WHU | Logo

The Future of Money

How Bitcoin and Co are changing the world of banking (part 4/7)

Axel Wieandt- June 9, 2021

Tips for practitioners

Bitcoin is not the same as money. While more and more people view it as a fungible substitute for gold in this digital day and age, speculating that its value will continue to increase against the backdrop of expected inflation, almost no goods and services are priced in bitcoin. Few people use Bitcoin as a means of payment still because of the limited scale-ability of its blockchain. In fact, only seven Bitcoin transactions can be processed per second, compared with 24,000 transactions per second processed by the Visa-Network. However, there is a Bitcoin use case for remittances. Traditional remittance services are expensive: across all corridors and all providers, the global average cost for sending remittances is over ten percent, whereby the average costs among banks are higher than the average costs among money-transfer operators. Bitcoin transfers, on the contrary, are performed withoutfees, unless you want to accelerate your payment and incentivize the miners in the network to include your transaction in the upcoming block. Such an advantage is only relevant if the bitcoins received can be exchanged into local fiat or are accepted as a means of payment.

Bitcoin and other cryptocurrencies are considered pseudo-anonymous because parties can only be identified by their publickey number, and not by their identity. For this reason, cryptocurrencies have been misused for money laundering and trafficking in illicit goods. Nevertheless, the underlying blockchain technology allows every transaction to be tracked from one wallet to another. If the computer IP and wallet addresses of wallets can be matched to specific identities, the public transparency and immutability of the Bitcoin blockchain would allow authorities to monitor transactions easily in real time with the help of so-called on-chain analytical tools.

Bitcoin is not considered legal tender and the regulatory framework governing its use is quite diverse across countries around the globe:

  • In the USA, cryptocurrency exchanges are legal, and their regulation varies by state and by authority. Since 2013, the Financial Crimes Enforcement Network (FinCEN) has regulated crypto exchanges as money transmitters, on the basis that tokens are “other value that substitutes for currency”. The Internal Revenue Service (IRS) considers cryptocurrencies property and taxes them accordingly. The Securities Exchange Commission (SEC) is looking at cryptocurrencies and crypto exchanges as potential securities and is bringing more and more actions against Initial Coin Offerings (ICOs) and exchanges that list them for violation of securities laws. It has not yet agreed to authorize the launch of a bitcoin exchange-traded fund (ETF) in the US. The Commodities and Futures Trading Commission (CFTC) is looking at bitcoin as a commodity and has allowed cryptocurrencies to trade publicly. In 2015, the New York State Department of Financial Services (DFS) was the first state to issue a virtual currency regulation, regulating receiving, storing, buying, selling, exchanging, and issuing/administering a virtual currency. As of last year, PayPal was one of the first payment companies to receive a conditional virtual currency license (Bitlicense) from the DFS, allowing all eligible account holders in the US to use cryptocurrencies through their PayPal account.
  • In China, cryptocurrencies are not considered legal tender and are treated as a form of property. Chinese regulation is highly stringent due to fears that cross-border crypto trading could undermine its capital controls regime. Financial institutions have been banned from handling bitcoin since 2013, and exchanges and coin offerings have been banned since 2017. The Chinese government even considered a ban on crypto mining as recently as 2019.
  • The EU broadly considers cryptocurrencies legal, but the exchange regulation and taxation vary by country, with most member states charging capital gains tax; exchanges of traditional currency for cryptocurrency are exempt from VAT according to an EU Court of Justice ruling. Exchanges are now required to perform Know-Your-Customer /Customer Due Diligence (KYC/CDD) on their customers. Exchanges are not regulated but need to register in certain member states and are eligible for passport authorization. Further tightening of KYC/CDD rules and comprehensive regulations on Markets in Crypto Assets (MiCA) are in preparation. Germany is leading the way regarding dedicated licensing requirements for crypto custodians, which have been in effect since 2021.

Stablecoins combine blockchain technology and fiat money

In the absence of Central Bank Digital Currencies (CBDC) and limited “on- “and “off-ramps” into and out of the cryptocurrency universe, so-called stablecoins such as Tether or USDC have been launched. In essence, stablecoins are tokens which tie their value to fiat currency or gold, etc. They seek to overcome the volatility that first-generation cryptocurrencies suffered from, which prevented them from being used as money. There are three methods to achieve this: one is through setting up a “reserve” that securely stores the assets (deposits, bonds, etc.) backing the stablecoin; a second, more complex method is the collateralization by other cryptocurrencies; a third method, highly contested by regulators, tries to gain stability through a minting algorithm: coins are either burned or created to keep their value in line with the value of the reference asset.

Over 200 different stablecoins have been launched to date. Some of these stablecoins look like ‘electronic money’ that we have become familiar with and which are well regulated – like PayPal and Venmo in the US, Alipay and WeChat Pay in China, or Paytm in India, etc. Others are more radical and bring Hayek’s vision to life – private stable currencies that will compete with national fiat currency systems.

The most prominent representatives of this category of cryptocurrencies are the centralized stablecoins Tether and USDC. In the wake of the recent increases in prices for bitcoin and ether, the market cap of USDC and Tether have reached 31 billion euros and 8 billion euros respectively, making both of them the top 4 and top 13 cryptocurrency in market cap respectively.

Tether was launched in 2014, and its creators claim that it is backed 1:1 by US dollars held in reserve by Tether Ltd. It runs on top of the Bitcoin blockchain using the Omni Layer protocol. Tether is also affiliated with Bitfinex, a large cryptocurrency exchange. This relationship has been the focus of public controversy and legal proceedings. There are allegations that the 2017/18 bull run of Bitcoin was driven by Tether Ltd. and Bitfinex colluding to buy Bitcoins with fraudulently minted Tether (without receiving adequate collateral). Only recently has Tether Ltd. been able to settle legal proceedings with the New York Attorney General´s Office in that regard, “resolving allegations about disclosures related to a loan Tether made to Bitfinex” while committing to “disclose…additional information about Tether´s reserves.”

USDC was launched in 2018 by a consortium called Centre, founded by Circle and including the cryptocurrency exchange Coinbase and Bitcoin mining (chip design) company Bitmain. It is backed by US dollars held in reserve. Circle is regulated as an official money transmitter and is backed inter alia by Goldman Sachs. All USDC tokens are regulated. The USDC smart contracts only creates USDC tokens if an equivalent amount of US Dollars has been wired to the issuers bank account. All USDC issuers are regularly required to report their US Dollar holdings, which are aggregated and reported by Grant Thornton LLP on a monthly basis.

Stablecoins come with specific risks that primarily relate to the existence and the value of the so-called fiat, gold, etc. reserve backing them up. If the reserve assets are stored with a third party, there is counterparty risk. If the centralized stablecoin operators are not fulfilling their licensing requirements, assets may be frozen. Liquidity risk might also materialize if rumors spread about the existence or the value of reserves, leading to a run for redemption. And there is technological risk relating to the base-layer on which the respective tokens are created. In other words, stablecoins offer digital fungibility, but are not as stable and risk-free as fiat.

But they can come very close if they are issued by a trustworthy, regulated counterparty like a bank. In fact, the J.P. Morgan Coin on Quorum, an open-source, programmable blockchain built on a soft fork of Ethereum, is an example for such a bank issued stablecoin. In fact, J.P. coins are backed by US Dollar deposits with J.P. Morgan Chase Bank N.A. Quorum is designed for processing private transactions with a permissioned group of known participants. The J.P. Morgan Coin is one of many possible applications that can run on Quorum. It is a stablecoin that is designed to facilitate instantaneous, automated payments, and settlement as part of the corporate treasury and cash-management offering of the bank.

Facebook´s Libra project shows the potential of global stablecoin arrangements to transform payments

Facebook´s Libra project, officially announced in 2019 and recently renamed Diem, has realized the full potential of a blockchain-based global stablecoin arrangement, thus triggering political and regulatory backlash. As cryptocurrencies began to thrive, Facebook saw both a threat and opportunity to its business that relies almost exclusively on advertising revenues. In fact, over 98 percent of its revenues are advertising revenues. If a competitor like Google or an upstart could build a popular coin that would allow them to monitor transactions and collect data on what people buy and sell, that would threaten Facebook´s advertising revenues. On the other hand, if Facebook could launch such a coin and embed it into its Facebook and WhatsApp service, which, by 2019, already had 2.5 billion monthly active users and access to 140 million business customers, this would strengthen the position of their offerings and allow them to further increase their revenues. In addition, there was an opportunity to recruit 1.7 billion people in emerging economies to their platforms who do not have an account at a financial institution or a mobile money provider.

Since traditional cryptocurrencies like Bitcoin and Ethereum that are built on public, permissionless blockchains were not scalable, and the value of bitcoin and ether was susceptible to price swings, Facebook decided to launch Libra, a global stablecoin arrangement. In order to support its adoption, Facebook recruited 28 founding members of the Libra Association, a Swiss foundation that would govern the project, oversee the development of the Libra token built on the proprietary Move blockchain, and manage the multi-currency reserve of real-world assets, essentially held in bank deposits and top-rated government bonds, that would be built up from the fiat currency received for the issuance of Libra tokens. Founding members included payment companies (such as Mastercard and PayPal, both of which later left the project), technology marketplaces (such as Facebook and Uber), telecommunication providers (such as Vodafone), blockchain companies (such as Anchorage), VC firms (such as Ribbit or Union Square Ventures) and non-profit institutions, with the notable absence of regulated banks. The target number of members was 100, and each member had to pay in US Dollar ten million or more in exchange for rights to the dividends earned from managing the reserve and the ability to operate a validator node.

How would the Libra blockchain work? Customers would download Facebook’s new wallet Calibra or competing electronic wallets and transfer fiat currency to Libra in order to obtain Libra coins. These coins could then be transferred and spent on the Facebook platforms. Once validated by a validator node, transactions would be recorded on the Libra blockchain, operating at a speed of 1,000 transactions per second.

After publication of the Libra whitepaper, the proposal drew immediate harsh criticism from governments, regulators and central banks around the world, requesting Facebook and the members of the Libra association to “immediately agree to a moratorium on any movement forward on Libra – its proposed cryptocurrency, and Calibra – its proposed digital wallet.“ Concerns were raised related to data privacy and security, lack of regulatory oversight and systemic risks for global financial stability. It is estimated that the Libra reserve could quickly reach a scale of several hundred billion if not one trillion US Dollars. This would make Libra comparable in size to systemically relevant financial institutions, but with no deposit insurance or lender of last resort to back it up in a liquidity crisis. Moreover, the effectiveness of monetary policy in countries with weaker currencies could be seriously undermined if citizens opted to hold most of their savings in Libra instead of local currency. Ultimately, in October 2020, the Financial Stability Board (FSB), mandated by the G7, published “High-level recommendations to address the regulatory, supervisory, and oversight challenges raised by Global Stablecoin arrangements”. In October 2020, the G7 again emphasized its resolve to stop global stablecoin projects such as Libra pending appropriate regulatory oversight.

Announcing the Libra project to the public as opposed to consulting with the authorities behind closed doors beforehand, as would be the normal course of action of regulated banks, has triggered an unprecedented global political backlash and forced the G7 to close regulatory loopholes decisively with new regulation. But Libra has also shown to the world the potential of global stablecoin arrangements embedded in social networks and e-commerce platforms to revolutionize payments.

Declining use of cash and the increasing share of alternative payment methods

Cash, i.e., coins and banknotes, is the only central bank money that individuals can directly access. The other form of central bank money, central bank reserves, are held by licensed commercial banks. These banks create money by making loans to the governments, institutions, corporates, and individuals. These loans create matching deposits in borrowers’ bank accounts, thereby creating new money. Over 90 percent of all money is held in the accounts of commercial banks.

The pandemic has accelerated the move to virtual banking and e-commerce. It is also likely to accelerate the decline in cash usage. This increases the reliance on digital payments and commercial payment providers. As demand for cash is declining, central banks across the world feel more and more obliged to provide digital central bank money, not as a substitute but as a complement to private payment systems and solutions.

Current commercial bank-based monetary system is not fully inclusive

In developed economies, the increasing digitalization of payments could leave parts of society behind as IT and data privacy concerns create a digital divide in an ageing society. In emerging markets, it is the absence of an accessible banking system that creates the opportunity for CBDC to improve financial inclusion. In the USA specifically, where a significant percentage of the population does not have access to the banking system, a CBDC could dramatically improve financial inclusion.

Central banks across the world are accelerating the development of CBDC

Against the backdrop of the growing popularity of cryptocurrencies, in particular Bitcoin, and the emergence of single currency and multi-currency global stablecoin arrangements à la Libra, central banks across the world have been accelerating research into CBDC. Globally, the People´s Bank of China (PBOC) has been well-recognized as one of the first central banks in the world to actively research and pilot CBDC. Starting in 2014, the PBOC began publishing work relating to digital currency. In 2017, PBOC established the Digital Currency Research Institute. PBOC is aiming for China to be the first nation to launch a Digital Currency/Electronic Payment (DC/EP) project. ­­­­­­­­­­­­­­

In 2020, PBOC confirmed it had been internally testing DC/EP in four cities, with the Agricultural Bank of China, one of the four largest state-owned banks, releasing a mobile test app. In fact, all four large state-owned banks will be pilot institutions for DC/EP. Once network functionality and security have been validated, DC/EP will be distributed to Tencent and Alibaba to be used in WeChat Pay and Ali Pay respectively. DC/EP is operating in two tiers. In the first tier, DC/EP would be issued to regulated intermediaries in exchange for funds. In the second tier, the intermediaries would transfer DC/EP from their e-wallets into the wallets of individuals and merchants. The back-end system and the electronic wallets have already been built. Tests will ultimately be rolled out in 28 cities including Beijing, Shanghai, and Hong Kong. Foreign firms such as McDonalds and Starbucks are reportedly also participating. The government has mandated that all merchants who accept digital payments must also accept DC/EP. DC/EP will have Near Field Communication (NFC) payment options that do not require the respective device to be online. Moreover, DC/EP is not tied to a bank account, which will also allow it to be issued to the unbanked part of the population. Despite all the progress made, however, there is still no specific timetable for the formal launch of DC/EP in China.

Contrary to China, the US does not seem to see an urgent demand for a digital currency. In fact, Federal Reserve Bank´s chairman Jerome Powell has argued that a digital USD is not direly needed given the very competitive and innovative payments landscape in the US. However, the Fed recently began actively conducting research and experimentation with CBDC and announced a multi-year research collaboration with the Massachusetts Institute of Technology in August 2020. The Fed is increasing international engagement on CBDC, inter alia through the Bank for International Settlements (BIS), which is coordinating a group of central banks to study CBDC benefits.

In Europe, Sweden´s Riksbank has been at the forefront of retail CBDC. The e-Krona project is responding to an acute structural decline in the usage of cash for retail payments. In 2020, after three years of groundwork, Riksbank launched an e-Krona pilot, working with Accenture and R-3 Corda to test payment, deposit, and transfer functionalities in a distributed ledger environment.

The ECB´s involvement with CBDC dates back to October 2012, when it released its “Virtual Currency Schemes” report. Subsequently, in 2017, project Stella, a research collaboration with the Bank of Japan was initiated to study distributed ledger technology (DLT) wholesale, i.e., inter-(central)-bank, CBDC use cases. Specifically, the use of DLT was explored with regard to four areas:

  • to process largescale payments (phase 1),
  • to support securities settlement (phase 2),
  • to improve cross-border payment efficiency (phase 3), and
  • to improve confidentiality and auditability (phase 4).

With the arrival of Christine Lagarde at the helm of the ECB, efforts to create a retail CBDC for all Europeans were accelerated. In October 2020, the ECB published a report on a Digital Euro, which “can be understood as central bank money offered in digital form for use by citizens and businesses for their retail payments.” After a longer public consultation period the ECB is now expected to formally launch the Digital Euro project this summer.

CBDC as digital fiat money makes critical design choices necessary

When launching a CBDC project, central banks around the world face critical design choices. The Bank of International Settlements (BIS) has established three foundational principles and core CBDC features:

  1. Do no harm to wider policy objectives.
  2. Ensure coexistence and complementarity of public and private forms of money!
  3. Promote innovation and efficiency!

There are four types of central bank issued digital money:

  1. central bank reserves and settlement accounts,
  2. central bank digital tokens (wholesale only),
  3. central bank (general purpose) accounts, and
  4. central bank digital tokens (general purpose).

(1) and (2) are both forms of wholesale CBDC and therefore not widely accessible and for use among central banks and commercial banks only. Contrary, (3) and (4) are both forms of retail CBDC, thus widely accessible.

The three manifestations of retail CBDC according to the BIS are:

  1. direct, i.e., an immediate claim on the central bank, with the central bank handling KYC and client onboarding and retail payments, or
  2. hybrid, with intermediaries handing KYC/client onboarding and retail payments, or
  3. indirect, i.e., a two-tier system à la the Chinese DC/EP, where CBDC is effectively a claim on an intermediary handling all the KYC, onboarding, and retail payment processing, while the central bank only handles wholesale payments with intermediaries.

A key question from a consumer perspective is the question of privacy, which will be more difficult to ensure for account-based than a token-based CBDC. For central banks, the question of infrastructure design is relevant. It can be either centralized, in the case of centralized CBDC accounts and tokens, or decentralized, i.e., DLT-based with a permissioned network of transaction validators.

Even more important than the distinction between centralized and decentralized, however, is the distinction between a token-based infrastructure and an accounts-based infrastructure. This is because business processes will fundamentally change as DLT becomes common, using tokens to represent goods and services and smart contracts to govern business relationships. As the flow of services and goods will be programmable, autonomous, and automated in the future, the payment system needs to become equally programmable for cash flows to be synchronized with the flow of goods and services. Machine-to-machine or pay-per-use payments in the future internet of things (IoT) will ultimately require a compatible, new, token-based payment system. The conventional payment system, even with instant access and 24/7 capabilities, arguably does not have the technical capacity to integrate smart contracts into payment processing. Cryptocurrencies or stablecoins, on the contrary, have this technical capacity but are still regarded as unsuitable because of limited interoperability and a lack of trust and stability. While trigger solutions could be conceived to bridge the requirements gap between smart contract execution and the conventional payment system in the near term, tokenized CBDC would bring the greatest functional and legal benefits, provided it is interoperable with other payment systems, and resilient to cyber-attacks and data hacks. However, DLT-based, tokenized CBDC, at the scale of Facebook´s Libra and beyond, has not been implemented yet by any private institution or central bank in the world.

What are the challenges of CBDC and how could they be addressed?

CBDC would introduce new operational risks and challenges to central banks. In order to implement a DLT-based, tokenized general purpose CBDC, central banks would need to build new technological skills and potentially enter into new forms of public–private partnerships with intermediaries and payment solution providers. In addition to such operational challenges, CBDC could also potentially jeopardize the financial stability of the banking system. In a financial crisis, commercial bank deposits would migrate into CBDC at an accelerated pace, exposing the banking system to the risk of a serious bank run. To mitigate this risk, central banks would either need to limit the amount of CBDC each individual could hold or introduce a multi-tier pricing system, subjecting CBDC holdings above certain thresholds to higher interest rates. The question of privacy of CBDC payments could be addressed by introducing so called privacy vouchers for transaction below a certain threshold.

What are the risks and opportunities of CBDC for banks and their customers?

CBDC present new business opportunities for banks and their customers. Hosting electronic wallets for retail and corporate customers and offering payment automation options for retail customers and improved corporate cash management applications are examples of new service offerings related to CBDC. However, banks need to move quickly if they want to compete with crypto brokers and exchanges like Coinbase. Wholesale CBDC could foster significant efficiency improvements by increasing efficiency and liquidity in interbank clearing and settlement and reducing the number of cumbersome reconciliations in banks’ back-offices. Fnality´s Utility Settlement Coin (USC) and Spunta´s Italian interbank clearing and settlement platform are two DLT solutions that demonstrate the economic potential of CBDC.

CBDC implementation will require significant investment in technological capabilities and the transformation of central banking. It also presents new business opportunities and challenges to financial intermediaries that need to upgrade their payment products and services.

Tips for practitioners

  • Financial institutions and corporations alike need to acknowledge that we have likely reached the tipping point – CBDC will arrive, it is just a matter of when.
  • Financial institutions and corporate treasurers alike need to recognize that CBDC is essentially a new payment system which requires a new, different IT infrastructure.
  • Banks should expect to integrate the full application stack and ensure that services can accommodate a variety of digital assets including CBDC – interoperability is key.
  • Banks and asset managers should follow CBDC very closely and counter competitive threats and risks of disintermediation by non-banks through experimentation and exploration of enhanced services.
  • Banks should think about introducing their own Stablecoins.
  • Corporate treasurers should explore the potential of CBDC to revolutionize cash and liquidity management.
  • Crypto investors should consider whether CBDC could ultimately undermine a significant part of their investment case.

Literature references


Professor Axel Wieandt

Axel Wieandt, a former CEO/CFO at a DAX-30-listed bank, Global Head of Corporate Development, FIG banker and McKinsey consultant, is a senior financial services professional with a focus on banking, fintech, and finance. Axel is currently advising American and European private equity/venture capital funds and real estate companies on their investments and value creation plans. He also serves on the advisory and supervisory boards of German fintech and real estate investment companies. Axel is an early fintech investor himself and has teaching assignments with top-ranked international business schools, including WHU – Otto Beisheim School of Management. Over the years, he has published over 70 research papers, op-eds, and interviews. He is a frequent speaker/panelist at conferences. Axel is the author of “Unfinished Business: Putting European Banks (and Europe) Back on Track” (2017).

WHU | Logo