- The recent announcement of the Libra Association, whose future activity has the potential to establish itself as a global digital currency with new financial infrastructure, has re-stimulated discussion on national digital currencies in the context of innovations in global digitalisation.
- Potential implementation of an Australian digital currency (eAUD) may be less about increasing transactional efficiencies and lowering costs for consumers and business (though important) and more about de-risking issues inherent with the banking systems’ implicit guarantee that ‘locks up’ significant financial resources and reduces competition.
- An eAUD may allow Australians to hold accounts directly with the Reserve Bank, bypassing intermediaries, enabling better security (a safer system) and a cashless society, with increased transparency and efficiencies (particularly for Government).
- While demand for an eAUD may not be significant yet, the introduction of digital currencies, either from organisations (like Libra) or governments (like central bank digital currencies), with accompanying global digital infrastructure innovations, represents a challenge to the Australian financial system that needs serious attention.
Global digitalisation and financial services
Accelerating advances in digital technology (such as cloud computing and mobile) is enabling many industries to globalise. The one exception is financial services due to the self-sovereign identity constraints of each country in the form of local currency and underpinning laws.
These constraints make global business and transactions increasingly costly and inefficient, often impacting those who can least afford it (for example, people sending money back to their families from overseas).
A digitally integrated, scalable and global financial services system may reduce systemic risk (more secure) and transactional cost, while increasing capital efficiency (more money in the system). As a result, Australia’s overweight to financial services and underweight digital innovation, coupled with a small population, make it vulnerable to global digitalisation (such as digital currencies) of its financial infrastructure.
Libra and digital currencies
On 18 June 2019, Facebook announced the establishment of the Libra Association, an independent, Swiss, not-for-profit organization with the mission to empower billions of people through the creation of a global digital currency and new financial infrastructure.
The initial group of 28 founding members of Libra have a significant presence within the global digital ecosystem and digital economy (billions of users and trillions of dollars in market capitalisation).
While global adoption is not assured, it is likely to progress quickly given the member organisations involved, their customer volume and reach, and their ability to leverage existing digital infrastructure.
The Libra Association indicates that there are billions of people who are either unbanked or underbanked, yet have access to the internet. More importantly, it asserts that the current financial system is complex and cost prohibitive, particularly to the most vulnerable.
Libra has committed to working with governments, regulators, industry and the public to introduce a secure, open source, stable and scalable solution, with stringent governance arrangements that emulate its commitments.
While supporters indicate its pragmatic merits in relation to issues with the current financial infrastructure and regulation, most of the initial criticism against the introduction of Libra has been its potential ‘destabilising’ effects. However, what does this say about our current system that fears an aspiration of greater financial inclusivity, accessibility, affordability and transparency for most of the world’s population? Are there other solutions or is it just about protecting the status quo?
The perceived threat of the de-stabilisation effects of Libra has re-stimulated debate about digital currency around the world. China, Sweden, Turkey, and the Marshall Islands have all indicated their desire to develop a national digital currency or central bank digital currency (CBDC) for various reasons, with other countries considering the pros and cons.
Australia’s banking system and the implicit guarantee
The focus on strengthening the Australian banking system post the Global Financial Crisis (GFC) has resulted in the Major Banks holding $246bn in shareholders equity (in 2018). This represents approximately $10,000 in capital per head of population in Australia to effectively provide an ‘implicit guarantee’ on bank customer’s money.
In addition, the Australian Prudential Regulation Authority (APRA) announced further capital measures that will be required by the Major Banks (another $80-100bn by 2023) to again lower the price of the implicit guarantee by raising total capital by another four to five percentage points of risk weighted assets. While the reforms lower the probability of the taxpayer ever being called upon, they also increase the cost of intermediation, raise the barriers to entry and lower competition within the banking system.
Under the current system of deposit guarantees (implied or legislated) we are unlikely to ever move away from the Major Banks dominating our banking system (76% of system assets), as by construct, the requirement to manage the risks associated with the guarantee reinforces the incumbent positions.
While the recent Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry addressed the implicit revenue versus compliance conflict, the behaviour that results from dominance is likely to be a persistent issue within the current system. These factors are turning the Major Banks into providing a utility service in exchange for the social licence granted by the community.
In the longer term, efficiency gains for the current banking system are only going to result from addressing the risks associated with the implicit guarantee which is driving the need for substantial capital levels, ‘locking up’ Australia’s financial resources.
Central Bank Digital Currency (CBDC)
Discussions around a CBDC have been circulating for some time. Its concern has been in relation to the evolution of money to provide a better fit-for-purpose global financial system where developed banking business models have a homogenous structure.
For example, during the GFC, the Irish Government moved to guarantee the debt of their local banks and changed the capital structure for banking globally. The Irish banks went from being some of the riskiest to the safest in the world, seemingly overnight. As a consequence, governments around the globe had to guarantee the debt of their local banks or risk their economies being locked out of capital markets.
In context of this history, if one central bank were to introduce a CBDC, it is likely that other countries would be compelled to follow suit. However, as highlighted by the Bank of International Settlements (BIS), the major concern raised by existing stakeholders in relation to the introduction of a CBDC is the impact on the current commercial banking system:
“A general purpose CBDC could give rise to higher instability of commercial bank deposit funding. Even if designed primarily with payment purposes in mind, in periods of stress a flight towards the central bank may occur on a fast and large scale, challenging commercial banks and the central bank to manage such situations. Introducing a CBDC could result in a wider presence of central banks in financial systems.”
In the United Kingdom, where the banking system was effectively nationalised post the GFC, PositiveMoney has been advocating for the introduction of CBDC to address the problems associated with the UK banking system. They highlight support from one of the biggest names in contemporary economics, Nouriel Roubini, who recently wrote an article stating that a CBDC:
“would disrupt the current fractional-reserve system through which commercial banks create money by lending out more than they hold in liquid deposits. Banks need deposits in order to make loans and investment decisions. If all private bank deposits were to be moved into CBDCs, then traditional banks would need to become “loanable funds intermediaries,” borrowing long-term funds to finance long-term loans such as mortgages.”
“In other words, the fractional-reserve banking system would be replaced by a narrow-banking system administered mostly by the central bank. That would amount to a financial revolution – and one that would yield many benefits. Central banks would be in a much better position to control credit bubbles, stop bank runs, prevent maturity mismatches, and regulate risky credit/lending decisions by private banks.”
As indicated by Roubini, financial systems that introduce a CBDC as an alternative store of value in comparison to bank deposits may end up creating a far less risky financial system. Furthermore, by introducing competition into the traditional fractional reserve banking model, markets over time are likely to more efficiently price the implicit guarantee.
David Andolfatto of the Federal Reserve Bank of St. Louis, who investigated the theoretical impact of a CBDC on a monopolistic banking sector, provides support for this assertion. In his preliminary work, he found two main results:
“First, the introduction of interest-bearing CBDC increases financial inclusion, diminishing the demand for physical cash. Second, while interest-bearing CBDC reduces monopoly profit, it need not disintermediate banks in any way. CBDC may, in fact, lead to an expansion of bank deposits if CBDC competition compels banks to raise their deposit rates.”
In other words, financial stability may end up costing far less under this model over time, and as was highlighted by the Irish during the GFC, in a globally homogenous banking market, financial systems that are less risky will be rewarded accordingly.
As the International Monetary Fund Managing Director, Christine Lagarde, commented in her speech titled ‘Winds of Change: The Case for New Digital Currency’:
“I believe we should consider the possibility to issue digital currency. There may be a role for the state to supply money to the digital economy. This currency could satisfy public policy goals, such as (i) financial inclusion, and (ii) security and consumer protection; and to provide what the private sector cannot: (iii) privacy in payments.”
On the back of the Libra announcement and countries actively exploring or developing digital currencies, a CBDC is looking increasingly likely as a result of global digitalisation and the needs of the next generation.
Significant debate and discussion regarding a potential Australian national digital currency (eAUD) has been stalled on a perceived lack of demand. However, the introduction of digital currencies, either from organisations (like Libra) or governments (like central bank digital currencies), with accompanying new global digital infrastructure, represents a challenge to the Australian financial system that needs to be taken seriously.
Overall, the primary benefit(s) of an introduction of eAUD would likely:
- allow de-risking of the banking system by reducing the need for an implicit guarantee and freeing up significant capital reserves for Australia;
- increase financial services competition as it alleviates inefficiencies and increases transparency and security in the system; and
- allow Australia to better integrate with the global financial system.
Secondary flow-on benefits would likely:
- lower transaction costs for Australians as accounts are held directly with the Reserve Bank and bypasses intermediaries;
- enable better security (a safer system) for users through better digital infrastructure and technologies; and
- inaugurate a cashless society, with increased transparency and efficiencies for Government and regulators.
Ignoring or ‘waiting to see what happens’ may not be the best strategic option in a global environment where the pace of digital change and adoption moves at lightning speed. The vulnerabilities of Australia’s financial system to global digitalisation and the innovation of global digital currencies warrants serious attention.
Footnotes  See Holon’s article for further discussion at https://holon.investments/transformative-innovation-scaling-business-for-the-global-economy/  See Holon’s article for further discussion at https://holon.investments/australian-exposure-to-global-digitisation/  https://libra.org/en-US/association/  https://www.banking.senate.gov/imo/media/doc/Marcus%20Testimony%207-16-19.pdf  Refer to Caitlin Long’s letter to the United States Senate Committee on Banking, Housing, and Urban Affairs at https://img1.wsimg.com/blobby/go/77b5c3fa-81c3-4bf3-9539-2023f2739d35/downloads/Senate%20Banking%2C%20Housing%2C%20and%20Urban%20Affairs%20Com.pdf?ver=1563207206550  https://www.apra.gov.au/media-centre/media-releases/apra-seeks-increase-loss-absorbing-capacity-adis-support-orderly  https://financialservices.royalcommission.gov.au/publications/Documents/some-features-of-the-australian-banking-industry-background-paper-1.pdf  https://www.bis.org/cpmi/publ/d174.pdf  https://positivemoney.org/  https://www.theguardian.com/business/2018/nov/19/why-central-bank-digital-currencies-will-destroy-bitcoin  https://research.stlouisfed.org/wp/more/2018-026  https://www.imf.org/en/News/Articles/2018/11/13/sp111418-winds-of-change-the-case-for-new-digital-currency  https://www.finder.com.au/rba-we-have-no-plans-to-create-digital-aud-no-demand-no-point