The Rise of Digital Money

After completing this reading, you should be able to:

• Describe and compare different attributes of means of payment.
• Describe the risks faced by the banking sector as e-money adoption increases and identify means of mitigating those risks.
• Explain reasons for and characteristics contributing to rapid global adoption of e-money.
• Evaluate effects of different scenarios of e-money adoption on the banking sector.
• Discuss regulatory and policy actions that could be implemented in response to risks arising from increased adoption of e-money.

Introduction

Over the past 20 years, the world has seen unprecedented growth in technology, which has in return fostered digital money. But what does digital money stand for?

Digital money refers to any means of payment (or currency) that exists in a purely electronic form. Unlike fiat currency (the traditional government-issued currency), digital money is not tangible. You don’t carry it in your pocket as you’d carry a dollar bill or coin. Forms of digital money include:

• Central bank digital currencies (CBDCs) are essentially the virtual form of a fiat currency.
• Privately issued “stablecoins” whose value is pegged to another asset, e.g., Diem and USD Coin.
• E-money such as cryptocurrencies and M-Pesa.

In this chapter, we delve into the world of digital money and evaluate the risks faced by the banking sector. We’ll also look at the reasons behind the quick rise of digital payments and evaluate the effects of different scenarios of e-money adoption on the banking sector. Lastly, we will discuss regulatory and policy actions that could be implemented in response to risks arising from increased adoption of e-money.

Attributes of Means of Payment

All modern means of payment (including digital money and fiat currency) have four key attributes:

Type

Every means of payment is either a claim or an object. When you pay for groceries at the local store using cash, that’s an object-based means of payment. This type of transaction is settled immediately without any need to exchange further pledges or information. If you pay with your debit card, that’s a claim-based means of payment. By swiping the card, you give your bank the authority to transfer ownership of a claim on your assets to the seller.

Claim-based payments are more convenient than object-based payments. A merchant traveling abroad does not need to carry loads of cash. All they need is a letter of credit from their bank, and they’ll be able to do business.

Value

Some forms of payment come with a fixed value, but others have a variable value. For example, a payment made in USD has a fixed value and can be compared to fixed return assets such as bonds that can be redeemed upon demand at face value. On the other hand, a payment made in Bitcoin has a value that changes depending on market forces. Such a payment thus resembles equity-like instruments that have both upside and downside risks. However, it’s important to note that the parallels with debt and equity instruments are purely for exposition. Debt-like or equity-like means of payments cannot be recognized as such in a court of law.

Backstops

With some means of payment, redemption is guaranteed by the government. Government backstops include deposit insurance, lender of last resort, and emergency liquidity facilities. With others, there are no backstops beyond any prudent business practices and legal structures put in place by the issuer. Payments backed by the government are considered more stable and secure than those with “private” backstops. However, this attribute is only relevant for fixed value claims.

Settlement Technology

Some forms of payment are considered centralized because they pass through a centralized party or server. For example, when two account holders at a bank exchange cash via their accounts, the bank acts as a central clearinghouse. The bank effectively serves as a central “server” that completes the transaction.

Decentralized payments are processed by the parties to the transaction without relying on a trusted third party. For example, if client A hands client B $20 in cash, A’s cash account is debited while B’s account is credited, but no central authority is involved. Most cryptocurrencies utilize Distributed Ledger Technology (DLT) that allows for the storage of all information securely and accurately without the need for a central authority. Decentralization allows for scrutiny of ownership history and reduces transaction costs by avoiding intermediaries.

E-money and the Risks It Poses to the Banking Sector

By definition, e-money is any monetary unit stored in an electronic wallet on a technical device that may be widely used for making payments. E-money products can be software-based or hardware-based, depending on the technology used. Popular e-money products include Alipay, M-Pesa, Libra, Swish, We Chat Pay, and Stablecoins.

The use of e-money comes with several advantages, including:

• Instantaneousness where transactions can be completed in split seconds;
• Increased convenience since transactions can be initiated from anywhere in the world, at any given time;
• The storage of a digital historical record of every transaction for transparency; and
• Increased security due to the detailed historical record of transactions;

On the downside, e-money doesn’t enjoy government backstops like other forms of digital money. As such, its ability to honor redemption requests isn’t beyond doubt.

In general, e-money poses the following risks to the banking sector:

Liquidity risk: e-money issues may not always have funds available to cover all of the outstanding liabilities. As such, there may be delays before redemption requests can be met.

Default risk: The e-money issue can default due to losses on other business activities or the inability to meet one’s debt obligations. If this happens, customers may have their assets seized by other creditors.

Market risk: If the assets of the e-money issuer suffer sufficiently large market losses, the issuer may struggle to honor redemption requests.

Foreign exchange rate risk: e-money products denominated in a currency other than the domestic unit of account put the holder at the risk of loss during the currency conversion process. A good example of an e-money product that comes with this risk is Libra – a cryptocurrency denominated in a basket of currencies.

Risk Mitigation Methods

Investment in safe and liquid assets: To ensure that they do not run into liquidity problems, e-money issuers should only invest in safe and liquid assets such as T-bills and short-term government papers. Better yet, they can invest in central bank reserves either directly or through a well-established bank (proxy).

Keeping in check the amount of issued assets: To ensure that all redemption requests can be met promptly, an e-money provider must not issue e-money assets whose value exceeds the value of the client funds received.

Segregation: The assets of the e-money issuer must not be encumbered or used as collateral in other financial transactions. Ideally, these assets should be segregated from the balance sheet to ensure that clients’ funds a safe and readily available even if the issuer is declared bankrupt.

Setting aside sufficient capital: With enough capital, an e-money issuer would be able to offset losses and fully meet all redemption requests. There’s a need to urgently create and strengthen the regulation of issuers and perhaps make them subject to a strict set of capital requirements.

Transferring client funds to trusts: To minimize the risk of default, e-money providers can transfer client assets to trusts, a move that effectively segregates those assets from the provider’s balance sheet. The only downside is that regulations around the operations and use of trusts are not always watertight across jurisdictions. Therefore, there may be loopholes that could undermine the security and reliability of trusts.

Reasons for and Characteristics Contributing to Rapid Global Adoption of e-Money

E-money may not be a stable store of value like other forms of payment like fiat currency, but it’s still one of the fastest-growing digital money products around the world. For some context, the M-Pesa service in Kenya is used by almost everyone above age 14. In China, We Chat Pay and Alipay transactions surpass those of visa and MasterCard combined.

Here are several reasons behind the rapid adoption of e-money around the world:

• Convenience

With an e-money product like We Chat Pay, you can complete a transaction in a matter of seconds. Most e-money servicers are integrated with social media, making them even more convenient.

• Ubiquity

One of the best things about e-money is that you can carry out cross-border transactions faster than would be possible with bank transfers or cash. The market maker in the foreign country might even be able to provide redemption in local currency.

• Complementarity

E-money blockchains for assets such as stocks and bonds offer seamless payment of automated transactions, thereby potentially realizing substantial efficiency gains from avoiding manual back-office tasks. Supervised e-money products can offer a less risky form of demand deposit than a bank account.

In addition, the use of e-money products on open-source codes as opposed to proprietary technology can enhance the realm of the type of transactions that can be completed. For example, one could make philanthropic payments via e-money.

• Reduced costs

E-money transactions are less costly than most traditional forms of payments, including bank-to-bank transfers and card payments. For example, a person selling a car might prefer to receive payment in e-money because the money would reflect in their account almost instantly, without any settlement lag and corresponding risks.

• Trust

In some of the countries that have adopted e-money products, there are signs users trust these products more than banks.

• Network effects

The value of e-money grows as more and more people embrace it for day-to-day transactions, and as more users adopt it, the easier it becomes to migrate from traditional payment methods. As a result, the value to all participants—existing and prospective—grows.

The Effects of Different Scenarios of e-Money Adoption on the Banking Sector

E-money has had a rapid rise in the financial sector thanks to large-scale backing, particularly by large big tech firms with large existing user bases and nimble fintech startups. But does this spell the end of traditional methods of payment and b-money (bank-issued digital forms of payments)? Will we see a mass migration of users from banks to e-money providers? The answer isn’t straightforward, but there’s a consensus that despite the quick rise of e-money, traditional forms of payment will still play a critical role in the financial sector for a long time.

The adoption of e-money in the banking sector could lead to three plausible scenarios. Let’s go over each of them in detail.

Scenario 1: Coexistence

The most plausible scenario is that e-money and b-money will coexist, and there are several reasons:

First, banks enjoy stronger distribution networks than e-money providers and big tech firms and have “captive” users, even though they may not have as large user bases as big tech firms. Second, banks can cross-sell other financial services to customers that big tech firms cannot offer. That includes overdrafts, credit lines, and short-to-medium term loans. In addition, e-money providers might find some banking facilities useful. For example, they might recycle client funds back to banks as certificates of deposit or other forms of short-term funding. However, banks would not be too keen to propagate or nurture this kind of relationship with e-money providers for several reasons:

• Accepting funding from e-money providers would effectively amount to swapping cheap and stable retail funding for expensive and runnable wholesale funding.
• Reliance on e-money providers for funding would force the bank to cut off key client relationships.
• A reduced focus on customer transactions and deposit funding would result in loss of access to important data.
• E-money providers might only be keen to fund a few large banks, leaving smaller banks at the risk of funding strains and a greater risk of volatility in funding.

To counter the growth of e-money, banks have several options:

• They could offer a higher rate of interest on deposits. Banks generate profits using the maturity transformation model (holding assets of longer-term than deposit liabilities). As such, they may be able to offer higher interest than e-money providers. A higher rate on deposits can also be met through greater operational efficiency, for example, by replacing cashiers/tellers with ATMs.
• Banks could rival the quality of e-money services, for example, by offering touchless cards and phone-based apps that facilitate payments by debit card. Such services include Venmo, Apple Pay Cash, and Zelle in the U.S. They could even develop a payment system in the mold of the Target Instant Payment Settlement (TIPs) system used in the euro area, which allows the settlement of retail transactions nearly in real-time.

Scenario 2: Complementarity

The other likely scenario is that e-money providers will complement commercial banks and help bring more people into the modern financial system. E-money can encourage poor households and small and medium enterprises (SMEs) to embrace the formal economy and mo0dern technology. This way, they also get introduced to saving and credit facilities, accounting services, and consultancy services that can help them make better financial decisions. This scenario has already played out in Kenya. There’s been notable credit growth in the country since the emergence of M-Pesa in 2008.

Commercial banks could cultivate a partnership with e-money providers even in developed countries. These providers usually have a lot of customer data, including data belonging to customers who prefer e-money products over banking. E-money providers can analyze such data and generate informative findings that can be shared with banks for use in targeted campaigns or more efficient credit allocation.

Scenario 3: Takeover

The other plausible but unlikely scenario could see a radical transformation of the banking model. Banks could be forced to cede some of their products or facilities to e-money providers. For example, commercial banks’ deposit-taking and credit functions could be split, with the former migrating to e-money providers while banks concentrate on credit business. E-money providers could then channel deposits into government bonds or central bank reserves. The overall result would be an unprecedented transformation of today’s fractional banking model. Banks take deposits but only hold a fraction of these in liquid assets such as central bank reserves and government bonds, with the rest being lent to households and firms.

Possible Regulatory and Policy Actions in Response to Risks Arising From Increased Adoption of E-Money

As e-money continues to encroach on the fractional banks we know today, there’s a general agreement that policymakers cannot afford to stand idly by. Central banks, in particular, can play a starring role. To see just how important central banks can be in the financial power matrix between banks and e-money providers, it’s important to consider the role they play in the fractional business model. All banks are required to hold accounts at the central bank. Each bank must hold a specified minimum amount in this account. These monies are transferred from one bank to another to facilitate payments or credit (as happens in the repo market). This transfer removes credit risk from interbank transactions and opens channels for interoperability across banks. In the absence of the central bank, interbank payments would be expensive, slow, and potentially risky.

Therefore, it’s not surprising there have been calls for central banks to regulate e-money providers the same way they regulate banks. This would mean offering settlement services to e-money providers and requiring them to hold central bank reserves as long as they meet the required terms and conditions. Indeed, this is already happening in some countries. For example, the Hong Kong Monetary Authority, the Reserve Bank of India, and the Swiss National Bank have already issued special licenses that allow fintech firms to hold central reserves as long they accept being supervised and meeting certain conditions. In China, some of the country’s most popular e-money providers, such as Alipay and WeChat Pay, must hold client funds at the central bank.

The envisioned offering of central bank reserves to e-money providers would come with several benefits:

• First, the move would guarantee the stability of e-money. It could be argued that all it might take to compromise the trust e-money enjoys today is one major default by a popular, well-established provider. There is also the risk of illiquidity, foreign exchange risk, and potential overissuance relative to backing in client funds. All events related to these risks would undermine confidence in the payments system, destroy wealth, and ultimately compromise the stability of the entire financial system. Holding of central bank reserves by the central bank would attenuate default risk and eliminate liquidity and market risk.
• Second, central banks would ensure the interoperability of payments. It would ensure that if a user transfers cash from provider X to another user using provider Y, there would be a shadow shift of funds from X’s trust account to Y’s. This would ensure that the newly held e-money be fully backed and redeemable.
• Third, central banks would protect new or emerging providers from large international e-money monopolies. Such monopolies would naturally enjoy large-scale access to data and economies of scale, making it difficult for small firms to enter the market and conduct business. Central banks can help small local providers overcome these challenges by offering them the means to issue safe and liquid money. This would potentially prove more attractive to the local populace than the foreign, more established providers.
• Central bank reserves for e-money providers would pave the way for more effective monetary policy transmission. By paying interest on reserves, for example, central banks and governments would be in a good position to control monetary policy rates to consumers and potentially put pressure on banks to offer lending rates that are closer to the policy rate. If banks fail to follow the central bank’s lead, they would risk losing customers and potentially ceding more ground to e-money providers.
• Reserves would offer central banks the perfect platform to launch strict supervision and licensing of e-money providers. For example, providers would have a responsibility to enforce KYC (know Your Customer) and anti-money laundering checks and also enhance the security of wallets and customer data.