Believe those who are seeking the truth. Doubt those who find it. Andre Gide

Sunday, May 1, 2016

Monetary policy implications of blockchain technology

As I'll be at Consensus 2016 event speaking in a session on "Digital Cash for Central Banks" (agenda available here), I thought this might be a good time to gather my thoughts on what central bankers should be thinking about as a new wave of financial innovation comes crashing on our shore. (Warning: the views I hold presently are subject to change. And, of course, my personal views do not necessarily represent the official views of any central bank anywhere!)

Before talking about policy, what is a "blockchain technology?" Like a lot of new terms that are bandied about, it means different things to different people. But for my purpose, I'm just going to think about it as a different way to keep account of information. The Bitcoin blockchain, for example, is a distributed public ledger that records the entire history of bitcoin transactions (the movement of BTC credits from account to account), where the ledger is updated, maintained, and kept secure by profit-seeking accountants (miners) who are incentivized through a clever algorithm to act in the interests of the Bitcoin community (their actions are also publicly observable so any shenanigans, should they occur, are likely to be short-lived.) There are many possible variations of this basic idea.
Now, it just so happens that money is just a type of ledger, as I explain here: Money and Payments, or How We Move Marbles. The notion of money as a record-keeping device goes back at least to Ostroy (1973). We worry about record-keeping systems because people are opportunistic and cannot be trusted. This is what Kiyotaki and Moore (2001) meant when they quipped that Evil is the Root of All Money. A well-designed record-keeping system constitutes a solution to a social problem (the existence of people willing and able to fabricate information for their private benefit at the expense of the community). Similarly, money should be viewed as a solution to a social problem.

Needless to say, none the solutions that have emerged over time have been perfect although, a Darwinian might claim that there is a time and a place for every species (see also: The Byrds). And now, as the technological environment evolves, a mutation threatens the prevailing order. What are the implications for monetary policy?

In what follows, when I speak of cryptocurrencies, I'll I focus on Bitcoin, first, because of its relative popularity, and second, because it's designed to compete directly with central bank money and payment systems. But what I have to say pertains more broadly to all innovations in this space. I'll also sometimes refer to the Fed but, of course, feel free to substitute in your favorite central bank.

1. Currency competition. To a domestic central bank, Bitcoin looks just like a foreign currency which, of course, it is (since its monetary policy is governed by an entity that is outside the domestic government's jurisdiction). Viewed from this perspective, Bitcoin presents central banks with an old and familiar threat: currency competition. Americans traveling abroad are familiar with the phenomenon--one is often presented an opportunity to exchange USD for local currency at unofficial exchange rates. People in these countries are often just trying to avoid a very high inflation tax. 

Annual Inflation Rate
The willingness and ability of domestics to substitute into a competing currency with a more stable value will put limits on the ability of a government to use the inflation tax as a revenue device. Governments sometimes go to great length to restrict the use of currency substitutes. The new threat poised by Bitcoin is that it's likely going to be much more difficult to enforce domestic currency controls. Anyone with a phone and access to the Internet will have access to an alternative digital bearer asset to use as an exchange medium. Bitcoin, or even just the threat of Bitcoin, will put much stricter limits on the amount of revenue governments can extract through the inflation tax. 

2. Maturity transformation using a foreign currency. While Bitcoin is unlikely to displace a major world currency any time soon, it's likely to play a prominent role in certain niches. I am reminded of the role the USD plays in some countries. An issue that arises in those jurisdictions is the creation of USD denominated bank deposit liabilities by foreign-based banks. Fractional reserve banking can be problematic in the best of times, but could you imagine U.S. banks offering loans denominated in BTC and, more importantly, redeemable on demand for BTC? This type of arrangement is not fantasy--it happens all the time in the so-called Eurodollar market and elsewhere. How should regulators respond to such an activity? How can a central bank act as a lender-of-last resort when, in a crisis, people are wanting their BTC bank deposits and not USD? What role, if any, might the treasury in these circumstances? Lender-of-last resort interventions are not limited to central banks, after all.

3. The safe asset phenomenon. A safe asset is not a risk-free asset--it's an asset that people flock to in times of crisis. (They are more accurately described as "flight-to-safety" assets.) In the 1970s, real estate was a safe asset, and investors ran away from the USD/UST (hence, inflation and high interest rates). In the late 2000s, the USD/UST was a safe asset (hence low inflation and low interest rates), and people ran away from real estate. The set of assets that investors perceive to be "safe" evidently varies over time. Could BTC be the next great safe asset? Maybe yes, maybe no. But monetary policy is all about formulating contingency plans. What if BTC denominated deposit liabilities are a significant source of financing, like CUF denominated mortgage loans in Hungary prior to European crisis? And what if BTC is regarded a safe asset in our next crisis, the way CUF is perceived to be in Europe? If this happened in the U.S., it would mean a large depreciation in the USD/BTC exchange rate, price inflation (measured in USD), price deflation (measured in BTC) and, of course, all of the other wonderful things that accompany financial crises. Except that the Fed would have no direct control over the supply of BTC (i.e., for the purpose of expanding its supply to accommodate the elevated demand for BTC, thereby alleviating the BTC deflation). To the extent that the UST is not a safe asset in this event, the Treasury's powers would also be greatly diminished. 

4. Securities exchange. The standard macroeconomic model typically assumes that securities are exchanged in frictionless financial markets, where trade is instantaneous and property rights are enforced at zero cost. Needless to say, this abstraction is ill-suited for the purpose of understanding monetary policy. Most bonds are thinly-traded on over-the-counter (OTC) markets and so, are highly illiquid. Even the most liquid of bonds, like the 10-year on-the-run U.S. treasury, is prone to unsettling "liquidity events" (e.g., Oct 15, 2015). Despite improvements over time, it can still take days to settle and clear securities transactions. This delay, along with other frictions, generates a huge demand for collateral, largely in the form of USTs to guard against counterparty risk. Improvements in securities exchange brought about by the application of blockchain (or other) technologies has the potential to release billions (or more) of dollars in collateral assets into the market place. The effect of this is likely to lower the liquidity premia on USTs, leading to higher interest rates. The implication for the treasury is obvious, but clearly any force that is likely to impinge on the structure of interest rates is also relevant for monetary policy.

5. Financial stability. There are some who claim that blockchain applications will one day render fractional reserve banking (or maturity transformation in general) obsolete. Maybe. But I am not so sure. One way this might happen is if every asset, our homes, our human capital, can be somehow transformed into perfectly liquid bearer instruments. This won't be happening any time soon. Proponents of blockchain technology point out that it has the potential to remove opacity in financial markets, something that would surely lead to a more stable financial system. However, it's worth pointing out that the leading economic theory of bank sector fragility, the Diamond and Dybvig model, does not rely on the existence of opacity in the financial market. In that model, the portfolios of banks are perfectly transparent. A bank run may nevertheless be triggered by the expectation of a mass redemption event, which subsequently becomes a self-fulfilling prophecy. It is also interesting to note that (in the same model) bank-runs can be eliminated if banks adopt a credible policy of suspending redemptions once they run out of cash (this commits the bank not to firesale assets to meet short-term debt obligations). The perception of perfect credibility is essential for the result and, needless to say, the degree of credibility needed here is frequently lacking. If the suspension clause could somehow be made to trigger automatically and mechanically--perhaps a smart contract could be employed--then depositors would never have an incentive to run a bank and the contract would never be exercised. Of course, this solution relies on the common knowledge assumption required in MAD (see footnote 1 below). I'm not sure what implications for policy this has, but it's fun to think about and, well, who knows where all this might lead. 

6. Central bank digital cash. The existing structure of money and payments (including central bank design) was built for the pre-Internet world. The world is now changed and we must deal with it. Among other things, there is no reason why, in principle, central banks could not offer online digital money accounts for the public. I'm thinking here of a basic utility account, a place to keep your money safe and pay bills. (Private banks could still compete by offering full service accounts). There is a sort of precedent for this: the U.S. Treasury, for example, offers online digital bond accounts. And while that system is not specifically designed to make payments, it could be (again, in principle). There are a number of advantages to consider. First, there would be no need for deposit insurance since the central bank accounts have no default risk (they can just print the money, after all). Second, cash managers at large corporations could simply park their money overnight at the central bank, rather than seek collateralized lending arrangements (repo) in the shadow banking sector. Third, the cost of maintaining the paper money supply can be eliminated. Fourth, it is easy to pay interest (possibly, negative) on digital money accounts, leaving central banks with an additional monetary policy tool. There is the issue of how such an arrangement may impact the funding of private banks. But such an object, if it was to exist, could I think, compete favorably with Bitcoin and other cryptocurrencies, assuming that monetary policy is conducted responsibly, of course. (I discuss a more radical form of central bank digital cash--one designed to compete more directly with Bitcoin--in this blogpost: Fedcoin.)

There are so many more things to discuss, but I think I'm at my limit for blog post length. If you have ideas to share, or papers to link to, please feel free to comment below. Thanks!


Footnote 1: Naturally, one would never want anything to trigger a mutually-assured-destruction clause in a contract. And such an event would never occur, theoretically at least, if everyone is perfectly rational. Few people need to be convinced that this assumption is rather extreme. However, if the collective punishment cost is not too large (well, at least finite), then one might be able to live with the occasional "mistake" and subsequent punishment. I am reminded of the "contract" that governed Roman legions. Good behavior was rewarded (after 20 or so years of service) with land to retire on. While bad behavior in battle was easy to identify collectively, it was sometimes hard to identify individually (a legion consisted of thousands of men). To discipline group effort, a credible threat of group punishment is needed (Holmstrom 1982). Credibility (the ability to commit) seems to have posed no problem for the Romans (how they ever became Italians, I have no idea). A legion deemed to have performed in a cowardly manner was punished by having each soldier draw lots, with a 1 in 10 chance of winning the lottery. The "winners" were then summarily clubbed to death by their colleagues. (Incidentally, this is where we get the word decimation--to reduce in number by one-tenth.) The punishment was not carried out very often, suggesting that the credible threat of the punishment worked reasonably well.


  1. Very good post. Minor comments:

    3. " And what if BTC is regarded a safe asset in our next crisis, the way CUF is perceived to be in Europe? If this happened in the U.S., it would mean a large depreciation in the USD/BTC exchange rate, price inflation (measured in USD)..."

    That's not obvious. There might be a reduced demand for USD, but presumably the Fed could just reduce the supply of USD by the same amount, to prevent price inflation measured in USD.

    5. "It is also interesting to note that (in the same model) bank-runs can be eliminated if banks adopt a credible policy of suspending redemptions once they run out of cash (this commits the bank not to firesale assets to meet short-term debt obligations)."

    Make a minor change to the Diamond Dybvig model, by just adding more periods (or make it continuous time). If there's a run today, you would have an incentive to run if there's a risk you might need cash tomorrow, even if you know your assets are perfectly safe (but illiquid).

    1. Nick, thanks!

      With respect to your first point, I think you're correct. Of course, defending the USD in this case would likely entail increasing the policy rate. If, instead, the USD was the safe asset, the Fed could lower the policy rate (as in 2008).

      With respect to your second point, I'm not sure. Seems to me that if bank assets are never sold at firesale, then as long as they are sound, the patient agents in DD would never have an incentive to misrepresent themselves. Of course, you could be making other assumptions that are left implicit here. Can you point me to a paper in the literature?


    2. Suppose you are patient now, but there's a risk you might be impatient tomorrow. And if you do turn impatient tomorrow, you will absolutely need your cash tomorrow, and can't wait till the end of the month when the loans mature.

      No paper I know of, but this is *my interpretation* of a part of Morgan Ricks' recent book "The Money Problem" (not 100% sure if Morgan would say I've interpreted him correctly).

  2. I'm not sure how a bank could offer loans denominated in BTC.

    Banks create money thru fractional reserves, but every BTC comes from a miner and has a serial number. Bank-created BTC would essentially be BTC derivative contracts, likely issued in good old fashioned dollars, even if denominated in BTC.

    (This raises the interesting perspectives that fractional reserves are essentially managed derivative contracts on the CentralBank-issued reserves.)

    BTC-denominated loan contracts would be very useful for speculative purposes versus dollars, but I'm having a hard time seeing other uses. The lender of course bears all the inflation risk, the borrower any deflation risk, which would inevitably be hedged mostly by bankruptcy. And BTC is likely to continue to be more volatile than US$, hence a BTC loan has more non-performance risk.

    Thanks for the opportunity to riff!

  3. All points you're discussing stem from the question about who gets the proceeds of money creation, i.e. seigniorage; I don't see how that may be removed from the States' control without compensation.
    If you consider monetary base management as a public good or service; then, be it its mere printing cost (your 6.III §), its reliability (3.) in a wide sense (including even fraude), or the fiscal costs of having to face a situation such as described in 2.; IMHO all these are very controversial issues to deal with, off a State's monopoly to provide the basic input for money creation.

  4. Nice post. You have a flare with this topic and the points you raise are the right ones. Some practical issues I have been thinking about wrt to block chain, in addition to what you mention are:

    1) implications for market structure and competition - big difference in implications if ledger is permissioned or permissionless. Find it hard to believe we'll move all banking to a purely roots, "democratized" world of finance that some predict.

    2) who will end up to be the new big players? Banks could just acquire it. Or Apple et al. could become the new TBTF. Not sure how much that matters if it is properly regulated, although one would have to understand much better the broader stability implications of new players. Propagation of shocks could be different.

    3) how to regulate this anyway - some are saying "same activity same regulation" and some are saying that's over reaching and will kill innovation. Similar issues arise wrt to shadow banking agenda.

    4) even outside of crypto currencies, how should central banks think about participating in a distributed ledger? They are active users of ledgers and payments systems themselves. And who should have access to central bank money in these systems?

    One could think of this technology and conclude that it is a bit like VOIP that was adopted by the phone companies and we don't really notice the difference. Officials would primarily need to make sure that the benefits of the efficiency gains will end up in people's pockets, and that consumer protection and market integrity regulation is kept up to date. Or, one could think of this technology as bringing in a new era...

    It makes me hope that academics will be inspired to go back to theoretical basics (à la DD and your interesting exchange here w Nick) to think this through. It would help lay down some foundational elements for policy people like me. DLT promises efficiency and transparency, as you note. The trust bit only replaces the folks who reconcile and audit; plenty of trust needed for other aspects of the system. Yet I wonder what else DLT fundamentally changes regarding the frictions that give rise to financial intermediation in the first place or the market failures that justify financial sector regulation. Have you seen anything in this range of territory?