Note: I decided to branch out to a new volume at the start of every year. Beginning at an entry #1 gives me more motivation to write and it gives me something to look forward to.
As I implied in my last newsletter, I really enjoyed reading this book. It is about the technological advancements made in the realm of finance, and how these have the potential to revolutionize the way we think of money and upend the role of institutions like central banks. I think this book is good for a general audience, as Prasad is excellent in communicating the principles behind financial institutions and lucidly explains how fintech is disrupting these principles. He is not overly enthusiastic about these changes and also points out risks posed by the digitization of cash.
My purpose in writing these kinds of entries is not to write a review per se, but to highlight certain ideas or passages that struck me. For more formal reviews, let me point you to:
Gavin Jackson (FT)
Jon Frost (IMF)
On the measurement of money
Figure 2.1 shows the global distribution of currency (banknotes and coins in circulation) or, equivalently, M0. The United States accounts for 24 percent of the global total of $8.4 trillion, about the same as its share of global GDP in 2020. The eurozone accounts for 20 percent, although its share of global GDP is only 15 percent, and China accounts for 15 percent, roughly in line with its 16 percent share of global GDP. A sizable fraction of the currency issued by major advanced economies, particularly US dollars and euros, is held outside their borders. Recent estimates suggest, for instance, that more than half of all US currency is held abroad. In any event, US dollars, euros, Chinese renminbi, and Japanese yen together constitute nearly three-quarters of the global supply of currency.
Figure 2.2 shows the global distribution of M2, which includes money created by commercial banks. This distribution differs markedly from that of M0. China accounts for 30 percent of global M2, reflecting the massive size of its banking system. The United States falls to second place, at 18 percent, and the eurozone’s share is 15 percent. Bank deposits are typically not transferable across countries, so this hardly means that China is about to dominate the global financial system, a topic that we will discuss later in the book.
China is 3rd place when it comes to global M0, but jumps to first place at 30% of global M2, almost double that of the USA because of its giant banking system. It just puts into scale how massive the Chinese financial system is (although it is highly insular).
On Kenya’s M-Pesa payment system
The adoption of M-PESA has meant that shopkeepers, farmers, cab drivers, and their customers no longer need to carry around or transact in cash. This has reduced vulnerability to theft, robbery, and fraud. Small-business owners in remote and rural areas can conduct financial transactions safely and easily via their mobile phones. Individuals and business owners, who once had to endure long lines and hours-long waits to pay their electricity and water bills, can now make these payments easily and at their convenience using M-PESA. In a country with fewer than three thousand ATMs for a population of about fifty million, this innovation has proved crucial to providing financial products to a majority of households. For the mom-and-pop shops and small merchants who tend to dominate the retail landscape, this was a boon as it meant they could conduct retail and banking transactions without investing in the expensive point-of-sale infrastructure required by other payment systems such as credit cards.
I did not think of payment systems as substitutes for payment infrastructure before. But yes despite the “ease” of credit cards, there are transaction costs underlying these modes of payment. In the US, payment processors charge 2.5 to 3 percent of the transaction amount plus a monthly fee, as opposed to the less than a percent charge that Alipay and WeChat charge their vendors in China.
Another thing to take note is that while mobile payment systems are present in Africa for a while now, not just in Kenya but in countries like Somalia and Mozambique as well, obviously the economic outcomes of households hasn’t improved by a whole lot. Prasad doesn’t talk about this much — if fintech is supposed to generate new wealth by improving access to credit and other financial services, why hasn’t it drastically improved income levels in the region? He does mention that it is not a silver bullet, but I had to google studies that explain more the impact and limits of these payment systems in Sub-Saharan Africa (such as this).
On India’s digitalization
In 2009, India launched the world’s first initiative to provide biometric identities for a country’s entire population. The program, called Aadhaar (which means “foundation”), created an “identity rail” that provides unique digital identifiers for each citizen. This made it possible for everyone to get a bank account easily. The government then helped create a public digital infrastructure with open access that provides easy entry for payment providers, thus encouraging innovation and fostering competition. This “payment rail,” the Unified Payments Interface (UPI), is interoperable, which means that it allows transactions to be conducted seamlessly across various payment providers and financial institutions. This approach differs from the stand-alone private payment providers who now dominate retail payments in countries such as China. A third element is a “data-sharing rail” managed by authorized account aggregators that allow individuals to control their digital data trails and use the information to obtain access to financial services and products such as loans.
If you build it, they will come. By providing an easy and secure way to identify citizens, it becomes easier for fintech providers to operate. But this requires a high level of state capacity to do (think: can the Philippines implement this?)
On the deflationary nature of bitcoin
Bitcoin halving happens every 210,000 blocks and reduces the reward by 50 percent each time in a geometric progression. The latest Bitcoin halving took place in May 2020, when the reward fell to 6.25 bitcoins for each block mined. The initial block reward was 50, so this means that about 18.4 million bitcoins had been mined by the time this halving took place. The process is expected to end in 2140 with all Bitcoin having been issued.
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The supply cap means that Bitcoin is intrinsically deflationary. Consider an economy that used only Bitcoin as a currency. What would happen as the economy grew and produced increasing volumes of goods and services? The fixed supply of Bitcoin means that the prices of those goods and services in Bitcoin would fall over time.
This is also similar to what happened during the Great Depression, when the money supply was fixed and major economies didn’t have monetary responses available to them.
On Smart Contracts
Smart contracts are self-executing computer programs that perform predefined tasks based on a predetermined set of criteria or conditions. These programs cannot be altered once deployed—their integrity is protected by the public and transparent nature of the blockchain. This ensures the faithful completion of contractual terms agreed to by the relevant parties. A smart contract in effect plays the role of the trusted third party normally invoked to complete such transactions. Instead of a middleman who holds the relevant assets (or asset and corresponding payment) in escrow to make sure both parties fulfill their commitments, the escrow account is operated autonomously via a smart contract with predefined rules. Smart contracts can include deadlines that make them useful for time-sensitive transactions and also reduce counterparty risk. Smart contracts are usually set up such that the entire transaction will fail if any of the multiple steps involved in it cannot be executed, a feature referred to as atomicity.
Ah now we’re getting to the good stuff (for me at least). This is one area where crypto technology can really take over a function typically done by banks. One problem I always encounter in my line of work is negotiating with counter-parties how to execute real estate transactions. Resorting to opening escrow accounts is usually last on the list because of the fees that bank charge, but often times there is no other way to bridge the trust gap between the buyer and the seller. I think this is one area where blockchain technology can really change real transactions for the better, and I wish I can see the day when this will have widespread adoption.
On the E-CNY (electronic Chinese yuan)
The e-CNY functions with smart contracts but does not run on contracts that provide functionality beyond that of basic monetary requirements. In other words, the CBDC is in the first instance nothing more than a digital replacement for cash, with few additional features or functionality. This proviso seems intended to avoid the e-CNY being viewed as a security, which could affect its usability in domestic and cross-border transactions. In a 2017 paper, Yao Qian laid out a vision of the e-CNY (although it was still referred to just as the DCEP at the time) as programmable and extensible into other functions, but this seems to have gained little traction among more conservative officials who preferred to see the e-CNY mainly as a more efficient medium of exchange than cash.
All merchants in China who accept digital payments such as Alipay and WeChat Pay are required to accept the e-CNY because it is legal tender. Moreover, the e-CNY can be used across apps, which is not the case with the two major private payment platforms that do not support each other. The e-CNY will have near field communication (NFC)–based payment options. This means that two persons with phones that hold e-CNY digital wallets can exchange money by bringing their phones into proximity, even if those phones temporarily lack internet or wireless coverage. Any risks of double-spending in the absence of immediate centralized verification by a payment platform or a bank can be overcome by the electronic traceability of all transactions. Thus, the e-CNY provides the important cash-like feature of portability and at least partial confidentiality for small-scale transactions.
This will be the future of e-cash, I think. For all the libertarian fantasies of having an unmoored cash ecosystem, I think most people are willing to surrender some of their monetary sovereignty in exchange for stability and government legitimacy. But who knows?