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Central banks are best positioned to protect trust, the soul of money, be it fiat or virtual, says Agustín Carstens, general manager of the Bank for International Settlements (BIS). Private companies should, therefore, build their products based on a central bank-issued digital currency (CBDC) rather than investing in bigtech stablecoins or decentralised finance (DeFi) platforms.
In a speech delivered at the Goethe University's Institute for Law and Finance (January 18), Carstens said central banks are the best positioned to issue money, fiat or virtual, as people have trust in their currencies, and trust “holds the monetary system together”.
“My main message today is simple: the soul of money belongs neither to a big tech nor to an anonymous ledger. The soul of money is trust.
“Central banks have been and continue to be the institutions best placed to provide trust in the digital age. This is also the best way to ensure an efficient and inclusive financial system to the benefit of all,” Carstens said.
He, however, stressed the importance of the private sector. In a successful symbiosis, central banks provide “an open, neutral, trusted and stable platform” for the foundation of money, while private companies use “their ingenuity and dynamism” to develop new payment methods and financial services on top of it.
Few, large walled gardens
In discussing the future of money, Carstens put forth two potential nightmare visions for the future.
In the first scenario, he discussed a set-up where stablecoins issued by bigtechs compete both with national currencies and against each other.
Such a scenario would not only fragment the monetary system, but bigtechs, once they established themselves as a large player, are likely to strive for preserving their position and raise barriers against new entrants.
“We may end up with a few dominant walled gardens that compete both with each other and with national currencies, thus fragmenting the national and global monetary systems,” Carstens noted.
In a world where bigtechs issue their own money, it is possible that the data holder ends up knowing more about users' behaviour than users do themselves.
“Armed with exclusive access to data, big techs can quickly scale up and dominate markets.”
In such a world, users “may be handing the keys to our monetary system over to private entities, driven by profits and accountable only to their shareholders and other insiders”.
“Such an arrangement could erode trust. A public good like money needs oversight with the public interest in mind.”
DeFi is an illusion
In a second alternative, Carstens argued that the “elusive promise of crypto and decentralised finance”, which claims to offer a financial system free from powerful intermediaries, may actually deliver something very different.
DeFi promises to "democratise finance" by cutting out the middleman, such as big banks and to lay the groundwork for Web 3.0.
Although Carstens agreed that “in many applications, governance improves when power is genuinely dispersed, with appropriate checks and balances”, he noted that this principle is not what DeFi applications are actually delivering.
“There is a large gulf between vision and reality,” he said.
In contrast to the promises, DeFi has been often used for speculative activities, where users invest, borrow and trade crypto-assets in a largely unregulated environment.
“The absence of controls such as know your customer (KYC) and anti-money laundering rules, might well be one important factor in DeFi's growth,” he noted.
In addition, some argue that full automation and self-executing protocols are an illusion, as someone has to be there to write and update the code, and run the platform.
Meanwhile, stablecoins, another key element of these platforms, also pose a huge risk to customers.
“Without appropriate regulation, issuers can diverge from full backing, or test the margins of what counts as a safe asset,” Carstens warned.
But “more fundamentally, decentralisation comes at a cost”.
“Trust in an anonymous system is maintained by self-interested validators who ensure the integrity of the ledger in the absence of a central authority. So the system must generate enough fees, or rents, to provide these validators with the right incentive.”
Carstens argued that these rents accumulate mostly to insiders, those who hold more governance tokens, but efficiency gains for average users have so far failed to materialise.
He pointed at Bitcoin as an example to show that the “need for rents to maintain incentives in a blockchain is a feature, not a bug; it is a case of 'the more the sorrier' instead of 'the more the merrier'".
High leverage, liquidity mismatches and connections to the formal financial system mean vulnerabilities in DeFi could undermine the stability of the broader financial system.
For instance, in the event of a crisis, stablecoin transactions running on automated protocols could cause unpredictable interactions where liquidity dries up and losses cascade through the system.
As a result, “DeFi applications could take on a life of their own, interacting with one another in unpredictable ways”, Carstens said.
Multi-CBDC network as a public good
However, a third way exists that maintains the role of central banks at the heart of the financial system, according to Carstens.
In this set-up, incumbent financial institutions, bigtechs and new innovative entrants compete in an open marketplace, building on “central bank public goods”.
Carstens argued this alternative would result in an efficient and inclusive financial system because central banks “do not aim for profits, but to serve society. They have no commercial interest in personal data. They act as operators, overseers and catalysts in payments markets, and regulate and supervise private providers in the public interest.”
A global network of CBDCs, which already has the necessary credibility, could lower the cost of cross-border payments, increase their speed and transparency, and broaden access to users in different countries.
The role of the private sector would be to build new financial services on top of such a system, driving innovation and opening up new opportunities.
“Central banks and public authorities are still the glue that holds the monetary and financial system together. Private sector services and innovation are essential and should thrive on this foundation.”
“But trust can never be outsourced nor automated,” Carstens concluded.
