The global financial system is in the midst of profound transformation. This shift represents both a great opportunity for the United States in terms of job creation and potential growth and a new set of national security dilemmas. The danger we face is the very real possibility that our policymakers will misunderstand what is happening and block sensible change—or perhaps even move us in an unfortunate direction.
Experience since 2007 has taught an important lesson: Damaging financial instability is possible even in the world’s richest countries, despite strong legal systems, enforceable contracts, and what was previously thought to be well-functioning financial regulation. In the 2008 crisis, this instability derailed global growth, resulting in mass unemployment on a scale not seen in decades. Subsequent problems in the euro area—along with concerns now spreading in emerging markets—indicate that global financial structures continue to be fragile.
After nearly a decade of crisis, bailout, and reform in the United States and European Union, we have a financial system—both in those countries and globally—that is remarkably like what we had in 2006. Of the nearly $300 trillion in measured global financial assets, about 25 percent are in the United States and close to 30 percent are in Europe. Most of this finance flows through banks—the banking system accounts for half of all intermediation in the United States and around 80 percent in Europe. Taken together, these banking systems are dominated by about a dozen big banks. In the United States, the 20-plus regional banks combined have a balance sheet about the same size as that of JPMorgan Chase, the largest bank. In Europe, big banks comprise almost the entire financial system.
These major banks are actually complex conglomerates of legal structures operating across international borders. The full extent of their operational risks is opaque to outsiders, only partially understood by regulators, and sometimes apparently even misperceived by the executives and board members who are supposed to be in charge. It is particularly hard—and often controversial—to understand the full extent and nature of risk exposure at global banks heavily engaged in derivatives transactions.
Some financial companies failed and others were taken over during the crisis in the United States; there has also been a degree of consolidation in Europe. None of this amounts to significant change.
There is a long list of reform efforts undertaken since 2010, including increasing capital requirements, changing the rules for the resolution (i.e., official handling) of failing financial companies, and centralizing derivatives markets. Some jurisdictions have also introduced additional restrictions on banks’ activities, including some limits on risk-taking.
But the most important capital levels—the amount of shareholder equity relative to total risk exposure—have changed little from pre-2008 levels; the new resolution powers exist on paper more than in practice; and significant risks begin to become obvious in the clearinghouses that now handle more derivatives. Irrespective of any potential adjustments to rules following the U.S. presidential election, the potential for destructive systemic risk persists—and fundamental debates continue among officials about how to reduce this risk on both sides of the Atlantic.
In this context, two relatively new interrelated ideas hold considerable appeal: that central banks should issue their own digital currency; and that financial transactions more broadly could be recorded on a decentralized ledger (or, more specifically, on a version of what is known as a blockchain). A central bank-issued digital currency would provide the essential safe harbor for transactions balances—money that is not subject to runs—as well as offer low-cost access to the payments system for people who do not currently have bank accounts. A fully transparent and robust decentralized record of financial transactions would increase accountability and reduce counterparty risk; it could also significantly lower the cost of buying and selling assets.
Let’s take the first idea. Central banks issue one form of currency: the paper that you have in your wallet. One real possibility is that everyone—individuals and firms—could essentially have a bank account at the central bank. In all crises there is a run for safety—toward financial assets that have more implied protection from the government. But nothing is safer than cash, and cash in the modern world is simply a liability of the central bank that can be used to make payments. If people are already holding a sufficient amount of this safe asset in the form of central bank-issued digital currency—if, that is, they have an account at the central bank rather than at Washington Mutual or Wachovia—the potential for destabilizing runs is greatly diminished.
That said, there is also a very real risk on the horizon. The success of a new private money—a blockchain-based digital encrypted currency, such as Bitcoin—may dramatically drive down the demand for central bank-issued money. From a consumer and transactional point of view, such a development could be positive, and an easy-to-use version of this technology could spread quickly around the world. From a central bank perspective, however, this would result in a significant loss of control over the economy.
The second idea, that of a “blockchain” or decentralized ledger, is perhaps even more profound. (The “blockchain” entered into general usage as a stand-in for the cryptographic system that runs Bitcoin, although this precise word was not used in the seminal paper by Bitcoin creator Satoshi Nakamoto; the term has now acquired a broader but vaguer meaning.) Almost all your financial transactions today are recorded in a central database somewhere (hopefully, with backups). Your bank has a record of your deposits; your broker tells you how much your stocks are worth; and your pension plan keeps track of the value of what you have saved. Similarly, in most financial markets, when ownership changes hands, there is a centralized record of who now has property rights over what.
Bitcoin is founded on the idea that we can have a better—or at least a different—system, which is decentralized, so there are many versions of the same record stored on different computers around the world. This might seem cumbersome, and the process of updating such records and keeping them consistent is still evolving. But when this works—and it does work today on a moderate scale—there is no need for a centralized authority or database.
No centralization means no one is in charge—so no one person or organization can distort or damage the system. Essential infrastructure does not reside in a single firm—so the failure of any single firm is less consequential. If a single computer or even a large number of computers and their interconnections go down (or are hacked), this does not disrupt the Internet; the same is true for a distributed ledger. In addition, there is real potential for greater transparency in markets organized in this fashion. There is an active debate about how public the encrypted ledger for any set of assets should be, but it is also quite likely—for cybersecurity reasons—that we will end up using a large public version of the blockchain (perhaps even based on what Bitcoin uses today).
In that case, all holdings by everyone would be visible, although the encryption system provides some privacy. Still, this provides opportunities for greater visibility into market structure and how large players are operating. A great deal of effort will go into understanding who holds what kind of risks in their portfolio. Rather than relying on selective public disclosures and fragmented publication of expensive data, we will have access to a huge amount of information that is essentially free.
Why hasn’t this happened already? In part, this is due to the general inertia in all legacy systems: We do things today just as we did them yesterday, because it requires less effort and thought. In addition, the pressure for change is diminished by the implicit free subsidies provided to systemically risky activities in our current structures.
The largest banks in the world are regarded as too big to fail by investors, so people are willing to hold a claim on those banks (i.e., a bank account) as part of how they make daily payments, or—in the terminology of financial markets—to accept a great deal of counterparty risk, at least until things get very bad. The problems with this structure are both that it induces inappropriate forms of risk-taking and that, when things get bad, central banks and ministries of finance have to step in with a great deal of support. And even when such support is provided—as it was on a massive scale in 2008-09—it will not necessarily prevent a deep recession, or worse.
The most important source of economic and political power for large banks today is that large financial flows must move through centralized—but private—structures. These banks are protected by regulatory barriers to entry: It is hard to get a banking license. The big banks also have a hotline to the authorities, in part because they are important in the selling and holding of government debt.
Tomorrow’s flows will move much more through decentralized structures. And this system will be more stable if the central bank offers ready access to the safest possible asset.
Without question, big banks and their allies are not enthusiastic about moves in this direction. And these firms have proved remarkably effective in slowing and blunting recent attempts at financial reform. Standing in the way of technological change is much harder, but the next President—and the regulators he or she appoints—will need to make some important decisions. There are three main reasons to press for sensible innovation in this sphere.
First, apart from the implications for systemic risk, there are a number of other potential benefits arising from a well-designed new system, in terms of the operation of the payments system, the settlement of securities transactions, increasing financial inclusion, and even the better functioning of monetary policy.
Second, the adoption of this new technology is likely to be facilitated by innovative information technology companies, including startups, and by competition between existing nonbank firms already in the finance space. Innovation will happen with or without rule changes, but sensible rules should ensure a smoother transition.
Third, if governments decline to take these issues seriously, private money will take over sooner and more completely. Over time, all financial systems will likely converge on a more decentralized global structure. If policymakers coordinate, there is a better chance that some central bank-controlled form of money can anchor this system. Exactly how monetary policy would operate is still the subject of expert discussion, but there are advantages to allowing the supply of money to increase in line with the size of the economy (Bitcoin and similar supply-constrained systems do not allow for this). Abolishing or completely bypassing central banks is unlikely to help promote system stability.
Any such shift in the nature of our financial system is not a guarantee that nothing bad will ever happen. It is presumably impossible to completely eliminate systemic risk, and we should understand and monitor the potential for financial innovation to prove destabilizing in unforeseen ways. However, the U.S. and European financial systems were not so prone to instability in the immediate postwar years, and there is real potential to regain some of that robustness.
In terms of the implications for U.S. foreign policy and national security, think of it this way. The next President could decide to impose prohibitive taxation on any private money (like Bitcoin) or prevent the Fed from broadening access to its money. But if the United States had blocked or refused to adopt the Internet and related technologies in the early 1990s, would our role in the world be greater or lesser than it is today? Presumably, the answer is the latter—we derive great benefit from being at the center of technological development. In part, this is due to the jobs we create and the way we continue to attract talent from around the world. But there are also important, more direct implications for our access to information and the functioning of law enforcement. At the same time, no one wants the U.S. government or any powerful private-sector firm to control the Internet.
The world’s future looks likely to be much more encrypted and decentralized than in the past. Genuine privacy and the protection of personal data can be greatly enhanced. We can resist this change—or we can figure out how to ensure that the United States remains the essential place for another round of intense innovation and deployment of sensible systems.
This involves making the right decisions in terms of technology policy, but also getting the financial regulations right. It’s good news that important parts of this strategy fall under the purview of central banks. These organizations tend to be run as meritocracies that are protected from excessive political intervention. Central banks have also learned, the very hard way, that it is not wise to just rely on private firms to manage financial innovation and its implications.
For example, allowing firms to create private or federated blockchains would be fraught with risk, including the vulnerability to hacking. There is nothing wrong with allowing myriad forms of innovation, as long as system stability remains an important priority—and central banks are well placed to provide this (in fact, this is now clearly one of their most important priorities).
There are important decisions about the public interest to be made, including: To what extent should central banks use Bitcoin or any non-government encrypted currency? Should deposit insurance continue to be provided, and on what basis? And should there be a broader push away from debt and toward equity-type funding within our private intermediation system?
Leading central banks around the world—and the Financial Stability Board, which operates under the authority of the G-20—are beginning to engage with these topics. Representatives of big banks are also having their say. Hopefully, other parts of finance and other sectors will also weigh in. We need civil society to understand what is going on and offer input.
The future of global finance is far too important to be left to the financiers. Hopefully, the next President will lay out a broad vision for our payments and monetary system and appoint people who can facilitate the implementation of new technologies. There is a great opportunity for American leadership, through persuasion and demonstration. At the same time, we must be mindful that previous waves of financial innovation have not always resulted in greater stability. American leaders have a responsibility—to their citizens but also to the world—to do all they can to prevent another version of the 2008 global financial crisis.