Regulating Digital Currencies: Towards an Analytical Framework

In a new article, I examine the development and regulation of digital currencies, which are monetary currencies that are evidenced electronically. Large “wholesale” payments among businesses and financial institutions already occur electronically, and bitcoin has been with us for more than a decade. Three recent events, though, are prompting the development of a “retail” digital currency – one used by consumers as an alternative to cash.

First, the People’s Bank of China has been working on a retail digital currency since 2014. It now has trial runs going in four cities. Second, Facebook announced in 2019 that it will be developing Libra, a blockchain-based global digital currency. And retail businesses have restricted the exchange of physical cash to try to control the transmission of COVID. In response to these events, governments and multinational organizations have begun exploring the feasibility of developing retail digital currencies. So far, however, their pronouncements provide only aspirational generalizations.

Two categories of retail digital currencies are likely to become feasible. Digital currencies sponsored by governmental central banks, referred to as CBDC (Central Bank Digital Currencies), are almost inevitable. Privately-issued digital currencies, such as Libra, are also potentially viable.

Privately-issued digital currencies have a token-based digital form that is secured by cryptography, such as blockchain. For that reason, they sometimes are referred to as cryptocurrencies. They can be divided, in turn, into currencies that are, or are not, backed by (i.e., redeemable or exchangeable for) assets having intrinsic value. The former are generally referred to as stablecoins. Cryptocurrencies that are not backed by assets having intrinsic value, such as bitcoin, are unlikely to gain wide purchase as a retail currency for payment.

Central Bank Digital Currencies

Two CBDC approaches have emerged: account-based and token-based. In an account-based CBDC, the currency represents an electronically registered claim against – that is, a deposit at – the central bank or its agent bank (for example, a commercial bank). A currency transfer simply involves debit-and-credit entries in the relevant accounts. In a token-based CBDC, the currency represents tokens issued by the central bank. The recordkeeping is maintained through central-bank-specified forms of identifying and verifying currency transfers.

Different jurisdictions are taking different approaches. The European System of Central Banks has engaged in a proof-of-concept for a token-based CBDC. The digital yuan being developed by the People’s Bank of China appears to combine account-based and token-based features. In the United States, a retail CBDC is likely to be account-based, at least initially. One reason for that is that an account-based retail digital currency should be able to use wholesale-digital-currency technologies already in place at commercial banks and merely extend their access to a wider user base.

A basic design question for an account-based retail CBDC is whether the accounts should be at the central bank or at commercial banks. Maintaining those accounts at commercial banks – what sometimes is called a “hybrid” CBDC structure – should be less costly and disruptive for several reasons, including that commercial banks would not need to replace a primary source of their funding: low-cost consumer deposits.

Except insofar as differences between retail and wholesale currencies mandate, a retail CBDC should be regulated similarly to the regulation of wholesale digital funds transfers. In the United States, such funds transfers are regulated by Article 4A of the Uniform Commercial Code (“UCC”). A retail CBDC will need additional regulation, though, to address consumer protection and financial stability concerns.

Stablecoins

Being privately issued, stablecoins face a challenge not faced by government fiat currencies: assuring their stable value by designing reliable redemption rights. Any failure of the issuer to satisfy such redemption rights, or even the perception that such a failure might occur, would likely lead to a loss of confidence in the stablecoin and a collapse in its value.

That would expose the issuer and stablecoin holders to default risk, similar to the liquidity “run” risk of a bank run – that the issuer might be unable to obtain sufficient reference assets to satisfy correlated demands by stablecoin holders. It also would expose the issuer to valuation risk on the reference asset – the risk that the issuer would have to acquire additional reference assets to satisfy demand when the market price of the reference assets has gone up. Facebook or any other issuer of a viable stablecoin will need to protect currency holders and itself from these risks.

An issuer could attempt to hedge these risks with derivatives, but the derivatives market might not be deep enough to provide that hedge for an affordable price. The issuer could try to collateralize its obligation to exchange the reference asset for the stablecoin, but that could be very expensive. To try to protect against these risks, Facebook’s Libra dollars are expected to be backed by a managed reserve of the U.S. dollar reference assets, which also could be expensive. My article examines how inventive public-private partnerships could more cost-effectively protect the value of stablecoins that are backed by government fiat currencies.

Stablecoins can pose externalities both to their holders (that is, the stablecoin users) and to governments. Regulation may be needed to address these externalities. There appear to be two significant externalities to holders. There is a risk they may be unable to redeem their stablecoins, at the agreed rate of exchange, for the reference assets backing their stablecoins. That inability not only would harm holders seeking currency redemption but also would impair the value of the stablecoins. Another significant externality to holders is the risk that the protective cryptology underlying stablecoins may fail or be compromised. As mentioned, stablecoins also can pose externalities to governments. The primary externality is the risk that a stablecoin could become so widely used that it would undermine the ability of a government to use its currency to affect monetary, and thus economic, policy.

My article examines how to design regulation to try to control these externalities.

Cross-border Digital Currency Payments

Because payments routinely cross national borders, CBDCs and stablecoins should be designed to be used both domestically and in cross-border transactions. For an account-based retail CBDC, cross-border retail payments would be made exactly as cross-border wholesale digital currency payments currently are made.

Global stablecoins also have the potential to efficiently facilitate cross-border payments. Cross-border payments have been suffering from high costs and inaccessibility. The high costs are due to various factors, including bank-intermediation fees, lack of standardization for communicating payment information, and the need to coordinate and comply with the laws of multiple jurisdictions. The inaccessibility is due to the fact that not all consumers currently have deposit accounts – a problem that is especially acute for residents of developing countries. Developing countries could find it difficult to motivate banks to service remotely located or poor consumers.

Using global stablecoins to make cross-border payments could help to address these shortcomings and broaden financial inclusion. Stablecoin payments generally are made through peer-to-peer arrangements, which would avoid bank-intermediation fees and at least some of the need for standardizing the communication of payment information. Using global stablecoins also could address inaccessibility because consumers would not need to have deposit accounts to make cross-border payments.

The remaining implementation challenge is regulatory: the high cost of coordinating and complying with the laws of multiple jurisdictions. Even if digital currencies are regulated domestically in all applicable jurisdictions to ensure their domestic legitimacy, two critical implementation challenges remain: minimizing the high cost of coordinating and complying with the national laws of different jurisdictions, and controlling the risk – which goes beyond the particular interests of individual nations – that cross-border digital currency payments pose to international monetary and financial stability.

When facing similar legal coordination-and-compliance challenges, regulators have devised a solution: persuade the relevant jurisdictions to enact, as their national law, a uniform model law. The UCC itself epitomizes such a model law, designed to reduce the high cost of coordinating and complying with the different commercial laws of U.S. states in multistate commercial transactions. To address these challenges, my article recommends that a neutral and respected international organization consider drafting a model law proposing uniform text to be enacted into national law by jurisdictions that recognize global stablecoin payments. My article also examines in detail how to regulate global stablecoins to protect international monetary and financial stability.

This post comes to us from Steven L. Schwarcz, the Stanley A. Star Distinguished Professor of Law & Business at Duke University School of Law and a senior fellow at the Centre for International Governance Innovation (CIGI). It is based on his recent article, “Regulating Digital Currencies: Towards an Analytical Framework,” available here.

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