Digital Monetary Crypto-Solutions for Small Countries

Introduction

This paper is focused on the financial and monetary economies of small countries.

Small Countries

The World Bank classifies 50 countries as small countries. These have populations of less than 1.5 million, and some are rich, whereas others are poor. Some, such as Luxembourg, are high-income countries whereas others, including Djibouti, are low-income ones. Most of the small states are islands or are widely dispersed multi-island states.

The evolution of Money and Banking

In 1694, the Bank of England was founded as a profit-making company whose purpose was to purchase government debt. Using bonds as backing, it issued bank notes, thus receiving both the interest on the bonds and the seigniorage of the bank notes. Other European central banks followed suit, prompted by similar objectives: to deal with monetary disarray and to aid in government finance. Early central banks issued private notes which served as currency, and they often had a monopoly with respect to the issuance of such notes.

The importance of the balance sheet

A simplified balance sheet of a generic bank has assets such as loans, securities, and cash and liabilities such as deposits and other forms of borrowing. Banks face two main challenges. One is solvency, in which the value of assets an organization owns is greater than the value of its liabilities so that its net worth is greater than zero. The solvency of an organization depends upon the market value of the assets on its balance sheet and that of its liabilities. However, banks differ significantly from other corporations because of the issue of liquidity. While banks that are insolvent can continue to survive for a long period of time, liquidity issues can very quickly cause a bank to close its doors.

Financial institutions

Until about 1950, there were mainly three type of institutions: the private sector, the banking sector, and the central bank. Today, however, there are many more types of participants, many having overlapping roles, and these are listed in the table below. All operate on a national basis, but many also do so on a global basis.

Financial markets and instruments

Two dimensions describe the use of financial instruments: there is elasticity and there is discipline (quantity and quality). In a boom, quantities increase (i.e., the quantity of credit increases) whereas in a crisis, deleveraging occurs (i.e., quantity of credit decreases). With respect to quality, in a boom, credit begins to look like money and moves up the hierarchy of financial instruments. Forms of credit become much more liquid and so much more usable as an instrument with which to make payments.

Blockchain technologies

In times of serious crisis, when more is needed than simply trying to influence the economy around its edges and liquidation events are occurring, the central bank must implement extreme measures to avoid a liquidity spiral. For example, to avoid major problems in 2007, several central banks, including the US Federal Reserve Bank, had to deal with asset prices by buying mortgage-backed securities. That is something that the governments of small countries cannot do, and therefore they require a different solution for situations such as this.

Loans

Whether the loans are secured or unsecured, the lending process itself has changed in the last 20 years. During the last financial crisis in 2007, banks had to lay off many employees and simultaneously automated their lending processes and procedures, which can be incorporated into smart contracts. Smart contracts are a way to implement business logic in a trustless way and enable lenders to validate transactions, verify the legitimacy of counterparties, and perform routine account administration tasks almost instantaneously, thereby reducing costs and accelerating the speed of the process. With smart contracts, no third party is needed for background checks or proprietary credit ratings. By design, the very nature of loans built on a distributed ledger is trustless, thus making the transfer of ownership of an asset possible, without the need for an intermediary such as a bank. This attribute could help revive peer-to-peer lending practices.

International payments

A stablecoin is a cryptocurrency pegged to a stable asset, such as a fiat currency like the U.S. dollar. Stablecoin prices correspond to the value of the pegged asset, thereby distinguishing them from other cryptocurrencies (e.g., Bitcoin), whose price is driven by market dynamics.

Remittances

In 2016, migrants living in different parts of the world sent more than US$570 billion (4) to their home countries, using a money-transfer market dominated by the top three (Western Union, MoneyGram, and Ria). Such transfers are expensive, take time, and require a lot of paperwork. Average remittance costs average around 7% but, on the high end, (e.g., remittances to South Africa) run as high as 16%. Banks are the most expensive means of making such remittances, with an average cost of 11% (5).

Payment systems

In a crisis, a country needs to react quickly to avoid an escalation of problems. For example, a natural disaster requires a fast reactivation of agricultural activities. In large countries, organizations having budgets that enable them to react quickly can intervene (for example FEMA in the US). However, small countries lack this type of rapid response. For example, farmers in such countries will have no insurance and so cannot immediately begin farming following a crisis. Thus, the government has to apply for loans or grants, and the money is distributed through banks (creating further delays and increasing the costs), as shown in the current process below:

Funding of small projects

In most small countries, a shortage of long-term, local-currency financing for small-scale projects impedes local economic development. Inadequate fiscal transfers, lack of (for the project) skilled labor, little own capital and low creditworthiness make it difficult for local governments to fully fund projects on their own.

National currencies on a blockchain

Adding a national currency onto a blockchain will have several advantages, and it is only a matter of time before countries will begin doing so.

Security Tokens

Security tokens are tokens that are generally backed by a real asset such as equity, shares, or commodities and their holders can be granted ownership rights or shares of the company. Security tokens are tradable financial instruments with monetary value. Security Tokens bring a number of improvements to traditional financial products by removing the middleman from investment transactions:

Central bank crypto assets

Many central banks across the globe hold gold as one of their reserve assets in order to hedge against periods of market unrest and for instances when they need to quickly liquidate their assets. Although no other asset is more liquid than gold, gold also has its downsides: it is difficult to hold (physically) and difficult to transport and the price of gold is volatile. Except for price volatility, Bitcoin or a basket of cryptocurrencies does not have these issues. It is easy to hold, and transfer and it cannot be changed. Moreover, it is highly liquid and can easily be converted into other currencies.

References

(1) Mehrling, P. (2014). Why Central Banking Should Be Re-Imagined. BIS Papers. In Bank for International Settlements (ed.), Re-Thinking the Lender of Last Resort, Vol. 79, 108–118. https://www.bis.org/publ/bppdf/bispap79i.pdf