Tuesday, December 5, 2017

The Federal Reserve and Cryptocurrencies - The Pot and the Kettle

A recent speech on innovation in the world's payment systems by one of the Federal Reserve's insiders, Randal Quarles, gives us an insider's perspective on the current attention being given to cryptocurrencies/private digital currencies which are based on blockchain technologies.  Of course, we have to realize that Mr. Quarles has a vested interest in protecting his employer's currency of choice, so-called "cash" which may account for at least some of his sentiments.

In his recent talk entitled "Thoughts on Prudent Innovation in the Payment System", Mr. Quarles, Vice Chairman for Supervision and Board of Governors member at the Federal Reserve, began his talk which, ironically, was held in the Cash Room at the Federal Reserve Bank of Cleveland, by noting the impact of new technologies on our lives, particularly impacting how we shop, get our news (fake or otherwise) and transport ourselves.  Innovation in financial services have also taken place, particularly in consumer lending, financial advice and retail payments.  He then goes on to state the following:

"Today, I will talk about the necessary trust and confidence that the system requires, the tension between the need for financial stability and the need to innovate, and the challenges that digital currencies, in particular, present relative to the current system. These considerations highlight the need for a prudent approach to innovation in payment systems."

With the current bull market (some would use the dreaded "bubble" descriptor) in cryptocurrencies, the Federal Reserve is certainly paying heed to the payment systems that lie outside of its bailiwick.  Mr. Quarles observes that payment systems of the past were far less technical in nature, mainly involving the storage and transfer of physical forms of cash, both notes and coins, from the Federal Reserve into the banking system.  Today's payment systems use technology to electronically process fund transfers from one individual or business to another.  The main source of the monies used in these transfers is the nation's regulated banking institutions with the Federal Reserve playing the role of clearing and settling transactions that occur in the interbank world.

He then goes on to discuss one of the biggest advances in financial technology:

"As part of the new technology associated with fintech, we are now seeing the emergence of privately developed digital currencies using new decentralized technologies. Fundamental to these digital currencies is the establishment of a new asset, the unit of the digital currency--for example, a bitcoin--and a new record-keeping and transfer mechanism that enables users to store and trade those units--for example, a blockchain--often without reliance on traditional financial institutions...

But when we examine the assets at the center of digital currency systems, I think we should begin to think clearly about the long-term properties we seek for large-scale payment networks and systems used by the general public. Today, the vast majority of our payments by volume and value are processed by regulated financial institutions. In the U.S. payment system, digital currencies are a niche product that sometimes garners large headlines. But from the standpoint of analysis, the "currency" or asset at the center of some of these systems is not backed by other secure assets, has no intrinsic value, is not the liability of a regulated banking institution, and in leading cases, is not the liability of any institution at all. Indeed, how to treat and define this new asset is complicated.

While these digital currencies may not pose major concerns at their current levels of use, more serious financial stability issues may result if they achieve wide-scale usage. Risk management can act as a mitigant, but if the central asset in a payment system cannot be predictably redeemed for the U.S. dollar at a stable exchange rate in times of adversity, the resulting price risk and potential liquidity and credit risk pose a large challenge for the system. During times of crisis, the demand for liquidity can increase significantly, including the demand for the central asset used in settling payments. Even private-sector banks and certainly non-banks can have a hard time meeting large-scale demands for extra liquidity at the very time when their balance sheets may be in question. Moreover, this inability to meet the demand for extra liquidity can have spillover effects to other areas of the financial system" (my bold)

As the world's leading purveyor of fiat currency, it is interesting to see a Federal Reserve insider fault cryptocurrencies because they have "no intrinsic value".

Mr. Quarles goes on to briefly mention one of the issues that impacted the United States, particularly in the 1930s; bank runs.  Bank runs occur when people lose faith in their payment/banking systems.  He notes that Congress introduced the central bank and deposit insurance programs to ensure that depositors had confidence in the banking system.  As a caveat to cryptocurrency holders, he observes that:

"Without the backing of a central bank asset and institutional support, it is not clear how a private digital currency at the center of a large-scale payment system would behave, or whether the payment system would be able to function, in times of stress."

Ah, the Federal Reserve.  Don't leave home without them.

Mr. Quarles makes it quite clear that the Federal Reserve believes that the nation's insured and supervised institutions are at the core of the payment systems in America and that there are "...potential financial stability problem(s) (with) relying on payment systems with unbacked and unregulated digital currencies at their heart."

Let's close by looking at how the supply of fiat currency as represented using Money Zero Maturity or MZM has changed under the Federal Reserve's supposed supervision since the beginning of the Great Recession:

Since January 2008, the supply of zero maturity money has risen from $8.132 trillion to its current level of $15.17 billion, an increase of 86.5 percent.  Perhaps this along with the current global political instability at least partially explains why investors are looking at alternatives to fiat currencies, no matter their level of stability.

Interestingly, according to William Dudley, President of the Federal Reserve Bank of New York, not to be left out of a good thing, even the Fed is considering getting in on the digital currency action with a caveat attached:

"But it is something we are starting to think about: what would it mean to have a digital currency, what would it mean to offer it, do we actually need it.  But I would be pretty cautionary because it’s (Bitcoin) not a stable store of value and it doesn’t really have the characteristics that you’d like to have in a currency.” (my bold)

Yes, like the ability to "print" an endless supply of physical paper and boost the money supply to whatever level a central bank deems necessary to keep the economy afloat?

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