The Rise of Digital Money

After completing this reading, you should be in a position to:

• Describe the characteristics of e-money that could drive a rapid global adoption of this type of money.
• Describe the risks faced by the banking sector as e-money adoption rises.
• Evaluate regulatory and policy actions that may be implemented in response to risks arising from increased adoption of e-money.

Characteristics of E-Money that Could Lead to Rapid Global Adoption

Electronic money or e-money is an electronic store of monetary value on banking computer systems that may be a widely accepted means for making payments to entities other than the issuer. E-money is mainly used for electronic transactions due to its convenience. The following features may lead to a rapid adoption of e-money.

Convenience

E-money is the best form of money to use for international transactions since there are no hassles of currency exchange. Today, with e-money becoming more popular, banks are competing to reduce transfer costs and provide account holders with good deals. A cheque, for example, may take a few days to clear. This, however, is not the case with online money transaction where the money reaches the other person’s account almost instantly. Online money transactions do not require the service of the bank for transactions to be made.

Ubiquity

E-money can be used anytime and anywhere. Cross-border transfers of e-money is faster and cheaper than checks and bank deposits. This, however, may require market makers in foreign countries to prepare to provide redemption in their local currency.

Complementarity

E-money can potentially realize substantial efficiency gains by avoiding manual back-office tasks. More generally, the functionality of e-money lends itself to being extended by an active developer community, which may draw on open-source codes as opposed to proprietary technologies underpinning b-money. For example, developers could allow users to determine the goods that e-money could buy.

Lower Transaction Costs

Transfers in e-money are almost costless and immediate, making them more attractive than cheque payments and bank-to-bank transfers, especially when making across borders payments. With e-money payment, the funds show up almost immediately without any settlement lag and corresponding risks.

Trustworthiness

Money is primarily about trust and, therefore, the trust of the people and firms who promote the system is essential. In countries where e-money is popular, users have more trust in telecommunications and social media companies than banks.

Two-Dimensionality

E-money transactions involve the transfer of money from the consumer to the merchant eliminating the need for a third party. E-money is valid for discharge and means to pay the price of products without requiring the seller to verify the adequacy of the bank account of the buyer.

Factors Influencing the Widespread Usage of E-money

Although e-money has several advantages favoring its adoption, other factors may influence its usage. Some of the factors that affect the widespread use of e-money are as outlined below.

The Progress of Banking and Financial Industry

A weak infrastructure of the financial industry hinders the spread of e-money. However, training e-money issuers on relevant risk management will facilitate the spread of e-money.

Existence of Sufficient Publicity

Advertising plays a vital role in marketing goods and services. The novelty of the existence of e-money and lack of publicity leads to a low rate of penetration and lack of interest. E-money needs to be advertised, especially in the early stages of issuance.

Psychological Factors

People tend to accept everything new. Psychologists explain that there is a state of anticipation and caution in the beginning up to a point where clear advantages and disadvantages emerge.

Availability of Security Controls Related to the Internet

Economists believe that the use of e-money depends on the evolution of the systems that ensure its security. The increase in the number of hacking attempts will lead to reluctance or a lack of enthusiasm for the acquisition of e-money since it may be an easy target for hackers.

Risks Faced by the Banking Sector as the Adoption of E-money Increases

E-money is a product of technological innovations, which remains subject to breakdowns, among other problems. The following are some of the risks that the proliferation of e-money adoption poses to the banking sector.

Risks to Monetary Policy Transmission and Seignorage

Monetary policy transmission and seignorage risks could emerge from currency substitution, especially in countries with weak institutions and high inflation, as new forms of money may become widespread. The widespread foreign currency e-money may result in the domestic unit of account switching to that in which e-money is denominated. For example, both merchants and households may be happy holding e-dollars coming into the country from remittances rather than redeeming them into domestic currency. Merchants would be tempted to price their goods in dollars resulting in central banks losing monetary policy control.

Money Laundering and Terrorism Financing

Blockchain-based money providers and their partners involved in orienting clients and verifying transactions remain liable to counter-terrorism financing and anti-money-laundering obligations. They should identify customers, monitor transactions, and report any suspicious transactions to the appropriate authorities respecting the United Nations or country-specific sanctions lists. However, in cases where transaction verification is decentralized, with a large number of entities involved, fragmented across sectors and even countries, the enforcement of Combating the Financing of Terrorism (CFT) and Anti-Money Laundering (AML) obligations is much tricky.

The risk to Meet Market Contestability

The emergence of large monopolies of e-money issuers may hinder the entry of new firms and extract rents. As a result of the strong network effects prompting their adoption, e-money providers, who are first movers, may obtain monopoly power. There are very high fixed costs required to establish operations at scale and exponential benefits of extensive datasets that allow inference of client behavior based on randomized trials controlling for a rich set of characteristics. This leads to firms extending their monopoly position to the related services.

Liquidity risk

There may be a lag before the redemption requests are met. Liquidity risk is dependent on the market liquidity of the assets held by the issuer of e-money.

Default risk

The default risk emanates from a scenario where the e-money provider defaults. This leaves client funds at risk of seizure by other creditors. Default risk may occur as a result of losses on other business activities or even the inability to meet one’s debt obligations.

Market risk

Market risk pops up from the assets held by the provider of e-money. The e-money issuer may suffer losses arising from movements in market prices, such as foreign exchange rates, which may make it challenging to honor redemption requests.

Regulatory and Policy Actions to Respond to Risks Arising from Increased Adoption of E-money

E-money Providers to Hold Central Bank Reserves

The central bank reserves could be used to offer settlement services to e-money providers. Just like large banks, the providers could also be required to satisfy specific criteria and agree to supervision. Some central banks already offer special-purpose licenses allowing nonbank Fintech firms to hold reserve balances, for example, the Hong Kong Monetary Authority, the Swiss National Bank, and the Reserve Bank of India.

However, these licenses are subject to an approval process. The central bank reserves would allow e-money providers to overcome market and liquidity risks. This would also transform the e-money providers into narrow banks since they would be able to cover 100% of their liabilities with central bank reserves but would not lend to the private sector.

Potential Advantages of Holding Central Bank Reserves

The following are benefits that would arise from offering e-money providers access to central bank reserves, or requiring them to do so.

Ensure stability of e-money

Trust in e-money can be shaken by various risks, including default, liquidity, market risks, among others. These risks could lead to devaluations, destruction of significant wealth, undermining confidence in the payments system, and potentially putting financial stability at risk. However, holding central bank reserves could eliminate liquidity and market risk, and thus mitigating the default risk.

Control of the growth of e-money monopolies

Central banks and regulators may not be in a position to contain the growth of e-money monopolies as they could be large international firms operating as natural monopolies, given the low costs required for entry. The requirement for providers to hold reserves would enable the central banks to give preference to domestic e-money providers operating under their direct supervision, giving them the means to issue safe and liquid money. This, therefore, will make the domestic e-money more attractive than the foreign e-money.

Effective monetary policy transmission

The effectiveness of monetary policy transmission may be attributed to the following:

1. The increased attractiveness of payment in domestic currency makes it less likely to substitute into foreign currency provided by global e-money providers.
2. Central banks would also pay interest on the reserves held by the e-money providers. This would transmit monetary policy rates to consumers and put more pressure on banks to offer rates on deposits that are closer to the policy rate.

The Creation of a Synthetic Central Bank Digital Currency (SCBDC)

In central bank digital currency (CBDC), central banks are the major operators, responsible for offering and vetting wallets, performing customer due diligence, developing and selecting the underlying technology, among others. Synthetic central bank digital currency (SCBDC), on the other hand, would be established in a public-private partnership. The central bank would only be responsible for offering settlement services to the e-money providers, including access to central bank reserves. The private e-money providers, who are under regulation, would be responsible for all the other functions. The public needs to understand that the SCBDC is not an entirely central bank branded product since otherwise, it would pose a reputational risk for the central bank. SCBDC preserves the comparative advantage of the private sector to innovate and interact with customers, with the central bank providing trust and efficiency.

Practice Question

Which of the following forms is a potential benefit arising from granting e-money providers access to the central bank reserves or requiring them to hold these reserves?

A. Controlled growth of large e-money monopolies

B. Effective monitory policy transmission

C. Ensuring the stability of e-money

D. All of the above

The correct answer is: D).

A, B, and C are potential benefits emanating from granting e-money providers access to the central bank reserves or requiring them to hold these reserves. 

Control the growth of e-money monopolies: Central banks and regulators may not be in a position to contain the growth of e-money monopolies as they could be large international firms operating as natural monopolies, given the low costs required for entry. The requirement for providers to hold reserves would enable the central banks to favor domestic e-money providers operating under their direct supervision, giving them the means to issue safe and liquid money. This, therefore, will make the domestic e-money more attractive than foreign e-money. 

Effective monetary policy transmission: Monetary policy transmission could be more effective as:

• First, it offers an attractive means of payment in domestic currency.
• Second, central banks may pay interest on the reserves held by e-money providers. This would more directly transmit monetary policy rates to consumers and put higher pressure on banks to offer rates on deposits.

Ensure stability of e-money: Trust in e-money can be shaken by various risks, including default, liquidity, market risks, among others. These risks could lead to devaluations, destruction of significant wealth, undermining confidence in the payments system, and potentially putting financial stability at risk. However, holding central bank reserves could eliminate liquidity and market risk, and thus mitigating the default risk.