This article first appeared in Personal Wealth, The Edge Malaysia Weekly on July 29, 2019 - August 4, 2019

The rapid adoption of e-money has led to concerns that it will eventually replace traditional methods of payment and displace banks altogether in the future. However, this is an unlikely scenario as banks and big tech firms can leverage their respective strengths, according to the International Monetary Fund (IMF).

In its July 15 paper, titled “The rise of digital money”, the IMF explores the various forms of digital money in today’s global landscape. It defines b-money as currencies that cover commercial bank deposits and are associated with debt-like instruments, which are denominated in a unit of account that is redeemable upon demand at face value. E-money, on the other hand, is emerging as a prominent player in the payment landscape.

E-money’s most important innovation vis-à-vis cryptocurrencies is the ability to issue claims that can be redeemed in currency at face value upon demand, says the paper. “Borrowing from our earlier analogy, it is a debt-like instrument. It is like b-money except that redemption guarantees are not backstopped by governments. They merely rest on prudent management and legal protection of assets available for redemption.”

Tobias Adrian and Tommaso Mancini-Griffoli, the authors of the paper, say banks — which are often in a position of strength — have captive users and strong distribution networks. However, they have much smaller user bases than big tech firms. This means they can cross-sell financial services to customers, such as offering overdraft protection or credit lines to overcome cash constraints. “Moreover, e-money providers may recycle many of their client funds back to banks as certificates of deposit or other forms of short-term funding.”

Nevertheless, the authors note that from the banks’ standpoint, the outcome of these efforts is not optimal. “First, they would swap cheap and stable retail funding for expensive and runnable wholesale funding. Second, they could be cut off from client relationships and third, they could lose access to valuable data on customer transactions.

“In addition, funding from e-money providers may be concentrated in a few large banks (though it would eventually trickle down to other banks). So, smaller banks may feel greater funding strains, or at least experience greater volatility in funding.”

According to the paper, there are three ways banks can respond to this — offer higher interest rates, improve services to retain deposits (including acquiring promising start-ups) and search for other funding sources. “Since banks make a profit from maturity transformation (holding assets of longer term than deposit liabilities), they may be able to offer higher interest than e-money providers … [which] must hold very liquid assets. Thus, e-money providers could offer approximately overnight money market rates. Higher rates on deposits could be met with greater operational efficiency, lower profits and potentially slightly higher lending rates.”

The authors say b-money has grown increasingly convenient due to innovations in payment methods such as mobile applications and touchless cards that facilitate payments by debit card such as Venmo and Apple Pay Cash in the US. Meanwhile, “fast payment” systems rolled out by central banks in many countries allow banks “to settle retail transactions nearly in real time at negligible cost”.

“A related example, though developed by a consortium of banks, is Swish in Sweden. Even JPM Coin is a prominent example of how banks are fighting back by entering the e-money space,” says the paper.

Swish is a mobile payment system launched by six large Swedish banks in cooperation with the Central Bank of Sweden in 2012 while JPM Coin is a digital coin designed to make instantaneous payments with the help of blockchain technology.

However, the authors question the ability of banks to adapt fast enough in this environment. Can banks be passionate about online customer satisfaction, user-centred design and integration with social media the way big tech firms are? Are they agile enough to shift business models?

“Some will be left behind no doubt. Others will evolve, but must do so quickly. In the transition, central banks can help. They can provide temporary liquidity if banks lose deposits rapidly,” says the paper.

“But central banks will be reluctant to offer this crutch for too long as their balance sheets may grow and they could be embroiled in difficult lending decisions. Short of this, banks can also find alternative forms of funding by issuing longer-term debt or equity.”

In an alternate scenario, the paper notes that e-money providers could complement commercial banks, which can already be seen in some low-income and emerging-market economies. “E-money can draw poorer households and small businesses into the formal economy, familiarise them with new technologies and encourage them to migrate from making payments to seeking credit, more complex saving instruments, accounting services and financial advice provided by commercial banks,” it adds.

Regardless, the authors of the report argue that a partnership could be envisioned even in advanced economies, where e-money providers could leverage their data to estimate customers’ creditworthiness and sell their findings to banks or intermediate bank funding for a more efficient credit allocation. “Moreover, it is perfectly possible that some of the larger e-money providers will eventually migrate to the banking business, bolstered by the data they have accumulated and their scale and attracted by the margins from maturity transformation. Thus, while today’s brands could disappear, the banking model is unlikely to be forgotten,” they say.

What if e-money providers could access central bank reserves?

In terms of providing a level playing field, the paper discusses the possibility of e-money firms holding central bank reserves like the large banks do, to the extent that they meet certain criteria and agree to be monitored. It points out that this would allow the providers to overcome market and liquidity risk and transform them into narrow banks.

“Narrow — as opposed to fractional — banks are financial institutions that cover 100% of their liabilities with central bank reserves and do not lend to the private sector. They merely facilitate payments,” says the paper.

Fractional banks would then feel greater pressure as they would no longer benefit from wholesale funding from e-money providers, it adds.

Fractional banks take deposits but only hold a fraction of these in liquid assets such as central bank reserves and government bonds. The rest is lent to households and firms, thus helping the economy grow.

The suggestion of allowing e-money firms to hold central bank reserves is not new. The paper says some central banks — such as the Reserve Bank of India, the Hong Kong Monetary Authority and the Swiss National Bank — already offer special purpose licences that allow non-bank financial technology (fintech) firms to hold reserve balances, subject to an approval process.

“The Bank of England is discussing such prospects. Meanwhile, China has gone even further. Its central bank requires the country’s large payment providers — Alipay and WeChat Pay — to hold client funds at the central bank in the form of reserves,” it adds.

If this is accepted in a big way, banks should be able to deal with it by offering attractive service offerings, says the paper. But would banks be able to hold their ground in times of crisis? Would there be massive runs from bank deposits into e-money in such times? Bank runs occur when many customers withdraw deposits at the same time from a financial institution over concerns about its solvency in the future.

The authors argue that if client funds that back e-money were held as wholesale funding for banks, the run could be the other way round as clients seek the protection of banks’ deposit insurance. They point out that uninsured deposits may migrate from banks to e-money providers, but attenuating this threat is the fact that systemic bank runs are associated with runs to foreign currencies and would happen regardless of e-money.

Additionally, there are already safe and liquid assets in many countries, such as treasury-only funds that did not see massive inflows during the 2008 global financial crisis. “While bank runs can be destabilising, they can be countered by central bank lending as long as the effects are temporary. In this case, lending to banks would balance inflows to central bank reserves. In any case, the risk of rapid disintermediation of the banking sector should be taken seriously,” says the paper.

Offering providers this access could also facilitate oversight of issuance related to the scenario of client funds being dispersed across many banks, it adds. Assuming the elimination of default risk, e-money would then be “credibly redeemable at par for domestic currency”.

“Central banks could ensure interoperability of payments and thus protect consumers from the growth of e-money monopolies offering payments among a large network of users. A payment from one to another in e-money must be shadowed by a shift of funds from one e-money provider’s trust account to another. Only then would the newly held e-money be fully backed and redeemable. Such contemporaneous transfers of client funds would be seamless if carried out on the central bank’s books,” says the paper.

In addition, central banks could require e-money providers with access to their accounts to adopt technological standards that allow e-wallets to communicate with each other, enhancing interoperability and competition. Banks and regulators may be unable to contain the growth of large e-money monopolies, say the authors.

“These could be large international firms operating as nearly natural monopolies, given the importance of network effects, rents from access to data and the sunk costs required for entry. In that case, central banks may want to give preference to domestic e-money providers operating under their direct supervision by offering them the means to issue money that is perfectly safe and liquid, and thus potentially more attractive than the foreign offering,” they add.

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