Key takeaways
- Tokenisation represents a transformative innovation to both improve the old and enable the new. It paves the way for new arrangements in cross-border payments, securities markets and beyond.
- Tokenised platforms with central bank reserves, commercial bank money and government bonds at the centre can lay the groundwork for the next-generation monetary and financial system.
- Stablecoins offer some promise on tokenisation but fall short of requirements to be the mainstay of the monetary system when set against the three key tests of singleness, elasticity and integrity.
The past several years have seen a wave of digital innovation that opens up unprecedented possibilities for money and finance. This papper discusses how central banks can light the path to the next generation of the monetary and financial system. This is a system designed to expand the quality, scope and accessibility of financial services by leveraging innovative technologies backed by sound regulation, while preserving the solid foundation of the existing system: central bank reserves as a trusted final settlement asset, supporting private financial sector innovation.
At the heart of this vision is the concept of tokenisation, the process of recording claims on real or financial assets that exist on a traditional ledger onto a programmable platform. Tokenisation represents the next logical progression in the evolution of the monetary and financial system, as it enables the integration of messaging, reconciliation and asset transfer into a single, seamless operation. Its potential lies in its ability to knit together operations encompassing money and other assets that would reside on the same programmable platform. This could be made possible by a new type of financial market infrastructure – a “unified ledger” – which may or may not use distributed ledger technology (DLT). By bringing together tokenised central bank reserves, commercial bank money and financial assets into the same venue, a unified ledger can harness tokenisation’s full benefits.
How do stablecoins measure up as money?
Stablecoins and the singleness of money
Asset-backed stablecoins are akin to digital bearer instruments. They behave like financial assets and typically fail the test of singleness.
To date, stablecoins are traded in secondary markets at an “exchange rate” that can deviate from par, similar to deviations observed between the price of exchange-traded funds (ETFs) and the net asset value of the portfolio they reference. Granted, small deviations from par could be viewed as consistent with a somewhat looser definition of singleness. But deviations from par undermine the no-questions-asked principle. And money-like claims that are not able to circulate with no questions asked cannot really function as money. More generally, in contrast to predictable deviations arising from frictions such as fees, stablecoins of various stripes have seen substantial deviations from par (Graph 1.B), highlighting the fragility of their peg.
Stablecoins and elasticity
Stablecoins also fail the elasticity test. This is because the issuer’s balance sheet cannot be expanded at will. Any additional supply of stablecoins thus requires full upfront payment by its holders – ie a strict cash-in-advance setup with no room to create leverage when it is required for the functioning of the system. This differs fundamentally from banks, which can elastically expand and contract their balance sheets within regulatory limits.
Stablecoins and the integrity of the monetary system
Stablecoins have significant shortcomings when it comes to promoting the integrity of the monetary system. As digital bearer instruments, they can circulate freely across borders onto different exchanges and into self-hosted wallets. This makes them prone to KYC compliance weaknesses. Transactions originating from self-hosted wallets are traceable on public blockchains. Nevertheless, this traceability can be disrupted using mixers, which amalgamate funds from multiple users and subsequently distribute them to newly generated addresses. Individuals may maintain anonymity until they encounter KYC requirements when converting stablecoins into fiat currency. But holders of a stablecoin are probably not the customers of its issuer, who may not know if holders have had their identity verified. More worryingly, stablecoins may be sent to individuals who have definitely not verified their identities. Importantly, stablecoins’ KYC limitations are also problematic in the light of geopolitical constraints (such as sanctions) on existing payment systems.
The promise of tokenisation
Tokenisation stands to be the next logical step in the evolution of money and payments. Tokens are not merely digital entries in a database. Rather, they integrate the records of the underlying asset with the rules and logic governing the transfer of that asset. Tokenisation enables the contingent performance of actions, meaning that specific operations are triggered when certain preconditions are met.
The canonical example of the contingent performance of actions is delivery versus payment (DvP). With DvP, the transfer of an asset is a precondition for payment, and vice versa. DvP can greatly enhance the efficiency of securities markets by reducing counterparty risk and removing the need for escrow and other mechanisms. It can also reduce the need for reconciliation and other post-trade operations. But beyond this, contingent actions can enable entirely new use cases, particularly by automating different types of financial transactions. Households and businesses can benefit from the contingent execution of actions. For example, businesses can better manage cash flows through DvP. Efficiencies in capital markets can increase the returns on household investments, for instance in their pension savings.
Conclusions
Trust in money remains crucial for the economy’s functioning, regardless of technological change. Money is the coordination device for the economy, subject to important network effects. The singleness of money sustains this coordination. Elasticity and integrity are further crucial features that ensure money is fit for purpose.
Technology offers many paths forward, but not all are equally promising. The issuance of private currencies like stablecoins satisfies a demand for new technological features. Yet even with regulation, stablecoins’ limitations cast serious doubts about their ability to be the mainstay of the monetary system. There are better ways to meet the legitimate demand for new functions in the monetary and financial system. Innovation built on unified ledgers is promising, unlocking efficiency gains and new contracting possibilities. The tokenisation of central bank reserves, deposits and government securities could represent stepping stones towards the next-generation monetary and financial system.