Alex Lipton, Thomas Hardjono, and Alex Pentland
The Global Financial Crisis was a wasted opportunity to reorganize the world financial ecosystem. Too-big-to-fail banks became bigger rather than smaller, massively increasing their share of the banking business. For instance, JPMorgan has nearly twice as many assets now as it had at the end of 2006 just before the onset of the crisis; over the same period, assets of China’s four systemically important banks more than tripled.
Although better capitalized, banking institutions have become so complex that their stability and credit worthiness cannot be established with certainty. Their balance sheets are opaque and have complexity risks which are not well understood by regulators, depositors, investors, or even internal management. This complexity can reach high levels and may become too-big-to-manage. Frustration of the general public with the status quo manifests itself in a number of ways—in politics, in general discourse, and, most directly, in the incredible rise and more recent fall of Bitcoin and other cryptocurrencies.
However, not all is lost. The introduction of new technologies is unleashing competitive threats to the existing players and will reshape the entire financial ecosystem. In our estimation, this competition is going to be the fiercest in the following areas: fractional reserve banks vs. narrow banks; digital cash vs. physical cash; fiat currencies vs. unpegged cryptocurrencies vs. asset-backed cryptocurrencies; centralized payment systems vs. distributed payment systems; centralized identity vs. decentralized identity.
Technology makes the narrow banking business model a viable proposition. Modern fractional reserve banks, originated during the Renaissance, were always prone to collapse. The Great Depression brought the idea of narrow banks to the forefront. Not surprisingly, it gained traction again after the Global Financial Crisis. The main characteristic of a narrow bank is its assets mix, which includes solely marketable low-risk securities and central bank cash in the amount exceeding its deposit base. As a result, such a bank cannot “go broke” except by operational failures. Accordingly, narrow bank deposits would be largely equivalent to currency, thus abolishing the need for deposit insurance with all its perverse effects.
The absence of physical cash would partially cure societal ills, such as crime, or, at least, make them more difficult. It would lubricate the wheels of commerce and help the unbanked, benefitting society at large. On the flip side, with cash abolished, interest rates would be determined only by policy makers and could be set as negative as central bankers liked.
Another even more serious hazard of a widely used digital currency is enabling a repressive surveillance state. If the government can track all of its citizens’ payments, then they can exert unprecedented control over their lives.
To avoid this “big brother” situation, small financial transactions, such as currently performed with cash, must be anonymous. In exceptional circumstances, it should be possible to override this anonymity using carefully vetted and expensive methods such as legal court orders.
A properly constructed narrow bank issuing its own digital currency is a much more palatable and practical solution than CBDC.
Fiat currencies, while undeniably useful, are not well suited to the needs of 21st century commerce, especially trade and supply chain finance. In addition, the USD, being the world reserve currency, causes serious trade imbalances, which can trigger trade wars and exacerbate the international frictions.
By combining the ideas of narrow banking (for stability), blockchains (for efficiency and transparency), and an asset-backed currency (to reduce trade distortions and inequality), we see the potential for dramatic improvement in the global financial system. Today, for the first time ever, there is a possibility of designing a digital supranational currency, which we call digital trade coin (DTC), which could combine the best features of historical currencies, including finality of settlement, partial anonymity, and usability on the web, and be ideally suited as a medium of trade and exchange for groups of smaller nations or supranational organizations.
Our solution boils down to assembling a pool of assets (contributed by sponsors), appointing an administrator (who provides enforcement of policies in extreme situations), digitizing the ownership rights on this pool, and building a special purpose narrow bank to facilitate activities of the administrator. This solution was published a year ago in both Scientific American and the Royal Society under the name Tradecoin.
We believe that DTC has the potential to provide an international reserve currency, which remains stable in the long run and does not suffer from the inherent deficiencies of credit-based fiat national currencies, for the following reasons: (A) DTC has real value, because its price is pinned to a representative basket of commodities; (B) the price of the DTC vs a single fiat currency has low volatility compared to other cryptocurrencies, and can be used as a transaction currency; (C) DTC can also be used a unit of account and a store of value. To conclude, DTC can serve as a much-needed counterpoint for todays’ fiat currencies by ensuring world-wide financial stability and inclusion.
The flavor of the month is a new proposal to replace hard cash and credit cards, this time from a group of tech-oriented companies led by Facebook. This proposal is both good and original; however, as Samuel Johnson famously put it “the part that is good is not original, and the part that is original is not good.” The “good part” was developed as way to bring greater fairness and security to the world’s financial systems, and published by us in the above quoted papers. On the other hand, the “original part” leaves a lot to be desired.
Libra has provoked a lot of hand-wringing and apocalyptic prophecy, most of which falls into four categories: fear, greed, envy, and the voice of experience:
- Fear: People who hate tech and Facebook in particular. These are mostly people who make their living selling disaster adrenaline through books and newsfeeds, but despite their overblown rhetoric they make the very good point that the tech in general believes in “move fast and break things,” and that approach will have negative impact on local economies and communities. Yet, this fear is not unreasonable, given that Facebook created a reputation of disdain for privacy and personal information, accumulated superpower in the area of social medium (remember Standard Oil in 1920s?) and is notorious for extremely weak corporate controls. Now that tech increasingly manages critical parts of our social systems they need to act, and be governed, more like traditional institutions.
- Greed: Incumbents in finance and payments, who worry that this sort of radical change could lead to disastrous financial crashes…and of course sharp and permanent reduction of their revenue streams.
- Envy: Tech libertarians who promote bitcoin and similar decentralized visions of the future. They want to kill off centralized authorities and view Libra as a perversion of that which looks decentralized but is really centralizing financial power in the hands of tech giants. Good point, but history, social science, and the math of complex systems teaches that complete decentralization leads to the madness of crowds more often than to collective wisdom. Besides, in actual fact, Bitcoin and other cryptocurrencies are highly (albeit implicitly) centralized. Some provision for governance by representatives of the broader stakeholder community is required for robust stability and broadly shared utility.
- The voice of experience: These are people who worry that this will concentrate power in the hands of just a few people, thus undercutting democracy and personal freedom, and will also enable “bad guys” to have a field day unless strongly regulated. Facebook, which is notorious for its loose attitudes to and multiple egregious violations of users' privacy, is particularly dangerous in this context. Abstractly this is not so different from the other points, but is cast in the political terms and not as a problem in system engineering. They make the good point that such a system needs to have strong guarantees that it will not harm the vulnerable. Moreover, while recent history has washed away almost all sympathy for financial incumbents, longer history also teaches that it is immensely hard to foresee financial difficulties, and that these “unknown unknowns” can lead to broad and intense suffering. One important danger they point to is the likelihood of inflation and instability in smaller economies.
Despite all the criticism, however, the technical design of Libra is really quite good…at least we think so, since we published our version of it a year ago. The main difference between Libra and Tradecoin is that we envisioned that such a system be introduced as a way that small countries, sovereign wealth funds, and retirement funds could get a fair shake in the world’s financial system, instead of being ignored or exploited by the big central banks. With such an expert user base, backed by real assets rather than financial instruments, and used by stakeholders who represent the national wealth of a large fraction of humanity, the efficiency and robustness of a system such as Tradecoin would benefit humanity relatively directly, while being both more transparent and accountable than today’s financial system, and thus consequently safer. Only later, when proven out, would it possibly become available to consumers directly. Such a Tradecoin would be aligned with the ebb and flow of the real economy, thus providing a much-needed counterpoint to fiat currencies and facilitating rather than exacerbating international trade, a point, which becomes especially relevant in the day and age of trade wars, competitive currency devaluations, etc.
In the hands of experienced and trusted stewards of our collective wealth advancements in computer technology, including distributed ledgers, can make an asset-backed Tradecoin a viable and much needed instrument for both domestic and cross-border payments, which can beneficially affect the entire financial system.