What are deposit tokens?
And why they might be more important than cryptocurrencies and even CBDCs
On the go? No problem. We have you covered with the audio version:
Forget the wild gyrations of Bitcoin. A new type of digital money is stirring excitement within the walls of Wall Street giants. These are deposit tokens, essentially digital IOUs for your traditional bank deposits. But instead of residing on a bank's internal database, they exist on a secure, distributed ledger called blockchain.
Imagine a dollar in your checking account, but rather than a simple entry, it's a token you can hold and even trade. This seemingly minor change unlocks a world of possibilities. Deposit tokens offer several advantages over traditional commercial bank money, which accounts for over 90% of circulating money today. There are two key differentiators.
The first is instant settlement, a quantum leap compared to the days and weeks currently prevalent in international transactions. This is enabled by a simultaneous exchange of assets and money (= atomic settlement). The money and the assets are directly linked to each other to ensure the transfer can only occur simultaneously. This speeds up many transaction types such as cross-border payments, thus slashing the hefty costs associated with it.
The second advantage of deposit tokens over traditional money is their programmability. Thanks to blockchain’s smart contract capability, the tokens can be instructed to perform specific actions upon meeting certain conditions. In other words, I can set up if-then scenarios on a tamper-proof, incorruptible ledger and thus highly automate processes. For those familiar with traditional cryptocurrencies like Ethereum: Imagine it like a centralized variant of DeFi.
It is no wonder then that titans of traditional finance are leading the charge. Like with many other blockchain applications, JPMorgan Chase is at the forefront of deposit tokens. America’s largest bank already introduced its JPM Coin in February 2019 for its institutional customers. Later it participated in Project Guardian, a collaboration with the Monetary Authority of Singapore. The project saw a successful usage of deposit tokens as the settlement mechanism for a currency trade between Singapore and the Japanese yen, thus showcasing their potential for cross-border payments, asset purchases, and automated market making.
Deposit tokens are the grown-up cousin of private stablecoins
Cryptocurrencies have never really been a realistic contender to the current monetary system. But the blockchain does offer two highly promising alternatives to speed up clearance and settlements: Private stablecoins and CBDCs. So why do we need deposit tokens?
Let’s first look at private stablecoins like Tether or USDC. They are not traditional cryptocurrencies. Though they rely on distributed ledger technology they have their value fixed to fiat currencies, mostly the US dollar. One USDC always aims to be worth as much as one dollar. But numerous investors have burned their fingers on such stablecoins when some of them lost the peg to the dollar and imploded. Issuers of private stablecoins don’t need to have the deposits to back the coins in circulation. Even if they claim they do, there are no external control mechanisms in place. Most coins are undercollateralized, some are outright scams.
Unlike private stablecoins, whose backing can be shrouded in secrecy, deposit tokens are directly tied to deposits held at licensed banks. This inherent connection fosters trust among users, mitigating concerns about the underlying assets supporting the token's value. Furthermore, deposit tokens operate within clear regulatory frameworks, ensuring transparency and adherence to established financial rules. By utilizing existing banking infrastructure, deposit tokens benefit from a unified risk management framework. Additionally, deposit tokens can be eligible for deposit insurance, offering yet another layer of protection for users.
Can deposit tokens offer more than CBDCs?
The other blockchain alternative deposit tokens compete with are CBDCs. Those are digital currencies based on a blockchain but issued by a central bank. A Fed-CBDC would be the equivalent of a dollar in cash, only recorded on a blockchain. CBDCs are very similar to deposit tokens. The only difference is the issuer. Deposit tokens are on the balance sheet of a commercial bank, CBDCs on that of a central bank. So, CBDCs are actually more secure as the risk of default is zero. The other advantage of CBDCs is that they are interoperable across the entire economy. So why bother with deposit tokens?
There is the pragmatic argument: Deposit tokens can be introduced and scaled years before CBDCs. Neither the US, nor Europe, nor the UK will see a functioning CBDC before 2030. It is even possible they will never see it.
Then there is the ideological argument: All innovation since the advent of blockchain has been driven by the private sector. The central bank getting into the arena would build on these private pioneers, yet at the same time it would end or heavily impede further innovation. Private actors would compete with somebody who cannot fail commercially and who has the power to regulate them. This is everything but an efficient market.
Last but not least, privacy fares far better under a private sector solution. On the one hand, because a commercial bank’s customers have other alternatives if their data are misused. And on the other, because there is an independent authority that can levy fines on private actors and even withdraw their license to operate. Not so with the central bank. Study after study shows that privacy tops the list of user-concerns about CBDCs. This means that a huge chunk of the population, if not the majority, might boycott CBDCs, which would leave any such initiative dead in its tracks.
In essence, deposit tokens bridge the gap between the innovative world of digital currencies and the established trust of traditional banking systems. With their clear regulatory framework, unified risk management, and potential for deposit insurance, deposit tokens offer a compelling alternative for those seeking a secure and reliable option in the ever-evolving digital currency landscape.
Can only banks offer deposit tokens?
If deposit tokens are so powerful and banks are the only actors that can offer them, does it mean licensed financial institutions de facto cannot be challenged in the money business? Not completely.
Readers of The New Frontier or my books will know that there is one actor group that I see as the main challengers to commercial banks: The five tech giants Meta, Apple, Microsoft, Alphabet, and Amazon. Their entry into finance has been and continues to be the most transformative trend in decades. Tech titans are becoming increasingly more like banks and are thus in a better position to issue deposit tokens than any other type of company. Some are taking deposits with licensed partners (e.g. Apple with Goldman), others have tried to do it without a licensed bank (e.g. Facebook’s Libra initiative), and China’s tech giants have already obtained banking licenses themselves (e.g. Alibaba’s MyBank).
The only question then remains how far Big Tech is in its blockchain efforts? Read my latest book and you will be stunned: Big Tech in Finance: How to Prevail in the Age of Blockchain, Digital Currencies and Web3.
Note: None of the content of this article and this newsletter, nor my books, presentations, and seminars is legal, tax, financial, or investment advice. Nothing contained constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instruments. The content is gathered from publicly available information and the expertise of the author. It does not contain any insider information. Also, as an Amazon Associate I occasionally earn from qualifying purchases.
Clearly this is the future of finance. Very illuminating piece.