The first part of this article last week discussed how bankruptcies are soaring globally, spurred by tightening monetary policy and significant bank failures. This widespread financial distress has highlighted growing global economic vulnerabilities and the bank failures of Silvergate, SVB and Signature have drawn attention to banks once again. The fragilities of fractional banking and relying on commercial banks to create ‘e’ (electronic) money have been exposed since depositors are able to remove money on-line at the click of a button. Between 2001 and 2023, 567 US banks have collapsed, and there are concerns regarding a further “186 banks at risk of failure.” Meanwhile, commercial real estate (CRE) remains a particular concern, especially for smaller banks with significant CRE loan exposure. The most recent bank in the US to go under is Republic First Bank (Philadelphia) and unfortunately banks in various other jurisdictions have suffered equally, such as Credit Suisse in 2023 and Flow Bank in June 2024
In addition, the way we pay for goods and service is changing. Digital (‘d-money’) which is, in effect, a bearer instrument with a digital fingerprint, is programmable whereby enabling almost real time transactions backed by actual cash. But will the d-money ‘promise’ crowd out traditional commercial banks and so increase interest rates? Certainly, the introduction of digital money is poised to impact traditional banking and economic growth significantly. For instance, the proposed digital euro - a retail central bank digital currency (CBDC) - could reshape financial dynamics. A study by Copenhagen Economics indicates that if the digital euro's holding limit is set at €3,000, up to €739 billion in deposits could be withdrawn from banks - which is equivalent to 10% of the total household deposit base in the euro area. And this shift could elevate banks’ funding costs and constrain their credit provision, particularly for long-term financing. Lowering the holding limit could certainly mitigate these effects but still challenge financial stability and banking profitability and, furthermore, depending on the adoption of a retail €CBDC, GDP could decrease by 0.34% annually. Hence, this potential reduction highlights the need for careful consideration of how digital innovations are integrated into the financial system to balance benefits with potential drawbacks and ensure sustainable economic progress.
Yet, despite these concerns, the benefits of digital money are undoubtedly compelling. Blockchain technology enhances transparency with its real-time, immutable ledger, so allowing stakeholders to track and verify transactions with great clarity, and when artificial intelligence (AI) is integrated with blockchain, the advantages are further amplified. AI can process vast amounts of data to detect systemic risks and predict their potential effects on the economy. By identifying patterns and anomalies that might indicate emerging risks, AI enables pre-emptive action to address vulnerabilities before they become major problems. And this fusion of blockchain transparency and AI-driven insights strengthens regulatory efforts to monitor financial stability and reduce the impact of banking failures. Regulators can benefit from blockchain technology to boost oversight and financial monitoring accuracy, and with its real-time, immutable ledger of transactions, blockchain also supports more efficient audits and compliance checks. Examples of successful use include blockchain-based trade finance and regulatory reporting systems, showcasing its potential to refine regulatory processes. However, challenges such as integrating blockchain with existing systems, addressing data privacy issues and achieving widespread financial sector adoption need to be addressed; overcoming these hurdles will be vital to fully harnessing blockchain’s advantages in regulatory frameworks.
Meanwhile, central bank digital currencies (CBDCs) and tokenised money market funds are driving significant transformation in the financial ecosystem. With over 98% of global central banks engaged in researching, piloting or deploying CBDCs, these innovations are poised to reshape systemic payments and securities transactions among financial institutions. Moreover, central bank money (CeBM) has long been essential for interbank payments and securities transactions due to its virtually risk-free nature, minimising credit and liquidity risks whilst ensuring settlement finality and enhancing financial stability. And, despite the rise of alternative payment methods, CeBM remains crucial for systemically important transactions. Wholesale central bank digital currencies (wCBDCs) represent an advanced form of CeBM, promising to unlock new economic models and integration points not possible with current systems; they establish a foundational layer for future digital payments in financial markets. The differentiated value of wCBDCs lies in several key areas and they can create a global settlement window by harmonising foreign exchange (FX) and securities market settlement times, thus overcoming operational hour disparities among major trading corridors and facilitating seamless cross-border transactions. Furthermore, wCBDCs enhance currency liquidity through expanded payment-versus-payment (PvP) arrangements, providing cost-effective solutions that support various currencies. They also enable the secure transmission of settlement data across parties and jurisdictions, promoting automation, reducing settlement risks and improving trade and post-trade activities. Another significant benefit is their ability to tokenise credit risk-free settlement media, which is crucial for settling tokenised securities and supporting emerging tokenised payment instruments.
Two fundamental areas of wholesale financial markets where the adoption of wCBDCs is particularly impactful are: interbank payments and securities transactions. In interbank payments, wCBDCs facilitate domestic payments by settling obligations between banks and other financial institutions within a jurisdiction, whether single or two-legged. They also streamline cross-border payments via nostro accounts, enabling transactions between central banks, banks and financial institutions across different jurisdictions. Additionally, wCBDCs provide currency liquidity across borders through central bank infrastructure managed by market makers or dealers. In the realm of securities transactions, wCBDCs support the settlement of trades involving equities and fixed-income instruments both domestically and cross-border, including tokenised securities. They play a crucial role in collateral and liquidity management, serving as a payment instrument for posting collateral or acquiring intraday liquidity. Furthermore, wCBDCs facilitate post-trade operations which are integral to the delivery versus payment (DvP) process for securities. A BIS survey anticipates that by 2030, at least nine wCBDCs will be in circulation, with live pilots already underway in Switzerland and Singapore; notable projects such as mBridge and various cross-border initiatives are focusing on addressing inefficiencies in international payments. As tokenised money market funds emerge, they pose a competitive threat to traditional bank deposits, potentially creating systemic risks for banks. No doubt, the evolution of wCBDCs and tokenised assets is set to reshape financial markets, demanding adaptation from existing institutions and offering new opportunities for efficiency and innovation.
However, the recent failures of banks offer valuable lessons for both investors and the broader financial system. Firstly, it is essential to keep abreast of industry changes as regulatory landscapes are constantly evolving; this awareness is critical for adapting and minimising risks. Secondly, diversification of assets remains crucial; recent bank failures (similar to those of the 2008 financial crisis) show that spreading investments can protect against major losses. Thirdly, the events emphasise the risks associated with fractional reserve banking - with traditional banks maintaining only a small fraction of deposits in reserve, this system becomes problematic in the digital age where immediate fund access and online transfers are the norm. Then again, blockchain technology provides a viable remedy to these problems by introducing a more secure and transparent option compared to fractional reserve banking. With blockchain, transactions are documented on a decentralised ledger so reducing dependence on intermediaries and bolstering financial stability. In essence, transparent communication between stakeholders, including policymakers, regulators and financial institutions, is critical; such dialogue can address systemic challenges and aid in transitioning to stronger financial frameworks. Although true decentralisation could eliminate intermediaries, realising this goal demands ongoing partnership with government agencies. Hence, those firms offering digital assets must concentrate on educating and innovating to advance decentralised technologies. By pushing the boundaries and fostering collaboration, the industry can work towards achieving widespread adoption and a more resilient financial framework.
This article first appeared in Digital Bytes (3rd of September, 2024), a weekly newsletter by Jonny Fry of Team Blockchain.