Does money grow on trees? The future monetary system

The Bank for International Settlements (BIS) has, rather grandly, set out its vision for the future of the monetary system in its recent annual economic report. Its vision is remarkably similar to a lot of others and will continue to polarise a debate that continues to divide opinion. It argues that the crypto universe is structurally flawed and unsuitable as the basis for a monetary system that services society’s everyday needs. Instead, it believes central bank digital currencies (CBDCs) and fast payment services are the way forward.

What does the ideal monetary system look like?

According to BIS, in addition to programmability, composability (i.e. the capacity to combine different components in a system, such as DeFi protocols) and tokenisation, which many innovative systems possess, the ideal monetary system must achieve other fundamental goals: it must be safe and stable, accountable, efficient in scale and cost, promote integrity and financial inclusion, and be globally interoperable as well as adaptable to society’s future needs.

How does crypto fall short?

The BIS argues that crypto has a number of structural shortcomings. The prevalence of fiat-backed stablecoins, it says, indicates ‘the pervasive need in the crypto sector to piggyback on the credibility provided by the unit of account issued by the central bank’. But it says these coins are at best an imperfect substitute, as they are still potentially unstable, as shown by the recent implosion of the TerraUSD stablecoin and its twin coin Luna.

Also, the BIS says that crypto has a tendency towards fragmentation due to the inherent limitations of permissionless blockchains, which sees users offering higher fees to have their transactions processed faster. Persons responsible for recording transactions on the blockchain are thus incentivised to limit its capacity and sustain congestion. These incentives significantly impair any positive network effects that could accrue to the system the more people use it, curtailing crypto’s ability to serve as ‘money’ in society.

While regulation and stability may be improved through reform, the BIS believes the inherent weaknesses of the current crypto system cannot be overcome.

What does the future hold?

The BIS is of the view that the future monetary system should be shaped by combining new technological capabilities with a representation of central bank money at its core. It sees the future monetary system built on the trusted division of roles between the central bank and private sector entities (e.g. payment service providers (PSPs)).

In describing the future monetary system, the BIS uses the metaphor of a tree, whose solid trunk is the central bank. In addition to the provision of central bank money, this tree is rooted in payment finality through ultimate settlement in the central bank’s balance sheet. In the canopy we find a diverse and multi-layered ecosystem of participants and functions where competing PSPs strive to serve users. A well-thought-out data architecture enables interoperability domestically and cross-border. At the risk of over-stretching the metaphor, the BIS suggests that in order to see the global monetary system you need to zoom out to focus on the canopy of a forest. This canopy fosters cross-border and cross-currency activity through multi-CBDC platforms that communicate ultimately with the various central banks via application programming interfaces.

It’s an appealing future but in our view one that remains a long way off and does not take account of the significant practical and political challenges that will figure prominently in shaping both the journey and the final destination.