#266 David Andolfatto: The Impact of Central Bank Digital Currencies on the Banking Sector

Transcript

[Music] this episode of epicenter is brought to you by top-down experience a new way of hiring has topped out delivers only the top 3% of applicants including highly skilled locked in engineers if you're looking to scale your team with the very best talent visit top.com slash epicenter hi welcome to epicenter my name is Sebastian Cujo and my name is Frank Rob anything let's go Brett yes very good yeah well yes actually as we're

reporting this I'm in your hometown I'm here in Basel and apparently not too far from where you grew up which is kind of interesting and just want to mention that over the course of the next few weeks I'm gonna be releasing some content that I reported here some so many views with some of the key members of the population community and also brian behlendorf who we had on the show a couple weeks ago so look for those interviews on our YouTube channel and also you know we'll be tweeting about of course and like sharing them on our social channels but yeah it's a great conference and I'm really happy that my realtor invited me or the Living Foundation sorry invited me to come out here and do these interviews it's kind

of a it's kind of a welcome change from the the other side of things which is sort of like def cons and permissionless systems here we're seeing a lot of enterprise other guys in suits very different vibe from that from Def Con I must say but yeah so today we're speaking with David Alfaro who is a researcher at the st. Louis Federal Reserve and we had David on years ago to talk about fed coin and so today we were fortunate enough to be able to speak with them again and we talked about a number of things including you know sort of like the sort of space and how it's evolved since we last spoke the the idea

of central bank digital currencies we also talked about is a recent paper that he wrote about the impact of central Bechdel currencies on the banking sector and touched on some other sort of interesting high-level economic theorizing about you know sort of the tokenization of liquidity so here's our interview with David undal fatto hi welcome to epicenter my name is sebastian cuiture and my name is brian crane we're today with David an old fellow he was on the podcast before actually we just checked before and spent three and a half years so a long time last time we talked about fed coin which was you know basically the idea of how could the central bank

like the Federal Reserve issue its own cryptocurrency I think a lot of people were like what is this horrendous idea so yeah today of course in the meantime lots of things have happened and we were really excited to have David back on to speak a little bit about you know some of the these had years back then and the activities around central banking and federal and cryptocurrencies and some of the other research topic that he's been working on so thanks so much for coming on David that's my pleasure thanks so yeah you before mentioned well fortunately not much has happened so let's come to that let's come to that question since the last time he spoke and I think it at the time you know it

was hardly anybody from a central bank writing about Bitcoin and writing about crypto it's become lots of activity so what do you think are the most important developments in the last three years when it comes to the kind of central banking and cryptocurrencies well I think in terms of central banking I'd probably say the most important development from my perspective is just a greater awareness of the possibility of the central bank a central bank becoming more directly involved in issuing digital money to to regular people and are just limited in a privilege to a set number of of banks give us a bit of an overview I guess

from your perspective sort of what is the the state of research and maybe specific projects being developed in the area of central bank digital currencies well I guess uh a lot of that answer will depend on exactly how we define digital currencies you know I think that the research is is multifaceted I mean there's there's a lot more to digital currencies and just currencies as you know it basically has to do with database management so I'm aware of efforts throughout central bank's in studying kind of broader applications of say distributed ledger or blockchain

technologies there's considerable amount of research being done trying to study the financial market implications of the submergent technology what impact that might have for regulatory policy going forward or central bank policy going forward and then there's a some some some work actually you know asking the question of whether or not the central bank itself might enter into the space and issue its own form of digital currency in this primarily is in the form of what I would call just digital money not necessarily a crypto asset like a digital token but more of like just a regular account based money that

is available to non banked individuals all right so I guess I guess on that side we're talking about like this sort of realm of digital currencies from like all across the spectrum right so from having a digital ledger which is based on a centralized database model or more of an account based system like the ones that we see in cryptocurrencies in blockchain and on the other hand we also have like central bank's positions on decentralized cryptocurrencies like Bitcoin and Imperium with regards to the latter and you did say that there has been a broadening of awareness how are

central bank's now looking at the the public permissionless crypto currencies like Bitcoin etherium has there been a change of opinions with regards to how things were you know three or four years ago a change in opinion I would characterize it more as a not a change there was really no opinion before and that's not just in central banking but almost everywhere because I would say as of three years ago the last time we spoke not many people had really understood what the underlying technology was and what it was delivering relative to existing protocols of in database management central bank's central bank

researchers have become more aware of the underlying technology as has everybody else and so I would say that the way the opinion you know it's hard to it's hard to generalize because you know what we're talking about here our individual researchers sprinkled throughout the research divisions of central banks around the world and there to be a wide variety of opinions out there but I would say for the most part central bankers you know being trained economists for the most part are highly skeptical of the endeavor in terms of providing at least a digital currency there maybe ten percent I mean from what

I've seen kind of our kind less skeptical so but by-and-large there's a skepticism of the role that our private money might play or to displace a well-managed kind of state money that's kind of how my measure of what the attitude is of this stage so this skepticism what's there what are the biggest things that make central bankers so skeptical of cryptocurrencies well I would say that a combination of things to be generous you know I think that one way to think about it is you know the skepticism is is based on kind

of this or historical experience this is with private money issues they haven't often turned out particularly well now in fairness it's really hard to assess the historical data because there's so much going on the interaction of regulations with the private money provision so it's very hard to tell sometimes whether it's the private provision of the money supply that should be criticized visa vie the underlying regulation that prevents it from operating well but by and large you know there's just this this this this intuitive feel based on the data you

know if we look at the so-called free banking era in the United States that Ryan from about 1836 to 1863 and what you saw was just literally thousands of different monies issued by thousands of different banks and you know this the system didn't it functioned in it by some measures that functioned relatively well but you know there's just a great inconvenience of having these different private monies coexisting circulating there's counterfeiting problems etc so rightly or wrongly I think that a large amount of the skepticism just comes from based on what we have seen in the

history of private money provision that's very interesting you know so we have because we have this technology right and having people in the blockchain space of a like forward-looking say oh this is something totally new it's revolutionary it's never been seen before and to technology so much at the center and then you have maybe like people are looking at it from a central bank in this historical perspective and saying like oh but it's similar to the thing in the 1800's they did not you know in the private banking area I think kind of applying that framework on it it feels like a very big very big difference knowing in terms of the perspective brought to the topic yeah well you know it's it's almost a

universal truth that almost there's almost nothing you when you look around there's some some example we can for example so we can draw on in history that are very close and this is no different you know financial FinTech financial innovations have been with us all the time from the beginning of recorded history you know the invention of the checking account for example that largely replaced small denomination bank paper notes you know this is a database management technology and it was facilitated with the use of wire communications and you know then techniques for storing the data basically what we see today is kind of more or less the same thing as I've

written about before but kind of on a much broader scale just because of the innovations we have in communications storage capacity and also you know cryptography and things like that that's interesting I find this I find it a bit puzzling so you you think really that generally the best way to predict the future is to you know sort of say okay how is it similar to some episode in the past and then use that well let me put it to you this way think about what bitcoin is fundamentally and blockchain more generally what it is fundamentally and I think to my view it

is a database management system money is one example of a ledger of a ledger system you have it's information that is stored in accounts and you need a way to manage that account those accounts keep the data secure and to manage the information flow across accounts the debits and credits of money across accounts this is database management it's very important but it's nothing new and so you know in that sense we can look to history because this this database management problem is around us everywhere not just in monetary systems but as you know supply chains for

example or you know the relationships between suppliers and their their customers and so on big big issues there perennial issues so in that sense nothing you what is new what is new are the emergent technologies that facilitate communications we can now speak by phone or communicate over the Internet we can now store data more securely and in larger quantities these are the innovations that lead to innovations in these database management systems these are the innovations that permit a wonderful technology like Bitcoin to emerge and no one can really predict exactly what's going to happen

but at the same time one can appreciate that the fundamental problem is always the same it's database management how do you keep the data secure and you know how do you read and write to the database keep the data secure and make sure that there's easy and widespread access to the database or to the constituents that you're kind of targeting sorry I mean I certainly agree with you right like you can look at Bitcoin and this is a perfectly fair description of Bitcoin but I feel like you can also have you know we're looking at Bitcoin you could say Bitcoin is kind of like this this is term decentralized autonomous organization right so you have in a way all of these different players and the miners and the developers and the users

and exchanges and there is no central organism yet they somehow all coordinate this like massive system and it devolves in some way right so this is so that's something that feels pretty novel to me no no no I mean it doesn't sound awful to me at all in fact it I've written on this saying it sounds like the most ancient thing that I can think of it's called you know decentralized you know communal behavior little communes little hunter-gatherer societies operate on this principle of not having any centralized Authority but people getting together and communally deciding on how to manage the the societal history for

the general prosperity of the of the tribe this principle is not you and all again what is new is the technology that permits this idea of communal record-keeping to scale on a global scale that is new but the underlying principle is not new at all yeah it's just gonna get to that is the way throw away that I perceive blockchain in this context and whether that be cryptocurrencies or permission networks or what have you is that they are essentially you know governance mechanisms that attempt to apply governance to a sort of human interaction at scale and governance of human interaction at scale sometimes

gets complex if you look at like democracy as a governance mechanism you know there are definitely advantages to it but there's also issues with democracy once you get to a certain point you know corporate structures also have their advantages and their fail points and so to me blockchain is a type of governance Meccans the governance mechanism that allows you to scale that also has its its advantages and points were where it might fail and it's sort of finding the balance between you know what are you most care about do you care about user experience or privacy or the ability to have a governess that's more decentralized or less decentralizing you sort have to pick you know some of these and find the

right balance with for your application bitcoin is one certain way and in theory you might go another way or you a permission network where you know you have we are dealing with an own set of actors might interact in a different way much like our society is interacted in different ways when thinking about governance yeah I think that's exactly the right way to think about it I you know there's database management is a problem there's many problems many many different you know there's no one solution fits all the problems and so it depends on what the constituency is looking for in terms of the properties of the database management system and as you mentioned if some you know if the decentralized record-keeping is is

something that the constituents find it desirable then kind of a blockchain structure kind of sounds like the type of database management system that to better serve their needs but for a lot of people that's just not important for a lot of people they're very willing to trust delegated record keepers trusted historians if you like to manage the data but by and large I kind of see room for coexistence here I don't see why it necessarily has to be one thing or the other I think that as always we see coexistence to fit the various these demands of the constituents okay so then I would like to maybe bring it a sort of

different a different way or different blockchain direction and here you take on that so if you look at you here might this idea of a world computer where anybody can write their application on a then it can interoperable with other applications and you know I can create my application it didn't talk to with yours but we don't know each other we don't trust each other anyone can kind of employ it on their it you know have global censorship resistant so people now doing you whether that's lending or derivatives or these kind of organizational structures or issuing Oh of assets to games does that not feel like something like really radically

revolutionary novel that just is not comparable to something we've had in the past you're you're really searching for something they're truly awful so so let's think about it here you know this this notion of a decentralized autonomous organization sounds pretty cool and I don't mean cool and necessarily in a good way it's either really exciting or it could be very frightening too if you start thinking about it can i off the top of my head draw some analogy from history I mean what do we got here decentralized autonomous organization is just basically yeah there's there's no central authority so that's that's okay

yeah well you got beyond this one maybe maybe there is something uh you know you know we basically have the prospect of robots governing how contractual terms are executed you know some sort of contract that you know we could write up and code and share we write a contract I don't know you you don't know me we can write the terms of the contract the terms of the contract can be executed on kind of publicly available information and the terms are going to be contracted whether they're going to be executed

whether we like it or not I mean that's that's I guess something that sounds very new and in any case it certainly is something that's feasible with this this new technology and I think it's exactly that area that I think is is the decentralized autonomous organization that I think will be seen policymakers are going to be starting to open their eyes a lot more to that dimension of the of this endeavor because I think that actually potentially this that part of it is is likely to have the most profound implications for society yeah I very much agree with and then of

course you absolutely right that with any powerful new thing there is the upsides and the downsides and and certainly those with dollars it's very absolutely possible to imagine you know quite horrendous ways this could be used as well as wonderful ways it could be used so there's no and I I think it could be a perfectly reasonable stance in my view to say okay I see those possibilities and I see the good the good possibilities and the bad one and for me I I you know I I think the bad ones are maybe too likely or too bad so that I'm overall against this I think that's it in a reasonable position to have hmm I'm glad to hear that you think I'm reasonable hiring is stressful let's

face it it's a long process of sifting through resumes and interviewing candidates without any guarantee of quality but it doesn't have to be this way companies all over the place are experiencing a new way of hiring with top-down if you go to their Trustpilot page you'll see that of the hundreds of people that have left reviews over ninety eight percent were four or five star ratings including one guy who wants to give his developer a bear hug that says a lot top dog gets all this great feedback because they focus on their clients and their top priority is quality they only accept the top three percent of applicants including highly skilled blocks and engineers one of these engineers is Radek Ostrovsky Roddick has experience as a lead software engineer and data scientists for Sony and Expedia then he discovered blockchain and he

became totally consumed with aetherium he worked as a consultant for the firm start on chain and his time lock tap when the top quarter consensus you port and identity blockchain hackathon then he expanded his reach through top tile he worked with a bunch of clients on projects such as smart contract development and a POC the leverages blotching if you want to hire engineers like Roddick for your team go to top tile comm slash epicenter for a Norris trial a top tile director of engineering will deliver your next hire in as fast as 48 hours and you'll get $1000 credit when you decide to hire we'd like to thank top towel for their support of epicenter before you move on to to the next topic which is this paper that was recently released I

wanted to ask you your thoughts about so in the Bitcoin space there are some people that throw around the idea that central banks should and any governing entities should start holding crypto in their reserves we'd like to get your thoughts on this if you think that's a good idea or something desirable or not at all yeah well uh that's it's interesting I'd like to know yeah I personally think that central banks around the world should oh should it start stocking up on reserves on my own personal io u--'s yeah and I guess the point of that really terrible joke is to ask what is

motivating people saying things like that it sounds like they're just trying to generate some sort of additional demand for something that they're heavily invested in the idea of a central bank holding reserves in some security like a crypto or bit going to be specific to me seems kind of strange I'm not sure why I mean maybe not central banks but but perhaps government entities that typically would hold you know currencies of other countries in reserves or gold or or perhaps some sort of of security to hedge against risk or to I mean I'm not sure exactly but you know you I

think you'd get laid the idea yeah yeah I guess I mean I have to say I I don't think that that's a particularly good idea but but I mean we kind of live in in second-best worlds or maybe even third best world so could I imagine scenarios where that might make sense and I guess I can I mean one scenario would be for example if you're living in a country that permitted say banks to issue liabilities denominated in Bitcoin it's perfectly feasible I mean banks could no potentially de nominate their their deposits or make their loans denominated and whatever

they want legislation now I would actually argue for legislation legislation that would prevent that from happening at least for banks that had access to Deposit Insurance or the lender of last resort facility the central bank but imagine you're living in a country where for whatever reason banks are permitted to write loans in issued deposits Dyneema denominated in Bitcoin then well we have a lot of historical experience of what happens with these types of structures just replace Bitcoin with gold what you get is the possibility of these bank runs and fracture in fractional reserve banking systems the banks collectively are not going to have enough gold or

Bitcoin to make good on their obligations and so you know you could imagine a government wanting or instructing banks to hold sufficient Bitcoin reserves if they're going to get into the business of issuing Bitcoin denominated liabilities so those are a lot of ifs I mean if if if but whether government should get involved in this as a matter of principle I don't know I could argue against I mean you could say listen if you're a bank and you want to get into this business get into this business but you know make sure that either you hold a hundred percent Bitcoin back make you know hold sufficient reserves of Bitcoin

or you know then the threat is if you get into trouble we're not going to bail you out but the problem with government's is that they can never commit to those those those promises and so I just think it's a bad idea yeah I mean I guess let me let me sort of try to articulate what I think is the position and yeah I think basically the position is in them and you will probably disagree with this that okay Bitcoin you know is going to grow and more and more people will use it and it will become this you know digital gold thing right that's held by many your individuals and that you know so over time that you may have a kind of erosion

off of the the value in the trust that some people have in fiat currencies and it will increasingly shaped a Bitcoin and said then it will be you know important for the central banks to have you know in their thing backing their currency have you know Vic on reserves just like they have maybe gold reserves today and that then there could be some sort of mechanism where near it is if if let's just say that the different central banks believe that there is a some good chance of their happening and you know if it happens it will have some effect on become price that you didn't have the incentive to be basically a first mover and say okay I'm going to go ahead because then I'm on a relative basis you know better off than the other central

banks and so yeah yeah maybe but you know my view is if a central bank can't be trusted to manage the domestic money supply in a responsible manner you should get out of the business and just let Bitcoin take over just let private banking take over so why why should a central bank intervene by by buying up a Bitcoin when it has the power to create its own money and manage it responsibly on its own buying up Bitcoin doesn't necessarily endow the bank with any magical management prowess uh so I just think it's wrong either the central bank can be trusted

to manage the money supply responsibly and this is oftentimes a very complicated thing because the way it interacts with the fiscal authority but this should be just all up to Eltham Utley to the voters of the jurisdiction and if it turns out that the central banks and fiscal authorities cannot be trusted to manage the money supply in this manner that then I think naturally these these other competitors like Bitcoin or gold or whatever will provide the substitutes that people want that are better managed but I don't see any reason for why the central bank should dabble in the in Bitcoin reserves so moving on to the next topic we want to

talk about your paper which came out in October it is titled except assessing the impact of central bank digital currency on private banks by digital currency I presume he you're talking about little currencies of the crypto flavor and so you know why just how does this paper build on your previous research topics regards to central bank cryptocurrencies well so crypto currencies again this is more of I I make the distinction between what I call it digital money and digital cash I guess digital money we already have digital money we use digital money all

the time debit card transactions most of our transactions are done with digital money we have bank accounts and the idea of central bank digital currency is the idea of instead of having a bank a digital money account with a regular chartered bank why not permit people to just open up bank accounts with the central bank directly that's what I mean by central bank digital money one could go one step further and have the central bank or some other entity issue what I call digital cash which kind of has more of the token aspect to it but that would be distinguished simply by you know I think

the analog would be like imagine the central bank permitting users to open up kind of anonymous Swiss style bank accounts so in that scenario people would be sending money from account to account and where art would be relatively anonymous as opposed to the system we have today where you'd have to identify yourself you identify your account number and you know that I'm sending money to you so my paper was really about central bank digital currency which is I I think probably the empirically more relevant case because I don't think a lot of central bank's will be willing to experiment with a notion of issuing you know the equivalent of

digital cash just for a lot of regulatory concerns like you know your customer requirements are anti money laundering rules and so the purpose of this paper was to kind of say look if you take a look at the way the payment system is structured at the United States today there seems to be a kind of two classes of individuals yeah agencies I guess on the one hand you have these big powerful depository institutions these private banks that have access that can hold accounts directly with the Federal Reserve Bank on these accounts are interest-bearing accounts they presently earn something

like 2% interest they the banks can send money between themselves using Fedwire which is a real-time gross settlement system so you can send money instantaneously and there's like trillions of dollars that that that flow through the system every day and moreover the banks it costs almost nothing to operate this this database management system it's basically free as far as the big banks are concerned so this is the banks on the one hand and on the other hand you have kind of the retail experience the one that that I have to go through or or you know in some small business for example they either have to use cash which is very

costly I mean it's filthy it takes a lot of you know resources to keep it secure to transport it securely to a bank to deposit it it's subject to theft for example if instead you want to use a digital money you have all these interchange fees you have to pay I mean and this can it can often be a significant fraction of the sale so in contrast to these big banks that pay basically nothing for instantaneous payments you got a small business person who's working on very small margins they have to pay these big interchange fees and that and the payments don't clear

for two or three days it's on it's on a completely separate the ACH system that was basically developed it at 1970s so this proposal in this paper is to say listen what if we kind of combine what if we permit these irregular you know tell people to have access to interest-bearing central bank digital money where the payments clear instantaneously on a real time gross settlement system why don't we do that and the the answer one often gets is that there are some you know there's some I guess constituencies in the economy there are very opposed to that sort of system and and and typically they are the incumbent banks people

argue that these banks are going to be worried about whether or not they're going to be losing business somehow it's going to you know disintermediate them in some manner you know what if everybody moves their money to the central bank for example what's that going to do for for for banks who are who are interested in funding their investments and so the purpose of my paper was to kind of study that question formally in the context of an economic model where you had basically been ah Polly banks and that's very different than what's commonly done what's commonly done in this literature is to assume that the the banking sector is competitive which is I mean everybody knows it's not quite competitive but you know the other extreme is to it to think

of it as being more oligopolistic or more monopolistic and that's what I do in my paper I argue that that's a much better approximation of the of the current US banking system and then I ask the question of what happens if the central bank introduces a and interest-bearing digital money instrument for the masses what effect is's have on on on the lending activities of monopolistic banks and also lend their profits basically and what does it do in terms of financial inclusion and what I find in the paper is that not surprisingly the introduction of this central bank digital currency increases financial inclusion because if it makes it more

attractive to hold interest bearing digital money at the central bank instead of the zero interest bearing paper stuff that the that that you know relatively poor people are now kind of forced to hold so one it increases financial inclusion it makes you know the regular depositor better off it has no effect on the ability of banks to fund their investments I think that's a striking result so for banks who are arguing that's going to impinge on their in ability to fund investments I think that that's a very questionable claim that they're making and then finally what I find is not surprisingly that it cuts into bank profits but it cuts into bank

profits but it makes kind of everybody else better off and it doesn't impinge on the banks lending activity so that's basically the upshot of the paper was tight try to identify at least in the context of a simple model kind of what the likely impacts repercussions of introducing a central banker and see would be on the incumbent banking system the conclusion is basically don't worry about it this for us the banks will have lower profits but central bank and and governments are not put in power to maximize the well-being of incumbent banks that put into place to maximize the well-being of the broader population

so I say on those grounds that would justify this paper justifies that type of intervention there's a lot to unpack here and it's a really interesting paper I mean that so the it does also describe this model that you talked about in a very mathematical form so if for those who are not very comfortable with reading lots of mathematical formulas and then mathematical models this might not be the paper for you but you you've described it and summed it up very very nicely I would like to come back just to sort of the notion of digital currencies of central banking sort of the spectrum

that we have there so on one hand we have something that's quite familiar I guess which is a you know akin to having a bank account right so there's a there's a ledger it's it's privately owned and privately managed and that ledger has a set of accounts and those accounts have balances only instead of having that ledger at a bank right like you're like Chase or Wells Fargo or BNP or whatever it's with the central bank so essentially rather than holding cash and money that you have on this private ledger this this this money this digital money is held with the central bank and then there are there may be gradients of

that and these are theoretical of course where you get to a point where perhaps a central bank has some sort of a DLT style or blockchain style digital currency where essentially the the central bank would be sort of the only node and and what's interesting with with this idea and I think this is probably what we discussed in our last conversation is it here you sort of have permissionless innovation on top so the wallets the applications that you can build on on top of these on top of this theoretical central bank cryptocurrency the innovations is opened up for so if anyone to partake in you clarify why you

said oh you said there's a single node yeah right where the with a central bank essentially that was using a little bit right is that does the clearing but it's an open source stack of technology so that one can build applications on top so regardless of where you were one things up on the spectrum that the paper addresses so the more general idea of okay a central bank has accounts where individuals companies you know small and large can hold balances there and and in fact since our last conversation this is something that I thought about quite a bit and talked with people about it sort of opened my mind to like the role the central bank's play in our inner economy

and and also the role of banks play and one thing that I find really interesting about this is that having opening opening accounts to individuals and businesses as central banks effectively renders some of the activities of a bank obsolete apart aside from the lining part I believe yeah so if this was the case if you if you could have a account with a bank central bank rather has an individual and that that account was generating 2% interest what what what is the scenario like what does that

look like in terms of the more like broader economy what is the effect that that has on the economy as a whole yeah yeah you know the this is uh this is something that ongoing research is trying to answer okay so the short answer we don't know for sure and of course my paper was just an example of trying to chip away at that to under try to understand what the likely effects might be some of the likely effects might be you know if I if I had a guess yeah let's hypothesize that yeah all of a sudden yeah people don't hold savings and banks anymore well savings have no longer well but back up a second I mean

that's not necessarily the assumption you want to make the assumption you want to make is suppose that the central bank offers a competing product that banks do now now first of all we have to think about this I mean I have in mind something kind of modeled more like the old US postal savings system and this is an old idea many countries have postal savings banks and the idea is that the the government is getting involved in providing a very basic utility service it's not a full service account it's just a basic plain vanilla bank bank account that could potentially pay interest very low fees fully insured and it just that you make payments you just pay people use it your phone or whatever

now you've charging interest on that so banks are going to have to compete compete against that product and the way they're going to compete against it is one of two ways they're going to like start raising the interest rate on the deposit accounts they offer you to attract your business but they are more likely that a try to try to compete away compete on the basis of kind of non-interest bearing benefits there's a whole bunch of other services that banks offer so they'll they'll get into their full service bank account they might offer insurance on the side there's there's all sorts of things that the you know that the the banks might still profitably be able to do even though this is basic utility service central

bank digital currencies available so I don't think it's necessarily going to see deposits flocking from the private banking sector into the central bank you might see some and the fact that the central bank is is paying interest on these deposits might is likely to force the private banks to offer better terms to depositors because if you take a look right now take a look at right now since 2015 when the Fed started raising its interest rate and take a look at what's happened to deposit rates in the United States they've basically remained zero even though the interest on reserves the interest rate that the Federal Reserve pays banks is a 200 basis points at the

same time you see the lending rates that banks are charging have gone up appreciably I think the lending rate on home security something like 600 basis points so they're making that big spread so my view is that if nothing else even if if nobody comes over to the central bank the very threat of the central bank offering a 2% you know interest bearing account would be sufficient to induce the banks to compete and so they'll be forced to compete to keep the deposits and this will show up as how your interest rate on her earner counts and better service ultimately as they compete the keeper accounts oh so I want to ask a sort of related

scenario which may seem outlandish to you but but maybe not right I think we talked about it a little bit last time maybe so I mean let's say now because right today we have this fractional reserve system right so where you have you know banks can basically create more dollars right and you have this deposit and and Bitcoin in a way is like a full reserve system right so there's you know you have a Bitcoin you have a Bitcoin like I can't give you or nobody can really issue sort of you know fraction reserve Bitcoin or when it happens it's considered a fraud right like let's say on Mount Cox you could say that was so

sort of a fractional reserve Bitcoin system at one point so why not create you know full reserve US dollar system but I said there is no fractional like let's say you made a cryptocurrency and it's the US dollar cryptocurrency and anybody can check the ledger right you send me some some US dollar I can check on the ledger and like okay this is you know real US dollar so it wouldn't make any sense for anybody to accept some sort of fractional you know fractional back US dollar what do you think of that is that a good idea well in fact the the central bank digital currency that I proposed is essential a variant of that right the accounts that you're holding

are 100% backed there is no fractional reserve banking there but the the basic idea that you're you're you're espousing right now was an old idea it's just called narrow banking the narrow banking proposal or full reserve banking proposal it's called the Chicago plan if you take a look at the literature there was a big proposal I think in the 1930s from the University of Chicago making exactly this point the idea that fractional reserve banking should be separated from the payments system and what that basically means is that if you're a bank and you're in the business of processing payments you

better make sure that these liabilities that you've issued these deposit liabilities are fully back with reserves either in the form of gold could be bit going to government Treasuries whatever they have to be fully backed and that the credit market should operate separately from the banking system I honestly don't know where I come down on this idea because I'm still exploring kind of the history and also the theory here the idea of fractional reserve banks is not inherently a bad idea I did the the question is is water banks doing when they're issuing fractional reserves you know when they go to you

you know to either you know when they go to you and make you a loan what are they doing they're creating money out of thin air and they're giving it to you what they're in effect doing is monetizing your human capital they're giving you credit they're saying you know what Brian you know what Sebastian we believe in you here's the money and by the ways it happens to be redeemable for cash so we're going to have to keep some cash on hand but we know that by and large you could just pay this money account to account it doesn't necessarily have to be redeemed in cash except under special circumstances and so what the banks are effectively doing is monetizing the the debtors you know if you if i buy the

investment I want finance the banks are in a position to translate your I your dream your investment into monetary purchasing power everything hinges on the ability of the bank to make good decisions in assessing credit risk but conditional on assessing you know making the correct assessments the idea of issuing and creating money to facilitate positive net present value projects like yourself like your education and holding only a little bit of cash on the side just a to satisfy the occasional redemptions that come whenever people have to like pull out a ten dollar bill to pay for a cab ride there's nothing inherently wrong with that business model I my my my view so

so we have to ask ourselves what is it that you're trying to like why would people you asked that you said something I'm sorry that if people had access to a full Reserve account that they would never deposit their money in the fractional reserve account I think that's false the difference between these two accounts is that the fractional reserve account is going to offer you how your interest rate so there's going to be a cost benefit analysis this high interest rate that the fractional reserve bank is able to charge is a byproduct of a profitable investments it's financing and you and your friends and other positive net present value projects and so it's not clear to me that that depositors are going to go flocking to the narrow Bank as a narrow bank is going to be a pay a

very low interest rate it'll be safe but a very low rate of return and so there's going to be a trade-off okay this is a great point but I guess we're you know in many people in the Bitcoin space right if they kind of look at the history of banking where they see fractional reserve banking and correct me if this history is wrong but it seems like it basically started as a bit of a fraud right so people would put in gold let in a bank and then you give up sort of a receipt for the gold right and then you could give the bank you could give up more receipts then you had gold without people necessarily knowing and it does have a bigger business right

which is basically what you just described I guess the nd I think you're probably right that if you if you had as this sort of full Reserve like the crypto US dollar right probably still people will create these fractional systems on top of it but in today's system right you don't like in that system it will be transparent whether you have a you know real US dollar which you don't have some kind of you know it doesn't have a dependency on how well a bank has managed its credit portfolio versus you know JPMorgan u.s. dollar which JPMorgan promises you if you go there and bring

JPMorgan s dollar they're gonna give you like a real US dollar but you you're aware that there's an additional risk there because JPMorgan doesn't have full backing because they issue more JPMorgan US dollars then you have you know real dollars correct wildly they issued more JP Morgan dollars so they have real dollars but they don't know they don't necessarily issue more JP Morgan Dollars and they have assets right right so the whole question the whole issue of fragility in the banking sector is the liquidity of these assets but that's the whole business of banking is to render those illiquid assets liquid if those assets were already liquid if your human capital was already

liquid you wouldn't have to use it as collateral for a loan you could just sell off pieces of yourself tokenize yourself little little bits of human capital of know Brian and Sebastian claims on your future wages and you wouldn't have to go and raise money at a bank so the whole reason of banking is there to overcome these these frictions you said one other thing you mentioned that the history of banking is a history of fraud you have to be careful you go look in history all sorts of activities are fraudulent why pick on banking you know there's oil and mining is fraught with fraud as well you know we don't ban mining I mean we don't mining exploration so the the Goldsmith a story

that you told is a one that's commonly told in in in textbooks and I guess there's some truth to that but it's an anecdote you take a look at monetary historians people like George Celgene or Warren Weber who studied these episodes go take a look at the Scottish free banking episode in the 1700s they're the banks had I think double liability I mean the bankers if if they're if their operations went under they were personally liable to make good on the losses for example so it's it is not and and that system arguably by my reading worked pretty well so you have to be careful at kind of reading select anecdotes from your favorite economics

textbook and kind of generalize as to what the historical X have spent for fractional reserve banking the stories mixed was there fraud of course there was fraud there's fraud in every endeavor in history that's not the issue the the issue is just uh how did it work was it relatively did it work relatively well or not and if thought why not was it because there's something intrinsically wrong with fractional reserve banking or did it interact some way with the existing legislated legislation that prevented the banks from otherwise op operating from fractional reserve bank from operating in a more stable manner sometimes that's a very key part of the equation is the legislation often prevents banks from

operating in a way that you might consider in a more prudent manner yeah this kind of falls into the next topic which is so the token of that tokenization of of the quiddity and you you you made a great point that a banks job is is to create value out of things that are illiquid and I think that to Brian's point and I think this is what he's sort of alluding to is and and perhaps you know since the last banking crisis in 2008 have become aware that banks were were were backing debt with with illiquid assets but giving him way

too much value to these assets with regards to how much they were actually worth so there was a great disparity gap between the under VAT the underlying value an asset and what the banks were we're lending out and I think this is what has caused you know a lot of the skepticism around banks sort of generally and and a lot of the skepticism I guess in the Bitcoin space perhaps because Bitcoin came out around the same time so you know after every financial crisis people suddenly recognized the province of banking that the Federal Reserve was born out of a financial panic of 1907 the US postal

savings system was formed in 1911 that the s'posed 'el Savings Bank that offered small deposits that were fully insured by the government it was a tremendously popular program and it came in the aftermath of the panic of 1907 so what you say is true it's just kind of in some sense remarkable that the same sort of mistakes keep on getting repeated although in in some defense I mean the the crisis the most recent crisis did not happen at the retail level the the recent crisis did not really happen in the regulated banking sector you know people have a Deposit Insurance nobody lost their money in the

bank there were no bank runs you know Deposit Insurance rose to two hundred and fifty thousand dollars in the United States the the crisis this time happened in the so-called shadow banking sector the kind of less regulated more opaque sector of the economy but the principle is exactly like what you said kind of this liquidity mismatch and and also some very bad or questionable investments were made and some questionable ratings were attached to these investments and and this this all came crashing down not in the retail sector this time but in the wholesale sector but the principle is the same and now I think what you want to ask it's like what can we do about it like what

do these new technologies how can they kind of mitigate these problems well well your blog post and we'll link to the show to this post in the show notes so describes a scenario where one can tokenize his own assets so basically the the job of a bank or one of the jobs of a bank is to say okay these are illiquid assets and we're going to lend money with those assets as collateral but if one could say okay this is you know I'm me I I consider my time to be valuable my my you know experience and I have these abilities and so therefore I'm

going to use that as collateral in in some sort of transaction or perhaps it's you know physical assets like I've got a farm with cattle or something some basic example so maybe yeah maybe we walk us down this route and with this blog post in mind one thing I love about this whole endeavor cryptocurrencies Bitcoin blockchain it has has brought a to attention what the fundamental issues are in in monetary theory uh this idea of money being a ledger for example was you know nobody nobody knew what I was talking about what I used to do I've been lecturing on this for almost thirty

years I preface every one of my monetary theory courses with you know why is it when I go to buy a cup of coffee why can't I just pay with a personal IOU that represents a claim to the lecture that I'm giving you guys yeah I'm a professor I give economics lectures people value that why can't I just issue tokens I didn't I didn't use the word tokens I used personal IOU use but it's the same thing I should in principle be you know if it's some sort of famous person probably they could do it in fact but I'm just anonymous and and if I if I attempted to do so or to issue a claim against my house for example suppose I

want to buy a cup of coffee in the morning you know a dollar cup of coffee with a one one-millionth share of the bathroom of my house why can't I do that the answer is in economic theory you can do that and it's exactly in a friction of frictionless world that's exactly what you can do there's no liquidity issues I mean if you can use your if you can use your imagination and just imagine a world where these frictions are absent you should be exactly able to do what I described and so then the question is is well what are the real-world frictions that prevent this from happening why is it that when I go to the coffee shop and I offer a 1 1 million slice of my salary as payment

why doesn't that work and and the answer is well first of all they don't know who I am they don't know if I'm a professor or not they they don't know what sort of claims I'm making it's very easy to fabricate information I could be lied and almost surely I might be lying second of all even if I'm not lying what makes anybody think that I would honor the claims of these personal tokens or IOUs I mean I claim that my house can generate rental income of $10,000 a year and I issue a token against that revenue stream well who's going to enforce the payment of that token who's going to who's going to enforce the tenants of my

house to pay the rent I mean just because I'm recording the ownership on a blockchain or some sort of ledger doesn't magically solve the problem of enforcing payment of the tenant or of enforcing my payment of my set part of my salary to the obligations I've issued so it doesn't necessarily solve a whole pile of informational frictions that render certain types of capital like your human capital my human capital illiquid that's exactly the job of banks banks have credit officers that are specialized to interview you to go and make an assessment of your home we trust these these these third parties to make

accurate assessments of the underlying collateral note they often fail of course they don't operate perfectly but my question is how does a decentralized database management system where the data is recorded by in some Merkle tree structure how is that supposed to solve these underlying frictions of basically enforcing property rights and these kind of informational issues that are associated with the asset that makes the asset illiquid so I think these are the issues that need to be addressed in this kind of tokenization endeavor and you know I'm I'm still studying it so maybe

maybe there are some good answers but I don't know what they are you know this is a very interesting point I mean my I think it is a commonly held view in the blockchain space that exactly one of the things that is being created is that all of those things are becoming much more liquid and that we would go to a world have you know almost perfectly liquid market and you know to give giving examples I you once years ago worked a little bit in commodities trading and was dealing with like you know the execution of these trades and it's like a complete nightmare and and you know super tedious and you know one of the issues is that you have then you know let's say I have a promise of payment if I deliver these goods there but this is a highly liquid right so let's say it is

a commodity trading company it has all of these promises of payments but it can't actually sell the individual promises or payments on an open market it has instead to go to the bank and the bank looks at all of it and it gives you you know a loan which is probably much less than you could get in a liquid market and now there's many projects oh you know to give one example is a project called centrifuge right they're trying to take all you know give anybody the ability to put like purchase orders or invoices and stuff like that and immediately sell them you know how and and so I in then at the same time you have things like prediction markets right so you could have maybe liquid market own information there's a lot of work that's being done on having exchanges right that may be how can have

kind of liquidity and and narrow prices even on like a large number of you know markets pair there's knowledge big order books and stuff like that so it does feel to me like we are going to a place where okay it's not going to be perfect liquidity and perfect markers everywhere but I get massive step in this direction do you feel that so did you see that as well and and it let's just assume this actually did end up happening what would be the consequences of that hmm well do I see it happening yes I do see it happening but you know I see it happening even kind of an independent of blockchain technology I mean it's what you just said was true things are

becoming more liquid because of the you know what renders optics liquid though it's enhanced communications you know enhance you know security of information making information more symmetric renders things liquid and database management systems are can be designed to enhance communication between different parties to to to render you know what's on the books more transparent these are statements that we can make independent of blockchain these are just the properties of a database management system in general the question I have is you know what people say tokenization they are specifically

meaning using a decentralized database structure where the data is recorded in some Merkel tree form and that the the clearing is undertaken in a decentralized manner by some sort of consensus protocol that's the part that I have some issue with I haven't actually I have a hard time seeing where apart from the application in terms of like daos you know I'm not entirely clear how decentralized consensus is supposed to enhance the liquidity of an object independent of the other innovations that I'm speaking of that are occurring even to even you know independently of

kind of blockchain kind of considerations and and I'm sorry you had one more question what is the limit I mean what what happens if things become more and more liquid I think that what what you'll see is basically a gradual disintermediation the whole reason we have intermediaries like firms or banks or whatever is is to deal with these issues if we if we go to the limit in a world where everything is fungible that there's no questions about when I make a promise it's a good promise that I'm good for it at least that it's risk-adjusted prices is priced correctly in that sort of world a lot of the institutions that we see around us the

very existence of corporations and firms would would cease to exist there would be no need to organize activity through any intermediary we could just go about our daily business and be trading you know with this and this is a very futuristic world but we we could in principle just undertake all of our economic activities independent of belonging to any particular firm or having a particular bank account at any sort of trusted intermediary that's what the limit would look like yeah absolutely I mean I think the big the big difference is if you have let's say these assets that are issued on this open system then anybody can you know can build things

that like interact with each other right so for example you haven't had this purchase order and somebody can use it on aetherium two back alone and and that doesn't really work if you know with normal FinTech companies right now that back up you know the the fact that it's open is something that you don't need blockchain to make a database open do you I think I would disagree with that so if I if I publish my diary online I can publish my diary online and everybody in the world can download it that database to their computer that's effectively a distributed ledger of my life yeah but when like who has then the authority of copy or like if somebody

changes it you change it retroactively Lee or like how am I going to rely on that I have the master copy I I print out a new version every day I only I can write to it but I make it open to everybody can read it you can't go on my blog site right now and change my blog any but everybody in the world can read it it's a distributed open database so I don't need blockchain to make a database distributed and open no I think I disagree I mean in this example like you're okay you're publishing your database right and I I can like okay copy it locally but now you fiddle with it you retro actively change something okay I have the evidence but someone else has a different record now of the I

mean blockchain massively gets rid of the coordination problem by okay there's one authoritative copy we all know the sequence in which it has been created nobody can mess with it nobody can change it like you can go and change it back like you can go on your website right you can you can pretend you have some blog posts that you wrote a year ago that you didn't actually a year ago but a blockchain you would be able to write so you can I can easily build an application that builds on your data feet without having to worry about like those kind of risks I think if I could just sort of interject here I think what I think David is right on the on the point that this is possible the

blockchain but it it doesn't scale and and this has come back to what I was saying earlier governance and I guys similarly one thing that's kind of similar in this sense where of course you know we can achieve it but it doesn't scale is like PGP so in the 80s and 90s and even today I mean you know sort of cypherpunks and people that are conscious about the security use PGP to send encrypting email and there's this like web of trust system and everybody thought that we were going to move to the system to send secure data communications but that system simply isn't scale because you have to like meet people in person and exchange keys on paper or like to verify that you know

your key is in fact the one that it that I have and we're watching solve some of the issues here is with the scaling aspect is so like we can now do this at scale and we're finding solutions where this secure exchange of information that is sort of anchored in time and where I can go back and look at a record and know that that record hasn't been tampered with this is what blockchain enables yeah so totally agree with what you said I think that the we can come to a mutual understanding here by understanding that we can what we're arguing here is the conceptual distinction between the right privilege to a database and the read

privilege I'm talking about the read privilege so I'm saying suppose that you trust the writer me for example you suppose you trust that I'm not going to go back and fabricate old blog posts I'm just assuming that then there's the question about the read privilege can we make it open and my answer is yes I don't need a blockchain to make the database open in fact it could work perfectly functioning I can be transparent I can be honest of course it requires you to trust the writer hmm if you don't trust the writer then what you say is absolutely true what the blockchain enables that the centralized consensus

protocol permits us to not happen to trust the writer either and that and that permits the system to scale in a system where you want open read privileges and you don't trust any single writer to the database so I think we can reconcile these two I just wanted to push back that you you don't necessarily need blockchain to make a database openness and transparent was my point yeah I think also so I think you're right but what what what blockchain also does to a large extent is it it allows you to forego having to even think about whether or not you trust someone and so as as we enter and as we live in in a society where our data is free-flowing

on all types of systems and we have interactions whether financial or purely on a communication basis with you know dozens hundreds of entities every day the blockchain sort of allows you to forget about the trust issue you know you don't have to think about whether or not I want to trust someone or whether or not that exchange is genuine and it sort of takes it that out of the equation some extent trust I I want to push back a little bit uh I know where you're coming from and I kind of agree but on the other hand I don't think that's exactly true you still have to if I'm using blockchain for the first time

I have to I have to enter it with some degree of trust may I I can't write C++ code I don't know the cryptography behind anything how do I trust this is true this is true how do I trust that my automobile is going to get me to work safely I don't know how the internal combustion engine works in detail the way the trust happens is we on the basis of experience and so if it turns out the blockchain kind of renders very and user experience people will come to trust it but the exact same thing is true of my bank so the question is really where do you want to place your trust I think as opposed to not having to think about it of course yeah so this is all very fascinating I think we could go on for

four hours here but we're very conscious of your time and so before I wrap up I just want to get your final thoughts um where if you if you look forward ten years from now and so at the rate at which the space is growing and the way to rate at which government entities central banks are now changing there or so that changing but sort of observing these technologies and perhaps experimenting with them from your perspective where where do we can we expect things to be in the next ten years Wow thank you that's this is tough right I mean you're not going to hold me to any of this but no but we could use a prediction market dickham right you know

well I see basically more of the same in terms of the innovations in FinTech and database management and I think that central banks will have to be increasingly on guard I think to you know to make sure that they are managing their policies in a socially responsible manner and I actually view this emergent class of technologies is kind of useful in terms of like disciplining banks central banks in kind of incentivizing them to kind of really look for kind of a use value that they can deliver Society and

if at the end of the day they can't they can't pass that market death test they should probably disappear I don't know if that's going to that's not going to happen in the next ten years but the other thing I think I would look for is again going back to what we alluded to earlier is this this issue of decentralized autonomous organizations I can envisage very very rapid spontaneous growth in that in that dimension along very various aspects and I I think this is going to of regulators and policymakers headaches and less headaches because I don't think it's something they can necessarily pay they're not going to be able to control and that makes regulators very very nervous and maybe it's good but I can

also see some dangers as and we don't we can spend another episode I guess uh discussing what those might be but it's going to be very interesting I think I think it's just going to see that de oh space developed very rapidly and with it kind of the discussions by policy makers wringing their hands about what what can be done about it what's the proper policy public policy to take public policy view to take on these issues right well I mean I guess we can we can say that we'll have you back on again I hope maybe in three years though with pleasure so do come back any time we'd love to talk to you again about all

these things and sort of follow the trends with regards to central bank's and you know how they're experimenting or thinking at least where the research is going in this time that's a fascinating topic so I've been a lot of fun always fun talking to you guys likewise thanks very much thanks so much my pleasure thank you thank you for joining us on this week's episode we release new episodes every week you can find and subscribe to the show on iTunes Spotify YouTube SoundCloud or wherever you listen to podcasts and if you have a google home or alexa device you can tell it to listen to the latest episode of the epicentre podcast go to epicenter TV slash subscribe for a full list of places where you can watch and listen while you're there be sure to sign up

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