Blockchain technology and decentralisation is sweeping across the world. Some like to only focus on the crashing waves, failing to see that yet another wave is swelling up behind it, believing that finally, this or that hack, scam, failed project or Ponzi scheme is the last nail in the public blockchain technology’s coffin. But then there are those who understand its true potential: a disintermediation of most centralized services.
Public blockchains are open source. They are messy. They are unstable. They are unpredictable. They move and evolve faster than anyone can anticipate. And that is by design. It is a feature, not a bug. In the open source world, evolution and stability is not reached by investing billions in hiring some top geniuses, having them crunch at problems behind closed doors and protect their solution behind walls of secrecy as an extra layer of security as in typical proprietary software. On the contrary, open source thrives through trial and error, having billions of eyes examining the publicly available code, and billions of hands trying to hack and break it. Linux, the highly successful open source operating system, has been forked many times and developed into several different releases and builds. Not all of versions of Linux are stable or reliable. But the longer Linux has been around, the more stable and user friendly it gets.
Public blockchains are the new “Linux”. It started with Bitcoin, which was forked into thousands of parallel blockchains, each with their own features and tweaks: some aiming at improving transaction speed, some aiming at improving scalability etc. But ultimately, the most prominent feature everyone was looking at was the use case behind the technology: an immutable shared ledger or database, which could be updated in a permissionless way, yet was secured via cryptography and computing power in such a way as to prevent any third party from arbitrarily tampering with the data. The natural use case was… money.
Most money, nowadays, takes the form of a line of code inside a database. For the moment, a centralized database, protected by high levels of security, and managed essentially by private commercial banks. But the technology is old and very little innovation has happened in the last few decades. While the Internet has managed to connect people across the world, try sending money from one continent to another and see if it’s as easy as sending an email or a WhatsApp.
Private companies have attempted to solve these issues, with centralized businesses leveraging the failings of the market by proposing certain money transfer services (see Transferwise, for example). But the centralized way of doing things has just become too burdensome. With all the scare about terrorism and money laundering, any centralized business must shoulder the burden of tons of regulation and KYC procedures to onboard the local peasant or burger flipper, because of the tremendous danger they represent to the financial system’s stability or to terrorist financing. Thankfully, we have proof that all the AML/KYC/TF (Anti money laundering, know your customer, terrorist financing) laws work really well and are worth this extra “friction” and the risks of financial exclusion for a segment of the population. Oups! Actually, no they don’t. Many big banks have been caught red handed in the last few decades, laundering millions if not billions of € worth of money, mostly from homeless people and undocumented migrants (sarcasm X100)… And sure, they received a slap on the hand from regulators, who concluded that AML/KYC/TF laws needed to be tightened even further, rather than to simply recognize that they don’t work. Also, please ignore the fact that ultimately, you could create financial products like basic bank accounts, with limits to the number and amounts of transactions per month, and require absolutely zero credentials or identity. Nowadays, an AI can easily identify patterns in the usage of a bank account which is considered “normal” and flag any suspicious types of spending and source of income. The hurdles come from elsewhere. While it may be lucrative to launder millions, especially at a time with record low profitability, there is no profitability in onboarding certain client profiles. There is a metric for that: the “CLV” or customer lifetime value. Most customers would be expected to subscribe to insurances, take out loans and mortgages, and invest into financial products across their lifetime. Those are the customers you want to onboard. But the local peasants and burger flippers? They’ll just use a basic account and card to make and receive payments for most of their lives, (ab)using your services for nearly zero cost, creating an extra administrative burden, and on top of that, probably annoy your staff with plenty of questions and problems given their lack of financial literacy. No. Those customers can go elsewhere. What’s practical is that there is a big overlap between the non profitable customers and customers who don’t fill the AML/KYC/TF requirements. For one, all the undocumented migrants, the homeless, etc. Thank god we have AML laws, or else these hoboes on the street would be laundering so much of the money they collect that the financial system would collapse.
But then comes public blockchain. Now, anyone with an Internet connection can open an account without asking anyone’s permission. In fact, anyone who can get even a temporary access to an Internet connection could create a so called “paper wallet” and receive payments even without having access to the Internet, simply with a QR code, and make payments by memorizing a “seed phrase” (a string of 12 or more words). Sure. So long as it’s Bitcoin, or “Magic Internet Money”, that’s one thing. Public authorities and banks may not like it, but it’s not really competition. It’s perceived more like a speculative asset than a threat to their payments infrastructure. But then stablecoins came along. And there were many. From clever ones like the DAI stablecoin (MakerDAO) or the USDC to less clever ones (like the now defuncts Terra UST or the controversial USDT or Tether). Regardless, the same principle applied. Anyone with an Internet connection could open a stablecoin account and receive and make payments using stablecoins. Now that is another matter altogether. Suddenly, anyone could send dollars around the world without any form of AML/KYC. A person from Venezuela or Lebanon could receive dollars from anyone else in the world, and start using them to make payments to anyone else in the country, and the public authorities couldn’t do much about it, except turning off the Internet. And that is not all. With smart contracts and the so called DeFi space (decentralized finance), there are many things people could do with their stablecoins: putting them into liquidity pools or lend them out and generate yield or interest… Programmable money is just getting started and the possibilities are endless: micropayments, decentralized insurance, lending/borrowing, etc.
Now, that caught the private banks and public authorities’ attention.
Part of the attention was focused on consumer detriment. Many people lost their entire life savings by investing in failed projects like the Terra UST, lured in by too good to be true rewards and yields (over 20% APR on UST!!!) But that, as I have explained above, is a feature of the open source way of doing things: trial and error. Every hack, every scam, every fraud makes the next one more difficult to pull off or less likely to happen, simply because an open source ecosystem adapts and digests all of these mistakes, often, unfortunately, at the detriment of the end user. However, the current attempt at “cracking down” on public blockchains via regulation is rather futile or counter productive. It is like trying to make open source not open source, or removing the iterative and trial/error mechanism which is at the heart of open source software’s natural evolutionary process. The main problem is that most people do not understand this fact, and thus mistakenly believe that a project with millions of followers is “safe”, forgetting to diversify, to hedge their bets and to rely on ecosystems which have been around for longest since they have been exposed to more attempts at hacks and have gone through more iterations of trial/error, and are thus naturally less likely to suddenly collapse in an instant like Terra Luna did.
But a big chunk of the attention was also on the fact that disintermediation was now a real threat. Why keep paying monthly fees for your bank account which gives you 0% interest rates, sometimes even charging negative interest rates, when you can freely and instantly open a stablecoin account, make payments via layer 2 solutions for a very low cost, and get an interest rate of around 5% at least on your stablecoin through various DeFi ecosystems or online platforms which would easily offset transaction costs, leaving you with an actual net positive yield ?
But what could private banks do about it? Their payments systems were already digital. What more could they do? And so in come the central bankers, proposing the concept of the “digital dollar” or “digital euro”, which would be like a digital version of cash.
And that’s when my eyebrows are rising, because the more I look into the digital euro, the less I understand the concept. Let’s go through the things that puzzle me:
The digital euro will be digital cash?
Only about 5% of the total monetary mass takes the form of cash. The rest is mostly “debt money”, or money that has been created out of thin air whenever a private commercial bank grants a loan to someone (a business, a consumer, a state, etc). This kind of money is subject to the principle of double entry bookkeeping, meaning that for every euro created, there must be a counter-asset or liability. For instance, whenever a bank creates a loan, the 1000€ that appear on your bank account is essentially money that the bank owes you. And in return, you signed a contract saying that you owe 1000€ to the bank. So that money cancels itself out in a way. The bank writes “+1000” in one column, and “-1000” in another column, and after a while, when the credit is repaid, it is as if you added +1000 to -1000 and you’re back to zero. Of course, this is an oversimplification of how things work, but you’ll understand just how important it is when we talk about a digital euro. Cash is very different. It is never destroyed. It is what is called “base money” or a part of the monetary system which is always there. It’s hard to clearly identify it’s role, but I would say it’s kind of like oil for the economic engine. It creates a stabilizing layer for transactions to continue, for the economy to chug along, even when there is a bit of instability at the level of debt money.
At a more complex level still, I would argue that the amount of cash available in any economy represents the interest on debt. This might be hard for you to understand, but when you take out a loan, the only part of the loan which does not get destroyed is the interest. If you take out a loan of 1000€ at 10% interest rate, payable in one go at the end of the year, one way or another, you’ll have to re-capture 1100€ through your labour, and repay the bank 1100€. While 1000€ will be taken out of circulation or destroyed, the extra 100€ represents the bank’s profit. That 100€ will thus continue to circulate in the economy. I would argue that the amount of cash in the economy or in a financial system could be a physical equivalent to the interest that banks have raked in on debt.
What has any of this to do with the digital euro?
Well, everything. The digital euro is presented as a form of “digital cash”. But what does that look like? First, we must ask how a digital euro can be “created” or printed into existence. For bank notes, or cash, it’s quite easy. The central bank prints the euro bills, distributes them to banks, and then banks make them available to their customers via their ATMs. Essentially, whenever you take out cash from your bank account, you are basically demanding the bank to make good on the promise of the money it owes you. As I said earlier, when you have 1000€ on your bank account, what it means is that the bank promises that it is ready to put 1000€ of cash at your disposal. Think of it this way. That 1000€ on your account is like a contract between you and your bank which says “I owe Martin 1000€”. If you ask for it in the form of cash, it’s as if you asked your bank to honour that promise. Once you have that 1000€, if you place it in another bank, that bank opens an account for you, and credits your account with 1000€. In exchange for depositing those 1000€ in that other bank, you receive, once again, a visual promise that the bank owes you those 1000€ (in the form of the balance you see on your bank account).
But how would it work with the digital euro? From the looks of it, people would be able to directly create an account with the central bank. If so, it would be an equivalent to cash indeed, since with cash, there is no counterparty other than the central bank. In the case of debt money, there is always a counterparty or a counter-asset as explained above. Most money in existence, which appears on bank accounts, only exists because it is matched by an equivalent amount of debt that someone, somewhere, has agreed to repay. In other words, it is money which has only a temporary lifespan, contrary to cash. The stability of the entire financial system relies on the seamless creation/destruction cycle of money, which is a mirror to the creation/destruction cycle of goods and services. In an ideal world, the goods you buy should only last as long as the credit or money which was used to create them in the first place. For instance, if a business had to borrow one million € to create 100.000 shoes, and it has to repay that credit over 5 years, then after 5 years, ideally, those 100.000 shoes will have been thrown out by their customers and will have thus “disappeared” from the economy at the same time as the money that was created to make them, disappeared from the financial system. If there are too many goods available on the market compared to the amount of money, you get deflation (too few money chasing too many goods). If there are not enough goods available on the market compared to the amount of money, you get inflation (too much money chasing too few goods). So there goes your dream of solving programmed obsolescence. It’s a vital feature of the current debt based financial system. A thriving second-hand market would actually kill the economy and the financial system. Ultimately, that’s what cash is for. It’s the “oil” which facilitates limited second-hand, consumer to consumer transactions, like your yard sales or your Facebook Marketplace trades. Apple understood this issue only too well, with its infamous policy of scrapping old phones, as do many other companies which prefer to destroy products rather than donate them to the poor (like fashion and clothing). If goods don’t leave the economy at the same or similar rate as the rate at which debt is repaid, the economy and the financial system are in trouble.
Let’s follow the trail of a customer who opens a digital euro account at the European central bank. In all likelihood, to open such an account, a customer would have to undergo a KYC process, so that the account can be directly linked to his/her identity. So far, this is very much like opening an account in a private bank. Except for the fact that such an account would be free to use, at least I would assume. But then, the trouble starts. In order to “charge” the account with euro, the customer would either need to receive payments in euro from another account, or send some euro from his/her bank account to the digital euro account. However, how would that work? Would the ECB actually generate a “special” IBAN format, like CBXX XXXX XXXX XXXX XXXX, for every european consumer in order to be able to send euro to such an account, and then convert that money into digital euro in a special account which does not have an IBAN format? And that’s just the tip of the iceberg. What happens on the back-end? Normally, when you send money from one bank to another bank, there is more than just money that moves around. The assets/liabilities have to move more or less in sync. In other words, if you move 1000€ from bank A to bank B, you’re basically transferring a contract or promise that bank B now is indebted to whoever you transferred the 1000€ to. In order for bank B to accept to take on that promise, it would ask of bank A to transfer some kind of asset which is worth 1000€, like a bond, or cash. But how would that work with the ECB? Would it also require banks to transfer some of their assets to its balance sheet? And then, when the ECB converts digital euros back into debt money, and sends it to a bank account, would it also transfer some of its assets to that bank? There are so many questions to be answered here. For instance, since the ECB’s balance sheet can go negative with no repercussion, could a digital euro be used as a way to salvage banks by draining them of the liability of holding people’s euro? Would banks take advantage of the fact that the ECB’s balance sheet is virtually invulnerable and send the ECB junk bonds or other worthless assets it wants to offload, at the same time as it is sending the ECB some debt money euro?
This also raises questions as to what exactly happens when someone wants to convert digital euro to private bank debt money again. Does the ECB send the bank a collateral, destroys the digital euro, and asks the receiving bank to credit the person’s account with debt money? In short, the creation/destruction cycle of a digital euro needs to be clarified.
What’s in it for banks?
If the digital euro truly succeeds, then I don’t see why people would still have bank accounts in private banks, where they need to pay fees, and where there are counter-party risks which are non-existent at the ECB or central bank level. In an extreme situation, central banks could transform all current private banks into branches. Private banks would still sell insurance, provide credit and mortgages (or be in charge of monetary creation), but the money would be directly credited to the ECB’s accounts and converted into digital euros, and the collateral (the debt contract) would move to the ECB’s balance sheet. Banks would just sell the credit, but would not be liable for it. This raises many questions in terms of moral hazard and prudential risk. In such a scenario, banks would keep the profit (the interest), but would not have to shoulder the risk of defaults.
What would be the limitations placed upon the digital euro, if any?
And of course, any limitations will make the digital euro less attractive than either existing digital bank money, or decentralized stablecoins. If the digital euro manages to perfectly emulate all of the characteristics of cash, then maybe it has a future. This means essentially:
No KYC: anyone can open an account anonymously.
Full privacy: transactions are untraceable and encrypted.
Full non-custodial features: no third party can arbitrarily freeze transactions, block them, or in any way limit, restrict or reverse them.
Offline capability: it is possible to send money from device to device without having to rely on the Internet. This could work in any number of ways, but leveraging mesh networking could be something worth exploring.
On top of these, allowing the digital euro to be compatible with smart contracts (making it programmable), would really bring cash into the 21st century, and convert money into a real public good.
Some may be afraid of such a digital euro, as it would mean surrendering control, something that any authority has had trouble with from time immemorial. In fact, this brings me to my 4th point…
Command economy in disguise?
Programmable money on a centralized ledger has a very interesting property: if it is under the control of a centralized entity. The current macro-economic policy tools that ECB uses to achieve certain economic objectives, namely the level of interest rates and quantitative easing, are equivalent to using a sledgehammer to kill a mosquito. It will do plenty of damage, and yet the mosquito will likely survive. For over a decade, ever since the 2008 financial crisis, growth and inflation was flat, far from the 2% objective, even while interest rates were at zero or even negative. And now, inflation suddenly jumped to 10%. The ECB needs novel policy tools, and the digital euro could very well be one of them. Programmable money can be used in so many ways: impose negative interest rates to “stimulate” consumption, punishing people who oppose the “system” one way or another (see the sanctions of Canada against the protesters organising the blockade between Canada and the US, or China’s social scoring system), preventing people from buying non-ESG friendly financial products, or perhaps even regular products that are judged as being non-sustainable, more generally, orient consumption patterns on a more granular level, trace every transaction in real-time to better monitor the economy and the financial system and use various tools to micro-manage spending, use the collected data about spending in various ways (advertisement, risk premium assessments like credit scoring or insurance,…) And of course, any well-versed public official will affirm that the digital euro will never be used for those dystopian goals. And yet… It’s like creating plenty of nuclear weapons and trusting that they will never be used. Do we really trust that in the future, regardless of the type of government or political party that seizes power, these tools will never be used in these ways? But again, I kind of get it. It would seem that communism and capitalism are playing a little game of switcheroo. Communist countries such as China have gradually added the illusion of freedom element to their political arsenal. Consumer capitalism has been extremely powerful at artificially creating needs via heavy marketing, advertising, and various other social engineering strategies, ensuring that for any offer, there will be a demand. It is a very powerful system since people believe that they are free every time they go to the super market. This alleviates the sentiment of the daily prevalence of a communist dictatorial and oppressive regime, and lulls the masses away from dangerous ideas like wanting democracy or freedom. Capitalist countries, on the other hand, are gradually adding the communist command economy policy tools, as they are very practical in order to achieve certain goals. Instead of having to manipulate people via propaganda and marketing, to convince them that a particular behaviour is for their own good, and only then going through with making it mandatory, command economy tools allow to move much faster. Perhaps the digital euro and the ESG (environmental, social and governance) criteria and score are steps in that direction. What is sad is that ultimately, public authorities have taken the two worst features of both systems, based on fear and control, rather than taking the two best features, which are about trust and freedom. Manipulative capitalism and control communism as opposed to liberal capitalism and care communism. Normally, a real merger between communism and capitalism should create a society where the basic needs of each individual are covered (care communism) which allows each individual to express freely their talent (liberal capitalism), creating a space for the freedom of individual expression in all forms (art, work, creativity…) which would lead to the birth of a decentralized higher order, or “wisdom of the crowd” effect, where the economy would reflect the decentralized wisdom of billions of free individuals, no longer busy fighting for their survival or being manipulated by various private and public actors. Our policy makers seem to be afraid of their people, believing that if you gave people that kind of freedom, they would consume this planet in a matter of years, and humanity would perish in atrocious conditions of raw resources scarcity, climate change, apocalyptic natural disasters, etc. And so, to save humanity from itself, many policy makers, consciously or unconsciously, probably see themselves as some kind of “saviour”, like a daddy rescuing their drug addicted teenager, bringing him or her home, under his safety, protection and very strict control, because his or her child (citizens) “cannot be trusted”.
Many of you may actually agree with this viewpoint. Humanity is an irresponsible teenager. Without strict controls over people’s behaviours and consumption patterns, we are doomed for sure. The rebuttal to such a viewpoint would take me way too far into metaphysical territory, which is beyond the scope of this article. But I can assure you that ultimately, there is no hope for humanity under any kind of system of global centralized control. Imagine if in your brain, there were a few “elite” neurons which had the ability to arbitrarily decide how the other neurons should or should not organize. How dumb do you think you would be? What we have the opportunity to achieve, at this point in human history, is the emergence of a form of collective distributed intelligence, birthed from billions of humans who have secured their survival and basic needs, and are free to make decisions, whether personal or financial, in a way which best reflects who they truly are, expressing their authentic selves, as a mirror to how our own bodies work, where each cell is cared for, receives what it needs, and is free to express what it does best: be a stomach cell, a skin cell, a heart cell, without having to forsake such an identity or individuality to “please daddy” or to “secure it’s survival needs”.
If you want to know what the digital euro should be like, I invite you to read my paper, “Mirroring biology”, which explores the future of the current outdated and broken financial and monetary system. In the meantime, I will be following the developments of the digital euro closely, as there is a lot at stake.