9 + 10. Money, ancient and modern

What are the functions of money?

• It is a medium of exchange which allows for the transfer of goods

• It is a unit of account for pricing; it allows one to price goods

• It is a store of value for saving; traditionally this value has been asset-backed by things like gold or sheafs of wheat (cryptocurrencies are often excessively volatile and thus disadvantageous to hold as money)

What are the three types of money?

• Commodity money (money backed by commodities like wheat, salt, or cows)

  • Can be debased (e.g., cutting chunks out of silver coins)

• Representative money uses tokens which represent amounts of a specific asset — the best example of this is gold

• Fiat money is a currency which isn’t backed by a physical asset; it has value simply because a government says it does

  • Since 1931, notes in Britain have been fiat money

What are the effects of paper (representative) money?

• Allowed for a higher rate of growth and superseded commodity money, changing commerce and government finance

• Avoided the problem of the coincidence of wants (arose under barter, where a sheep-owner wants shells when the potential buyer only is offering wheat); people can use this token to represent the goods they want

• Resolves the problem of commodity money which can be debased (chunks can be cut out of silver coins, not all stores of value are easily transportable or findable — one might not be able to find gold)

Minimal history and effects of fiat money?

• Venetian explorer Marco Polo wrote about money in the East and helped spread the idea to the West

  • From 1260-1308 paper representative money dominated in China

• After Charles I in England, goldsmith’s storing merchant’s money and charging a fee realised they could lend this money and issue receipts promising to pay the receipt-bearer

• Allows for fractional reserve banking; banks lend more than they have in their vaults by assuming not everyone will ask for their money at once

Issues with fiat money

• It is created by Central Banks and divorced from any real value apart from that which we give it → money becomes a mere social institution

• It holds value only due to trust: it is backed and created by trustworthy institutions and so trust is enabled in what could be a vacuous item

  • It will only fail if the economy fails or of there is sovereign debt default

What are the uses of fiat money?

• It is a useful social institution which allows for exchange and stability of the financial system

• It is acceptable because the CB is the sole issuer, meaning it can’t be forged, the institution is fiscally backed by the government

• Thus, money only loses credibility if the economy fails, there is a sovereign debt default, or if a government takes over CB policymaking and money-printing functions

• It also affords the CB stronger control over monetary policy

What is a CB digital currency (CBDC)?

• Digital currency a central bank can issue and is an alternative to physical cash

• It doesn’t have a physical form at all, and exists only electronically as a number on a screen

• It is part of both banknotes and bank deposits/e-money; the digital pound is worth the exact same as a physical pound

• It means that individuals have a direct claim on the CB itself rather than commercial banks

The difference between retail and wholesale CBDC’s

• Retail CBDC’s are only used for retail transactions, whereas wholesale CBDC’s already exist in financial markets

• Wholesale CBDC’s already exist and act similar to bank reserves; thus when referring to CBDC’s, it is primarily retail ones which are referred to

Why might a retail CBDC be useful?

• Helps to maintain the ‘singleness’ of money in an increasingly digitalised landscape → important for CB to enact monetary policy

• Allows for exchange between all forms of money, contributing to stability of the financial institutions — regulation involves ensuring that money is issued at par value across different currencies

• Might help to solve the rise of other digital currencies and declining cash transactions

How might a CBDC work?

• Could institute a centralised ledger who records transactions, but this has to try and maintain public confidence in it

• Payment interface providers (PIPs) are regulated private sector intermediaries who facilitate such transactions between individuals and their accounts

What is a cryptocurrency?

• A privately issued digital asset which are often unbacked by governments — they have generally performed poorly due to excess volatility

• According to BitKE, more than 24,000 currencies have been issued since 2014 and in 2023, 65% of them had failed

  • Failure is being short-lived or abandoned, and this is often caused by lack of demand or fraud (rug-pulling)

What is a stablecoin?

• Like Bitcoin, they’re run on distributed ledgers but they are different in that they are centralised because they are owned by a specific private company (no-one owns Bitcoin)

  • If a distributed ledger is the record-keeping system, native crypto assets are the currency intrinsic to this system (like Ether is to Ethereum)

• They are often pegged to another currency, commodity, or financial instrument, like US Treasury Bonds which act as reserve assets

• They are less volatile because they are centralised and collateralised → collateral is required to maintain the peg and this collateral is often liquid

An outline of Tether as a coin

• Founded in 2014, it has several tokens, often denominated by a specific currency (UST, EURT, GBPT, XAUT) which aims to stabilise their value — these are EMT (e-money tokens), and it is pegged 1-1 to US $

  • Its current jurisdiction is El Salvador

• It was fined $41m in 2021 for lying — it claimed it was fully backed by US dollars (a 1:1 mapping) but this only occurred for about ¼ of the 26-month period between 2016-2018

How does Tether work?

• The company controls how many tokens are in circulation and is the only company that can do this (mint new coins)

• They can be bought via cryptoexchanges or redeemed (turned back into Fiat currency); if redeemed, the Tether can be ‘burnt’ to reduce the currency in circulation or held by Tether, ready for future issuance

• They are used as a medium of exchange and are a lot faster and cheaper than fiat currency (don’t need to make payments or engage with banks with different operating hours)

• Used for cross border transactions for this reason — applying laws to regulate these transactions is challenging

How are Stablecoins regulated?

• Dominate in the crypto-market: accommodate for 60% of on-chain transaction volume in 2023

• IOSCO (International Organisation of Securities Commission) has long advocated for regulation of coins which are market dominant and therefore systemically important

• In the EU, MiCA regulation exists which attempts to ensure stablecoins remain pegged to their assets and are backed by liquid assets which are separate from the issuers own assets

  • Only approved institutions can issue stablecoins and they must provide a white paper specifying rights, obligations, and expected risks

• In the US, the GENIUS Act (2025) operates which requires coins to be backed 1-1 by US $ or other assets and prevents re-hypothecation (pledging stablecoins, which aren’t recognised as securities or national currency under Federal Law)

What are the consequences of Stablecoins?

• Will become in-demand to the US government who need it to fund their plans

• They facilitate decentralised finance, but it is not decentralised based on computer code/algorithm like Bitcoin, but there is centralised trust in the issuers

• Dollar-backed stablecoins are market-dominant, which could lead to dollarisation

• Poses an existential threat to smaller economies which have previously failed; it is tempting to use a stablecoin from a trusted company like Amazon rather than an untrustworthy local central bank currency — this is also pegged to the dominant global currency

Traditional and new types of money

Why might Central Bank’s fear digital money?

• The decline of use in cash reduces the effectiveness of Central Bank money as a monetary anchor — people just might not demand cash so the FED’s promise to supply it is ineffectual

• People wouldn’t hold it if they aren’t able to exchange it for these other crypto assets

What are the benefits of a CBDC?

• Backed by the CB and thus backed by fiat currency, meaning it is not volatile

• It is the only currency whose face value is guaranteed; private coins rely on convertibility

• It enables people to keep using the centralised bank in a time of digital primacy

Could a CBDC boost financial inclusion?

• Inclusion refers to people without bank accounts or non-cash assets, particularly in developing and emerging countries

  • If accepted as payment, it could act as an entry point to financially excluded institutions

• Fees for small transactions would be low or zero

• Involvement of the CB aids adoption and confidence

CBDC Developments

• 130 governments and all of the G7 are looking into CBDC; a digital Euro is past the planning stage for a potential first issuance in 2029

• The China E-CNY is in pilot and is encouraged by its compatibility with other institutions and potential features like ‘expiry dates’ to stimulate spending

• The Bahamian Sand Dollar is the first digital currency (October 2020) which saw 25% population uptake (although volume of transactions < 1%)

• Nigeria have introduced the eNaira but with low adoption (IMF)

• Danish eKroner project cancelled in 2017 since efficiency gains didn’t outweigh administrative difficulties

What are the impacts of a CBDC on the banking system?

• There is higher competition for deposit funding, greater wholesale funding to replace deposits, central banks make lower profits due to squeezed margins

• It could better financial inclusion if it addresses barriers to participation

• Dollarisation is mitigated against because local CBDC are backed by the local currency of the CB

• The BoE has even suggested that 20% of deposits to commercial banks would move to CBDC wallets, with assessors asking for greater research into this wider impact on the commercial banking system

Would a CBDC lead to a credit crunch?

• A credit crunch is the financial systems lessened ability to lend (due to less deposits) leading to lower investment and economic downturn

• Deposit flight might occur if people stop making deposits with commercial banks and move directly through the CB

• Leads to disintermediation of the banking sector (investors can operate directly without the need for intermediaries)

Final impacts on commercial bank disintermediation (graphical analysis)

Problems with Tether

• Over time, its collateral has fallen, it doesn’t have enough safe assets in reserves (only 64% in short-term T-bills),

• It is making riskier investments in assets like corporate bonds, crypto, and gold (24% in higher-risk unaudited investments)

• It has collected over $180 billion in deposits, which it can’t pay interest on (so is guaranteed profits)

• It got ‘junked’ by the S&P, who rated it 5, as extremely weak and volatile

• It also possesses 78% of stablecoin market share, making it vulnerable to systemic risk due to liquidity dominance

The political dimension of Tether

• It is incredibly dominant with 78% of the Stablecoin market share; it is linked to the Trump administration via Howard Lutnick

• It is also deemed the ‘go-to digital asset’ for criminals by many jurisdictions, used by drug cartels, paramilitary movements and it pops up in criminal cases

Disintermediation

• People move from deposits at commercial banks and instead make direct claims on the CB instead

  • This would lead to more expensive credit and tighter lending criteria

• It can be slow or fast: slower disintermediation refers to general commercial banking sector shrinkage, faster refers to a digital bank run → people flee the commercial banking sector for perceived financial instability

  • To stop this, commercial banks might raise their deposit rates. Alternatively, this could increase financial stability if there are less commercial banks/volume of transactions for runs to occur to

• Commercial banks need to have sufficient reserves to accommodate for deposit outflows meaning they might need to reduce reserves or borrow

• Disintermediation could also apply competitive pressure to commercial banks to retain users, forcing them to improve their services

Other stablecoin examples: DAI and USDC

• DAI is an asset-referenced token (ART, backed by other cryptocurrencies) which was pegged 1-1 with US $ until March 2023

  • Since the collapse of Silicon Valley Bank in 2023, DAI had to unpeg since USDC was massively impacted

  • USDC has since recovered and is the first stablecoin to have complied with MiCA

• It used to be largely collateralised with Ether and USDC, but now it is mainly US treasuries

• DAI is generally overcollateralised (at around 150%)