When JPMorganChase announced last month that it would issue a JPM Coin, the crypto community yawned.
The "coin" is initially available only to the bank’s corporate customers that use the bank’s blockchain with a fixed 1:1 conversion rate to the U.S. dollar. Consequently, the crypto community viewed it as a merely a digital currency. A proper cryptocurrency is issued on a decentralized public blockchain where no entity can interfere with the transaction and participants are anonymous, as this CoinTelegraph article explains.
Market analysis so far has missed the most important component of the innovation.
The issue (forgive the pun) is NOT the technical mechanism used to unlock payments. The issue is that the coin is created by a regulated financial institution that has an account with the Federal Reserve….and the value of the coin is pegged to the U.S. dollar.
Let that sink in for a minute.
The JPM Coin does not create much competition for Ripple or other issuers of cryptocurrencies, since the overlap between JPMorgan Chase customers and these other issues may not be large.
The real competitive issues are between JPM Coin and the Federal Reserve’s Real Time Gross Settlement System (RTGS).
The RTGS provides a platform for irrevocable “large-value, time critical payments” among the roughly 7300 Fedwire Funds Service participants, which are only banks.
JPMorganChase has made clear that it seeks to generate "instantaneous" payments from blockchain-powered smart contracts. Some estimate that the bank moves over $6 trillion in payments occur every day just inside JPMorganChase. As CoinDesk noted over the weekend, the JPM Coin will still require the bank to “credit the account of a user when presented with a digital certification that has a redemption value of a dollar.” In other words: the JPM Coin automates the bank’s existing payment mechanisms.
The bank is therefore saying that existing Federal Reserve payments utilities are too slow and antiquated. Its solution is to issue a currency.
This is not the first time that a private bank has issued currency as a unit of account to facilitate commerce. The most high profile modern examples come from the 19th century (the era of “Free Banking” in the United States) and the 20th century (the creation of the “European Currency Unit” or “ECU” which served as the precursor for the euro).
The US Free Banking Era
Private bank currencies operated in parallel to federally-issued currencies starting in 1776, according to the official history of the United States currency. During the 19th century, a unified economy for the United States did not yet exist despite rapid industrialization (predominantly in the north) and westward expansion.
Individual banks issued notes linked to gold or silver; sometimes note holders held priority over bank creditors in the event of default. Research from the Federal Reserve Bank of Philadelphia and the Federal Reserve Bank of Minneapolis catalog the vulnerabilities banks then faced from runs and what we now call systemic risk.
These experiences form the foundation for modern payment system oversight and regulation by central banks. Susceptibility to bank runs, economic depressions and the growth of the central government in Washington ultimately generated a unified currency following adoption of the Federal Reserve Act of 1913.
The main point is that banks in the United States have in the past issued currency used by private parties to support their transactions.
Historical Precedent 2: The ECU
During the 1970s and 1980s, European banks and policymakers created a “European Currency Unit” (ECU)which served as a unit of account for invoicing long before the Maastricht Treaty established the legally binding path towards a central currency (the euro). An exhaustive history of the ECU and its relationship to the euro can be found HERE.
The private and public versions of the virtual currency existed long before the common currency (and paper notes) were issued by the European Union. The private ECU market in the 1980s consisted of contracts between third parties and the bank in which the bank promised to deliver hard currency to the user through a decentralized, multilateral clearing structure.
The official sector ECU was pegged to gold. Private banks issued ECU pegged to the value of a basket of convertible currencies. In order to insulate themselves from exchange rate risk, and in the absence of a central bank to manage payment settlements, the banks also then created a clearing mechanism.
This structure should sound very familiar. However, like the 19th century American banks, the ECU issuers were at risk of runs in the event of an influx of users demanding immediate conversions.
Policy Implications – Four Major Questions
The JPM Coin is thus either following the U.S. Free Banking example or the European ECU example. In both cases, the parallel currencies paved the way to centrally issued currencies. Of course, the difference today is that the coin issuer (JPMorganChase) operates in a much more regulated environment.
Four significant regulatory policy questions arise in connection with JPM Coin. The answers will hold material implications for the evolution of cryptocurrency regulation by central banks.
1. Payment Systems Regulation -- Are These Transactions Denominated In US Dollars? If a private bank that is a shareholder in one of the Federal Reserve Banks issues an electronic token for transaction settlements with a 1:1 pegged exchange rate to the US dollar, is this a payment system subject to the jurisdiction of the Federal Reserve, which has jurisdiction over payment systems?
If the JPM Coin constitutes U.S. currency, then the Federal Reserve has the authority to supervise JPMorganChase as a payment system operator and require that it meet the best practices for payment systems identified by the CPSS-IOSCO Principles for Financial Market Infrastructures (PFMI).
After the global financial crisis and passage of the Dodd-Frank Act (Title VIII), the bank additionally could be named a “financial market utility” subject to oversight by the Financial Services Oversight Council. The blockchain-based settlement system conceptually serves the same functions as CHIPS (The Clearing House Interbank Payments System) due to its wholesale and multilateral nature. If some JPM Coin users are banks (rather than just corporations), the resemblance to a financial market utility increases.
The risks and burdens of associated with determining that JPM Coin is US currency also apply to the Federal Reserve. If JPM Coin constitutes US currency, the Federal Reserve's operations to provide intraday (and in extreme cases, overnight) credit against collateral would need to expand to include blockchain-based currency. As noted below, this opens the door to central bank digital currencies at the very least.
Of course, policymakers could determine that the JPM Coin is more like a SWIFT message than currency. In this case, the crypto community would be delighted to debunk the notion that JPM Coin is a cryptocurrency. The big winners will be commercial banks and credit card companies who will race to issue their own blockchain-powered payments automation upgrades. Nodes of private blockchain ecosystems could easily displace decentralized blockchains as the preferred mechanism for legitimate commerce.
2. Monetary Policy/Risk Management: Will JPM Coin (and other bank-issued crypto currencies, if issued) increase the velocity of money, adding a new dimension to consider when formulating monetary policy? Will it decrease demand for central bank issued money?
Consider the main rationale for creating the JPM Coin: ensuring instantaneous and automatic payment for blockchain-powered smart contracts. Execution times could rival execution times in financial markets (in the nanoseconds). Because JPM Coin has a 1:1 exchange rate with the US dollar, this means that all transactions in JPM Coin operate with U.S. monetary policy in the background.
Monetary policy at its most basic seeks to influence the decisions of economic agents by tightening or loosening the price of money (the interest rate). Commercial banks are a key transmission mechanism for monetary policy through their lending channel.
The JPM Coin materials do not indicate whether the coin will be used exclusively for B2B transactions or whether, additionally, the JPM Coin will be use to effect payment for bank credit supporting those transactions. They also do not indicate whether the transactions in question are classic commercial transactions or whether they include fast-moving financial transactions in the swaps and derivatives markets which contain multiple re-set dates and other staged disbursements.
If the JPM Coin is used (now or in the future) in the credit process, the velocity of payments flowing through the virtual channel could insulate users from incremental shifts in interest rates during the contract period. This is a particularly salient question if some of the B2B transactions using JPM Coin are in the capital markets where traders can – and do – adjust their exposure to risks on a nanosecond basis and compete for server placement in order to reduce latency in trade execution.
The ability to hedge interest rate risk at scale and at the margin holds material implications for the effectiveness of monetary policy.
3. Regulatory Reporting/Transparency: Presumably, the Federal Reserve would continue to receive regulatory reporting regarding transactions from JPM Coin because value transfers between counterparties would still trigger shifts in dollar balances at bank accounts. But other details are murky from the publicly available materials.
Would all payments using JPM Coin trigger transfers in account balances, or would account balances adjust only at the end of the day reflecting the net transfers? If the efficiency and risk management gains from the derivatives markets are any indication, there may be strong incentives to record only end of day net transfers among counterparties conducting multiple transactions.
Reporting only net transfers would create a blockchain analog to the internal matching networks currently operated by large global investment banks. Matching trades among existing clients may deliver lower costs and efficiency gains for clients, but listed markets are deprived of order flow and crucial price formation data.
This begs the question of whether netting is even possible within the blockchain context.
RegTech architects would have a field day designing automatic mechanisms to operate in the blockchain context. People are only just starting to explore how to operate audit trail utilities within the blockchain context. Good examples of the technical challenges can be found here from SemanticScholar.org and Deloitte.
4. Central Bank Digital Currency – JPM Coin as a Sandbox: As noted above, history suggests that private bank currency issuance can provide a prelude to official sector currency issuance.
Central banks globally have started to discuss publicly the possibility of issuing central bank digital currencies. Key research papers have been published by the National Bureau of Economic Research, the Bank of Canada, the IMF, and the Bank for International Settlements.
It does not require too much imagination to view the JPM Coin as providing the Federal Reserve with a valuable "sandbox" in which to observe how a digital or crypto currency might operate “in the wild” within the economic mainstream.
Conclusion: Debating whether or not the JPM Coin is a crypto currency may be entertaining, but it is a diversion. The real action is in the regulatory and central banking arenas. The U.S. regulatory response to JPM Coin will generate important parameters for the shape and scope of cryptocurrency regulation.