want to know if being an early issuer of a central bank digital currency could give their currency a competitive advantage, while others see it as a tool to improve the stability of the financial system and prevent crises.

Either way, for Chain it won’t be any different than the work it does with its enterprise clients.

Ludwin said:

"The main purpose of blockchain is to enable issuers of assets to issue those assets into a new medium, and in the case of cash, hopefully the issuer is a central bank. We're happy to talk to a variety of issuers, and that means traditional investment banks because they issue corporate securities, sometimes large corporations because they issue their own securities directly, Nasdaq Private Market as an issuer of private market securities, brands as issuers of loyalty points. So one of our key components is always issuers. That might look like a central bank - that's crazy, but it's not. They're just issuers of certain types of currencies and assets, which are government-issued currencies. In a way, the Federal Reserve and Delta are similar in our technology. Delta is issuing points, the Fed is issuing dollars. They're just assets on a network. Obviously, there are big differences between the two, but from a technology perspective, they're filling the same basic need, which is modern infrastructure to secure and move assets."