Central Banking and Fintech—A Brave New World?
IMF News, September 29, 2017
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Bibliographic details
- Authors: Christine Lagarde
- Published: September 29, 2017
Overview / framing
- Speech by Christine Lagarde, IMF Managing Director, at Bank of England conference, London, September 29, 2017.
- Purpose: consider how fintech could change central banking over the next generation by examining three innovations: virtual currencies, new models of financial intermediation, and artificial intelligence.
- Narrative device: a forward-looking vignette set in 2040 to explore practical and institutional implications.
Virtual currencies
- Definition and distinction:
- Virtual currencies provide their own unit of account and payment systems, enabling peer-to-peer transactions without central clearinghouses or central banks.
- Not to be confused with digital payments in existing currencies (e.g., Paypal, Alipay, M-Pesa).
- Current limitations (reasons virtual currencies "pose little or no challenge" today):
- Too volatile.
- Too risky.
- Too energy intensive.
- Underlying technologies not yet scalable.
- Opaqueness for regulators.
- Some have been hacked.
- Potential developments and implications:
- Technological challenges could be addressed over time; historical parallels invoked (personal computers, tablets).
- In countries with weak institutions and unstable national currencies, increased use of virtual currencies could resemble "dollarization 2.0."
- IMF experience example: in the Seychelles, dollarization jumped from 20 percent in 2006 to 60 percent in 2008.
- Motivations for citizens to hold virtual currencies vs. physical foreign currency:
- Easier and safer access than obtaining paper bills in remote regions.
- Virtual currencies could become more stable if:
- Issued one-for-one for dollars, or a stable basket of currencies.
- Issuance is fully transparent and governed by a credible, pre-defined rule or algorithm that can be monitored.
- Issuance could include a "smart rule" reflecting changing macroeconomic circumstances.
- Private virtual currencies potentially offering:
- Cost and convenience similar to cash for small-value, frequent, peer-to-peer transactions, often across borders.
- No settlement risks, no clearing delays, no central registration, no intermediary to check accounts and identities.
- Policy response options:
- Central bankers should continue running effective monetary policy while remaining open to fresh ideas and new demands.
- If privately issued virtual currencies remain risky and unstable, citizens may call on central banks to provide digital forms of legal tender.
New models of financial intermediation
- Structural shifts described:
- Unbundling of banking services: minimal balances for payments in electronic wallets; remaining balances in mutual funds or peer-to-peer lending platforms using big data and artificial intelligence for automatic credit scoring.
- Faster product cycles: "six-month product development cycles and constant updates," a premium on simple user-interfaces and trusted security.
- Rise of many new players without branch offices; data becomes central.
- Implications for the fractional banking model and monetary policy:
- Fewer bank deposits and alternative channels for money flows could put the fractional banking model under question.
- Central banks' traditional transmission via primary dealers/big banks (liquidity provision, open-market operations) may be less effective if banks become less relevant and demand for central bank balances diminishes.
- Possible central bank responses:
- Increase the number of counterparties to operations (example: Bank of England including large broker-dealers and central counterparty clearing houses).
- Expand regulatory coverage as more firms may fall under central bank regulatory umbrellas (the "price to pay for liquidity on a rainy day").
- Regulatory and institutional consequences:
- Need to better regulate shadow banks; Financial Stability Board (FSB) progress noted.
- Growing remit for central banks will likely bring increased public scrutiny and political pressures, requiring stronger defenses for independence and clearer communication.
- Regulatory frameworks may need to shift from overseeing well-defined entities to overseeing financial activities (e.g., social media company offering payments without an active balance sheet).
- Regulators may need expertise in assessing the soundness and security of algorithms.
- International cooperation:
- Cross-border dialogue is critical as regulation focus widens from national entities to borderless activities.
- Questions raised: what is "home" vs. "host"; how to avoid regulatory arbitrage and a race to the bottom.
- The IMF, with global membership of 189 countries, is presented as an ideal platform for these discussions and for ensuring the safety of global payments and financial infrastructure.
- The IMF should be open to change, including bringing new parties to the table and considering a role for a digital version of the SDR.
Artificial intelligence
- Data environment and AI capabilities:
- Observes that "90 percent of the data available today was generated in the past two years."
- Abundant behavioral data from smartphones and the internet can be paired with artificial intelligence.
- Recent AI advances (e.g., self-learning programs outperforming top human players of Go) indicate rapid progress in pattern recognition and optimization.
- Potential central banking applications:
- Machines assisting policymakers with real-time forecasts, spotting bubbles, and uncovering complex macro-financial links.
- AI could help process vast data to identify economic relationships and risks.
- Limits and governance considerations:
- Economic uncertainty and changes in basic economic relationships require human judgment, diversity of opinions, and peer questioning.
- Communication remains essential: monetary policy's effectiveness depends on clear storytelling so the public can form expectations—question whether machines can explain decisions in plain English.
- Accountability is necessary: machines cannot easily be held accountable to citizens adversely affected by policy errors (e.g., a young couple unable to buy a house).
- Without accountability, independence is compromised; independence is vital for sound policy.
- Conclusion on AI role:
- Machines will play a larger assisting role, but will not replace human policymakers; "the governor walking into the Bank will be of flesh and bones," and people will remain behind the door.
Key projections, analogies, and figures cited
- Temporal anchor: vignette set in 2040 to explore future scenarios.
- Historical/institutional milestones: "20 years of independence" for the Bank of England referenced in opening remarks.
- Dollarization example: Seychelles dollarization rose from 20 percent in 2006 to 60 percent in 2008.
- Data generation statistic: "90 percent of the data available today was generated in the past two years."
- Employment automation reference: Andy Haldane’s prediction of "15 million jobs being automated in the U.K."
Policy takeaways and recommendations
- Central banks should continue to run effective monetary policy while staying open to innovation and evolving demands.
- Monitor virtual currencies closely; prepare for scenarios where private virtual currencies become stable or where citizens demand central bank digital legal tender.
- Expand and adapt regulatory frameworks:
- Broaden focus from entities to activities.
- Increase coverage of counterparties to monetary operations as needed.
- Strengthen oversight of shadow banking.
- Build capacity to assess algorithm soundness and security.
- Preserve and defend central bank independence; enhance transparency and communication to maintain public trust and accountability.
- Strengthen international cooperation to manage cross-border, borderless fintech activities and prevent regulatory arbitrage; leverage IMF’s global platform and consider new instruments (e.g., a digital SDR) as part of the response.
Source: Speech by Christine Lagarde, IMF Managing Director, Bank of England conference, London, September 29, 2017.