Digital currencies: Economic and geopolitical challenges

Digital cryptocurrencies are rising up the financial policy agenda as tech innovators seek to capitalize on their technological expertise and data from billions of users.

Explainer
3 minute READ

Stewart Fleming

Former Associate Fellow, Global Economy and Finance Programme

The governments of the G7 are well aware of the benefits of digital financial technology, but are also hugely concerned about the public policy and geopolitical threats from this potentially disruptive innovation, especially from so-called ‘global stablecoins’ (GSCs) operated by loosely regulated, non-financial technology giants, but denominated in national currencies.

A recent G7 report warns such innovations raise serious questions about a range of public policy issues, including ‘challenges to fair competition, financial stability, monetary policy and, in the extreme, the international monetary system’. G7 ministers and governors have stated quite explicitly that no global stablecoins should begin operation until regulatory and oversight issues are resolved.

These governments have recognised the need for international cooperation on how private digital currencies should be regulated, not least because the alternative – a global free-for-all – could be chaotic and dangerous.

However, they also see that well-regulated digital currencies can provide significant public benefits in greater efficiency and lower costs for both domestic and, in particular, international payments systems, and help ensure financial services reach the hundreds of millions of people – especially in developing countries – without bank accounts.

China has so far been well-advanced in its public sector response, launching domestic trials of a government-backed digital renminbi (RMB) in 2020 and also beginning to clamp down on Ant Group, the country’s biggest finance-focused hi-tech company. Many other major governments and central banks, notably the European Central Bank, are now considering whether and how to follow China by launching official digital currencies.

They are also aware these are decisions with important implications for the wider international financial system, such as the future role of the dollar and other reserve currencies, and their part in supporting international trade and finance.

What are digital currencies?

Digital ‘crypto-currencies’ and ‘crypto-assets’ aim to mirror some, or all, of the uses of traditional money – a means of payment, a store of value, and a unit of account.

The terms used to describe them are often confusing and misleading, covering a wide range of financial instruments with different technical, legal, and practical characteristics. They range from decentralized digital tokens such as Bitcoin at one end of the spectrum to official, sovereign-backed, central bank digital currencies at the other.

Bitcoins and their many look-alikes, often known as ‘crypto-assets’, are best viewed as a volatile, speculative asset class, which some users are prepared to accept as a form of payment.

Partly because their security relies on a combination of cryptographic and decentralized ‘blockchain’ technology which protects the identity of holders, governments are deeply concerned about their use in illicit activities such as money laundering, terrorist financing and tax evasion.

The form of digital currency which has attracted most interest, both from companies examining whether to launch a digital token and from governments insisting on the need to regulate them, are ‘stablecoins’, particularly global stablecoins such as Facebook’s proposed global currency previously known as Libra, now rebranded as Diem.

Why do central banks want their own digital currencies?

One stated reason is the efficiencies in payment systems which could result, but the reality is their motivations vary and go well beyond the efficiency argument.

In the case of China, a digital RMB could promote RMB internationalization and help curb the dominant role of the dollar in international trade and finance. This could help limit China’s exposure to US sanctions policies which rely heavily on the dollar’s pre-eminent position in international finance.

Sanctions are also a motivator for the European Union (EU) since the Donald Trump US administration imposed secondary sanctions on some EU companies.

The European Commission argues that in order to achieve ’strategic autonomy’ the EU should aim to ‘improve the implementation and enforcement of EU sanctions regimes and increase the EU’s resilience to the effects of unlawful extra-territorial sanctions … by third countries’. A digital euro could further this goal, as well as boost the international role of the euro.

European banks are also making it clear they want their governments to ensure the EU is not left behind in any race to develop both private and public sector digital currencies and tokens, so they can capitalize on the resulting efficiencies.

They face potentially powerful new ‘tech giant’ competitors – such as Facebook – unconstrained at present by banking regulation, with superior technology, a potential global customer base of billions, and proven capacity to scale up the business at speed. Tech giants have the capacity to move ahead quickly if allowed.

How will digital currencies affect geopolitics?

The expansion of big tech firms into global finance is still in its infancy. But, as these giants expand and banks themselves widen their digital footprints, financial technology will reshape not just the commercial but also the geopolitical sphere.

Former UK national security adviser Sir Mark Lyall Grant recently warned of the Chinese financial threat from a digital RMB, writing that the introduction of a ‘digital yuan’ would give China the ‘ability to bypass the world’s traditional banking systems and then challenge the dollar’s pre-eminent position’.

In 2019, then Bank of England governor Mark Carney spoke of the ‘destabilizing asymmetry’ of the international monetary system, lamenting the ‘domineering influence’ of the dollar and indicating an active discussion is well underway about the potential impact of digital currencies on global politics.

Carney identified the RMB as the most likely candidate to join the dollar as a ‘true reserve currency’, noting the RMB is making significant progress as a medium of exchange particularly in trade and finance. He said his view was that technology could play a role in facilitating the emergence of a new global reserve currency - and a digital RMB could be one step in that process.

Are we heading towards currency cooperation or confrontation?

The widespread introduction of digital currencies has the potential to transform the world financial system. In January 2020, a group of advanced economy central banks – from Canada, the UK, Japan, Sweden, Switzerland, and the European Central Bank – announced they were working together on central bank digital currencies under the auspices of the Bank for International Settlements (BIS).

The US Federal Reserve Board has since joined too but China, despite launching trials of a domestic digital RMB, appears not to be part of the group. Certainly the looming geopolitical challenge from China is a motivation for others – especially G7 economies – to cooperate.

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But cooperative agreements among these central banks could also play a pivotal role in shaping not just international standards for sovereign digital currencies, but also for the regulation and supervision of a more deeply digitized global financial system. And the chances of this advanced economy group of central banks working together are enhanced by the arrival of President Joe Biden in the White House.

As China takes forward its own plans for a digital currency with a financial system boasting some of the largest ‘fintech’ firms in the world, this is a threat to US leadership in digital finance and the dollar’s role at the centre of the international monetary system.

Given the globally-integrated nature of finance today, the US would protect its own interests best by cooperating with other like-minded governments to shape the overall design of digital finance together, rather than focus on a dogged defence of the dollar’s traditional position.