Why banking infrastructure is broken blog #4 – how will the fabric of money change?

The increasing digitalisation of our world is impacting all of our everyday lives - and money is no exception.

At its core, what money is and its capabilities are. We’re seeing government, big tech, traditional banks, fintechs and crypto firms exploring and harnessing the potential of CBDCs, stablecoins and other forms of digital money that rely on blockchain technology.

This shift has put digital currency on a collision course with analogue money, causing new complexities and friction.

In this article, I’ll explore how the fabric of money is changing, how the introduction of digital money is at odds with existing banking infrastructure and throws up both opportunities and challenges, along with the need for a new type of clearing model that can bring these two worlds together.

The fabric of money over time

‘Digital money’ refers to crypto currencies, Central Bank Digital Currencies (CBDC)s, stablecoins, and other forms of digital currency. Initially a completely new concept that hit the mainstream in the form of bitcoin, digital money is rapidly evolving into many flavours and integrating into the world’s traditional systems –changing them from the foundations up. The scale of this change has the potential to be seismic because digital money systems function so differently to the legacy systems common today.

The world’s financial infrastructure is built on billions of centralised records around who owns what, who owes what and who has paid who, held in banks and central banks. The world’s payment schemes and rails run on this centralised model, managing ‘analogue’ money - the numerical entries in the ledger balances of financial institutions.

Digital money fundamentally challenges this model. It’s decentralised, meaning records of amounts and payments are shared among many participants in blockchain constructs that are virtually impossible to corrupt.

It is also intelligent because individual units of digital money can follow rules and behaviours set for it by issuers and bearers, with the ability to evolve these rules over time. This ability to inject intelligence into units of value in particular is radically different to how analogue money operates, giving rise to both opportunities and challenges. 

Fundamentally, unlike analogue money, digital money has no physical form such as coins or notes.

The impact of digital money

Like all new technologies, digital money creates both opportunities and challenges.  

The three biggest opportunities are:

• Reducing financial system risk: As it exists as decentralised records coped many times over in blockchain networks, digital money eliminates the need for a third party to maintain central accounts and records, or to centrally manage transactions.  In addition, it does not carry the same existential risk that existing centralised market infrastructures do, making it far more resilient.

• Boosting creativity and innovation: The programmable nature of digital money creates opportunities to develop new innovative services for consumers, business and governments such as deep anti-money laundering controls, smart routing and permitted use-ranges to protect minors.

• Catalysing a much fairer Internet: It enables web monetisation, sometimes referred to as Web 3.0, where digital money can support micro-payment amounts that can move across blockchains all over the world immediately with transparency - like information does today.

In contrast, the three biggest challenges:

• Waste: Digital money that uses mining as the method to record transactions into blockchains   is slow and expensive to move, consuming enormous amounts of energy, as mining computers compete to validate transactions and earn new coins. New flavours of coins are coming on-line that  use different, faster methods that can support enormous volumes

• Individual freedom: The intelligence built into digital money can lead to a reduction in civil liberties where government issued digital currencies CBDCs can be programmed to prevent certain types of spending by individuals or specific groups. 

• Fiscal disruption: Digital money not issued by a government can draw capital away from countries with fragile currencies, creating asset pools of money totally outside any state’s control.

Clearing 3.0

But before these risks and opportunities can fully play out, the immediate challenge is re-purposing the world’s financial market infrastructures to embrace digital money and smoothly transitioning into a new way of operating.

The first wave of interoperability were the crypto exchanges, enabling people to trade across different digital currencies and fiat money held in wallets.  These and other players are now branching into custody of digital money investment, and financial institutions are starting to offer ‘termination/origination’ services, to send and receive payments between fiat money and digital money.

The biggest change comes when national currencies ‘go digital’ with CBDCs and fiat-backed stablecoins. These types of digital money are issued by central banks, in the case of CBDCs, and commercial banks, converting fiat value 1:1 to digital coins. This link to state-backed money gives businesses and consumers alike the assurance that their money is protected in digital form, which should boost adoption and lead to ubiquity, where digital money becomes the norm. 

But re-purposing legacy fiat currencies, empowering it, and managing the shift is fraught with risk and uncertainties. And the low-risk CBDC/stablecoin route alone is not enough. To embrace the dynamism and opportunity of digital money, the full range of independent points need to have the freedom to develop and find new ways to add value to society and commerce, all while keeping the lights on, and ensuring people are not negatively impacted by the many challenges of this shift.

Smart, thoughtful and inclusive regulatory engagement is vital to a smooth and value-creative transition. Getting the balance right in such a profound journey of change will require open-minded, inclusive and attentive oversight by the world’s regulators and incumbents.