Digital Money: Building Capacity for a Virtuous Circle

The confluence of new technologies is making various types of digital money increasingly used or adopted. A high level of adoption of any digital money can help achieve policy objectives, such as financial inclusion, while managing risks, such as cyberattack. 

If well regulated, digital money adoption should have four attributes:

1. improving efficiency
2. lowering cost
3. strengthening security
4. building trust in the payments and financial system

Its sustainable adoption highly depends on the service quality on the distribution, circulation, and redemption of digital money by payment service providers. 

To ensure adoption achieves a sustainable level, digital money payment service providers should meet four requirements:

1. harnessing digital technology
2. developing business models that ensure cost recovery
3. serving various use cases
4. complying with regulation

In this process, some payment service providers could in fact develop into new organizations, such as platforms, which often have payment and transaction data at its core and all other financial activities organizing themselves around that function. These platforms serve in two-sided markets, where they build up economy of scale and economy of scope, as well as achieve network effects. 

Digital money can equally induce a vicious circle that can, for instance, result in data silos, market power, anti-competitive practices, harmful to consumers and financial systems. So, how to ensure these platforms create a virtuous circle to encompass innovations and economic benefits, while preventing a vicious circle, is an important question for policy makers and regulators. 

Bolstering capacity on digital money

The International Monetary Fund (IMF) is receiving an increasing number of requests from member countries for capacity development on digital money, which explains why it chose to feature this topic during a Capacity Development Talk at the 2022 Spring Meetings of the IMF.

Taking central bank digital currency as an example, 4 categories of increasing complexity and novelty are emerging from member countries: exploration, design, pilots, and policy implications. 

And the IMF is gearing up to provide 4 capacity development products: bilateral assistance, regional workshops or conferences, analytical work, and pilot reviews.

In this process, the IMF’s capacity development program has received funding from the Government of Japan. The funding intends to strengthen capacity development in central bank digital currencies in selected low-income developing countries and emerging market economies. Mr. Yoshida, Deputy Director General for International Bureau at the Ministry of Finance of Japan explained why building capacity on digital money is such a priority for the Government of Japan during the aforementioned event.

Regulating Digital Money

It is essential to ensure that authorities can harness the benefits of fintech – including digital money – while managing the risks.

Innovation in the payments' space has usually come in the form of payment service providers like e-money institutions that are generally small in size. They are usually referred to as fintech start-ups. More recently, we have seen the growth of large technology conglomerates in the payments space – commonly called BigTech.  

Fintech can also be deployed by incumbent entities, so authorities might have to strengthen their surveillance to monitor developments from these different types of entities. This could be through existing supervisory structures, or through dedicated fintech units like innovation hubs and regulatory sandboxes. 

In most jurisdictions, payment service providers – large or small – are required to meet baseline requirements to protect markets and consumers. Requirements like segregating and safekeeping funds, recovery and resolution, complaints procedures, and operational and cyber resilience. Those last two elements are particularly important for digital only offerings because of the digital nature of the product – any system downtime could leave consumers unable to access their funds with little recourse to alternative means.  

In some jurisdictions, certain payment service providers might already be too-big-to fail or too-connected-to-fail, and this could also have cross border implications. Policy makers here will want to manage risks around consumer protection, financial integrity, market integrity, and financial stability. Authorities should therefore ensure regulation is robust, proportionate, and in line with global standards where such standards exist without stifling sensible innovation. 

New enabling policies like Open Banking can provide new payment service providers with the ability to compete effectively against incumbent banks. On one hand this has generated greater competition by unbundling payments products from banks, but conversely, the expansion of BigTech into financial services has the potential to reverse this unbundling and shift risk from banks to BigTech. These entities generate systemic risks but aren’t regulated in the same way that incumbent banks are particularly around prudential regulation where liquidity, credit and resolution requirements might not be as stringent. We are also seeing BigTech expand into new areas of financial services, as well as providing key infrastructure to incumbents, like cloud computing. IMF financial sector experts Parma Bains, Nobuyasu Sugimoto, and Christopher Wilson cover some of these risks in their BigTech Fintech Note published in January 2022. 

While “technology neutral” is the mantra of financial regulation, payment service providers might use new technologies with new risk profiles, and the unique risks of these technologies should be considered part of regulation and supervision, which means tech neutrality might not hold – for example the use of certain types of distributed ledger technologies that rely on certain consensus mechanisms might not provide settlement finality, or might be slow, expensive or energy intensive could generate unacceptable risks for some authorities. IMF financial sector expert Parma Bains explores some benefits and risks of blockchains in his Blockchain Consensus Mechanisms Paper published in January 2022. 

Where new technologies enable new business models, authorities should consider any new risks. Certain types of stablecoins for instance have the potential to be digital money in the future and introduce new types of intermediaries as part of their broader ecosystem. These might include reserve managers, network administrators, governance bodies, exchanges, and wallet providers.  

Authorities might consider the interrelationships between the entities to understand where risks reside, and how best to manage these risks. While blockchains aim to decentralize and disintermediate – which isn’t a bad thing, there has been a growth of new centralized intermediaries. There are two things here – firstly, those centralized key entities that carry out core functions should be authorized and licensed, and secondly stablecoin issuers themselves might be regulated according to their use cases and the composition of their reserves – for example payments or securities regulation – or, where stablecoins become systemic, proportionate bank-like regulation. This was covered by the IMF in the October 2021 Global Financial Stability Report and a December 2021 IMF Blog. 

 Supporting IMF members through technical assistance and training

The IMF's flagship fintech regulation course has been delivered across multiple jurisdictions and the IMF has provided capacity development in the form of regional workshops on 13 different occasions. The IMF also provided bilateral capacity development to several jurisdictions across key fintech topics. 

Last year, as part of IMF capacity development work, we spent some time working with authorities in Albania to help operationalize their crypto asset regulation – called the Fintoken Law. While not all crypto assets are likely to be digital money, the mission focused on potential challenges and practical implementation issues relating to licensing of firms and subsequent supervision. 

The IMF worked over the summer primarily with the Albanian Financial Services Authority, but also collaborating with the Albanian Central Bank, the National Agency for Information Society and key industry participants. We provided training on the critical components of crypto asset regulation and offered several recommendations related to internal processes, outreach, monitoring, and engagement.  

Crypto related activities seem to be small in the country, but the passing of this legislation has the potential to legitimize the market which could result in the growth of consumer demand and increase reputational risk for authorities. 

Strategic foresight and global partnerships 

We are facing regulatory challenges worldwide which we couldn’t envisage a decade ago and we need to ensure that we can balance the benefits and risks of digital innovation to keep moving forward while protecting markets, consumers, and financial stability.

The IMF works with a wide range of development partners to meet the increasing demand for capacity building on digital money. The new funding from the IMF's largest donor in capacity development, Japan, will allow the institution to step up its work in this field.

This article was written by Tao Sun and Parma Bains, respectively Senior Economist and Financial Sector Expert in the IMF Monetary and Capital Markets Department, and derives from the Capacity Development Talk on "Digital Money: Building Capacity for a Virtuous Circle" organized at the 2022 edition of the Spring Meetings of the IMF.

Find out more on IMF Capacity Development here.