Digital finance makes international cooperation even more important

In a world without physical cash, differing standards for digital currencies risk creating exclusionary trade blocs.

Jenny Gordon

15 September 20223 min read

In an excellent recent article for the International Monetary Fund, Cornell University’s Eswar Prasad lays out the potential benefits and costs of digital finance. “The era of physical currency, or cash, is drawing to an end, even in low- and middle-income countries,” Prasad writes, with electronic payments ever more popular.

Digital finance is much more than replacing cash issued by central banks with electronic payments. It opens the door for non-central bank issuers of “money” and a whole new range of financial service providers. On the benefits side of digital finance is the scope to substantially bring down the costs of financial transactions, and with this, increase access to payments and credit for people underserved by the current system. On the costs side are the risk of instability that comes with a decentralised system that has fewer regulatory constraints, and the potential for misuse of the considerable data about customers that will be accumulated by the providers of transaction and credit services.

Maximising the benefits of digital finance while minimising the costs is a massive challenge for central banks and the international financial system.

Prasad makes the point that central banks will have little choice but to issue a central bank digital currency, which comes with questions about how this will impact on their ability to manage monetary policy and maintain competitive neutrality.

Maximising the benefits of digital finance while minimising the costs is a massive challenge for central banks and the international financial system. At its best, a decentralised system has many providers competing for customers through innovative products that more efficiently match needs, bringing down costs and increasing access to services. The regulatory system would establish a set of rules, and customers would have sufficient information to impose discipline on the providers. But in a world of naive customers and scale economies, the market is unlikely to deliver even close to this best outcome, even if there was general agreement on what the rules should be. Enforcement is essential.

In the past, the regulatory institutions could safely ignore risks that are limited to small market segments (although governments may have to pick up the pieces as local businesses fail and communities lose their savings and services). The 2007–08 global financial crisis demonstrated that risks that look local can have global impacts. Digital finance means that all local risks can become global as the providers can be arbitraged across many market segments, and information (accurate and misleading) can quickly shift customer sentiment. The very thing that brings value in diversification and low transaction costs increases the risk of herd behaviour and contagion.

Perhaps the most important aspect in the design of the international finance system will be how to assess and enforce provider quality. The capital adequacy rules that have been the centrepiece of the system are less important in a digital finance world because to impose them would fundamentally undermine the value that digital finance brings as an intermediator. Digital finance means credit creation becomes a distributed system so the capital base of the provider matters less. What matters more than capital adequacy is the integrity of the providers’ systems, the control they have over their data to protect misuse, and the exposure of the operators as well as the owners of these businesses to sanctions for misrepresentation.

Reduced economic interdependence will restrict growth and pose increased risks to security.

Determining what constitutes provider quality for the services a provider offers and the markets in which they operate needs to be done at a global scale. There is a real danger that different standards for provider quality will be set that create exclusionary blocs. While this restricts financial contagion risk across blocs, it will reduce the trade in goods and services across these blocs.

Reduced economic interdependence will restrict growth and pose increased risks to security. As central banks ponder the issue of their own digital currencies, they face the much bigger question of how to ensure the international financial institutions can evolve to meet the challenge of regulating digital finance in a way that maintains the benefits of globalisation of trade and investment. Let’s hope they are up to the task.

Main image: Jake Allen/Unsplash

A product of the Lowy Institute Indo-Pacific Development Centre, with funding support from the Australian Department of Foreign Affairs and Trade.

About the author

Jenny Gordon

Dr Jenny Gordon is a Nonresident Fellow at the Lowy Institute and also a Honorary Professor at the Centre for Social Research and Methods at the Australian National University.

Topics

IMF Economy