How digital assets will change monetary policy
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How digital assets will change monetary policy
The rapid development of digital assets as programmable money and/or securities that can serve as collateral provides central banks with a way to reduce their reliance on traditional monetary indicators as tools for monetary policy.
Navigating Web3 tides with focused insightsAuthor | Manmohan Singh—Senior Economist at the IMF
Until the early 1980s, U.S. monetary policy was straightforward and operated entirely within the traditional banking system. Then, through rehypothecation and other collateral uses, it began to gradually seep into securities markets. These methods have since grown in importance relative to the fractional reserve component of dollar deposits within the traditional banking system.
Today, as the growing interconnection between large bank funding desks and digital assets becomes increasingly evident, the pendulum may be swinging back. This is because high-speed digital assets secured via blockchain could see more prominent use in collateral markets. Such a shift could significantly affect monetary policy, especially given that collateral reuse has declined since the 2008 financial crisis.
Collateral Reuse and Digital Assets as Securities
How can digital assets function in collateral markets? In theory, title-transfer-based collateral agreements can utilize these assets as eligible collateral (assuming they qualify as securities), ultimately settling just like U.S. Treasury ownership transfers do today.
Interest-based collateral agreements charge fees on digital assets. Digital assets such as securities are reusable, but crucially, while the chain length of collateral reuse for traditional securities cannot be precisely tracked, the collateral chain length involving digital assets can be measured in near real-time. Transparency is a key benefit of open blockchain technology, as these assets can be monitored without revealing privacy or proprietary trading strategies. The ability for risk managers and regulators to monitor leverage across collateral chains should be highly attractive.
Efficient Digital Assets: Programmable Money
Collateral reuse has long been a metric difficult to incorporate into monetary policy frameworks. Disclosures regarding pledged collateral typically appear only once a year in footnotes to bank financial statements. Auditing standards do not reflect whether collateral shown on a bank’s balance sheet is simultaneously reflected on multiple institutions’ balance sheets. But what if collateral reuse becomes less critical to monetary policy because money itself naturally begins to exhibit higher velocity?
Recently, a Federal Reserve paper by Wong and Maniff included discussion on the “programmability” of money—a feature tied to smart contracts, which are self-executing code snippets associated with a subset of digital assets posted on blockchains. (These currencies are either privately issued, such as stablecoins designed to track fiat value, or central bank digital currencies; IOSCO notes that for collateral markets, stablecoins could resemble regulated securities.)
For years, the digital asset world has discussed programmability, and now mainstream financial players are beginning to recognize its significance. Why? Because programmable digital assets exhibit high velocity, potentially exceeding that of traditional money in certain jurisdictions. In recent years, quantitative easing and similar programs have expanded central bank balance sheets, causing a sharp decline in the velocity of traditional money. Under these conditions, an increase in high-velocity money could significantly impact monetary policy.
Programmable instruments such as cryptocurrency-based stablecoins already exist. However, since they are issued by non-bank entities, they are not considered money and cannot provide settlement finality. With on-chain transaction volume exceeding $1.1 trillion annually (verifiable) and exchange-reported volume surpassing $12 trillion (off-chain cross-volume not independently verifiable), the scale is substantial. Mainstream institutions are taking notice.
Why do these specific digital assets exhibit much higher velocity than traditional bank money? They unlock funds previously trapped in unsettled payments, thereby increasing fund turnover (and capital returns) for users—from traders and investors to corporate treasurers. Their settlement speed far exceeds that of traditional payment systems—minutes instead of hours or even days. Moreover, they operate on shared infrastructure (blockchain), eliminating slow sequential settlements between institutions and reducing counterparty credit risk. They also offer finality, including protections against reversals and refunds that traditional payment systems may lack. Most importantly, they are deployed on API-based smart contract platforms, enabling users to build software applications that enhance processes such as payment reconciliation.
However, digital assets issued by non-bank entities—including Facebook’s Libra—pose a challenge for monetary policy. They hoard collateral in silos, making it unavailable for reuse in collateral markets, thus affecting global liquidity. A Macroprudential Bulletin published by European Central Bank staff (Adachi et al., May 2020) noted that Libra could become a $3 trillion collateral warehouse.
If banks issue commercial bank money in the form of digital tokens on blockchains, central banks would gain a new policy tool, allowing them to deploy existing central bank reserves that are currently dormant. Dollar tokens issued by commercial banks backed by central bank deposit reserves would complement—not compete with—the existing real-time gross settlement efforts of central banks like the Federal Reserve. Additionally, legitimate concerns expressed by the Fed’s Lael Brainard regarding legal, regulatory, financial stability, and private funding implications of non-bank-issued stablecoins would not apply to bank-issued money.
Banks are now following non-banks into the market. Swiss bank Sygnum received a banking charter from FINMA a year ago and began issuing Swiss franc stablecoins fully backed by central bank reserves in March this year. Japan’s bankers’ consortium Tokyo Tanshi, a joint venture with software firms Digital Garage and Blockstream, graduated from Japan’s FSA Innovation Hub in June and launched a yen stablecoin.
The rapid development of digital assets as programmable money and/or securities usable as collateral offers central banks a way to reduce reliance on traditional monetary indicators as tools of monetary policy. If applicable when integrated into traditional finance, old concepts in monetary policy may become new again.
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