Last week, Treasury Under-Secretary McKernan outlined a critical strategic phenomenon: the growing transformation of bank deposits into financial instruments lacking the sticky permanence or taxpayer backstops that characterize core deposits. Does the financial system need bank deposits, or could it do as well with other liabilities or even representations of liabilities? This question signals, Mr. McKernan said, a policy transformation warranting attention in the most senior quarters, not just among “technocrats.” He’s right, and here’s why.
As the American Banker rightly pointed out last week, analysis here must carefully differentiate tokenized deposits from deposit tokens. Tokenized deposits are deposits, albeit with additional functionality. Deposit tokens – the transformational alternative – are tokens with deposit features that are only deposits in practice, depending on confidence that others will accept the tokens as either a medium of exchange or store of value. Deposit tokens are thus private money and, if they work as an alternative to central-bank money, pose an even more profound strategic challenge to banking as we know it than all of the NBFIs gobbling up traditional bank assets.
Quite simply, deposits are the lifeblood of banking. Could deposit tokens prove to be the vampires that transform legacy banks before tokenized deposits mount a meaningful defense?
Stablecoins are the nearest concern because they are clearly deposit tokens and perhaps front of Mr. McKernan’s mind since Congress blessed them as a new monetary instrument. Stablecoins are of course digital representations of “money” exchanged on a blockchain that are intended to handle payments as seamlessly as bank deposits moving through the traditional payment system. Under new U.S. law, each token represents a dollar’s worth of other, dollar-denominated assets. These “reserve assets” are supposed to secure the deposit token’s redemption value, but there are many reasons to question how well this works under stress. This fragility is in sharp contrast to the reserves banks hold and post to ensure payment finality along with the backstops behind banking should this be in doubt.
But stablecoins are not the only form of deposit token providing alternative forms of money. Bitcoin, Ether, and other cryptocurrencies are also deposit tokens even though their price volatility in recent days makes it even more clear that funds into digital money may not be returned at par. Touted as money, these deposit tokens are actually investments, not alternative currency even if one can exchange them for goods and services. This confusion could be fatal to those who believe these deposit tokens will actually function like deposits in terms of holding value over time.
Another and even more potent form of deposit token arises in closed private-money systems. A new BIS study describes systems in which retailers or other ventures provide uncollateralized loans – essentially free money – with which to conduct transactions with the lender. No form of public money changes hands from the retailer to the purchaser, with the purchaser getting desired goods or services for which payment is then rendered in any form acceptable to the private lender. These private-money systems are dominant in China and growing in India, but they also exist in the U.S. via reward points and may soon be coming to a Walmart near you once stablecoins go into distribution.
These deposit tokens lack inter-operability – i.e., they are only good for purchases on the network in which they begin. Customers also abandon privacy rights regarding the use of their money because the private-money provider knows what the consumer seeks and can structure an offer to suit. This is, of course, very different than walking into a store with cash, pointing to a pair of sneakers, and walking out with no one the wiser because the cash derived from a bank deposit is infinitely inter-operable and, at the point of payment, wholly private. It’s inefficient to do business this way, but it is remarkably friction-free when conducted via payment instruments such as credit and debit cards with only minimal loss of privacy.
There’s another big difference between bank money and these private-money systems: risk. If a big-tech or retail platform extends an uncollateralized loan – i.e., extends a deposit token – for goods and services, the buyer can simply default and never hand over the fiat currency the provider needs to honor its obligations to third-party suppliers. Credit cards are another form of uncollateralized lending, but merchants rely on the card issuer, not the cardholder, to honor the obligations consumers incur. A direct-to-consumer form of money instrument thus comes with acute default risk.
Is this risk worth it to avoid interchange fees? Could the government properly regulate deposit tokens to mitigate consumer and macroeconomic risks, especially when they endanger an innocent consumer or sustained economic growth? These are among the second-order questions raised by Mr. McKernan’s thought-provoking inquiry. I hope we don’t find the answers the hard way.
Dollar deposits always hold their value – see the dash for cash in 2020 as an example of market faith in a simple deposit when stress grips other financial instruments. Thus, for as long as the dollar is an established fiat currency and especially for as long as it’s the global reserve currency, dollar-denominated deposits are an irrefutably reliable medium of exchange and store of value and are the funds that, via bank intermediation, power lending and thus economic growth.