Today, we're going to dive into money and the monetary system. Specifically, how money is created, the problem with money today and what the future of money looks like (and why it’s on the blockchain).

A few things to note before kicking things off.

Firstly, who's this post for? Anyone not involved in finance, economics or DeFi. We’re keeping things straightforward so everyone can understand, at a functional level, how money works today and how it's evolving. 

Secondly, I became immersed in this topic when I started working with the team at Millicent, who are focused on solving some big problems that arise from today's financial infrastructure. The below is a reflection of some of our thinking at Millicent.

Finally, a Full Reserve Digital Currency (FRDC) can also be cateogrised as a synthetic CBDC (sCBDC). There’s an important difference between that and a CBDC (Central Bank Digital Currency). We'll get into the nuances of this, but it's important to caveat up front.

Money is a technology

Before unravelling the acronym soup which is FRDC, let's zoom out a bit to understand the mechanics of money: what is it, how is it made and what allows it to function safely in society? The first thing to recognise is that money is a technology. Technologies change over time - and we're about to see money change once again. You can read more about the history of money in this piece by Millicent co-founder Kene Ezeji-Okoye.

To echo your Economics 101 lecturer, money needs to fulfil three functions:

• Be a store of value (it holds value over time)

• Act as a medium of exchange (it's widely accepted as a form of payment)

• Provide a unit of account (it allows us to measure the economic value of an item)
  

That's nice, but what exactly is money?

Well, what do you think of when you think of money? Many people might picture notes and coins. Yet despite it still being in wide circulation, physical cash only makes up 4% of money in the UK. That figure is a touch higher in the US, sitting around 11%. The rest is held electronically, known as 'bank deposits'.

OK, but how does money actually function?

Most developed Western Democracies have a 'two-tiered monetary system', designed around a central bank whose purpose is to maintain trust in money (e.g. The Fed, European Central Bank or Bank of England). On one tier, central banks supply cash and its electronic equivalent to commercial banks - these are known as 'reserves'. On the other tier, commercial banks provide deposits to individuals based on the central bank money they hold - these are the aforementioned bank deposits.

At this point, it's important to understand what it means for an entity to have a 'claim' on another entity. According to the OECD, a financial claim:

(a) entitles a creditor to receive a payment, or payments, from a debtor in circumstances specified in a contract between them; or

(b) specifies between the two parties certain rights or obligations, the nature of which requires them to be treated as financial.

Today, we use what's called 'fiat' money. Meaning money by 'government decree', as opposed to symbolising another asset such as gold. Historically, your banknote would be a token of gold (or other such asset) held in a vault, so your 'claim' would be to redeem the value of your token with the entity (the debtor) that held it. Today, an individual holding cash can claim that directly against a central bank. And if that individual holds e-money, their claim is against their bank. 

On the other tier of the system, reserves that are held by Commercial Banks can be claimed against the reserves held at the Central Bank. All of this ability to 'claim' is a protection mechanism built into the system, designed to maintain trust and stability to keep the economy functioning smoothly.

Let's get diagrammatical.

Here's what the (simplified) traditional two-tiered monetary system looks like today for you visual learners:

So... where does money come from?

The vast majority of money that is created is done so by Commercial Banks. Whenever an individual takes out a loan from the bank, that bank determines if the applicant has sufficient means to repay that loan (the applicant's 'assets', of which potential future earnings are considered). If so, the bank creates commercial bank money to the value of the loan. But banks cannot create as much money as they please - there are regulatory limits that prescribe how much capital a bank must hold, in case people default on their loans. This comes in the form of a ‘money multiplier’ - a ratio that stipulates the maximum amount of commercial bank money that can be created, given a certain amount of central bank money.

On occasion, a Central Bank creates money too, although this is less common as it can have inflationary effects (like we’re seeing now). They do so by buying securities on the open market and sending that money to commercial banks.

Enter crypto, stage left

As speculation and utility drew more and more curious souls (and their wallets) into web3 and DeFi, an emerging class of currencies surfaced that sought to bridge the worlds of fiat and crypto: stablecoins. The volatility of cryptocurrency prices render them all but useless for payments needed in everyday life - whether that's online, on-chain or IRL. 

Stablecoins are designed to solve this problem, pegging them to a fiat denomination (e.g. USD, GBP or the Euro). However, with fiat currency, there's trust and safety built into the system because of how they are collateralised by Central Bank reserves. So, how do you achieve an equivalent without the Central Bank's involvement? It can be done a few different ways and there are examples out in the world across the spectrum:

• Fiat backed: backed by fiat currency such as Euro, GBP, or USD

• Commodity-backed: backed by commodities such as real estate, oil or precious metals like gold

• Crypto-backed: backed by another cryptocurrency

• Algorithmic: uses specialized algorithms and smart contracts that manage the supply of tokens in circulation to stabilize prices

The reality is that none of these are as safe as today's monetary system as none of them are held in a central bank. Diving into the pros and cons of each is another topic for another day, but it's worth noting that we can finally write off algorithmic stablecoins after Terra Luna's disastrous crash.

Enter CBDC, stage right

Central Bank Digital Currencies (aka CBDCs) are digital money issued directly by the Central Bank. They come in a 'wholesale' variety, for use between banks. They also come in a 'retail' flavour, which we'll be referring to for this post. CBDCs have had, shall we say, a frosty reception in DeFi. The main concerns being that of privacy and government overreach due to it being on-chain and programmable. 

This could come in the form of limiting what citizens can and can't purchase, architecting social currency programs, modifying interest on the money or tracking how people spend in great detail. All of these are valid and not helped by the fact that China has been the first country to pilot a CBDC. And when I say 'pilot', it's a little more than that, with over 2 million people in the country participating. Over RMB 2 billion (~US$300 million) had been spent using digital yuan in four million separate transactions.

This is not an outlier case. 105 central banks—representing more than 95% of global GDP—are currently exploring CBDC. Some are rolling out soon, others will be up to a decade away. At this point, it's clearly that regulation is needed and is welcomed by many industry leaders such as Sam Bankman-Fried. It's also clear that there's an inevitability to CBDCs in some form. Yet the concerns mentioned above are real. The question we ought to be asking ourselves in this pivotal moment in history, is how can we design the future of money to optimise the net benefit to humanity?

To answer that, let's look at the systemic problems today and how distributed ledger technology can solve those issues.

Money works fine today, why do we need a different kind?

With blockchain came new possibilities with what could be done with money. Our world today has been built on a financial infrastructure that has allowed society to accomplish incredible things. From transferring money between people, to credit card payments to mortgages. This is all possible because of financial plumbing. But it has severe limitations. When I say severe, that may be an understatement. Here's a few facts:

• The programming language used for the financial plumbing tech stack is 60 years old. Folks are getting pulled out of retirement because no one today knows how to code new software on top of it.

• Keeping these systems operational costs hundreds of millions each year. This is a cost to the banks, but you, the banking customer, will be ultimately footing the bill.

• Retail merchants get stung with huge fees for the privilege of using the technology, with Visa & Mastercard raising fees once again this year amidst soaring inflation. These costs will erode already tight merchant margins. But they’re also being passed onto shoppers, as merchants can’t absorb them any longer. So much so, that the merchant surcharges are amounting to around $700 each year for individuals who use a 'no-fee' credit card

• International transfers can take a 20% cut of money sent to a family member abroad

• The poorest are penalised the most, with overdraft fees being a direct result of the technology and costs alienating 1.7 billion people from even entering the banking system (the unbanked)

These are just some of the problems. Blockchain unlocks some tidy solutions. The functional tech capabilities underpin radically different cost and incentive structures compared to what exists today. Of course, there are drastic performance improvements. Newer technology is also far cheaper to build and maintain than its 60-year-old counterpart. But it’s also a choice to make this network more accessible and affordable. That’s how you drive demand for the network, but also drive change for society. Here are a few examples of what that change can look like:

• Finally giving an on-ramp to the 1 billion unbanked who have a mobile phone, due to next-to-nothing fees; bypassing traditional retail banking processes that exclude them

• Undercutting existing financial infrastructure (card networks, remittance providers and foreign exchange) with far lower costs and transaction settlement times (which are almost instant, instead of taking days)

• Allowing micropayments, which haven't been possible until now, as transaction fees haven’t made small amounts worthwhile for merchants. Soon, you will be able to buy a single newspaper article for £0.15 (instead of a £15 monthly subscription), or a streaming episode for £1, or pay a street busker 50p with a QR code

• The money can be programmable, so it can power the machine-to-machine economy, allow 24/7 real-time settlement, or act as a currency that can only be spent with shops in a geo-fenced area, powering your local community economy

• Finally, it can enable an accessible on-ramp to DeFi, with peer-to-peer lending and high interest savings

So, WTF is an FRDC?

A Full Reserve Digital Currency (FRDC) is how we can do all of the above points, safely. It’s also known by another term, a synthetic CBDC (sCBDC). We’re avoiding that terminology so to avoid confusion regarding who is the issuer (private or public). For more on sCBDC, there are a couple of good articles from the Digital Euro Association and the International Monetary Fund.  

An FRDC a privately issued stablecoin, which provides a much-needed layer between the public sector and end users. The assets are backed by full liquid reserves held in a ring-fenced and safeguarded account at the central bank. An FRDC is neither a pure stablecoin, nor is it a pure CBDC.  It’s a hybrid that bridges the two, to deliver the benefits of both systems, while mitigating their weaknesses. This unique structure minimises risk (of liquidity, counterparty and intermediary), while simultaneously protecting against the erosion of rights, and invasion of privacy.

Millicent recently carried out the world's first test of an FRDC aimed at the retail market with a demonstration for UK Research and Innovation. The solution, the technology and the timing are all aligning and are destined to make a big impact.

What does it mean for me as a regular person?

All of this will be easy for anyone with a smartphone or a computer. Mass adoption requires a user experience that is familiar--the innovation is behind the scenes. So people can pay for things in the physical world, online or in the metaverse simply and seamlessly. 

The 'net benefit to humanity' is driving everything we do at Millicent. We believe that money that is designed collaboratively between people, business and government can progress humanity more than any other technology. It's why we're giving people a seat at the table for an evolved monetary system. It's why we're focused on helping small business owners. It's why we're protecting privacy whilst increasing access. Everyone should be able to experience the benefits of the financial system. A people-first financial infrastructure is the future of money we all need and it’s well overdue.