Fiat Currency, Central Bank and Commercial Bank money
A “fiat” currency is one that is government-issued, not backed by a physical commodity (such as gold or silver), but rather by the government that issued it and which has then been declared as legal tender (normally by law or regulation). The government controls the supply.
Within a given fiat currency, there is then normally Central Bank money (bank notes and Financial Institution deposit money held on “reserve accounts” at the Central Bank) and Commercial Bank money (which normally takes the form of customer deposits held at Banks and other financial institutions). Central Bank and Commercial Bank monies are convertible into each other at par (which tangibly takes place when a commercial bank customer withdraws banknotes either over a branch counter or via an ATM using money held in their account).
Central Bank deposit monies play a fundamental role as the settlement asset underpinning payment systems (e.g. as happens on a daily basis when UK Bacs net obligations are settled across balances held by the participating banks at the Bank of England). Since the monies are held at the Central Bank as opposed to at a Commercial Bank, they are deemed to be the lowest risk form of deposit.
In a payment chain (from end originator to end beneficiary), payments will normally take place using a combination of Commercial and Central Bank money; the Central Bank will normally act as the settlement institution, with settlement occurring in Central Bank money between two directly participating Financial Institutions in the relevant payment system used for the transaction. The debits and credits across accounts held by the originator and end beneficiaries will be in Commercial Bank money
As a subset of Central Bank money, bank notes (cash) are a physical store of value and are normally underwritten by the Central Bank. In the UK, the Bank of England has issued notes promising to pay the bearer since 1694 and, up to 1931, that promise could be made good by the Bank of England paying out gold in exchange for its notes. Nowadays, notes can only be exchanged for other notes.
Cash has a unique inherent characteristic when used in a payment transaction that is absent from other payment methods and that is privacy/anonymity. Whilst a retailer may, potentially, know the customer, the underlying payment asset itself is completely anonymous. This brings both downsides (in terms of crime) and benefits (for those who see no reason for the data associated with their transaction to be logged against their names).
Digital Wallets and Pre-Paid Cards
An extension of Commercial Bank money is present with Digital Wallets and Pre-Paid cards which can be “loaded” with funds (not necessarily from a bank account associated with a customer – e.g. Social Security benefits received from the state) and then spent in the normal manner. Such payment methods inherently carry additional risks to the consumer (e.g. the sum held on the card may not carry the same level of protection as that afforded to an account protected under local deposit protection legislation (e.g. the UK FSCS scheme) at a licensed deposit taking institution).
A cryptocurrency is not “legal tender”, is often privately issued and is therefore not backed by a central government or bank. As at April 2020, there were over 5,300 cryptocurrencies of which the following were the largest by market capitalization:
- Bitcoin ($128bn)
- Ethereum ($19.4bn)
- XRP ($8.22bn)
Unlike traditional currencies (which derive from a Central Bank’s core ledger), cryptocurrencies utilise distributed ledgers underpinned by “blockchain” technology. Holdings and transactions are backed by immutable time-stamped entries across the ledger base where pre-defined “consensus” mechanisms rather than a central authority control the modification of the “data blocks” and the creation of additional currency (e.g. bitcoin “mining”). The challenge of supply vs demand can result in substantial price volatility, which results in the cryptocurrency often being seen as a speculative investment rather than a store of value or a means of procurement.
A number of Crypto-currencies have gained adverse publicity in recent years due to them being linked to criminal acts such as ransomware demands and their value volatility. As a consequence, there is little or no public demand for their use in day to day payment transactions.
A stablecoin is a new class of cryptocurrency that attempts to offer price stability by virtue of being pegged to one or more fiat currencies. Examples include Facebook’s Libra proposition. Stablecoins are beginning to gain traction as they attempt to offer the best of both worlds—the instant processing and privacy of payments of cryptocurrencies, and less volatile valuations.
However, for there to be any widespread acceptance of a stablecoin, they must be as risk-free as a fiat currency and for their operation to be subject to full regulatory acceptance/oversight given the systemic risk that could otherwise arise through large-scale adoption. They would also have to gain widespread public trust.
All cryptocurrency solutions (including stablecoin offerings) currently suffer from the same inherent issue – there is a very restricted user base. Even if someone possesses some cryptocurrency or stablecoin and wishes to spend it, the likelihood of someone being able/willing to take it as part of an everyday purchase is currently remote.
 A point made by Governor Brainard (a member of the Federal Reserve Board of Governors) in a widely reported speech given in December 2019. https://www.federalreserve.gov/newsevents/speech/brainard20191218a.htm
Central Bank Digital Currencies
Central Bank Digital Currencies are a newly emerging form of currency. As inferred by their name, they are Central Bank issued and with a value that, like commercial money, is on a par with the fiat currency of that country. As set out in the Bank of England’s March 2020 discussion paper on CBDCs, “a UK CBDC would be a new risk-free form of (digital) pound sterling, issued by the Central Bank, and would therefore perform all the essential functions of money”.
CBDC deposits would be free of credit risk as opposed to the inherent risk present in commercial bank deposits. As such, customers with balances in excess of the level secured under local deposit protection mechanisms might seek the protection of CBDC denominated accounts vs that of Commercial Bank deposits. This, in turn, might cause banks and other financial institutions to alter the terms of their accounts to make them more attractive to investors.
Whilst cryptocurrencies are recognised by their dependence on blockchain technology, the same is not true of CBDCs (which could operate on either a centralised or distributed ledger basis).
An increasing number of Central Banks are actively researching the introduction of digital currencies. In January 2020, the BIS reported on the results of its latest CBDC survey; of 66 Central Banks that responded, 80% are engaging on some related work, 40% progressing on from proof of concepts and 10% have developed pilot projects. In terms of likely implementation in the short (1-3 year) or medium (4-6 year) term, just under 40% thought it likely.
On 21st July 2020, the Banque de France announced it was about to work with eight institutions in testing applications for CBDC interbank settlements.