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Digital Legal Tender: The Foundation of Future Digital Trading and Finance

June 21st, 2016 Posted by Central Banks, Cryptofinance technologies 0 comments on “Digital Legal Tender: The Foundation of Future Digital Trading and Finance”

With the rapid increase of digital financial services, the urgent need for a central bank issued digital currency has become apparent in order to create inclusive, frictionless, and efficient national economies. A national digital currency will provide a  boost to economic growth allowing all financial service providers to participate and leverage their niche, while benefiting from unified global system.

Mobile money operators have made huge progress leapfrogging traditional brick-and-mortar banks providing digital financial services directly to users via mobile phones across underbanked regions such as Sub-Saharan Africa. Mobile money has done more to expand financial services in the past year than banking in the past decade.

With over 271 mobile money services now in operation, we are experiencing the same problem economies faced years ago before the existence of central banks. As the economy evolved from the exchange of fundamentally valuable assets such as gold, commercial banks began to issue their own private banknotes (based on deposits). Issues of interoperability arose – trust held in different institutions played a role in when and where your private bank note could be spent and interbank settlement was costly and problematic.

Central bank issuance of one national unit of account solved all these problems. Remove a five pound note from your wallet and you will read the fine writing – ‘I promise to pay the bearer on demand the sum of 5 pounds’, followed by the signature from the chief cashier of the Bank of England. This note is a bearer instrument – whoever physically holds it is assumed to be the owner of the property and the note is backed by our trust in the central bank.

Mobile money services are fragmenting national financial ecosystems through the issuance of private digital currencies – network specific tokens’ representing the national currency based on deposit accounts are issued onto their systems. These tokens are only tradable within the network they are issued into – in Kenya for example Safaricom M-Pesa customers can only transact with other customers of the same network. Any interoperable solutions that are arising are based on complicated technical bridging solutions between networks. Friction in the economy is occurring as the funds kept within these systems are not legal tender. They are not insured by the central bank and there is a systematic risk of loss. Certain methods of payment can only be used in certain places for certain things and a constant cycle of exchange between the digital world and physical legal tender exists.

There is a way to solve this problem – the same solution the central banks used years ago with the creation of physical legal tender. Central bank issued digital legal tender.

For conceptual purposes, the issuance, storage, and transacting of digital legal tender works in an identical manner to physical legal tender today (just safer and without the limitations of space and time). It provides one unit of account fully backed by the central bank, that can be utilized by digital financial service providers nationwide. Moving from multiple private issuers to a single issuer totally eradicates the need for privately issued ‘tokens’ and provides seamless interoperability between all systems.

Central Banks have been investigating this opportunity in the past year. On a macroeconomic level, the opportunity to take advantage of the digital economy whilst maintaining regulation and reducing costs is an undeniably attractive prospect.

The burden of managing an economy based on physical cash is heavy – a study by theFinance Ministry of Indiaestimated the cost of cash to the economy as 5-7% of the GDP in developing countries. The production, security, distribution, and eventual destruction of notes and metal coinage is expensive. Switching to a digital payment systems will reduce costs drastically whilst expanding the size of the formal economy through the provision of more accessible digital financial service offerings. The new found option for unbanked and underbanked individuals to forgo their reliance on physical cash (read here how cash based economies hits the poorest hardest) and enter the formal economy will reap large economic benefits for a country. A study by Tufts University estimates that in Mexico every 1% of the informal economy that is formalized represents US $560 million of new revenues with no change to tax rates.

In today’s fragmented digital systems, central banks are unable to keep track of the amount of privately issued digital currency in circulation. Digital legal tender will contribute to the ability of central banks to maintain security and stability within the national economy through execution of monetary policy in an efficient and targeted manner across all digital financial service providers. Furthermore, counterfeiting will be totally eliminated. The use of digital legal tender will create a more transparent system. Financial service providers can implement tiered AML/KYC regulations for domestic and international transactions offering far more reliable and complete identification than traditional paper-based systems.

It is clear that digital legal tender will not replace physical notes and coins completely in the near future. Central banks however must adapt and embrace the digital economy in order to fulfill important economic goals for growth and financial inclusion. Digital legal tender will move through the economy in a complementary manner to notes and coins. The emergence of cryptofinance technologies provides the ideal platform on which this new format of national currencies can be created and used in the most secure and efficient manner. I outline briefly the three key steps in the creation of a truly digitized financial system through the use of digital legal tender below:

1. Issuance: Central banks are the exclusive party to have the required software and hardware for the issuance of digital legal tender. The issuance process is identical to how physical money is issued today. Cryptographically secured, digital cash cannot be counterfeited. Digital legal tender enters the economy alongside, and in the same manner, as physical cash.

  1. 2. Storage: Digital legal tender is held by users in digital wallets exactly as cash is held in a physical wallet. Digital wallets hold bearer instruments (digital legal tender) directly on a mobile phone, can exclusively be accessed by the individual in physical possession, eliminate counterparty risk, and allow the user to be the sole party in complete control of their assets at all times.
  2. 3. Transacting: Legal tender is transacted between wallets in the same manner as physical cash today – directly from person to person with no involvement of financial intermediaries. Each transaction is a direct value transfer.

Disclaimer: Blog posts reflect the views of the respective authors, and do not necessarily represent the official view of Monetas.