Central bank digital currencies and stablecoins could introduce new efficiencies, transparency and protections into our monetary system. However, for ultimate benefit, new forms of digital money require a purposeful design with fungibility and interoperability in mind, and a mature, regulated environment to operate within, writes Rebecca Hackworth, Head of Communications.

Everyone’s talking about money. Not just in terms of personal finances, but the actual nature of money: what it is, how it’s issued, how it maintains value and how it can be best moved between people, businesses and across borders. This discussion has moved beyond the remote corners of academia, the payments industry, and economists’ circles into mainstream conversation. The reason for this, of course, is the rise of cryptocurrencies. In November 2021, the global market cap of cryptocurrency reached $3 trillion, with 16% of Americans and 18% of Brits owning this new digital asset, according to Pew Research and the Financial Times.

Increasingly this conversation highlights the word “fungibility”. This once-obscure term essentially means tradability – whether consumers, businesses and governments will accept a form of money as a consistent unit of value.

Cryptocurrency advocates worry about the continued fungibility of fiat money – the money issued or backed by central banks. They cite the cumulative impacts of quantitative easing, eroding democratic values and shifting political winds on the long-term value of fiat. In some cases, they may be right. However, they are wrong in the view that cryptocurrency and decentralisation offer a panacea against these threats. Cryptocurrencies are not backed by central systematic controls, so the individual actions of significant holders or ‘whales’ can drastically impact value. Moreover, with its extreme volatility – Bitcoin dropped 65% this year alone – insufficient regulation and governance, crypto in its current state is unlikely to be the currency of choice for day-to-day payments or financing. Even Elon Musk, until recently one of the world’s greatest crypto enthusiasts, now seems to agree. In late July, Tesla sold 75% of its Bitcoin holdings, once valued at $2bn, to shore up liquidity, but might this move also demonstrate a lack of faith in the so-called ‘gold standard’ of cryptocurrency?

Could central bank digital currency provide the answer?
CBDCs, a new form of public money issued by central banks, aim to bring stability and consistency to this new world of digital assets. CBDCs endeavour to marry the functionality of smart contracts including near-instant settlement and reconciliation, the existence of permanent, auditable records, and programmability to trigger payments, with the solidity of fiat currency.

Furthermore, CBDCs have the potential to prevent fraud and to provide real-time information about risks to the financial system. Quant Founder and CEO, Gilbert Verdian, says that “a CBDC, if it had been in existence, could have provided information to warn regulators about impending mortgage defaults that led to the 2008 financial crisis, and enabled central banks to take preventive measures.”

Many people are rightly concerned about their privacy and financial inclusion with respect to CBDCs. Democratic governments realise this and are actively consulting with stakeholders on how privacy protections and financial inclusion can inform currency design. These institutions view money as a public good that needs to be based on democratic principles and trust for widespread public acceptance and adoption. If CBDCs arise in this consumer-friendly format, could they be the ‘Rolls-Royce’ of digital currency in terms of fungibility? If the answer is yes, what about the role of private money?

The new role of private money
Today, private money issued by commercial banks in the form of loans represents 95% of the total money in circulation in the U.K. This money isn’t printed as notes; rather, it’s issued and transacted on ledgers. Tokenisation takes this concept of private money one step further. Circle’s USDC, backed 1:1 by U.S. dollar deposits in Silvergate Bank, is essentially a form of private money. In its nascent form, digital private money is used on crypto exchanges and cold wallets as a liquid asset to park fiat and take earnings after crypto trades. Proponents of privately-issued stablecoins want to take them mainstream, as a new ‘digital dollar’ to be used not only in crypto trading, but also, in everyday payments. Opponents cite data privacy concerns: do we really want banks and big tech companies to track our every spend? Whether consumers warm to this use case remains to be seen. But if people start using stablecoins for day-to-day payments, this form of money will become–or need to become–another example of fungible currency.

Key concepts of fungibility
So back to the original definition of fungibility: it’s essentially the aspect of money or currency that make it tradeable. Its hallmarks include:

  • Is it trusted? The U.S. dollar is highly trusted, backed by longstanding democratic institutions and dependable fiduciary and prudential regimes to mitigate risk within a strong regulatory and legal framework. As a result, the greenback is often a de facto currency of choice, not only in the U.S., but in other countries with weaker monetary controls.
  • Is it dependably backed? Is the digital currency backed by a strong, trusted central bank or a regulated, commercial bank? Or, in the case of algorithmic stablecoins, backed by other stablecoins, cryptocurrencies or ‘defi’ investments that are questionably audited? Or, like Bitcoin, is it not backed at all; rather, its inherent value is derived purely from market sentiment?
  • Can it be securely held? This concept also goes back to trust. If it could be easily hacked or emptied from your digital wallet, then perhaps it’s not the best unit of value. Equally, if its a paper note that could be easily counterfeited, it might become less valuable.
  • Is it stable, or is it volatile? If its value fluctuates a lot in one day, then it becomes difficult to use as a consistent store of value and unit of account.

How a strong regulatory framework supports fungibility
Trust is a crucial feature of fungibility. And for this, we need a practical regulatory and legal framework to define what the new form of money is, how it can be issued, operated and traded, and how to manage risk. This framework and policy would also cover the roles, responsibilities, and oversight of different governing bodies and participants within the monetary ecosystem: central and commercial banks, regulators, government departments as well as third-party infrastructure providers. It would also set out the liability requirements of different issuers to protect consumers.

The framework would also define the prudential obligations, that is how the currency is backed and the thresholds for when more onerous risk management provisions come into play. The E.U.’s Market’s in Crypto Assets regulation delves into this detail by defining how stablecoins should be backed, how they can be brought to market, and whom is a ‘significant’ issuer or service provider, subject to additional oversight.

These rules also aim to mitigate the systemic risk of ‘too much’ private money, which could undermine the ability of governments and central banks to employ controls to assist economic recovery in times of steep inflation or recession.

Lastly, the regulatory framework would also set out probity requirements for ethics and sound processes so the whole system has proper oversight. To prevent bad actors from entering the system, anti-money laundering and know your customer rules would also come into play.

The difference between fungibility and interoperability
Closely related to regulation is the need for standardisation. There are four principal types of distributed ledger technology on which new digital currencies can run: public (permissionless), private (permissioned), hybrid and consortiums. Each type of DLT is best suited for a particular use case; for example, intra-company repos like JPMorgan’s Onyx are run in a private, ring-fenced blockchain, whereas commercial stablecoins such as USDC, supported by a network of banks, is operated on a consortium blockchain. Whilst these use cases are powerful, they take a siloed approach that leaves open the question of interoperability – and hence fungibility – between the different digital currencies.

Gilbert Verdian believes that “in the future, enterprises extend and scale the way they use stablecoins for payments.” He proposes that banks may want to develop commercial stablecoins that operates on public ledgers for consumer to merchant transactions, and through consortium banking networks.

For this to happen, international standards and technical harmonisation need to be agreed and implemented. ISO TC/307, Blockchain ISO Standard, is one such body creating international standards. Organisations like INATBA, the International Association for Trusted Blockchain Applications review and classify different blockchain projects to support international harmonisation.

Gilbert further explains that “standardisation puts in place the framework needed for interoperability. And interoperability is essentially the technical and business considerations that enable stablecoins or a CBDC to easily transact from one network to another.”

In the near future, we will probably see more and more digital currencies coming into existence. As improved governance, regulations and standards take hold, the market will mature to a state in which commercial stablecoins and CBDCs can transact ubiquitously across networks.

Gilbert anticipates that “traditional currencies, cash and even cryptocurrency may have roles as well. And each country and jurisdiction will have a slightly different mix of currencies. Ultimately, merchants and consumers will have more choice in how and where they transact, and this will spur a wake of new business opportunities.”

The key to this is purposeful design so we build on the principal concepts of fungibility and enable interoperability to ensure that money remains a public good.​

Back to Perspectives

A CBDC, if it had been in existence, could have provided information to warn regulators about impending mortgage defaults that led to the 2008 financial crisis, and helped enable central banks to take preventive measures.

Gilbert Verdian
Founder and CEO
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