The New Nature of Money meets Reality

Is the future of money undoubtedly digital?  If so, will this transformation of money as we know it fundamentally rewrite how ordinary people and businesses behave?  What about the transformation underlying all these new methods of payment, the ‘underlying currency’?  Ultimately, how do we determine the level of risk both businesses and individuals should take when it comes to this new nature of money, both the methods we utilize for payments and the underlying currencies we trust.

In this blog article, Deborah Lorenzen sheds light on how the transformation of money will fundamentally alter the behavior of people and businesses.

Speaker Deborah Lorenzen

CEO | Lorenzen Advisors, USA/Denmark

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Undoubtedly Digital: The Transformation of Money in the Fintech Era

In a world where we buy our coffee with mobile pay, set all of our utilities to pay automatically from our current accounts, receive our paychecks directly in and watch the mortgage payments disappear with disturbing regularity without touching a button, the question of digitization is already answered.  All of these forms of payment and receipt are digital, they are payments that exist purely in electronic form.  So yes, not just the future, but the current world of money is undoubtedly digital.  This is true all around the world as smartphones provide access to markets and digital wallets previously inaccessible in underbanked corners of the world.  In Indonesia, for example, Digital Wallet payments were the leading method of e-commerce payment in 2022, at 39%.  Credit and debit card payments combined only reached 17%.

This transformation of money from a user perspective is really about the ‘how’ we engage with money, a story about fintech.  And the story is wild.  In only one generation we have shifted making retail payments by cash and paper checks to using apps on our smartphones.  The array of options for how we make payments today, and the reach these options have, is enormous.  

Take a cross-border example.  Traveling from the US to Europe in the early 1990s it was still a good idea to take paper travelers checks which you could cash in for local currency at a bank or major hotel in your destination country.  To make that work you needed to buy the travelers checks at your home bank using a withdrawal or a personal check, fly to your destination, find a bank or hotel who would cash them, then walk around with a wad of local currency in your pocket that you may or may not be able to use before you fly home.  Today you simply take your debit or credit card on the trip to use at point of sale, or increasingly any number of mobile apps which pull the correct amount of home currency from your current account to match the local currency paid to the merchant. Everything is in real time.  These collective capabilities have completely rewritten how ordinary individuals and businesses behave.  

Underlying Transformation: From Fiat to Cryptocurrency

The dizzying array of change in the methods we use to interact with money can create opacity about an even greater fundamental change taking place behind the scenes, the shifting of our underlying currencies.

What is different today, is that the choice of currency underpinning our transactions is changing.  Let's start with a quick tour of currency types.  Prior to 1971 and the collapse of the Bretton Woods System, many western currencies were pegged to the price of gold, so-called ‘commodity money’.  Post Bretton Woods, most governments issued ‘fiat money’ which is the same currency we had used under Bretton Woods, but now backed by the taxing power and the level of trust users have that the government will stand behind the currency.  Until very recently virtually all digital payment transactions were completed in fiat money.  Fiat money is the money we understand today, what we grew up with, and which can be converted easily to notes denominated in Euro, Dollar or whichever other fiat currency you desire.  

Today it is no longer certain that digital transactions are underpinned by fiat money. These days we need to add at least three more types of currencies to the list of possibilities; cryptocurrency, central bank digital currency (CBDC) and stablecoin, and the key difference between them is backing.

Cryptocurrency is a decentralized system for verifying parties have the money they claim to have. There is no state involvement. Today payment gateways allow merchants and individuals to accept cryptocurrencies as payment in a similar way to acceptance of fiat money.  From a merchants perspective the processing is no different than accepting a visa or debit card as the funds - in fiat currency - ultimately land in the merchants current account.  

Not wanting to be left out, central banks are busy creating their own digital currencies (CBDC), with the first two launched in Nigeria and Zimbabwe.  In Nigeria today it is possible to transact on eNaira central bank digital currency wallets using a code on your mobile phone.  These CBDC are backed by the central banks, but separate from their fiat currency as a separate obligation of the institution.  Again, from a merchants perspective the transaction feels the same as a fiat currency transaction.

It is unsurprising to see the first CBDC launched in sub-saharan Africa given the deficiencies in financial inclusion and cross-border payments capabilities evident today.  But this is coming to a neighborhood near you.  Much of the world is hot on the heels of Africa when it comes to CBDC.

Outside of cryptocurrency and CBDC, other forms of payment are cropping up, like stablecoin. Online retailers such as Ant Group, affiliated with Alibaba and Alipay in China, Paypal, in partnership with BitPay, and even social media firm Meta have tried, to varying degrees of success, to issue stablecoins.  These are often pegged to a fiat currency - Meta’s for example was to be pegged to the US Dollar - but crucially they are not backed by the fiat currency, and in reality they are backed by the balance sheets of the issuing party.  Others, Amazon for example, has been issuing its own ‘coins’ for use on its platform, backed purely by its own balance sheet. To make this point explicit, if holders wanted to redeem the value of their Amazon ‘coins’ held in Prime accounts but Amazon either would not or could not, there is nowhere else to turn since the coins are backed only by Amazon, an unregulated online retailer.

As an aside, both cryptocurrency and stablecoin offer challenges to the effectiveness of central bank monetary policy.  If private currencies exist outside of state control, they could undermine a central bank's ability to manage inflation, which is traditionally done by tightening or easing the amount of money in circulation.  If a central bank fiat currency shrank in percentage terms in comparison to the cryptocurrency and stablecoin in circulation, the percentage shift in fiat currency would necessarily be greater to try to wedge a change in the broader market.  That could prove politically and practically problematic.

Definitions of Money:

Commodity Money - currency backed by a precious metal such as gold or silver

Fiat Money - currency backed by the ‘full faith and credit’ of a government with the power to tax its citizens

Central Bank Digital Currency (CBDC) - a cryptocurrency which is centralized and controlled by a central bank

Cryptocurrency - decentralized system for verifying parties have the money they claim to have, not linked to commodities or governments

Stablecoin - a type of cryptocurrency pegged to a reference asset other than commodities or fiat money

For each of these new forms of money it all comes down to trust. Do we, should we, trust the balance sheet of the world's largest firms like Amazon, Alibaba and Meta, more than we trust the taxing power of our governments?  Is the answer to that question different for major economies than for smaller ones, or for ones in crisis?  The starting point is ensuring you know which type of currency is backing your payment transaction, regardless of which digital method you are using to make the payment.

Navigating the Uncertain Terrain of Currency Risk: Understanding and Evaluating the Challenges Ahead

As we begin to confront these various currencies in our business and personal lives, how do we make sure we understand what we are choosing and successfully evaluate the associated risk, both at a transactional level and as impact to broader monetary policy?

Regulators around the world have been watching this space closely.  For currency backed only by balance sheets, such as stablecoin, they don’t seem impressed. In 2023 the European Central Bank (ECB) warned “trading in unbacked digital assets should be treated by regulators like gambling.”  You can’t get a much more explicit direction on stablecoin than that.  Other major financial players have weighed in.  The IMF admits to ‘playing catchup’ when it comes to regulating crypto, referring to crypto, CBDC and stablecoin. They worry that the slow approach to regulating cryptocurrencies and contrasting national policies will result in a patchwork of global regulation applied to an asset which does not respect borders.

That said, in principle, CBDCs backed by trustworth central banks should have similar risk profiles to their relevant fiat currencies.  Spot transactions - ones that happen at a point in time with no money left in reserve - should be straightforward in the cryptocurrency world.  Investing in cryptocurrency as an asset is a totally different question.  This learning process will take some time to work through, and the interim will offer turmoil.  Regulators are not yet ready to fully embrace the challenge, which leaves individuals and businesses on their own when it comes to understanding the level of risk in a given payment stream or transaction.  There are two basic questions which can be asked for any given payment transaction:

What is the method of payment (credit card, debit card, smartphone app, crypto payment gateway etc.) being used and do I trust that method?

What is being used as the underlying currency (fiat money, cryptocurrency, stablecoin etc.), do I understand how it is issued and do I trust the backers?

None of this will be straightforward in the short run.  On January 17, 2024 at the World Economic Forum Sam Altman, CEO of OpenAI, noted that “safety is not binary” in talking about the risks of cryptocurrencies and AI for ordinary people.  He expanded by saying that, on the one hand, the sky is not falling because these innovations are rolling out around the world, and on the other hand, it won’t all work out perfectly. The question for each of us in the meantime, is how much risk are we willing to accept to be an active participant in the new nature of money.

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Everything is currently going by leaps and bounds and women have to progress alongside the technological process.

A thought-provoking read on the intersection of technology and finance in today's interconnected world. Good job Deb!

Well done Deb - helpful, clear, and concise overview of digital money. A followup piece covering the costs of transacting in these various types of money would also be interesting. Cheers, Dick

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