Why does the central bank want to issue digital currency?

Recently, Japanese banking giant Mitsubishi UFJ Bank announced the development of its own digital currency, the Bank of Canada announced a digital currency trial, and the Dutch Central Bank is also testing its own DNBcoin. Central banks around the world are gearing up to establish their own blockchain alliances and issue their own digital currencies. What does it mean for these banks or central banks?

This article is excerpted from a speech by Adam Ludwin (Chain CEO) at the “Financial Disruption: Technological Transformation of the Financial Sector” conference, held by the Federal Reserve in conjunction with the International Monetary Fund and the World Bank in Washington, D.C., on June 1, 2016. The speech was scheduled before a speech by Fed Chair Janet Yellen.

Introduction

I would like to thank Chairman Yellen, all the staff of the Federal Reserve and the organizers of the conference for the invitation. I am very pleased to be gathered here with these world-class multinational groups today.

The theme of today's speech is "The New Medium of Money", which is what blockchain can achieve. Chain's partner organizations include Visa, Citi, Nasdaq, Fidelity, and more and more central banks are participating. Together, we will develop the next generation of financial networks on blockchain.

Before we start to imagine the future, let's go back to November 2008, two months after the collapse of Lehman Brothers. Looking back at history can help us better look forward to the future. At that time, American International Group (AIG) and other financial institutions received $200 billion in federal aid, the Federal Reserve announced an $800 billion stimulus plan, and Obama was elected president. It was a busy month for the news media.

But something like this happened quietly, without any media attention. In a hidden corner of the Internet, an anonymous person or organization published a mathematical paper, the "Bitcoin White Paper", which solved a problem that has always puzzled computer scientists: how to create a digital currency without a trust center. The key to breaking through this problem is the invention of an encrypted data model, namely the blockchain.

Back then, the financial system was suffering from a bank run. The credit crisis was made worse by unclear asset ownership. The author of this paper was well aware of the crisis and its root causes. In fact, he/she embedded the headline of a London Times article about bank bailouts into the genesis block.

Seven years later, Bitcoin now has 250,000 BTC transactions per day, which has proven the robustness of the Bitcoin network. Before 2012, few people cared about Bitcoin, but now it is clear that this model is very viable, although there are constant debates about it.

Bitcoin has created a new asset class, digital currency. It has no central network manager or central issuing authority. Bitcoin is issued on this network, and its maximum issuance is pre-written in the code, a total of 21 million.

So the question is, how can Bitcoin influence financial institutions and some central banks to issue their own digital currencies? But if they don’t use Bitcoin directly, what exactly are they going to do?

Simply put, banks use the technology behind Bitcoin to create a similar network to digitize their asset classes, such as securities and currencies, so that they can transfer these assets more efficiently and securely. Financial institutions create new networks instead of using the Bitcoin network directly. The reason for this is that the Bitcoin network is not designed to support the issuance of assets, such as stocks, bonds and currencies. From both a management standpoint and a technical perspective, it is designed for the issuance and transmission of Bitcoin.

After 2008, regulators appropriately improved the safety and robustness of the financial system, and the crisis also gave rise to an unexpected invention that started on the fringes and is now making its way to the heart of financial markets.

Blockchain: The New Medium of Money

The idea of ​​blockchain can be simply summarized as follows: it activates a new medium of money. This money is in a native digital format.

New media often change the structure of a market. Think about how media shifts affect other industries, such as recording, publishing, and telecommunications. The shift in the medium of music from live to recorded, to digital, and most recently to streaming, has seen rapid and dramatic changes in the structure of the music market, with old giants falling and new stars rising. Publishing has suffered similar shifts: from written text to book production, to web pages, and most recently to mobile clients, we have seen new players and new models at each stage. Finally, let's look at telecommunications: initially we were limited to verbal communication with people in our immediate vicinity, then telephone systems, and then voice-over-IP, and when our voices became digital and transmitted over the medium of the Internet, it was difficult to understand the high charges for long-distance calls and the business models based on them.

So what happens when this happens to money? Throughout history, the medium of money has changed very rarely, from precious metals to bearer currencies to our current electronic ledger systems. Bitcoin and blockchain represent a transition to a new medium of money, based on what is known as distributed ledger technology, named in reference to today’s centralized ledgers. It is helpful to review the history of bearer instruments like banknotes to better appreciate what this new medium enables: digital bearer instruments. Looking around, we are surrounded by the old U.S. dollar bill, which is also a bearer instrument.

A key rule of bearer instruments is that controlling assets is equivalent to owning them. If I have a $20 bill, I am the owner of it. But if I give it to you now, you are the owner because you now hold and control it.

Here is a random test: I give you a $20 bill, how do we settle this transaction? Of course, this is a tricky question, because the answer is, we don't have to settle. When using a bearer instrument, the transaction is already settled. It is a single step for the transaction and settlement. This is the flexibility of bearer instruments. However, because the instrument is a physical object, we must be in the same room to complete the settlement. However, using a digital bearer instrument like Bitcoin, we can complete the payment and settlement in one step at a distance (payment = settlement). For example, if I use Bitcoin to donate money to Wikipedia, I send the Bitcoin and it's done. The funds are transferred on the Internet, just like I paid with a banknote.

But wait! Don’t we already have digital payment systems? No, most of what we have today is a system of digital messaging that moves between institutions in a series of steps: recording, clearing, reconciliation, and so on.

The blockchain industry aims to eliminate these steps and make payments and settlements as simple as handing over money. This is what I call digital value transfer, and sometimes I call it money-over-IP. Soon, "cross-border payments" will feel like "cross-border emails."

Digital transfer without copying

What makes digital bearer instruments possible? How do we skip the clearing and calculation steps? The answer can be summarized simply as: using cryptography to transfer a digital object without copies.

Think about email. If I send a PDF attachment, the PDF file doesn't disappear from my computer when it's sent to your computer. You just get a copy. Similarly, if I send you a photo, it doesn't disappear from my phone when you accept it. But if I have $10 and I send it to you, I obviously lose $10.

In contrast to these examples, in a blockchain network, assets exist within the network, and each participant controls their assets within the network by holding something called a private key. So, they don't "own" the assets (you can "own" a wallet file), but rather they have the keys that allow them to control and transfer those assets.

So, digital assets exist in this network, controlled by their private keys, which have their owners. This cryptographic control is why I call these assets digital bearer instruments, which are different from traditional bearer instruments, because they have a public ledger that records every transaction. It is always difficult to find a perfect analogy for new technologies.

You can think of a blockchain as a wall of piggy banks towering into the sky. Each piggy bank has a unique number (public key) and a slot for people to deposit money. The owner of the piggy bank has a key that matches its number, which means that only the owner can access and transfer the assets in the piggy bank. A blockchain model is similar to this, just like banknotes and other bearer instruments. This is in stark contrast to models that require "authorized authority", like debit card networks.

We can put different types of assets on the blockchain. This allows us to trade assets without going through a central settlement. In the blockchain industry, more complex multi-asset transactions can use smart contracts. Remember, there is no clearing and settlement center, and the process is just like a normal transaction.

How do financial assets exist in such a network?

At this point you might be saying “Okay, so how do you get assets onto this network in the first place?” Let’s look at Bitcoin. We all know that Bitcoins are created on its network, issued according to its issuance schedule, as a reward to miners for processing transactions. However, this model is not good for issuing commercial paper and US bonds, which have their own commercial or political significance. As we have discussed before, companies and government agencies should not put issuance rights on such a network, which is not designed for such asset issuance.

So how do we put such assets into this network? We use the same cryptographic principles to allow us to mint assets (private keys and matching public IDs) into digital assets in this network. The private key is like an asset minter, and the matching public ID is like a unique identifier for this asset. We can also embed metadata into this issued asset so that holders can know what they are, who the issuer is, how to redeem, and other information.

For example, imagine a financial institution or a network of banks that issues a commercial bond for Ford, which Ford uses to borrow money from the capital markets. Ford's issuing bank generates a private key for Ford's new asset class and then issues a matching asset ID so that network participants know what the asset is. At this point, Ford's bank can sign the issuance transaction with the private key to mint a separate unit of the asset. The issuing bank then sells it to investors, who pay with digital dollars (a process that takes only one second). This is the only step required to exchange bonds for dollars, which is what we call automatic payment against documents.

Ford's commercial bond is a native digital bearer instrument because the Internet is its only medium.

But what about the US dollars we use to pay for this transaction? Where do they come from?

It is possible that they are placed online by a financial institution, which may hold "real" dollars in an offline trust. In this example, participants in the network who want to get digital dollars can deposit their deposits into this trust and receive digital dollars issued by this bank, which can be exchanged for your deposits at a ratio of 1:1. Users can use these digital dollars to make investment transactions online. We call this a topic model because the dollars in this example correspond to funds outside the network. The holders of these digital dollars will periodically exchange them back to real dollars. However, this topic digital dollar can also circulate, and if the holder accepts the counterparty contract risk of the issuing bank, it can also be used as an asset in the balance sheet.

The ultimate model is a central bank digital currency. This means that central banks like the Federal Reserve participate in this network and mint dollars digitally on it. Because the Federal Reserve is the legal issuer of the dollar, this can make the digital dollar a native digital asset. In this way, there is no need to redeem any "real" dollars, because the digital dollar at this time is the real dollar, only the medium has changed. There are many media that carry the dollar today - paper, coins, electronic reserves - we regard such digital currencies as dollars on different media, and behind them is full of trust in the credit of the US government.

Once we have central bank dollars in the network, imagine how much easier commercial paper trading will become! One entity owns and controls some Ford bonds, another entity owns and controls some digital dollars, both assets are native digital paper, a transaction is requested, both parties agree, each signs with their own asset private key, assets are exchanged, done! No clearing, no settlement center, very securely moving assets in real time, and it will also perfectly show where the assets are at any point in time.

This also brings up some more fundamental questions. If the central bank is issuing digital currency now, why is it only for banks? Why not open it to non-bank financial companies? Why not open it to enterprises? Why not open it to individuals? Because everyone can hold paper money, because it can be said that everyone can hold private keys, so they can also hold digital money. Soon, everyone will have a smartphone, and these phones will have chips to keep private keys secure. At that time, private keys will become the new wallet.

Even better, we can enhance the security of digital currency holders through a technology called "multi-signature". Remember the secure piggy bank wall in the cloud mentioned above? What if multiple private keys were required to open this piggy bank? In this case, a user can store one private key on their phone and one private key on a service provider, which can be a bank or a company like Apple or Facebook. The third private key can be safely backed up locally. In order to transfer these funds, two private key signatures are required, which can prevent thieves from stealing or losing the phone. This is just one example of how digital currency can be more secure than traditional currency. It also shows that this system is more flexible and resilient than centralized systems.

What does the future hold for central bankers and regulators?

In fact, when people think about blockchain technology, they ask the wrong question. The wrong question is: "How can we use blockchain technology to simplify our existing systems?"

The right question should be: “What role should we play in the emerging digital asset economy?”

I've put together some cheat sheets that may help you think through possible answers to this question and find the right role.

There are five roles in the next generation financial network. You can create and operate such a network, issue assets on it, hold assets or hold them on behalf of others, create products and services in this network, and finally observe it as a regulator.

I strongly recommend that central bankers consider playing roles 2 and 5 in the networks created by financial firms. The repo and commercial paper functions used by capital markets, the so-called “shadow banking system” are functions that these firms are trying to improve. Christopher Giancarlo, a commissioner of the US Commodity Futures Trading Commission (CFTC), recently said that “the most critical factor at the center of the financial crisis was the lack of visibility into the counterparty credit risk of the major banks. The most glaring oversight we have to deal with is the lack of visibility, and yet here we are in 2016, and it still hasn’t been fixed.”

Now, blockchain technology provides this visibility (with the added benefit of privacy). We now have tools to measure systemic leverage and counterparty risk. We can monitor performance in real time, and we can address the collateral ownership and rehypothecation issues that are fundamental to the system that operated in 2007. When central banks use digital currencies to process settlements, the system will have far fewer counterparty contracts to deal with. And, in the increasingly important capital markets, policymakers will have access to a whole new tool to influence liquidity, outside of depository institutions.

Central banks, and central bank alliances such as the International Settlements Center (BIS), should consider developing their own networks as new mediums for their issuance of currencies. At the beginning, they can issue such currencies to financial institutions and other central banks. Over time, they can consider allowing individuals and merchants to hold such currencies directly. Non-financial companies that hold private keys to such currencies may need a new license to help people and businesses manage digital assets. Asset custody and financial product services are separated, which will strengthen competition and stimulate innovation.

Ultimately, blockchain networks will evolve into a safer and better payment system, and central bank digital currencies will become the cornerstone of this system.

Such a financial future is accompanied by some questions, such as the impact on creating economic credit, whether it should and can become a new tool for monetary policy, and how to protect the privacy of digital currency holders. However, the technology is here, and those who eat crabs first will create a faster and more secure payment network, which gives their currency a first-mover advantage like a network effect. This is why central banks around the world are beginning to explore this technology by opening up real test sites.

Government leadership is key

In the infrastructure phase of a technology development, governments often play an important role as inventors and funders, such as the Internet, GPS, microprocessors, etc. We are now in the infrastructure phase of blockchain technology development, so I hope you will start learning, creating, and participating in the world's transition to a new medium of money.