Levy Economics Institute of Bard College Public Policy Brief No. 150, 2020 THE IMPACT OF TECHNOLOGICAL INNOVATIONS ON MONEY AND FINANCIAL MARKETS JAN KREGEL and PAOLO SAVONA Contents 3 Preface Dimitri B. Papadimitriou 4 The Impact of Technological Innovations on Money and Financial Markets Jan A. Kregel and Paolo Savona 10 About the Authors The Levy Economics Institute of Bard College, founded in 1986, is an autonomous research organization. It is nonpartisan, open to the examina- tion of diverse points of view, and dedicated to public service. The Institute is publishing this research with the conviction that it is a constructive and positive contribution to discussions and debates on relevant policy issues. Neither the Institute’s Board of Governors nor its advisers necessarily endorse any proposal made by the authors. The Institute believes in the potential for the study of economics to improve the human condition. Through scholarship and research it generates viable, effective public policy responses to important economic problems that profoundly affect the quality of life in the United States and abroad. The present research agenda includes such issues as financial instability, poverty, employment, gender, problems associated with the distribution of income and wealth, and international trade and competitiveness. In all its endeavors, the Institute places heavy emphasis on the values of personal freedom and justice. Editor: Michael Stephens Text Editor: Elizabeth Dunn The Public Policy Brief Series is a publication of the Levy Economics Institute of Bard College, Blithewood, PO Box 5000, Annandale-on-Hudson, NY 12504-5000. For information about the Levy Institute, call 845-758-7700, e-mail [email protected], or visit the Levy Institute website at www.levyinstitute.org. The Public Policy Brief Series is produced by the Bard Publications Office. Copyright © 2020 by the Levy Economics Institute. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or any information-retrieval system, without permission in writing from the publisher. ISSN 1063-5297 ISBN 978-1-936192-66-3 Public Policy Brief, No. 150 2 Preface Changes in financial regulation are usually driven by responses to While noting that some monetary authorities seem to be current failures and often generate additional, if unforeseen, risky inclined toward regulatory solutions that involve the coexistence behavior. In contrast, Hyman Minsky argued that the creation of privately issued cryptocurrency alongside traditional money, and maintenance of a robust financial system capable of sup- Kregel and Savona argue that a public monopoly on the issuance porting the capital development of the economy would require of cryptocurrency would be the superior alternative. For instance, dynamic macroprudential regulation that took into account the with a public platform, the stability of the payment system would evolving practices and technologies that continuously alter the be the responsibility of the central bank while the protection of financial structure. savings would be the domain of securities regulators. Regulation Jan Kregel and Paolo Savona suggest such an approach in would no longer be forced to serve “two masters,” as Minsky put response to some recent innovations, such as cryptocurrencies it—that is, to secure both the stability of credit and purchasing and associated instruments based on distributed ledger technol- power—which would remove a significant source of instability. ogy, the deployment of artificial intelligence, and, more gener- Ultimately, Kregel and Savona envision that these tech- ally, the use of data science in financial markets. In this policy nological innovations, if surrounded by the right institutional brief, they analyze the impacts of these innovations on the present framework, could promote financial stability and help repair institutional environment and outline an appropriate regulatory the disconnection between finance and the real economy. framework. Furthermore, given the proliferation of various proposals at the Attempting to maintain the status quo in the face of the intro- national level, they argue that the manner in which these techno- duction of cryptomoney will create risks that increase instability logical innovations impact integrated regulatory systems in the and threaten national financial systems, according to the authors. context of the globalized digital economy dictates a similarly inte- As with many innovations, they note that this new technology grated response, with a degree of uniformity necessary between has had an impact beyond its original purpose. While regula- countries. As such, the authors advocate a process reminiscent of tors are still mainly focused on potential disruption to traditional the Bretton Woods model, with an international monetary con- deposits as means of payment, Kregel and Savona warn that this ference aimed at establishing coordination in order to secure the underestimates the potential for instruments based on distrib- potential benefits of these new technologies while enabling the uted ledger technology to have much wider, systemic effects. The formation of a more resilient financial system. authors observe, for instance, that ICOs (initial coin offerings) As always, I welcome your comments. represent an alternative mechanism for underwriting investment and allocating financial resources, while the proliferation of cryp- Dimitri B. Papadimitriou, President tocurrencies complicates the exercise of monetary policy as cur- June 2020 rently designed. Kregel and Savona warn that a single, unregulated private cryptocurrency platform could come to supplant other crypto- currencies and even the official payment system. What would effectively be a private monopoly on the payment system would imply loss of control over the money supply and thus debilitate monetary policy. Moreover, the dominance of a single cryptocur- rency would disrupt the intermediation process, interfering with the traditional functions of banks and capital markets. Levy Economics Institute of Bard College 3 Introduction ledger accounts were initially promoted as more efficient substi- In increasingly integrated global financial markets, innovation tutes for bank notes, bank deposits, or bank transfers. Yet these threatens the stability of national financial institutions and the innovations have the potential to displace bank liabilities as the adequacy of domestic regulation. Quasi-cryptomoney—in the dominant means of payment and threaten revenues for tradi- presence of portfolio choices and capital allocation based on tional banking institutions. And while the introduction of DLT algorithms generated by artificial intelligence (AI)—challenges can guarantee transaction security and transparency, the choice the 20th century interface of central banks and private financial of private or public platforms will have an impact on monetary institutions that provides for the creation of the majority of the policy. For example, if the incentive structure for verifying private capital assets and monetary liabilities in financial markets. These transaction chains determines the creation and distribution of innovations create regulatory uncertainty for financial institu- digital currency (e.g., via mining), this would require reformu- tions, and the failure to apply suitable regulation increases the lation of monetary policy instruments and objectives. Further, potential for instability and recurrent bank and financial crises. the creation of hundreds of private cryptocurrencies already in This policy brief outlines the current institutional framework and circulation (Bitcoin, Ethereum, tokens, etc.) creates substantial evaluates competing proposals for managing the emergence of difficulties for monetary policy designed for a system organized technological innovations such as distributed ledger technologies around the control of interest rates for regulated institutions. (DLT) and data science methods. Competition in the introduction of digital currencies via ini- Prior to the era of globalization, domestic socioeconomic tial coin offerings (ICOs) represents an alternative mechanism of conditions, along with policy and regulatory responses, were underwriting private investment and threatens investment bank- the major causes of differences in national financial systems. ing activities, as well as providing an alternative mechanism for However, globalization has mitigated these country differ- allocating financial resources. While data science may deliver ences, particularly in banking and capital markets—through, for more effective portfolio allocation of private savings, it may also instance, European Commission directives and the promulga- distort the allocation of funds for productive investment. tion of global standards by the Financial Stability Board and the These changes have generated and will continue to gener- Bank for International Settlements’ Basel Committee on Banking ate subsequent actions and actors outside the confines of tradi- Supervision. As a result, financial innovations in instruments and tional monetary and capital market regulations, and have drawn methodologies and the national responses to them—which have the attention of government regulators in a number of countries. generally been implemented outside formal regulatory regimes— An array of different responses has been proposed, initially con-