Setting up a financial system driven by Digital Currencies and backed by Gold Standards, a consideration.

Digital Transformation Across Industries

We have seen leaps in digitization happening across all industries. All major industries have embraced digitization to remove inefficiencies and increase productivity Automakers for instance, have revolutionized manufacturing by using robots, while airlines have mastered pricing around real-time knowledge of supply and demand. Retailers are building strong inhouse digital capabilities or partnering with ecommerce platforms to create seamless omnichannel customer experiences. Healthcare has transformed through electronic health records, digital tools that track patients’ vital signs, and virtual consultations between doctors and patients. Manufacturers in every industry could improve operating performance, product quality, and supply chain transparency by redesigning processes and training workers to operate in the digital world.

However as one may be quick to identify banking and financial system as a whole is struggling to move to a digital footing.

Why Financial Systems are lagging behind in digitization? The financial system that the world runs around is a complicated structure that I would like to demarcate as 5 moving parts such as money, financial instruments, financial markets, financial institutions and central banks.

Subsystems in the Financial System This definition of these subsystems is based on the structure shared by Intelligent Economist - https://www.intelligenteconomist.com/financial-system/

1. Money Money is used as a medium to buy goods & services. It also is a standard unit of measurement and acts as a store of value. However, money may not be a good store of value since it loses value with inflation.

2. Financial Instruments Financial Instruments are formal obligations that entitle one party to receive payments or a share of assets from another party. Examples of tradable financial instruments include loans, stocks, bonds.

3. Financial Markets A Financial Market is a place or network where financial instruments can be sold quickly & cheaply.

4. Financial Institutions Financial Institutions are firms that connect borrowers and lenders, provide savers and borrowers access to financial instruments & markets. There are two types of Financial Markets – the primary market and the secondary market.

5. Central Banks Central Banks are large financial institutions that handle government finances, they regulate the supply of money, and they serve as banks to commercial banks.

For the system to be able to completely migrate into a digitized model, it requires each of these smaller sub systems to move into a digital realm. It is totally understandable that not all of these subsystems cann immediately move into all digital plane. However, a logical evaluation of each subsystem to identify where they stand in the process and what are the bottle necks that prevents it system from going to the next level of digitization is important to plan for a digitally savvy and robust financial system of the future that can amply support wholesale /retail industries which are already way ahead in the digitization curve.

Financial System Digital Readiness (FSDR) Model Financial System Digital Readiness is a model I have developed to evaluate each of the financial subsystems’ receptivity / advancement in the area of digitization. Here in the below table, we will try to access based on my research how each of these separate units have adapted to the digital age. We will rate them on a scale of 1 – 5 based on each systems adaptation to the digital age on the below parameters

? DIGITAL MIGRATION QUOTIENT- What %age of the subsystem uses tech / digitally assisted services in this area Vs what %age still works on the old model,

? TECHNOLOGY USED- What sort of technology back and runs the sub system

? ADAPTATION RATE - %age of users adapting the digitized version Vs still using the legacy system

Note: At this point we will be focusing on the FSDR of the world financial system as a whole. However, for more concrete insights we may have to analyze it at a regional level to be able to plan relevant digitization plan that will suit the needs of that region.

FSDR Model – A bird’s eye view of the world’s readiness as a whole

Note: (Research of each subsystem was done online to collect information on where we stand in being able to implement technology across the subsystem to create a fully supportive digital ecosystem)

As one can see, among the subsystems Money and Central Banks are lagging behind in the FSDR quotient. Indeed, the readiness of central banks is directly dependent on the economic and institutional motivations, policy approach of every country. However, we can largely say most central banks are far from being anywhere close to having an all-digital approach. As for money as a subsystem it comes as an extension to the central bank’s readiness to be able to put in the research to analyze the launch of a central digital currency. Here on we will focus on the single subsystem Money and see how we can improve the digitization of Money in the coming decade.

MONEY Money is controlled and generated by a monetary System - defined as a set of policies, frameworks, and institutions by which the government creates money in an economy. Such institutions include the mint, the central bank, treasury, and other financial institutions. There are three common types of monetary systems – commodity money, commodity-based money, and fiat money. The world moved away from commodity-based money to fiat currencies (backed by no metal but the government guarantees the value of the currency.) in the early 20th century.

An evaluation of existing world currencies We are living in a world where the Petro backed United States dollar (fiat currency) is the world’s largest reserve currency. Be it central bank reserve holding, corporate borrowing, bank funding (even that of Non-US banks) and invoicing of international trade, all of these areas of financial transactions majorly happen in USD. Indeed, because for the longest time United States Dollar is considered a ‘fairly stable’ currency and the advantage of better exchange rates makes it a currency of choice to transact, above all others?

The World’s Top Reserve Currencies in 2019

1. U.S. Dollar: $6.74 trillion (61.82%)

2. Euro: $2.21 trillion (20.24%)

3. Japanese Yen: $572 billion (5.25%)

4. Pound Sterling: $495 billion (4.54%)

5. Chinese Renminbi: $213 billion (1.95%)

Reference: https://howmuch.net/articles/worlds-top-reserve-currencies-2019

This worldwide reliance on USD as a choicest currency for transactions gives USD and the United States an undisputed advantage，one that gives the authorities in charge of controlling the cash supply an unequivocal amount of power. Such power in the hands of an exploitative regime can have undesirable effects on the world as a whole.

Analyzing United States Key Events in the Financial Markets Since the 2000s If you carefully analyze the major financial events that happened in 2000’s in the United States, we will learn that there were multiple instances of the economy having to be salvaged by the decision-making authorities through a slew of measures. Each time the United States economy was in distress or if there was a certain American organization they deemed fit to be bailed out, their uncontested economic advantage of holding the key to a dominant currency gave them the power to engage unquestioned in quantitative easing / inject large amounts of cash into the system, where by putting in danger the financial/economic foundations of the world financial systems in that most central banks all over the world hold large amount of reserve funds in the form of USD. A devaluation of USD will spell doom for all other economies too.

Listing some of the landmark events in the financial sector in the US in the 2000’s

Reference: https://www.cfr.org/timeline/us-financial-crisis

2000 – 2001 – Federal Reserve Cuts Interest Rates

Prompted by the burst of the dot-com bubble and the resulting recession, the U.S. Federal Reserve, lowers its benchmark interest rate eleven times.

2004 - Wall Street Places Riskier Bets

In April, the Securities and Exchange Commission (SEC) loosens the net capital rule, which had limited broker-dealers and investment banks to a 12-to-1 leverage (the ratio of debt to equity) on investments. The change allows firms with more than $5 billion in assets to leverage themselves an unlimited number of times. Qualifying firms at the time include Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs, and Morgan Stanley. These firms greatly increase the amount of leverage they employ to a point where they routinely use thirty times leverage on investments. None of the five firms survive the 2008 credit crisis intact as independent investment banks.

April 2007 - Subprime Bankruptcies Proliferate

In April 2007, New Century Financial Corporation, the largest U.S. subprime lender, files for bankruptcy as analysts worry about the impact subprime mortgages will have on the broader financial sector, which invested heavily in securitized debt from subprime loans. In July, Bear Stearns, one of the largest U.S. investment banks, announces two of its hedge funds have lost almost all of their investor capital and will file for bankruptcy. It is one of the first signs of major problems in financial markets beyond the subprime loan industry.

August 2007 Subprime Woes Go Global

Subprime mortgage problems spread worldwide as hedge funds and banks around the globe reveal substantial holdings of mortgage-backed securities. France’s BNP Paribas announces on August 9 that there is no liquidity in the market for the assets held by three of its hedge funds, as investors reject these so-called toxic assets, which are rapidly losing their value. Other European banks follow with similar announcements. The European Central Bank immediately steps in to offer low-interest credit lines to support these banks. With lending markets drying up around the world, the central banks of the United States, the European Union, Australia, Canada, and Japan coordinate to inject liquidity into credit markets for the first time since 9/11.

September 2007 Fed Slashes Rates and Market Peaks

In September, the Federal Reserve makes its first in a series of interest rate cuts, lowering the benchmark federal funds rate for the first time since 2003, from 5.25 percent to 4.75 percent. By December 2008, the Fed will cut rates to between 0 percent and 0.25 percent. During this period, the Dow Jones Industrial Average peaks at more than 14,000 points. By February 2009, the Dow plummets by more than 50 percent, to just over 6,500.

2008 March 14, 2008 -Fire Sale of Bear Stearns

September 15, 2008 - Lehman’s Collapse

September 16, 2008- Federal Reserve Bails Out AIG

September 25, 2008- Bank Failures Signal End of an Era

Washington Mutual is seized by the Federal Deposit Insurance Corporation (FDIC) and declares bankruptcy, the largest bank failure in U.S. history. Several days later, another major U.S. bank, Wachovia, is purchased by Wells Fargo. Meanwhile, the two largest U.S. investment banks, Goldman Sachs and Morgan Stanley, announce they will convert to bank holding companies, exposing them to additional government regulation but giving them access to more loans from the Fed. The move marks the end of independent investment banks, symbols of Wall Street’s success in the second half of the twentieth century.

October 10, 2008 Dow Finishes Worst Week as Fed Intervenes

November 25, 2008 Fed Announces Quantitative Easing

December 2008 Bush Launches Auto Bailouts

Consequences of US Financial crisis on world economy What did it cost the world during and after the financial crisis. Here is sharing an analysis from McKinsey on the long-term impact of US financial crisis on the world economies both advanced and emerging. According the an analysis done by McKinsey based on the information collected shows the world has not recovered even after a decade past the debacle.

Banks have posted weaker financial performance since the crisis

Public debt increased rapidly in advanced countries after the crisis

Source: SNL Banker Panorama by McKinsey

Indeed, the consequences on the general masses across the world have been far reaching. Could the fiat based / leveraged banking system coupled with power to control the supply of money have caused the debacle as we know it? As long as excess cash is printed into the system when compared to the goods and services transacted what are the odds of having the currency maintain its value? The advanced countries have become high cost economies with people contributing a larger chunk of their hard-earned income in the form of taxes. The expectation is that the central government system will provide quality access to basic necessities like medical care, pension etc. Taxes amounting to 30% - 50% of the base pay, coupled with high cost of living, leave the large majority of the population in the west with meagre or no savings/spending capacity. Cost of living coupled with heavy taxes gets even the above average earner to live frugally. The USD’s constant fluctuations in the 2000s, the economic crackdown and later with the Obama/Trump administration’s reckless decisions on injecting more and more money supply may have cost us more dearly that it ever actually accounted for.

Could the US financial crisis have been avoided if the USD was backed by gold?

Quoting Robert Batemarco, “For all practical purposes, the quantity of money is determined by the Federal Reserve System, the United States’ central bank. The Federal Reserve was created to make the quantity of money “flexible.” The theory was that the quantity of money should be able to go up and down with the “needs of business.” Before the Fed opened its doors in November 1914, the average reserve requirement of banks was 21.1 percent.7 This meant that at a maximum, the private banking system could create $3.74 of new money through making loans for every $1 of gold reserves it held. Under the Fed, banks could count deposits with the Fed as reserves. The Fed, in turn, needed 35 percent gold backing against those deposits. This increased the available reserve base almost three-fold. In addition, the Fed reduced member bank reserve requirements to 11.6 percent in 1914 and to 9.8 percent in 1917.8 At that point, $1 in gold reserves had the potential of supporting an additional $28 of loans. But then limits were never what central banking was about. In practice, whenever gold threatened to limit credit expansion, the government changed the rules. Cutting off the last vestige of gold convertibility in 1971 rendered the dollar a pure fiat currency. The fate of the new paper money was determined by the whim of the people running the Fed. If we desire a money that will maintain its value, we must have a money that cannot be created at will. This is the real key to the suitability of gold as money. Since 1492 there has never been a year in which the growth of the world gold stock increased by more than 5 percent in a single year. In this century, the average has been about 2 percent.9 Thus with gold money, the kind of inflations that have plagued us in the twentieth century would not have occurred. Under the classic gold standard, even when only a fractional reserve was held by the banks, prices in the United States were as low in 1933 as they had been 100 years earlier. In Great Britain, which remained on the gold standard until the outbreak of World War I, prices in 1914 on the average were less than half of what they were a century earlier.10 With gold as money, one need not constantly be concerned with exchange rate fluctuations. Indeed, the very notion of an exchange rate is different under a gold standard than under a fiat money regime. Under fiat money, exchange rates are prices of the different national currencies in terms of one another. Under a gold standard, exchange rates are not prices at all. They are more akin to conversion units, like 12 inches per foot, since under an international gold standard, every national currency unit would represent a specific weight of the same substance, i.e., gold. As such, their relationships would be immutable. This constancy of exchange rates eliminates exchange rate risk and the need to employ real resources to hedge such risk. Under such a system, trade between people in different countries should be no more difficult than trade among people of the several states of the United States today.” Thus, it can be concluded that if it weren’t for the highly leveraged banking systems and the real estate bubble that was created by Fed’s policies to print out cashfindeed as and when it needed more money supply, than having a more conservative approach where in the supply of money was monitored many of the horrors of the 21st century could have been completely avoided.

What would it take to have USD be backed by Gold Standards? Sharing an analysis from WWS Swiss Financial Consulting SA,”For the US to guarantee that US dollars could be convertible to gold, the Treasury would have to ask for a price of around $72,000.00 for an ounce of gold, and then the current money supply could then be redeemable in gold. A ton of gold has 32,150.7 troy ounces. A metric ton (British) has 2,240 pounds. To give an idea of what an ounce of gold would cost should it be redeemable in US dollars under a gold-backed currency, one can calculate that the US has 8,000 tons of gold (rounded off). Multiplying this number by 32,150 ounces per ton, the result is 257,200,000 ounces. The current US M2 money supply ( U.S. National Debt Clock: Real Time ) is $18,600,000,000,000 (rounded off). Dividing $18,600,000,000,000 dollars by 257,200,000 ounces of gold, one gets $72,317 per ounce. In 1971 when Nixon took the US off the gold standard, the official price was $35 per ounce of gold. The current gold price of slightly over $2,000 an ounce makes it clear that the constitution of a gold-based currency of any sort in any country would be a difficult undertaking.” Thus, it can be evidentially concluded that it is almost impossible to have USD be brought back to gold standards, therefore that possibility is indeed ruled out.

Is the world ready for a new dominant currency that is a digital currency?

Without doubt USD is still the single most dominant currency that is used for all trade and settlements. Major invoicing of international trade (In a sample of 43 countries, Gopinath (2015) finds that the dollar’s share as an invoicing currency for imported goods is approximately 4.7 times the share of U.S. goods in imports), corporate borrowing (According to the BIS locational banking statistics, 60% of foreign currency local claims of banks are denominated in dollars.), and bank funding (According to Bank for International Settlements (BIS) locational banking statistics, 62% of the foreign currency local liabilities of banks are denominated in dollars.) all are well dominated by USD currently.

Given the instabilities the USD has gone through (cited previously) having just a single dominant currency might put at risk every economy that holds USD as their reserve currency (64% of worldwide official foreign exchange reserves.). Gopinath and Stein (2020), quite pragmatically puts forward how USD may maintain its’ currency dominance in the short run is. However, the paper does not end before they take a moment to point out the chances of the US dollar being challenged if certain conditions come together.

The challenges mentioned are of two types,

1.     The chances of renminbi taking over as a dominant currency

2.     The chances of digital currencies like libre from Facebook taking over

However, chances of Yuan becoming internationalized is a far cry from reality for the simple reason that China’s financial markets remain closed. Also, for reasons as simple as one fiat currency cannot replace another and expect to remove the flaws created by the former. On this point what really matters is the consideration for a centrally owned token based digital currency being introduced into the system maybe the real game changer.

Are Digital Currencies the future? As the world moves on to embrace tech and digitization across all industries and value chain, it becomes important for the all subsystems in the financial system to be amply digitized to be able to support the changing ecosystem, As the FSDRA rating indicated the money and central banks are the two subsystems that are pretty much lagging behind in the digitization process. White the transaction methods have evolved from coins to banknotes to cheques to credit cards money as such still remained the same unit without any changes. However, time has come when the world is considering a move into central bank owned digital currencies.

How about a Digital Currency backed by Gold instead of a fiat /floating currency?What if we were on a gold standard system, right now? Or, to be a little more specific, what if we had been on a gold standard system for the last ten years, and continued on one right now, in the midst of the COVID-19 panic and economic turmoil?

In the end, a gold standard system is just a fixed-value system. The International Monetary Fund tells us that more than half the countries in the world, today, have some kind of fixed-value system — they link the value of their currency to some external standard, typically the dollar, euro, or some other international currency. They have fixed exchange rates, compared to this external benchmark. The best of these systems are currency boards, such as is used by Hong Kong vs. the U.S. dollar, or Bulgaria vs. the euro.

Actually, it would probably be easier to link to gold than the dollar or euro, because gold's value tends to be stable, while the floating fiat dollar and euro obviously have floating values, by design. If you are going to link your currency to something, it is easier to link it to something that moves little, rather than something that moves a lot. Big dollar moves, such as in 1982, 1985, 1997-98 and 2008, tend to be accompanied by currency turmoil around the world.

What does it mean to have a blockchain based gold backed Digital Currency? The BIS has promoted gold to the first tier of reserves so that the value of the gold counts 100% towards the total of the reserves of central banks. If there is going to be any sort of gold-backed blockchain digital currency, then the gold backing will be large amounts in the vaults of the central bank held as part of the bank's reserves to bolster confidence in the fiat currency in circulation. In fact, central banks have been buying large amounts of gold and increasing the amount of gold held in their reserves.

When finally, if a country will be able to ascertain a gold backed Digital Currency it would mean that

-         The value of gold will appreciate much higher

-         The current fiat currencies will become obsolete

-         Money laundering can be abolished once and for all

-         Private owned fractional reserve banking can be completely stalled

Country readiness to drive a digital currency - CBDC Research and Development

A recent paper by Raphael Auer, Giulio Cornelli and Jon Frost of Bank for International Settlements Rise of the central bank digital currencies: drivers, approaches and technologies, confirms at least 36 central banks have published retail or wholesale CBDC work. The paper confirms informal and stable economies with innovation capacity and stable governments are more focused on research and development of CBDC for both wholesale and retail purposes. At least three countries (Ecuador, Ukraine and Uruguay) have completed a retail CBDC pilot. Six retail CBDC pilots are ongoing: in the Bahamas, Cambodia (Bomakara (2019)), China, the Eastern Caribbean Currency Union, Korea (Bank of Korea (2020)) and Sweden).9 Meanwhile, 18 central banks have published research on retail CBDCs (eg Harahap et al (2017), Burgos and Batavia (2018), Kiselev (2019) and Bank of Japan (2020)), and another 13 have announced research or development work on a wholesale CBDC.

Why Asia might be the place where Digital Currencies might be released first

Recent times are a testament to how the world is at a crucial point where technology has democratized access to consumption across the masses, jet setting populous countries on a growth curve like we have not witnessed in the past 3 centuries. Allow me to share various observations on why there will be a larger participation from the eastern countries in the next few decades in driving the world economy

1.       Asian Countries Climb Becoming the World’s Largest Economies

In 2020’s some of the largest contributors of GDP are from Asia is indicative of a paradigm shift in how populous countries are soon to drive the next phase of economic growth. Shared herewith is the projection from World Bank and IMF on the world’s largest economies, a comparison between 1990s and 2020s. Clearly, we have more representation from Asia with China climbing ten spots to overtake USA as the world’s largest economy while India and Indonesia making it into the top ten list.

2.       Alignment Among Asian Countries to Drive Growth

The past three decades witnessed the coming together of emerging national economies to build their own ecosystem to power the future. The establishment of BRICS (Brazil, Russia, India, China, and South Africa) in 2006 followed by the establishment of New Development Bank (NDB - a multilateral development bank established by the BRICS states.) in 2014 and the very recent Regional Comprehensive Economic Partnership (RCEP consists of China, Japan, South Korea, Australia, New Zealand and the 10 members of the Association of South East Asian Nations (ASEAN) - Brunei, Vietnam, Laos, Cambodia, Thailand, Myanmar, Malaysia, Singapore, Indonesia and the Philippines. They are looking to progressively lower tariffs and aims to counter protectionism, boost investment and allow freer movement of goods within the region).

3.       Emerging Economies Embrace Digitization and Digital Migration

Another interesting aspect to note is emerging economies have been digitizing faster across all industries. Let’s say retail, since in China there was a dearth of brick and mortar retail in 2000’s it was easier for the population to adopt and migrate to digital platforms for their everyday shopping. In the case of banking, if we take specifically China’s case, while the traditional banking system only saw a few hundred million have themselves involved in the banking system, fintech firms like Ant Financial saw to it that the larger population migrated and owned a digital payment account. Everything like taking a loan became a one-click process. As Alipay famously says, it takes 3 minutes to apply, 1 minute to process and 0 seconds to disburse the loans, in comparison to the traditional bank loaning system, which can take 6 months to one year to go through the approval cycle. Therefore, we can say Asia and Africa is less inert to becoming digitized in comparison to their m ‘advanced’ western counterparts.

Conclusion

?As we can reckon digital transformation is sending waves of changes across all industries and Asian countries are more adaptive to this change as they have fewer legacy systems to detach from, high density population who are a mobile first generation, large informal economies with a need for financial inclusion. An inevitable transfer or at least sharing of economic prowess between the east and west is looming around the corner. It is too early to accurately predict the future as the world undergoes tumultuous changes of unprecedented order. Yet there are enough reasons to believe the tides are here to ensure a much-anticipated recalibration. It should be seen as an opportunity to undo the mistakes of the past and to be able to build a just and robust world financial system.

References

Robert Batemarco:https://fee.org/articles/central-banks-gold-and-the-decline-of-the-dollar/:

Gold-Backed Digital Currency Based On Blockchain Technology https://seekingalpha.com/article/4363035-gold-backed-digital-currency-based-on-blockchain-technology

Banking, Trade, and the Making of a Dominant Currency? https://scholar.harvard.edu/files/gopinath/files/dominantcurrency.pdf

Rise of the central bank digital currencies: drivers, approaches and technologies https://www.bis.org/publ/work880.pdf

The U.S. Financial Crisis https://www.cfr.org/timeline/us-financial-crisis

Monetary System https://www.intelligenteconomist.com/monetary-system/

Asia-Pacific closes in on world's biggest trade deal https://www.reuters.com/article/us-asean-summit-rcep-explainer/explainer-asia-pacific-closes-in-on-worlds-biggest-trade-deal-idUSKBN27T132

Emerging Markets in Digital Age

https://emergingmarkets.blog.franklintempleton.com/2017/09/20/emerging-markets-digital-age/