Wednesday, June 15, 2016

Another Fedcoin sighting

Early map of Fedwire. Source: FRBNY

The pace of Fedcoin sightings has been accelerating this year. If you're new to this blog, Fedcoin is a catch-all term I like to use for a central bank-issued cryptocurrency. Earlier this month the Federal Reserve itself hosted a conference called Finance in Flux: The Technological Transformation of the Financial Sector. The keynote presentation was given by Adam Ludwin, CEO of blockchain firm Chain Inc, who had some interesting things to say about a central bank digital currency.

A criticism I have of blockchain advocacy in general and Fedcoin in particular is that evangelists tend to understand little of the history or qualities of the institutions that they are trying to overthrow. The result is that they invariably end up mis-estimating the benefits of replacing existing systems with new ones.

For instance, Ludwin calls his presentation Why Central Banks Will Issue Digital Currency, a title that must have got Janet Yellen scratching her head since the Fed has been issuing digital currency, or reserves, for a long time now. A system called Fedwire, one of the most important utilities in the U.S., allows some 9,000 financial institutions to transfer these digital reserves among each other.

Ludwin goes on to provide more details on the sort of blockchain-style digital currency he is promoting:
...I find it more helpful to look back to bearer instruments, like banknotes, to appreciate what this new medium enables: a digital bearer instrument... With bearer instruments the payment is also the settlement. It is one step. This is a neat property of a bearer instrument...The goal of the blockchain industry is to collapse these steps into a single step, where payment is the settlement, just like with physical notes. 
Ok, Ludwin wants not just digital currency but instantly-settled digital currency. But Fedwire already achieves this. In a Fedwire payment between banks, the exchange of reserves constitutes settlement. Put differently, in the same way that a banknote or bitcoin payment involves a single step, a Fedwire payment also involves but one step. Say bank A wants to pay bank B $10,000 in reserves via Fedwire. The moment a bank hits the button to complete the payment, reserves change hands and the transaction is complete. An ensuing clearing process does not need to be initiated, nor does an underlying set of assets need to be mobilized to settle the payment. To top it off, trades cannot be undone. Fedwire payments are final. The moment reserves enter your account, you own them.

Fedwire is what is known as a real-time gross settlement system (RTGS); payments are made in real time and are irrevocable. Most of the world's central banks operate an RTGS. Ludwin's firm is leading the battlecry for central bank blockchains, but the main selling point—that Fedcoin collapses payments into a single step—brings nothing to the table that an RTGS like Fedwire doesn't already provide. So why bother?

Ludwin mentions security. Is he claiming that Fedwire is in any way insecure? Fedwire is a robust system that in 2015 processed 143 million transfers with a total value of $834 trillion. It has been operating without major mishap for decades. He also floats the idea that there will be "perfect clarity around where the asset is at any point in time." I'm sure that the Fed always knows the exact location of each reserve it has ever issued. He also brings up the question of speed. But as I pointed out above, Fedwire payments are instantaneous. In fact, Fedwire would probably be faster than Fedcoin.

As far as I can tell, the only difference between the two networks is that a proposed Fedcoin would be distributed while Fedwire is centralized. What this boils down to is that the Fedcoin network would be maintained by a large number of independent nodes whereas Fedwire is run out of a lone data centre in New Jersey (see my old post here for a map). If you take out a Fedcoin node the remaining nodes will continue to operate the payments network. Destroy Fedwire's New Jersey data centre (and its two back-up locations), however, and the system collapses. Redundancy is great, but is it enough to justify switching from Fedwire to Fedcoin? I'm not convinced.

What about operating costs? If Fedcoin and Fedwire have the same capabilities, but Fedcoin costs half as much  to operate, then an infrastructure switch could make a lot of sense. We know how much it costs for the Fed to process a Fedwire transaction because it publishes a set of fees that is designed to recoup its costs:

Source: Fedwire

A Fedwire transfer can cost as little as 15.5 cents (before incentives) for the Fed to process. So a $100,000 transfer might cost just 0.0002% in fees. That's not much. For comparison sake, the UK-equivalent RTGS—called CHAPS—costs just 16.5 pence per transfer. On a large transaction that's a pittance. Can Fedcoin beat theses costs while providing the same degree of speed and security? I'm not sure, but these are the sorts of questions that an advocate of Fedcoin needs to answer.

It's with small-value payments that Fedwire trips up. Between 1.55% to 7.9% of a $10 Fedwire payment will be eaten up by fees. That's not cheap. Payments of this size are the sort that a retail customer would typically originate, which means Fedwire is not a great retail payments network. If a proposed Fedcoin could bring down the cost of operating a small-value central bank payments than it might help banks serve retail clients. That's a worthwhile use case.

In addition to their RTGSs, central banks typically maintain a retail payments system. While the U.S.'s archaic system ACH is just awful (it takes several days to settle), more recent systems like the UK's Faster Payments Service (FPS) are decent. The drawback to FPS is that it isn't capable of collapsing a payment into a single step, say like Fedcoin or Fedwire. Instead of instantaneous settlement, FPS payments will typically be settled via CHAPS during one of three daily settlement cycles. Three times daily isn't bad, but it's not immediate. However, FPS fees are paltry, running around 3.51 pence per transaction. Even if Fedcoin achieves instantaneous settlement, would it be able to do so at a cost that is competitive with FPS? That's something Fedcoin advocates like Ludwin need to demonstrate before folks like Janet Yellen will make a move into small-value blockchain.

Finally, Ludwin suggests that central banks issue cryptocurrency not only to banks but also to non-bank financial companies, corporations, and individuals. He suggestion is a bit too casual for my taste and it probably made Janet Yellen wince. Central banks have a long tradition of steering wide of competition with banks. If the Fed (or any other central bank) were to begin providing digital money directly to the public, it would be breaking with this tradition; central bank digital tokens would effectively be competing head-to-head with private bank deposits. This would be one of the most momentous policy changes in Federal Reserve history and would have many far-reaching consequences.

Even if the Fed thinks the time is ripe to embark on such a historical path, Ludwin hasn't made the case for the blockchain. Why not just allow individuals to keep accounts at the Federal Reserve and make Fedwire payments via a Fedwire app?

Blockchain technology is cool and interesting and sexy. But I'm not convinced that the old fashioned centralized incumbents like Fedwire aren't up to snuff. I suppose time will tell.



PS: I won't be able to answer comments on this till the weekend.

15 comments:

  1. Do CBs deal with each other directly much, or have accounts with each other, or deal through the market?

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    1. They often have accounts with each other.

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  2. Some people really like the democratic governance of distributed ledgers. Central bankers can impose their will on the monetary network under their control, whereas changes to blockchain operation are decided collectively.

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  3. I haven't been paying attention, but are other blockchain systems reliant upon computing solutions to cryptographic problems (like bitcoin)? The entire Bitcoin premise is that electricity will be cheap forever, which is an unquestioned assumption of techno-optimists.

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    1. Care to explain where you get this premise from?

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    2. I believe that "bitcoin mining" (the solution of cryptographic puzzles to get new bitcoins) is a key component of the economics of running the servers that keep the system going. This consumes a lot of real resources, to the extent that people had to set up server farms in Iceland to take advantage of cheap geothermal power.

      What happens to.these business models if electricity prices rise significantly in real terms?

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    3. The same thing that happens in any other industry where the input prices rise. Does that mean that other industries are also techno-optimists and assume that their inputs will be cheap forever?

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    4. Brian, a system like Ripple is far cheaper to run while still being distributed.

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  4. Lol to a central bank issued digital token. You people don't have a clue what bitcoin is intended for. go read the whitepaper.

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  5. "A criticism I have of blockchain advocacy in general and Fedcoin in particular is that evangelists tend to understand little of the history or qualities of the institutions that they are trying to overthrow. The result is that they invariably end up mis-estimating the benefits of replacing existing systems with new ones."

    Says most of what needs to be understood about this.

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  6. In Ludkin's framework, banks are not key intermediaries (once you can store wealth AND make payments in Fedcoin, why have a DD?). It is unclear what role 'reserves' play. Whether or not it's a centralized RTGS or digital currency system, the real question is what happens to fractional reserve banking, and how does credit creation behave during the transition. For instance, would DD's be exchanged for Fedcoin? This would expand the 'base' while at the same time creating de facto 100% reserve requirements.

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    1. Yes, banks would face huge challenges with Fedcoin. That's why I think most of the Fedcoins currently being trialed are for internal use only and not for public consumption.

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  7. I think the other benefit of FedCoin is increased transparency, helping avoid opaque shadow-banking blow-ups. I think this is perhaps bc of distributed nature of ledger. Not sure if this could be just as easily achieved with just faster better payments, but also would require a new "data structure".

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    1. Fedcoin would certainly be more transparent. On the other hand, I don't think banks really want other banks to be able to see their books, for competitive reasons.

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  8. Blockchain ledgers for general use would facilitate taxation audit/implementation on money movement in the public in a way dollars today cannot. It would also enable negative interest implementation, and remove risks of bank runs by imposing a conversion fee to untracked dollars.
    A key benefit of the Fair Tax idea is to tax billions of dollars moving that can't be seen today. Blockchain history poses the potential to expose every transaction to visibility and taxation. Drug sales on the street could be taxed, not even knowing what was sold. Money moved.

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