The future of money and banking’s crypto reserve drain problem

As groups like the Finance and Society Network make clear, banking and finance are too important to be left to financial economists and industry lobbyists. We all need to take some interest in what the powerful do and how they do it. These days this also extends to the huge ecosystem of alternative finance, fintech and decentralised finance (DeFi). Most people’s experience of this at the moment probably extends little further than lurid headlines trumpeting the huge sums made and lost (currently mainly lost) in cryptocurrency. There is, however, a lot more at stake than one might at first think.

Like any focus of fevered speculative activity, cryptocurrency has attracted its fair share of hyperbole and misinformation. In a recent paper in Cambridge Journal of Economics I try to look past this and consider the multiple issues involved. I explore five issue-areas:

1. The scope for effects on the form and functioning of payment technologies.
2. The scope to empower/disempower existing actors in payment systems and to introduce new actors into those systems.
3. Impacts on trust, bank business models, effectiveness of central bank policy and security of payment systems.
4. New regulation and oversight in response to the previous three issue-areas.
5. What new forms of digital money tell us about philosophy and theory of money.

Of these five, the banking reserve drain problem (drawn from number 3) nicely illustrates how developments in money and payment systems reveal some of the inner workings of banking. Contrary to many economics textbooks, retail banks don’t use their reserves to create money. Banks create money by lending. When customers borrow, the bank creates a new deposit for the sum borrowed and this becomes new purchasing power in the economy. When the money is spent and passes from an account at one bank (e.g. Barclays) to another (e.g. Lloyds) a balancing payment is made in the reserve account of the retail bank at the central bank. While retail banks don’t use reserves to create money, they need sufficient reserves to cover the net payments between banks, and if they have insufficient reserves, they can borrow these from the central bank or from other banks or money markets. This costs in the form of interest charges.

Overall, however, there is a continual flow of money creation, customer payments between accounts at different retail banks (with matching net movements in the separate central bank reserve system) and destruction of money through loan repayment. Cryptocurrency, and especially something called stablecoin, can throw a spanner into this system. If a bank customer withdraws $100 from their deposit account and places it instead in a cryptocurrency digital wallet, then the retail bank’s balance sheet shrinks by $100 and it also, in principle, loses $100 of reserves (though see below). This becomes a problem if many people start to make use of digital wallets and this is exactly what central banks and regulators feared a couple of years ago when Facebook proposed its Libra (later renamed Diem) stablecoin. A large corporation (or coalition of corporations) with global reach, a massive customer base, existing platforms and payments systems, as well as sophisticated marketing techniques, could rapidly up-scale. This could cause a huge reserve drain problem and the threat has not gone away.

While you may not weep that banks suffer balance sheet shrinkage and a commensurate loss of reserves (sometimes referred to as a ‘disintermediation’ effect), we live in financialised and debt-dependent societies. Neither your need for a continual flow of credit nor a retail bank’s search for profit by lending to you disappears. If the bank resists balance sheet shrinkage and continues to lend at the same scale as before it will require new sources of reserves. This means more borrowing from central banks and money markets, since other retail banks will be experiencing the same problem. How this is funded, in turn, matters. Borrowing more reserves would tend to push up the commercial interest rates you pay. At the same time, the lowest cost funding available to the retail bank is short term, but short term funding exposes the bank to liquidity problems in times of systemic financial distress and we all know how that turned out during the global financial crisis.

The problem is also complicated by what happens to the fiat currency exchanged for tokens held in cryptocurrency wallets. Stablecoin issuers, for example, typically offer a guarantee of 1:1 redemption (you get your $ back if you return the token) and hold a ‘reserve’ (not to be confused with central bank reserve accounts). In principle, this is commensurate with the redemption guarantee. Buying high quality liquid assets to populate the reserve involves a payment to the asset’s current owner. This means in all likelihood that the stablecoin issuer makes a payment at a retail bank to the asset owner, and so many small deposits may leak out of the banking system into digital wallets and fewer larger wholesale payments return to some of those many retail banks. Wholesale deposits are regulated differently, and this effect too adds complexity to the system. Moreover, if a stablecoin cryptocurrency issuer becomes a major source of demand for financial assets (buying up sovereign and corporate bonds), any problems in these cryptocurrency markets can readily feed through to fire sales of other financial assets. At scale this has the potential to materially affect the market value of given financial assets. In a system of chains of leverage extending far into the shadow banking world, this can quickly become contagion. Again, this threat has not gone away, and one need not be alarmist about this to note that this is one reason why many central banks have been developing their own alternative digital money in the form of a central bank digital currency (CBDC), such as the UK’s ‘Britcoin’.

In any case, new forms of digital money are not separate from mainstream banking and finance, the two are entangled in multiple ways. The recent failure of Silvergate Capital and Signature Bank in the wake of SVB only serves to illustrate this, and the fact that cryptocurrency is currently undergoing a ‘market correction’ (sic) does not change this. As a final remark, ‘follow the money’ is usually good advice in political economy, but it is also important, as people like Daniela Gabor, Benjamin Braun, Jan Fichtner  and Andrew Baker do, to ask appropriate contextualising questions about frameworks and power. As I conclude in the paper, hyperbole notwithstanding, most of the development of cryptocurrency and discussion of that development are undertaken within the logics of our current financialised socio-economic system i.e. a capital accumulating economy. There is relatively little critique focusing on the social purpose of finance or that most pressing of all issues, how, with the climate emergency in mind, the future of money might facilitate and work with a system with different drivers. I doubt it comes as much surprise to you if you have taken the time to read this that there needs to be more collaboration between social ecological economics, degrowth and finance researchers.