Understanding Stablecoins and their Potential Economic Impacts

In 2014, the Hong-Kong-based cryptocurrency exchange Bitifinex launched the first widely-circulated stablecoin, Tether, and pegged its value to the U.S. dollar at a 1:1 ratio. Since then, nearly 200 stablecoins have entered the market. Stablecoins that peg their value to fiat currencies, other cryptocurrencies, commodities, or algorithms designed to regulate their supply are now available. The global stablecoin market is still relatively small, compared to the overall crypto market, with a global stablecoin market capitalization of roughly $133 billion (Tether accounts for over 50 percent of the market), compared to the over $2 trillion market capitalization for cryptocurrencies (nearly half of which is made up by Bitcoin). The development of stablecoins seeks to make decentralized digital currencies more suitable for mainstream adoption by reconciling issues with price instability and convertibility, and move them toward being used as an alternative to existing fiat currencies. Regulators have long been concerned about the decentralized and potentially pseudonymous nature of cryptocurrencies enabling their use in terrorist-financing, money laundering, or sanctions evasion, and stablecoins have added additional anxieties. Illicit finance makes up less than one percent of stablecoins’ and other cryptocurrencies’ overall use, but real issues over stablecoins’ potential economic consequences are becoming increasingly pressing. They include stablecoin issuers’ ability to hold adequate reserves, their role functioning essentially as unregulated international banks, and their impact on the effectiveness of monetary policy transmission and implementation. 

At their core, stablecoins serve as a private money supply, holding claims against a central bank as collateral (or some other backing) and lending out claims against that collateral to end users. Much like a commercial bank, a stablecoin issuer is only legitimate to the extent that it can honor outstanding claims against its underlying collateral. While stablecoins are a novel product, private actors’ creation of new sources of money is not a new phenomenon. In a fractional reserve system, like that in place in the majority of nations globally, most of the money created in the economy is in the form of bank deposits, which function as claims against commercial banks, not the central bank. Commercial banks are then subject to reserve requirements set by regulators, generally ranging from 0 to 10 percent of total deposits. Historically, this system has been plagued by financial crises in which loss of consumer confidence has generated bank runs, leading to various degrees of regulation enforcing reserve requirements globally. ​​However, most U.S. commercial banks rely on deposit insurance backed by the Federal Deposit Insurance Corporation (FDIC) (or a similar public/private agency for non-U.S. banks such as the Central African Deposit Guarantee Fund or the Deposit Insurance and Credit Guarantee Corporation in India), and not on holding adequate cash reserves.

As a new way of generating private money, stablecoins face similar concerns from regulators. Tether holds its reserves in Deltec Bank, located in the Bahamas outside of U.S. regulatory reach, and its reserves are not backed by FDIC insurance. In March 2020, only 5 percent of the assets backing Tether were held in cash or treasury bills, and the rest were riskier assets such as commercial paper. While Tether’s management team has promised to update these figures and become fully backed by reserves, its current estimated leverage is 383-to-1, meaning that just a 0.26 percent loss in value would render it unable to honor its tokens for cash reserves and would effectively break its peg to the dollar. Further, commercial entities that launch stablecoins are highly incentivized to make money by lending and investing the reserves they hold, in the same way that commercial and investment banks currently do, adding concerns that stablecoin reserves would not be adequately liquid to support an increase in holders redeeming them for cash (or other underlying assets). Tether has already faced legal trouble for allegedly hiding losses and lying about being fully backed by U.S. dollars. In February 2020, the company agreed to settle a legal probe into its activities for $18.5 million and a prohibition on conducting business in New York State but did not admit any wrongdoing. Whether concerns over reserve requirements and a lack of FDIC insurance makes Tether and other stablecoins a riskier option for payments is still open for debate. Popular payment processors that stablecoins compete against, such as PayPal and Venmo, are also not FDIC insured, and a wide-rangingshadow banking system—financial intermediaries that provide similar services to banks but operate outside of regulatory supervision—already exists.

Even though Diem’s ability to establish itself as a global payment option has not yet been tested, it has already had a profound impact on the digital currencies space. The potential for a company like Facebook to launch a sovereign digital currency has accelerated efforts from both governments and commercial competitors to establish alternatives. Since Facebook’s initial Libra announcement, a wide range of companies have begun exploring the possibility of launching their own stablecoins. Among these are J.P. Morgan’s JPM Coin, Japan’s Mitsubishi UFJ bank, Russian state-owned bank Sberbank, and IBM. Other payment providers have explored the possibility of either sponsoring stablecoins, such as Circle and Coinbase’s Centre Consortium, or providing payment options in stablecoins, such Visa’s settlement platform for stablecoins. Amazon is also reportedly exploring launching a new digital currencies project, but specific details have not been fully released. The rapid entrance of both established and new companies into the stablecoin space is accelerating competition and diversifying stablecoin offerings. For example, IBM has secured backing for its stablecoin project USD Anchor from FDIC-insured banks, a solution that potentially would mitigate the impacts of a run on its stablecoin. While many of these projects seek to address existing concerns by regulators, fundamental issues that are inherent to stablecoins, such as data privacy, dollarization, and private control over the money supply remain. Fear that privately controlled stablecoins will not be able to effectively address these issues is leading to increased government involvement, in both the form of regulation and the development of CBDCs.

Section 2

The Global Status and Implications of Central Bank’s Digital Currency Projects

Driven by the potential for increasing financial inclusion and transaction-settlement speeds, alongside fears that private-sector actors, cryptocurrencies, or foreign CBDCs will outcompete existing fiat currencies, central banks are increasingly exploring the prospect of launching CBDCs. To date, China is the only major economy to launch a digital currency, but many others, such as South Korea and Japan, are launching pilot programs for their own CBDCs. Singapore and the UK, meanwhile, are researching digitizing their currencies or setting up digital currency exchanges, and Nigeria plans to launch its CBDC, the eNaira, in October 2021. The majority of CBDCs are still in the early stages of development, and questions about how they will be designed, transacted with, and regulated are still being researched and debated. CBDC design considerations will in part determine their impacts on monetary policy, international transactions, accessibility, and sanctions along with their impacts on a wide range of sectors, including commercial banks, payment processors and intermediaries, and central banks. CBDC design can also impact their international attractiveness, and divergent strategies are emerging—from China and Thailand’s rush to test and implement their CBDCs, to the U.S. and the UK’s more cautious and measured approaches. A handful of smaller economies have already launched CBDCs (such as the Bahamas, Antigua and Barbuda, Saint Lucia, St. Kitts and Nevis, and Grenada), and their projects could serve as valuable test cases for larger countries to replicate or build on. Accompanying design considerations, countries have different incentives for launching CBDCs and different risks accompanying their development, as described below. While there is a long way to go before widespread adoption of CBDCs is a reality, the decisions that central banks make now will be critical for determining their future impacts and adoption, including whether they eventually become widespread forms of internationally accepted digital currency.

CBDC Design Considerations and Private-Sector Impacts

Launching a CBDC requires a broad range of technical and policy considerations including whether to use blockchain technology, how to distribute digital currency, and whether to target retail users or institutions. Without a standard framework for designing a CBDC, a range of different models have emerged. Central banks do not all have the same incentives driving their CBDC launches and, initially, the CBDCs developed by each country are likely to have unique features. Underlying the technical design considerations of a CBDC are fundamental questions about what each country is aiming to achieve domestically and internationally. Among the CBDCs already launched by smaller Caribbean nations, for example, the main driver behind developing a digital currency has been increasing financial inclusion and strengthening financial services in environments with underdeveloped banking systems. There are also logistical advantages—it is difficult to distribute cash across islands or set up retail banking branches (for example, the Bahamas consists of over 300 islands). CBDCs provide clear advantages in these scenarios, as distribution and transactions in CBDCs only require that residents have access to a cellphone or a physical payment card. The Bahamian Sand Dollar, the first CBDC, was launched in October 2020, aiming to address these issues, as well as providing the additional benefits of a CBDC, including 1) increasing payment speed, efficiency, and security; 2) cutting the cost of financial services; and 3) cutting down money laundering and fraud.

The Bahamian Sand dollar, along with the CBDCs of other Caribbean nations currently launched, are retail CBDCs. These CBDCs are meant for use by the public, and they function as other forms of cash in circulation. Retail CBDCs provide essential benefits, including pseudo-anonymity, traceability, and the potential to design them as interest-bearing assets. In contrast, wholesale CBDCs, such as projects currently under development in Hong Kong, Thailand, and Singapore, would create digital currencies that would be used by financial institutions holding reserve deposits with a central bank. A wholesale CBDC could be used to improve payment settlement, reduce credit and liquidity risks, and facilitate cross-border payments. The wholesale CBDC model would not issue a digital form of currency for consumer use; instead, it would create new infrastructure for interbank settlements by moving bank transactions onto DLT. In practice, that would not fundamentally change consumers experience with banking systems but would instead, in theory, improve the efficiency of the bank transfer and settlement process and potentially eliminate the need for intermediaries to conduct cross-border settlements. The wholesale approach would represent less of a fundamental change to the monetary system and would instead focus on leveraging DLT to improve existing mechanisms. Critically, it would not pose a significant challenge to domestic banks, or to private-sector payment service providers, which would still be responsible for consumer lending and payment processing. However, wholesale CBDCs do not address issues of financial inclusion and access. Accordingly, the retail CBDC model is generally favored in developing economies, where financial access is limited, and the wholesale model is generally favored in developed economies due to the perception that it would be less disruptive.

The idea of issuing a retail CBDC did not receive the same level of initial enthusiasm in developed markets as in the developing world. For example, despite researching retail CBDCs, initial CBDC pilot tests in the EU and Canada focused exclusively on the wholesale model. But interest in CBDCs’ ability to outcompete cryptocurrencies and the private sector’s stablecoin initiatives is now driving a shift in perspective, leading more central banks in developed economies to explore the potential for retail CBDCs to be used alongside the wholesale model. China launched its digital renminbi (the DCEP) in part to counter the popularity of cryptocurrencies and stablecoins, as well as to limit the influence of domestic private payment companies. The Canadian Payments Association has articulated similar concerns, listing the main incentives for Canada developing a retail CBDC, alongside the wholesale model, as a means to compete against private cryptocurrencies and stablecoins and to offer a competitive less-costly alternative to consumers as cash use declines (in contrast to private electronic and card-based payments that may carry associated fees).

Driven by these concerns, central banks are exploring three primary models for developing retail CBDCs: direct, hybrid, and intermediated. Notably, unlike wholesale CBDCs, not all retail CBDCs would need to use DLT or switch their banking system from an account-based system to a token-based system. In all three models, CBDCs would represent a direct claim on the central bank, but their distribution and recording would be handled differently. Notably, while both wholesale and retail models can exist on their own, many countries are working on using both models together.

Depending on the CBDC model adopted, the role of domestic banks and private-sector financial actors could be drastically different. A direct retail model would, in theory, eliminate the need for domestic banks and most payment intermediaries. This model represents the most radical departure from the current system and involves the central bank in all payments, while disintermediating the banking system and marginalizing the private sector. This system would give the central bank the most complete data on retail balances and facilitate honoring claims against the central bank. However, implementing this model would necessitate significantly expanding central bank infrastructure and capacity and would also increase the risk of payment delays or pauses if central bank servers were to go down. A two-tiered or hybrid model would potentially leave domestic banks in place while also including additional payment intermediaries and private-sector companies to facilitate CBDC distribution and payments. In contrast, a wholesale CBDC model without retail access would leave the current domestic banking system completely in place.  

To date, most CBDC pilots have used hybrid models—defining their CBDCs as claims against the central bank but distributing digital currency through domestic banks and payment intermediaries. This model is in use for both the Bahamas’ and China’s CBDCs, which act as claims against the central banks but leverage domestic banks as well as private payment providers such Mastercard (in the Bahamas) and Ant Group (in China) for currency distribution. These early projects indicate that there will still be strong private-sector involvement in the development and distribution of CBDCs. Additionally, wholesale CBDC pilots, like Canada’s Project Jasper, have leveraged private-sector companies to help test and design the underlying DLT. The extent to which the private sector is involved in CBDC development is likely to vary significantly, but it is unlikely that private-sector actors will be sidelined completely, since they possess most of the technological knowledge and customer interface experience necessary to effectively launch a retail CBDC. Design considerations for CBDCs will help determine the extent to which the private sector is involved in their development, but it remains unlikely that any central bank will completely cut out commercial banks from the process. For private-sector actors in the digital currency space, the major question remains the extent to which regulators will allow private stablecoins and cryptocurrencies to exist alongside CBDCs.

The Status of Global CBDC Development and the Risks, Benefits, and Implications of Widespread Adoption

Between May 2020 and August 2021, the number of central banks researching digital currencies increased from 35 to 81. While interest in CBDCs is quickly growing, most projects (over 75 percent) are still in the early stages of research and development, and several projects have been cancelled (such as Ecuador’s dinero electrónico, or DE, and Denmark’s e-Kroner), and at least 10 more are currently inactive (including projects in Malaysia and Finland). Retail CBDCs still face major hurdles to adoption, including concerns over privacy, cybersecurity, accessibility, and potentially de-stabilizing effects on the financial system. Likewise, wholesale CBDCs face questions about interoperability and whether they would truly make already highly developed settlement systems, such as the Clearing House Interbank Payments System (CHIPS), more efficient. Domestically, the roles of the private sector and commercial banks in a CBDC economy are still being debated. Public-private partnerships are currently being leveraged to help design numerous major CBDCs. These include the Central Bank of Nigeria (CBN) partnering with the fintech firm Bitt Inc., and the Bank of Canada partnering with TMX group, to help launch pilot CBDC programs. In addition, many central banks are looking at a hybrid model like that proposed by the Bank of England in which the central bank maintains a core ledger, but properly vetted private payment companies are granted API access, allowing them to build consumer-facing payment services on top of an existing CBDC network. This model would enable widespread private-sector competition in the payments space without stifling innovation or disintermediating financial services. It would also allow commercial payment companies to compete directly with domestic banks to provide payment services. 

Using hybrid designs for CBDCs would allow them to address some of the issues inherent in stablecoins and cryptocurrencies, such as reserve requirements and price volatility, without marginalizing the private sector. The successful launch and adoption of a CBDC would provide the ability to enhance financial inclusion, like a stablecoin would, while allowing the central bank to maintain control over the money supply and monetary policy. CBDCs would provide even greater flexibility for conducting monetary and fiscal policy by allowing central banks to theoretically set interest rates below zero, or issue stimulus cash directly into bank accounts. Fiscal policy could be expanded to include mechanisms such as temporary cash infusions (CBDC that expires if not spent within a certain time window) or even facilitate experiments with universal basic income.

CBDCs would not address some of the issues with financial transfers or value stores that a global stablecoin potentially could. In developing economies, launching CBDCs would expand access to banking services, but holding savings in CBDCs would not shield them from inflation or guarantee the ability to withdraw currency or transfer savings across borders. While developing countries have strong imperatives to launch CBDCs, their adoption still depends on public trust of the government, a key issue that led to the failure of projects in Venezuela and Ecuador. The BIS has raised additional concerns that a transition to CBDCs could worsen the impact of bank runs in the event of a crisis. The transition to CBDCs in developing countries could increase financial access, but they would not solve underlying currency issues, creating potential for stablecoins or other cryptocurrencies to play important roles alongside CBDCs in these markets. 

Internationally, CBDCs could weaken sanctions impacts (particularly from the U.S.), decrease the cost of international transactions, and eliminate the need for financial intermediaries like Society for Worldwide Interbank Financial Telecommunications (SWIFT). To get to that point, major technical, legal, and design hurdles need to be overcome for both wholesale and retail CBDCs to become internationally interoperable. For CBDCs to truly begin transforming the international financial system and not just recreate a more digitized version of the current system, there would need to be international agreements in place allowing seamless currency conversion between CBDCs. The process of creating a universal system would be immensely complicated, but the emergence of such a system and its potential to impact the power of U.S. sanctions provide significant incentive for some countries to try to create one. The BIS, IMF, and World Bank have all emphasized the need for international interoperability being designed into CBDCs from the start, but designing such a system would require a degree of international collaboration that would be extremely difficult to achieve given the different incentives and stages of CBDC development. Alternatively, there is a possibility for a multitude of private clearinghouses, messaging systems, and foreign exchange providers to fill the gaps in interoperability, or for countries to collaborate directly to build centralized clearing systems for a select group of member currencies. While each of these models would address existing issues with settlement times and transaction costs, their impacts on existing intermediaries, private-sector actors, and global CBDC adoption could vary significantly.

Given the complexity of developing a single universal system, it is likely that combinations of these models will be developed simultaneously. The emergence of multiple international systems would place pressure on governments and commercial actors to innovate in order to maintain their relevancy. If a country’s CBDC is widely interoperable with other foreign CBDCs, it would facilitate trade and investment with those countries and become more widely used. China could take this strategic approach by denominating its Belt and Road Initiative (BRI) loans and project financing in digital renminbi. Other countries looking to increase the international use of their currency, such as Russia, could follow a similar strategy. In contrast, if existing major reserve currencies, such as the dollar or euro, were to develop widely used digital alternatives, their dominant positions in the global financial system could become further established. The widespread availability of a digital dollar or euro could create currency substitution issues in markets with weaker domestic currencies and replicate the impacts of dollarization. Depending on the international agreements and norms established for transacting in CBDCs, common CBDC frameworks could strengthen economic ties between different blocs of countries. For example, if the BRICS (Brazil, Russia, India, China, South Africa) countries were to establish their own system for settling international CBDC transactions, and the U.S., Canada, and the EU were to establish a separate system, countries within each bloc would naturally be incentivized to transact more with countries within their CBDC system. Ultimately, that could re-order economic relationships and create a more fragmented international financial landscape. 

Countries are progressively piloting CBDCs, but there are still significant hurdles in design, interoperability, and technology to overcome, making an impending CBDC replacement of cash and other digital currencies unlikely in the near term. Instead, CBDCs will roll out globally at varying paces using a variety of models, achieving different degrees of success and adoption. As this process unfolds, it is possible that CBDCs will be used to establish new currencies or currency areas. In 2019, the UK proposed a global CBDC backed by a basket of other CBDCs to combat the outsized influence of the dollar and the potential rise of the renminbi. The necessary technical and governance infrastructure to create a global CBDC is still a long way off, but it is not unrealistic for smaller economies piloting CBDC projects to begin leveraging CBDC technology to forge new monetary unions. Finally, depending on how countries decide to design interoperability, existing financial intermediaries could either become obsolete, face increased competition from new entrants, or be forced to integrate new technologies into their existing operations to adapt to the emergence of CBDCs.

Section 3

Technological Disruption, Currency Competition, and Digital Transformation

The development of DLT and blockchain technology has unleashed the possibility for transformations in the financial system that reach beyond the development of cryptocurrencies, stablecoins, and CBDCs. These vehicles are serving as the primary applications for these technologies in the near term, but DLT holds the potential to eventually change the way financial intermediaries work, upend the traditional payments industry, and re-structure financial markets. These changes will have wide-ranging implications, from challenging traditional means of sanctions enforcement to disrupting established business models. Achieving this transformation is not a straightforward path, and as different actors adopt this new technology, the financial sector, among others, will likely experience a period of intense competition and experimentation. While eventually technological development and current trends toward a cashless society are likely to make some form of digital currencies ubiquitous, widespread adoption is still a ways off. The underpinning blockchain technology will need to be improved upon, and continual innovation from the private sector will be critical for that to be realized. Private stablecoin developers will continue to face regulatory hurdles and reserve challenges that will not be easy to overcome. Nevertheless, progress in the development of digital currencies is creating opportunity for disintermediation in the international payments space, through building different CBDC or stablecoin ecosystems. New competition in this space holds the potential to eventually render institutions like SWIFT obsolete, but a clear contender to replace the existing system has not yet emerged. As these trends collide, the future financial system is likely to look radically different. But arriving at that future will be a bumpy process as old systems struggle to maintain relevancy, and new systems attempt to perfect novel and disruptive technologies.

DLTs Impact on Payment Intermediaries and the Future of Sanctions Enforcement

SWIFT dominates the international payments-messaging space, but despite its ubiquity, the process of transferring money internationally using SWIFT and corresponding intermediary banks is slow and expensive. Using the SWIFT system in collaboration with a wire transfer provider such as Western Union for simple international remittances can take between one and five business days and cost between $25 and $65 per transfer. These payment delays and costs make sending remittances difficult, in addition to making international trade and investment significantly more costly. The development of DLT-based systems that allow for instantaneous transactions, without divorcing the messaging and settlement elements of the transaction at a fraction of the price, are now challenging the SWIFT model. DLT-based platforms, such as those that Ethereum and other cryptocurrencies run on, offer lower transfer costs (the average transfer cost on the Ethereum network as of October 2021 was less than one-tenth of a cent) to anywhere with access to the network and are increasingly being used to move money internationally.

While transactions using the Ethereum network are mostly limited to the exchange of ether tokens, other networks, such as Ripple, have built more complete DLT-based payment and messaging systems. Launched in 2012, Ripple designed its platform to make the role of SWIFT obsolete, by creating a DLT-based platform that facilitates instant settlement among fiat currencies, cryptocurrencies, and commodities for fees less than one cent. Since its launch, more than 100 financial institutions have joined Ripple, including major international banks such as Santander, the Canadian Imperial Bank of Commerce, and Itaú Unibanco in Brazil. The impact of Ripple has pushed SWIFT to launch an update to its system (called “SWIFT global payments innovation” and launched in 2017) and has drawn scrutiny from the SEC. In December 2020, the SEC filed an ongoing lawsuit against Ripple, alleging that selling the cryptocurrency it uses for payment fees on its network, XRP, constituted the offering of an unregistered security. While SWIFT still holds advantages due to its massive banking network and the legal scrutiny around the cryptocurrency industry, the emergence of viable alternatives to its system presents a unique challenge. Further, as DLT-based technology becomes more widely adopted, there is likely to be less of a role for international financial intermediaries. Banks are now able to build their own payment networks on existing open source blockchains, such as Ethereum, which allow them to directly settle transactions with other banks on the network. J.P. Morgan used this model, building the Quorum banking network on the Ethereum blockchain, which now has over 300 member banks. Other major companies, such as IBM, Microsoft and Oracle, have launched their own blockchains offering similar services. The development of interoperable wholesale CBDC networks could also potentially allow international transaction and settlement without going through SWIFT or a series of correspondent banks.

The ability to move money between countries cheaply through new channels will have wide-ranging impacts on remittances, sanctions enforcement, and international commerce. Global remittances totaled an estimated $702 billion in 2020, and the ability to send these payments cheaply and quickly could impact the lives of millions of people globally, particularly in developing countries. For businesses, the ability to transact internationally at a low cost could make new markets and international expansion more attractive. One of the largest potential global impacts is likely to be on the ability to enforce sanctions. As outlined in Part I of this series, the U.S.’s disproportionate power to enforce sanctions comes predominantly from the combination of the dollar as the world’s reserve currency and the necessity for international transactions to flow through intermediaries. The ability to transact directly through alternative networks would significantly weaken the U.S.’s ability to enforce sanctions, by creating alternatives to the current system. That would prevent the U.S. from unilaterally cutting countries like Venezuela, North Korea, and Cuba off from the global financial system. In this case, even if a digital dollar were developed and were to maintain its place as the dominant global reserve currency, governments and individuals could circumvent the dollar system by using alternative networks, either hosted on DLT networks like Ethereum or through other CBDC ecosystems. That could also impact countries and institutions that currently wield significant sanctions power, such as the EU and UN, while elevating the ability of new commercial actors and governments to enforce their own rules. The future lack of a single dominant financial infrastructure provider such as SWIFT, or a dominant currency, would ultimately create a more disintegrated and less centralized financial ecosystem. 

The emergence of new DLT-driven actors and decentralized financial instruments has led to a wide range of speculation about how these innovations will impact governments’ control over the money supply and the economy more broadly. While disintermediating the international financial system would make it harder for the U.S. to enforce sanctions through cutting off access to SWIFT, there are still significant hurdles to doing so amid other potential consequences. Domestic banking systems and existing intermediaries are likely to lead significant pushback, as existing transfer fees collected by the commercial banking industry are an extremely lucrative line of business. Innovations like the ability to host digital wallets outside of the banking system could potentially damage other revenue streams such as overdraft fees associated with bank accounts. (U.S. banks have collected over $11 billion in overdraft fees each year since 2015.) Additionally, a transition to CBDCs would allow governments closer insight into their money supply, and the ability to significantly tighten controls over spending. With CBDCs, instead of enforcing sanctions through correspondent banks, countries could simply program their CBDCs to not be accepted by certain companies or in certain countries.

Directly programing rules into digital currencies could, in some instances, heighten the ability to enforce sanctions and economic restrictions for some countries, and enhance their ability to directly target certain individuals or groups. That dynamic could ultimately push countries toward different CBDC ecosystems. For example, if the U.S. were to choose to cut a country out of its CBDC system, China or the EU could potentially offer an alternative. It is also still entirely possible that existing systems will prove highly adaptable. SWIFT and the BIS have extensively researched opportunities for using DLT in their operations and have in-depth industry knowledge and relationships already established. Likewise, commercial banks have strong influence in most major economies and have been some of the actors at the forefront of developing DLT payment systems. The popularization of DLT has started to open a wide range of possibilities for transforming financial markets, global trade, and consumer finance. While these possibilities broadly rely on the development and standardization of widely accepted digital currencies, these potential benefits are driving more companies and countries to look toward moving away from legacy systems, while pushing existing institutions to innovate and integrate new technologies into their operations.

Decentralized Finance and DLT’s Impact on the Wider Financial Sector

The development of digital currencies and the integration of DLT into the broader financial system can transform the way business is conducted across a wide range of industries. The ability to embed smart contracts into financial interactions, and instant settlement and execution of these contracts, open new possibilities for global trade and commerce. Likewise, the ability to broadly tokenize debt, equities, and physical assets could transform the way financial markets function and the way global trade and supply chains are managed. From 2008 to 2017, there was an estimated $8.7 trillion in trade value gaps generated from trade mis-invoicing—a practice where illicit actors deliberately falsify the value, volume, or type of commodity on invoices to transfer funds between jurisdictions. Moving trade contracts onto distributed ledgers would allow countries to combat this practice by automatically running checks that compare invoices against each other and market rates, in addition to comparing the values declared to customs with the values transferred in financial transactions. International supply chains are immensely complicated—Maersk conducted a study that found that shipping one container from Kenya to the Netherlands involved 30 different actors and over 200 separate transactions—and each interaction along the supply chain involves filing paperwork. Due to the complexity of transportation chains, important documents are often lost or misfiled, while being expensive and timely to produce and process. DLT could make these transactions both more secure, by allowing all parties involved to review each documented transaction, as well as cheaper and more efficient by eliminating paper filing. Further, trade financing is particularly expensive, since it is based predominantly on credit, and verifying the identity and validity of all parties involved is a time-consuming process. The application of DLT to this process offers a potential way to verify the legitimacy of all parties involved, while making settlement and lending across platforms instantaneous.

Beyond trade, DLT has a wide range of potential applications in markets and across the financial industry. The Hong Kong and Shanghai Banking Corporation (HSBC) is already using DLT to process foreign exchange transactions internally and is now exploring exporting their technology to multinational companies to help manage cross-border supply chains. Other banking functions, such as lending, project financing, and insurance, still rely heavily on paper documents and manual processes. DLT could replace paper records providing one shared digital ledger detailing shipments, ownership, and financing. In 2018, the World Bank sold the first bond created and managed with DLT. Since then, the European Investment Bank has used the Ethereum network to issue a bond, and HSBC has developed a blockchain-based platform that companies can issue bonds through. With DLT, smart contracts can verify lending qualifications automatically, without needing to go through a loan officer, a process that could help eliminate lending discrimination in addition to cutting down on time and paperwork. It could also be used to settle debt and equities security transactions instantaneously, a process that today takes an average of two business days per transaction. Further, legal ownership of any asset could be easily verified or transferred across the network, cutting down on paperwork and costs for selling physical assets such as cars and homes. While some of these functions are already being explored, such as trade financing currently being conducted on IBM’s blockchain, others such as integrating DLT into the core settlement operations of financial markets are yet to be implemented.

Conclusion

Throughout this series, we have outlined a broad range of factors driving transformation in the international financial system, from traditional challenges to the dollar system driven by sanctions overreach and the emergence of cryptocurrencies to major private-sector actors and governments’ adoption of digital currencies and DLT. An era of tremendous uncertainty, opportunity, and innovation is just beginning, and the form that the future financial system will take is still unclear. With the uncertainty surrounding the future role of the dollar, cryptocurrencies’ impact, the viability of stablecoins and CBDCs, and uses for DLT, it is important to remember the underlying factors that are driving actors to seek alternatives to the existing system. The 2008 financial crisis was as a major turning point and revealed serious flaws in the existing financial system. It led to widespread mistrust of the commercial banking sector for many individuals, the creation of Bitcoin, and a wholesale rethinking of the international financial system. While the current system has been disproportionately favorable to the U.S., perceived sanctions overreach, financial exclusion, and other factors are driving some countries to seek alternatives. While issues with illicit finance and cybercrime will likely continue to exist with the adoption of digital currencies, DLT-based currencies and systems also provide real opportunities to create more resilient infrastructures, address gaps in the commercial banking system, improve tax collection, and track illicit financial flows.

Ultimately, these emerging digital innovations are seeking to address fundamental flaws and gaps in the existing financial system. Developing economies have strong incentives to launch CBDCs to increase financial inclusion, countries under U.S. sanctions will continue to seek alternative ways to access the global financial system, and individual consumers will migrate toward financial products offering lower costs and faster transaction times. Critically, China has myriad incentives to push forward with developing a CBDC and creating an alternative to the dollar-dominated system in place today. For all of these actors, the underlying incentives to change this system will remain in place even as some individual attempts at developing solutions fail. The technology to transform the system already exists, and although its development and adoption are likely to experience setbacks, whether through programming issues, interoperability issues, or regulation, the competition to productively apply it will continue to play out. 

As this series has outlined, there are still many possibilities for how the geopolitics, technological development, and functional design for different digital currencies and financial infrastructure will evolve. The uncertainty surrounding these future developments has led some government officials to dismiss these potential transformations as nothing more than a fad, and U.S. officials have been mostly reticent about exploring the possibility of launching a digital dollar, citing a lack of need. In the short term, it is likely true that the dollar will not face major risks as a reserve currency, and digital currencies in any form will still take years to become widely adopted. Likewise, DLT is still in its infancy and will need significant refinement before becoming a globally viable technology. While no clear winners will emerge for years, the competition to shape the future of money and craft the underlying infrastructure that will dominate global finance has already begun. The impacts of this competition will potentially re-order the way that individuals and banks conduct financial transactions, change how central banks conduct monetary policy, develop new trade and financing relationships, and create new currency ecosystems. For private companies and governments alike, missing out completely on this competition poses the greatest risk of all.

Written by Christian Perez. Edited by Allison Carlson. Copyedited by David Johnstone. Art direction and design by Sara Stewart. Development by Andy Baughman and Wes Piper. Creative direction by Lori Kelley. Illustration by Doug Chayka for Foreign Policy.