October 2018 newsletter – The digitisation of money and banking

This is a report by Andy Mullineux on a ‘round table’ session at the 35th International Symposium on Money, Banking and Finance in Aix-en-Provence, France, on 7th June 2018.

The symposium was organised by André Cartapanis and Céline Gimet, members of the host organisations, Sciences Po Aix and CHERPA (a multi-disciplinary research centre), on behalf of the GDRE (Groupement de Récherche Européen) in Money, banking and Finance (MBF) with guidance from the other steering committee members, Jean-Bernard Chatelain (University de Paris 1) and Alexis Direr (Université de Orleans). The title of the symposium, which was a great success, was: ‘Money and Banking and Finance: Towards a New Deal’.

The panel session on digital money and banking was organised by Andy Mullineux1 on behalf of the UK’s Money, Macroeconomics and Finance (MMF) research group. The panellists were: Colin Garland (Director, Competition and Markets Authority, UK; Imran Gulamhuseinwala, OBE; Alistair Milne and Christian Pfister.2

Lael Brainard, a member of the Board of Governors of the US Federal Reserve Bank, famously stated the ‘fintech’ has the potential to transform the way financial services are designed and delivered as well as the underlying processes of clearing and settlement using distributed ledger or ‘blockchain’ technology; which can also be used to create digital currencies, such as Bitcoin. Is Bitcoin money and what would be the consequences for monetary policy of central banks creating digital money using distributed ledger technologies, or otherwise?

Open banking in the UK
The well attended panel session took place in light of the EU’s implementation of the General Data Protection Regulation (GDPR) in May 2018 and the UK’s introduction of ‘Open Banking’, which implements the EU’s PSD2 (second Payments Services Directive), in January 2018. The UK’s Open Banking regime goes beyond the requirements for PSD2 because it contains a series of sequenced remedies imposed by the UK’s Competition and Markets Authority (CMA) following its investigation of retail banking in the UK.
Colin Garland, the CMA’s Remedies Director explained that that the remedies were designed to address issues, such as: barriers to accessing and assessing information held by banks on their clients, which in the past had been treated by the banks as proprietary, rather than owned by the account holders. Other issues included: barriers to switching accounts to another bank; and low levels of customer engagement to overcome the strong information advantage banks have over their account holders, particularly SMEs. Open Banking was only one part of the CMA remedies package. Others included: improved switching arrangements; better information to customers; requiring text alerts regarding overdrawing; and requiring banks to set a monthly cap on charges for unarranged overdrafts.

Giving potential competitors (including Fintech companies, but also ‘Big Tech’ (Google, Facebook Amazon et al) and ‘Telcos’ secure access to consumers’ payments and other banking services usage data (with the customer’s express permission) could transform banking. Will the customers be willing to give the necessary permissions given concerns about data security and usage aggravated by the recent high profile Facebook/Cambridge Analytica scandal and the TSB information technology platform-switching debacle? If they do, will it be the new Fintech platforms that win the business from the banks, or will the big banks simply buy up the competition and adapt; or will the Big Tech companies finally prove the traditional banks to be dinosaurs ready for extinction; as prophesied by Microsoft’s Bill Gates a couple of decades ago? The success of the financial services subsidiaries of the Big Tech companies in China suggest that the big banks elsewhere will have to deal with similar competition form Big Techs. For Big Tech (and Telcos), the most valuable data relates to consumer transactions to enable the better targeting of advertising and there are already and so their entry into the provision of payments is already well underway (Apple Pay and Google Pay and Amazon loans etc).

The unique feature of the UK’s implementation of PSD2 is the required usage the API (Application Programming Interface) as a standardised method of sharing data to assure greater interoperability between providers and assure security. ‘Screen scraping’, which requires password disclosure and is thus less secure, is permitted under PSD2.

Imran Gulamhuseinwala, who heads the Open Banking implementation agency in the UK, believes the API-based approach will facilitate improved household financial decision making. Customers will find it easier to choose the financial services and products that best meet their requirements form internet based platforms through which providers offer and help find suitable products and services. It is however likely that the less financially literate (and least wealthy) will benefit least and so there is a role for financial education to play in in assuring that the most suitable products and services are provided to all customers. In the UK, platforms using APIs will require regulatory approval prior to operation.

PSD2 is a maximum harmonisation directive, and so has to be complied-with, but it is technologically agnostic and so does not require the use of APIs, unlike the UK. Even if the benefit the least, the financially excluded (three million adults in the UK do not have a credit file and are ‘non-banked’) might benefit as the new providers could construct credit files using transactions data. The greater the use of standardised APIs to assure interoperability, the less the opportunity for big banks to build esoteric consumer interfaces or ‘pipes’. There has been a tendency for big banks in the UK, and elsewhere, to hold back on financial innovation to maintain their market dominance. To survive, the big banks may need to develop ‘open platforms’ with other providers in order to serve their customers better, and some prominent banks are indeed doing so. Such developments are likely to see the end of ‘free banking’ (for customers in credit) in the UK and inefficient and the unfair cross–subsidisation associated with it.

Crypto assets and monetary policy
Next, Christian Pfister, making it clear that he was presenting his own views, not those of the Banques de France or the ‘Eurosystem’, gave a presentation on crypto assets and monetary policy. He concluded that, in the absence of central bank creation, crypto- currencies, such as Bitcoin, would have little impact on the conduct of monetary policy as they were unlikely to be widely used as money and might only begin to replace fiat monies if the latter lost their credibility. Interesting scenarios would follow from central bank issuance of digital (not necessarily ‘crypto’) currencies. This would particularly be the case if the central bank digital currency (CBDC) were legal tender and issued at par with paper currency and reserves held at the central bank by banks. CBDC would simply be an accounting device at the wholesale level but could facilitate the issuance of fractional crypto-currencies by commercial banks. What about retail CBDC? What would be the advantage to the central banks and governments of retail issuance? 

Issuance and distribution of notes and coins is costly and digitisation could progressively reduce the cost. Usage of notes and coins also affords anonymity, facilitating tax avoidance, ‘black economy’ transactions and money laundering etc. Anonymity may be seen a citizens’ right, whilst digitisation potentially allows all transactions and transfers to be tracked, opening up a possible ‘big brother’ scenario and a need to protect privacy where society deems it appropriate. If digital money fully replaced notes and coins as fiat money (perhaps by decree) then it would become a potentially powerful monetary tool, allowing negative interest rates (or a Friedman-style ‘tax’ on money) to be paid or ‘charged’ on all accounts held at the central bank. Furthermore, all might be allowed to hold payments accounts at the central bank, with the central banks providing payments services, and possibly also loans (instead of the central bank just issuing ‘electronic banknotes’, which would be distributed by banks); or contracting such services and products out to a competitive network of providers with API interfaces. Under such extreme scenarios, traditional banks could then potentially be disintermediated, leading to an end to fractional reserve banking under which traditional banks create around 90% of the money and thus to multiple credit creation upon receipt of new deposits. Traditional banks would lose their near monopoly of credit supply built on their traditional dominance of a current account based payments system and their profitability would evaporate, leading to their extinction.
Beyond this, do we need CBDCs to be issued by more than one central bank given that the technology would allow global issuance; or should CBDCs simply be allowed to compete (perhaps with privately issued digital currencies) in a framework of competing currencies advocated long ago by Hayek?

However, if central banks refrain from offering accounts to households, or if the households do not want them, all this is a matter for conjecture. CBs (and the governments that ultimately benefit from them) seem likely to try to safeguard their ‘seigniorage’ profits by trying to prevent currency completion, but this may become more difficult over time with progressive digitisation.

In the short to medium term, however, limited CBDC issuance can be anticipated: with the public preferring banks to continue to be allowed to create money through their lending activities, in response to demand. Hence, the fractional reserve banking system would survive with central banks continuing to use interest rates, perhaps supplemented by ‘macro-prudential tools’, to control consumer price (and perhaps asset price) inflation. The nature of the banking system itself may however be transformed by the IT revolution and the associated economies of scale in the payments system and data management along with the proliferation of digital platforms discussed above.

Digital currencies and banking
The final speaker was Alistair Milne, who gave a presentation drawing on his ongoing review of the burgeoning literature on digital currencies and digital banking. He broadly agreed with Christian’s assessment that the CBDC currency issuance currently being contemplated would have little impact on current monetary arrangements and that there is little reason to expect much demand for CBDC alongside existing banking liabilities and notes and coin. Crypto-currency technology could however be used to support more radical reform and to isolate payments systems form bank failures by ushering in a form of ‘narrow banking’ based on borrowing securities based on pledging loans to a distributed ledger. This sophisticated version of narrow banking would not be subject to the criticisms of previous narrow banking proposals, dating back to Irving Fisher and revived after the 2007-9 financial crisis by Laurence Kotlikoff, if the commitments to loan repayment indeed prove unbreakable.

Alistair wound up by asking if concerns about the impact of CBDC on monetary policy was simply ‘much ado about nothing’, as Christian had argued in the paper on which his slides were based? He argued that, if the CBDC system is essentially simply a ‘digital wallet’ system, then indeed not much changes. China provides examples of widely used digital wallet systems. It has recently decreed that the reserve funds are not the property of the payments institutions-ownership belongs to the users. The providers (e.g. Ant Financial, a subsidiary of Alibaba, and WeChat, a subsidiary of Tencent) can no longer make a profit on these balances, whether by depositing them with commercial banks to earn interest or using them to fund digital platform-based lending. Instead, from January 2019, the funds will ultimately be placed then with the central bank (Peoples Bank of China), where they will no longer earn interest. 

At least initially, the CBDC payments accounts would sit alongside a traditional banking system, which would originate the lending in competition with new providers using digital platforms. Fractional reserve banking would continue to operate, with the banks, and possibly also ‘shadow banks’ and all digital wallet providers, required to hold reserves with central banks. It should be noted that digital banking does not require the use of a wallet system, since direct transfers between bank accounts, not all or which need be in credit, is increasingly being utilised. An open small payments system, with a unified interoperable system payments interface accessed via APIs with common characteristics, has been developed in India, for example. Such systems reduce the accumulation of idle balances associated with wallet systems.

The issuance of crypto-CBDC though could be taken much further. It would be possible to use the technologies of digital currency creation to move to full reserve (narrow) banking. The distributed ledger system could be used to address one of the principal objections to narrow banking by providing elasticity in the supply of CBDC through securitisation of bank loans by pledging them to a ledger, Alistair explained. 
Is there a need for this, or could fractional reserve banking be made to work effectively through open banking and responsible lending? It may be best to regulate retail banks as utilities, but should this be done at the country, regional or global level in the digital age? With central banks as both the CBDC issuers and the credit suppliers governments might revoked central bank independence, so that the current financial repression is replaced by the direct use of CBDC issuance and credit creation to fund government expenditure. This was the initial purpose of the older central banks-why rely on variable seigniorage income, as opposed to direct funding?

1. University of Birmingham.
2. Respectively: Director, Competition and Markets Authority, UK; Implementation Trustee, Open
Implementation Banking Entity, UK; Professor of Financial Economics, Loughborough University; Banque
de France and Sciences Po.