Tim Graf (TG): This is Street Signals, a weekly conversation about markets and macro brought to you by State Street Global Markets, the markets and financing division of State Street. I'm your host Tim Graf, European head of Macro Strategy.

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And with that, here's what's on our minds this week.

This week we're going to talk about digital assets and a lot about central bank digital currencies, or CBDCs. As someone who has always approached cryptocurrency with a healthy dose of skepticism, and who is sadly also old enough to have seen plenty of investing fads come and go in my lifetime, I can't help but question the hype we have seen around them.

But that is what is so amazing about crypto right now. A private floating currency like Bitcoin is still near all-time high levels. It got there, thanks in part to very strong retail flows into institutional ETF issuance, among other reasons.

But that hype has actually died down. Bitcoin is a lot less volatile than it used to be, and price is still holding in. So as skeptical as I am, it's hard to argue against the notion that cryptocurrencies are here to stay, likely permanently.

And that's where this week's discussion gets really interesting, because that is also increasingly the case, I think, for safer stablecoins and then potentially central bank issued digital currencies. And my guest this week follows these trends closely, and I'm thrilled to have her on the podcast for the very first time.

Antoinette Schoar is a professor of finance at MIT's Sloan School of Management, and she's one of our academic partners who specifically focuses on trends in digital assets. Last week, Antoinette and I sat down to have a conversation about stablecoins and CBDCs as part of State Street's annual Official Institutions Conference held in Boston, from which this week's episode comes. I hope you enjoy it.

Nice to meet you, Antoinette. In person, no longer virtual so yeah, we're here today to talk about digital assets, central bank digital currencies. This has been something that has captured the market's imagination in some form or another for 15 years now. But now we want to talk about the future.

The proponents of cryptocurrencies, or CBDCs, they profess to their safe haven qualities. But of course, there's been a lot of volatility, not necessarily in stablecoins or CBDCs, but in Bitcoin, as one example. But there's a well-developed ecosystem for these freely floating currencies where that's less the case on CBDC.

So I think the progress we can talk about so far is that it's at the idea stage. I think there's some work being done, but with this session, I think we want to talk about where things can go and then what are the risks.

So as a baseline to that, I just wanted to see if you could start with the general trends around digital assets now, and particularly on the institutional adoption side. Where do we stand?

Antoinette Schoar(AS): Thank you. Yeah, these are very good questions. So I would say the following. If you think about the digital asset space, there are, as Tim said, CBDCs, which would be in, for most countries, this is still in hypothetical space, but almost no economy has issued a CBDC. There are a few exceptions, like the Bahamas or Nigeria have very limited introduction of a CBDC, but the large economies are not there yet.

TG: The volatility is always seen as an impediment to the adoption of it, as digital gold is the way it's referred to. It's interesting looking at realized volatility on something like Nvidia. It has weeks where it is more volatile than Bitcoin, which is quite interesting, given people are, I think, much more comfortable with Nvidia as an investment vehicle than maybe Bitcoin.

Do you think the stability, the relative stability to say tech stocks is sustainable, and that digital assets in that regard can have a more long term focused future as asset?

AS: A very interesting question. I would actually break it down in the following. Now, of course, Nvidia is one of the historically most volatile individual stock that you pick. I know you picked this on purpose, but actually, as a finance professor, I would also say I would not be so comfortable if retail investors just invested in Nvidia exactly as I wouldn't want them to take the big idiosyncratic risk in anything.

I would say the following. From all the research that we have done, it actually seems that the volatility of coins like bitcoin or ETH and so on is actually one of the attractions that draws the retail investors to those tokens. It's not that they're looking for stability in those tokens.

Now I see some of you smirking or smiling. People can make those choices as long as they understand what they're getting into. What we have seen actually, which is actually quite surprising, is that if you look at the Bitcoin market over the last ten years, even on centralized exchanges that have become like the Binance and Coinbase and the Geminis of this world, the implied volatility has actually not gone down, even though the market has become very deep.

So this tells you, right, that this is basically, but people are attracted to it. So it tells you basically that the disagreements and dispersion in the beliefs of where Bitcoin is going, right, has not been reduced, even when the market liquidity became very big. But this is also why this parallel ecosystem of stable tokens, whether it's stable coins or CBDCs, will always be important in that ecosystem, because people don't love to be in volatility all the time. They want to have something safe to trade into when they're getting out of the wallet.

TG: You've done my moderating job perfectly. And that is exactly what I wanted to talk about next where stablecoins and central bank digital currencies are the focus of this panel.

First, can you talk about what are they, a stablecoin? Let’s start with that and how is a stable coin different than the perceived idea or the conceived idea of a central bank digital currency?

AS: If you think about it, stablecoins are privately provided safe assets. That’s very important to understand. And the stability of a stablecoin depends basically on the asset that is backing them. So for example, if you think about Circle’s stablecoin, which is backed by cash, like safe assets, like fiat currency, US Treasury bills, and it is supposed to be held in well-regulated banks, right? In some sense, as long as the place where these backing assets are held, the stablecoin is as stable as the assets that are backing them.

Just as an aside, if you think about it, Circle is actually very transparent in how it documents where its assets are held. But when there was the SVB, Silicon Bank, Silicon Valley bank crisis, if you remember, Circle had some money held at Silicon Valley Bank, even though it was in cash, and cash like securities, people got very nervous because the regulated entity that was holding the money was getting into trouble until the Fed announced or the Treasury announced that it would be all fine. There was some volatility there.

But in some sense we can think of if they are well regulated stablecoins, and it's clear, the quality of the backing asset is clear. These stable coins can be as stable as the fiat currency.

What's also important from an economic perspective is that stablecoins do not allow the issuing issuer to create new money because, right, for every digital dollar that Circle creates, or any Tether, let's say one other dollar is put into a bank account, so to speak, to back the circulating dollar and we come there. But that's different from the CBDC.

And then just the one final little thing I want to say. We have seen some attempts to create stable coins without the stability of fiat currency or US Treasury. So famously, for example, the Terra Luna crash, that especially in Asia, actually created a lot of hardship for people who were holding this UST, the stablecoin token. That was an attempt to create a stablecoin without stable collateral outside the system, but actually by backing the stablecoin inside the crypto system with a very volatile crypto token. And that led very quickly then to an implosion.

This is just to say that we need to be very aware that the stability of the stablecoin really depends on the quality of the asset backing.

TG: Well, thinking about now, central bank digital currencies and moving into the more public domain, I wanted to see if you could go into a little bit more detail, particularly for the major economies, the US, China, the eurozone, can you talk about the progress and the efforts made so far and where they stand and their attitudes and approaches towards issuance of a CBDC?

AS: Absolutely. So I would say that from what I've seen, and some of you might have also read some of this, but the US, the Fed has taken a deliberate stance of, in a way, wait, do some research and see. Let's say it this way, right?

So, what the Fed is doing is it has a task force and a whole division that is investing in understanding some of the technological needs if it wanted to issue a stablecoin, right, and intellectually being basically involved in some of the research on what are some of the demand for it.

But the US has deliberately said two things. One, that it's currently not at all in a rush to issue a CBDC because the belief is that the payment guardrails, if you want, or the payment rails that are available in the US outside of CBDCs are good enough and efficient enough that it doesn't necessarily need a CBDC.

The second thing, and there might be some disagreement around this, but I think even with the introduction of FedNow and the overall system, is that at least on the wholesale side for the US, the payment rates are functioning very well.

Now, the other thing the Fed has said, which I think is very important, I very much support this stance, is that they have said that if they were to issue a CBDC, they would not want to disintermediate the banking system, which is a very big risk we will maybe talk about a bit later. But basically, what does this mean? So the Fed has said we will not be the retail bank provider of last resort. Because if you think about it, a CBDC, if we have a CBDC in the US, you could potentially hold the CBDC on a platform managed by the us central bank. Right. By the Fed.

The truth is that I think we all wouldn't like that because we wouldn't like the Fed to be in charge of the cybersecurity issues, the convenience of the interface designing, how that CBDC interface interfaces with private, your private bank access and so on. Right.

And so the idea that the Fed has floated, and which I think is very good, is to say that even if we had a CBDC, it would basically be intermediated by the private banking system and it would be in an account, a digital account that would be held by your, whatever the choice of your private bank is. And I think this has many benefits and I think it's a good idea.

I think if you look at Europe, I mean, the ECB, I think they're basically at a similar stage. The UK, I think, again, at a very similar stage. I think the UK central bank has been more outspoken that they really are not in a rush to issue any CBDC. And I think in general are a little bit more hesitant in the adoption of digital assets in general to start.

TG: With just the end user or the investor, especially with a room full of sovereign investors and potentially reserve managers. What advantages do you see in digital currency versus fiat, or in terms of their current ownership of reserve currencies, what advantages do CBDCs offer them?

AS: If CBDCs would replace fiat cash currency? I think there's a benefit that you actually have more for the central bank. You have in a way, more control of where your digital dollars are sitting. While, of course, the question of privacy then will become a very big issue.

But if you think about right now, just abstract from privacy, right now, there's a lot of dollars sitting in many parts in the world, cash dollars that are used for activities we might not like, like illegal activities, but they also often are just sitting there as a savings vehicle in countries where maybe the home currency is very volatile.

So I, and that actually means that there we have an approximation maybe of how much is sitting in different places, right, literally away. But often it's actually tough to know what the active circulation. So what I mean with this is the following. There are two incidences where you can see that it sometimes can havoc. So when Europe went from to the euro currency and say the German mark and French franc and so on were abandoned, the German mark had been a vehicle of cash savings in a lot of eastern Europe.

And actually the euro area finance system at the time was shocked how much marks were flowing into the central bank, because they gave people a window to exchange that money and they had thought a lot of that money had been abandoned, but then a lot of it was flowing back. However, several years later, there were people who were then trying, who woke up and said, oh, this was my retirement savings, I now want to change this into euro. But the window had closed and so these people, maybe very innocent people, had lost a lot of their savings, right.

I'm just saying that in this world that we live in, that's so digital, there are lots of efficiency benefits, right, from having the replacing physical cash that's completely untraceable with digital cash. And it's a benefit for the central bank in managing where its reserves are sitting, where its reserves are flowing, and even for people, better, because many of you probably have changed seasons and you grab into your pockets and you suddenly find the money that in the winter, last winter, you put into a pocket and forgot. I mean, this is for an individual, not a lot, but in general, this is just an inefficiency in the system.

And I think that basically ledger keeping, record keeping, can be beneficial here. The one issue from the private side that we will have to grapple with is how to deal with privacy issues. Because if the central bank has really a CBDC that it can follow from everybody's pocket into everybody's pocket, and knows where you're buying, where are you paying for things and so on. That is obviously sensitive data that we might be very careful, want to be careful about.

TG: From the perspective of the investor and their demand for currency, and digital currency in this case, what do you ultimately think they want CBDCs to replace? What need do they fill? Is it to replace fiat currency? Is it to just replicate and replace stablecoins?

From their perspective, what do you think it could replace? And then from the issuer's perspective as well, how aggressive or how, how forward thinking do you think they are in terms of what it could replace?

AS: Yeah, this is a really good question. And as usual as an economist, I'm really, really bad at hypothesizing about the future. But let me give you my best two guesses on your question.

So I actually would conjecture that CBDCs will not replace stablecoins, because stablecoins, if you think right, right now, are being used mainly to trade on DeFi platforms, to trade not even to be on centralized exchanges, but on decentralized exchanges, decentralized finance apps. We have seen that many participants who want to trade on these decentralized systems do not like the ability of certain stablecoins and the willingness of these stablecoins to trace where you're going and to freeze your stablecoin.

So, for example, one of the reasons why, say, Circle in comparison to Tether is not making as big inroads as you might think, given that Circle's stability is much more guaranteed because its assets are much more transparent. But still, many people do not like the fact that Circle has said that it's willing to freeze stablecoins when it can be shown that the holder of that stablecoin is using it for, say, illegal or untoward purposes.

And Tether has always pushed back on this. And so it already shows you that there is clearly a demand for people who want to stay completely untraceable. And I think the worry that the CBDC will be even more right, of course, regulated, and create that opportunity for the central bank to interfere, that will actually make it less of a substitute for these type of stablecoins.

I think for people who live in a digital world that have a good, well functioning banking system, most of the US, let's say, or Europe, the competition from stablecoins to replace, or from CBDCs to replace fiat currency will purely be an issue of competition of price.

What I mean with this is that we have already seen, right since the onset of the big debate of cryptocurrencies, suddenly payment platforms have woken up and have realized that the beautiful monopoly rents that they have been sitting on for the last so many decades are coming somewhat to an end.

And you see now lots of attempts to bring down fees, but maybe even more importantly, to modernize the payment system so that we have many more functionalities in our payment system, given that we are in the 21st century. And so I think I that as long as the CBDC is mainly a competition to the private market, to reduce prices and to reduce rent, it can actually lead to a lot of interesting new innovations and a benefit to all of us.

TG: Well, let's go there then, because I think the final bit of this I wanted to get to. And you've had a slide up talking about CBDCs and their interaction with banks. And we're going to talk about that in a moment. The first is to speak to those efficiencies that digital currency and a central bank digital currency specifically might offer the end user.

Can you elaborate on that a little bit more as to specific benefits that the user now, forget about the investor, but the actual, whether it's part of the payment system or just imagine the future, again, not something necessarily we're always great at, but I'm curious to hear about the potential efficiencies that might be gained versus existing payment systems or cash into that, right?

AS: So I would say two things. One is that the CBDCs allow retail investors to have cash at hand without needing physically to carry cash around. And therefore, depending on how the central bank sets up this system, really reduce the fees that are being charged on these transactions. Because if, as you all know, currently, say, Visa, Mastercard or PayPal or what have you, that are providing this infrastructure, are charging quite a bit for that infrastructure.

And in fact, at least in the US currently, even if you use cash, merchants are not, for example, offering you different prices on cash purchases, even though you're not using the payment reel from the credit card system. And so that actually keeps prices for everybody higher. And so here, the CBDC could offer the same conveniences of other digital forms like your credit card and so on, of payments, right. And enhancing competition in this market. Right.

The other benefit, but that's also a risk, I would say, is that if you, in terms of crisis, so let's say in terms when there might be an instability in the financial system, if people have money in the form of access to a CBDC, they can exchange their savings into a CBDC. And therefore they, in a way, if you think about it, right, they don't have to wait for a bank to collapse.

When they're worried about a bank collapse, they can get basically run on the bank, but run into something safe, basically run into the central bank rather than what is normally happening. Your money is, say, in a bank that is in turmoil. And you have to wait until the regulator, if you think about what happened at most recently at Silicon Valley bank, right, you have to wait until the regulator decides how to handle that bank in crisis. And so that's privately a benefit for the individual saver, let's say at a bank that is in trouble as a system. And that's kind of the question of the disintermediation of bank that could create stability issues.

TG: Yes. What systemic risks, I think, do we need to think about with respect to this?

Can you kind of describe in detail a worst case scenario that the introduction of this might mean for the financial system?

AS: Right. Imagine all your money, all your savings could be, at any moment's note, at a moment's notice, be changed into central bank dollars held at the central bank. What that would mean is that we would now allow people to have runs on steroids, if you want.

Because normally what happens is that even nowadays you have your money at a certain bank, when there are rumors, whether there is an issue with this bank or not, typically there is, in a way, delay or cooling period to figure out is this bank really in trouble or not? And if it is in trouble, that's why we have deposit insurance, that's why we have central bank oversight and so on, to make sure that we know which banks people should basically take their money out. And if they weren't quick enough to take their money out, deposit insurance makes sure that at least, say, the middle class or lower middle class savers are made whole.

But the problem that people have pointed out is that when individuals can run on their banks at a moment's notice, they might also run just based on rumors. And when they run on rumors, they might be creating instability that's not even there yet.

And in fact, if you think even worse it could be, then how to say ill meaning people could create these rumors to maybe undermine their competitors or undermine your country's financial system, because nothing worse than having havoc in a financial system. And there are some papers that have shown in some developing countries, actually, competitors sometimes do this.

Let me say the last thing on this is that this runnability and the risk that comes from this runnability is not completely hypothetical. But this is actually a really nice study that was done by Ayer and co-authors, published in the Journal of Financial Economics, that does the following.

It looks as this is from Denmark, where they have all the data on all depositors. And what they look at is there was an incident when the sovereign crisis in Europe. In Denmark, there were a few banks that were declared already too big to fail. And everybody knew that those banks would not allow to let go. All the other banks were not too big to fail.

And what you see massive drop in their deposits and people running into the systemic banks. And what they saw is basically, you know, that people were very sensitive to run into systemic banks. And also, even though there was, in the end, no crisis in Denmark at all, it was just because in Europe there was a crisis. Those deposits never came back to the smaller banks and actually then led to more concentration of the banking system and where the deposits were.

And so to me, you know, and there are other places where people might not have had as nice data, but they showed something similar. Why is this concerning? Because if you think about if we now have CBDC that allows this to happen on steroids, and then people are not running into the too big to field banks, but into the central bank, what would the central bank have to do? It would have to recapitalize banks all the time, right? I mean, otherwise everything will always collapse.

But think about, if it is now the central bank that decides which banks to recapitalize, how quickly to recapitalize, suddenly politicization of the banking market would go through the roof because lots of people would then start saying, if you are closer to the political system or if you have more ties to the Fed or even politics, maybe your bank has first dins on recapitalization while other banks will be delayed and so on. Right. You can see that that actually leaves a door open to a lot of concerns in how efficiently the recapitalization will happen.

TG: I have a last question that has been brought to mind by some of the things you've just said. But as well, the concept you talked about of undermining each other potentially, this is something being pursued by sovereign nations. And sovereign nations, of course, have competitive interests and wanting to set the future for the guardrails and the payment systems of the future.

And I'm wondering if you could speak to that as a final thought. It's a very big question. So if you want to punt, that's fine by me.

But I'm just thinking that the major actors in the global financial system all have a vested interest of getting there first. And I'm wondering if you can speak to that where we stand and whether that worries you at all as a potential risk for this whole ecosystem.

AS: No, this is an excellent question. I would say two things. Clearly, sovereign actors are very aware of it, they're concerned about it.

But I would also say the following. If you think about it as a sovereign nation, right, you don't want, say, the large economies like the US or China or Europe to undermine your sovereignty in setting your own monetary policy. And so you really don't want a dominant US CBDC that is freely accessible by citizens of other countries around the world, because it does undermine those countries sovereignty.

And the US also has to be careful about it, because, you know, there's give and take, as you have seen with kind of the war in Europe. I mean, Russia, you know, the Russian invasion of the Ukraine, right. There is clearly a lot of thinking around the world of the fact that the US is such a dominant player in the financial system gives it a lot of power to help its geopolitical interests, also in an economic sense.

And so I think from the US perspective, it's important that it doesn't politicize whatever financial infrastructure it's providing because otherwise lots of countries will opt out of this system. All this points to if countries adopt CBDCs, it really matters how you design them. And I think the two big things that we need to solve is to avoid the run ability and to avoid the risk to other countries’ sovereignty.

Actually, several economists have proposed, and I very much agree with this, is that if there was a CBDC, the amount that an individual can hold in CBDC should be very limited, maybe something like US$3,000 or US$5,000 per household, so that it can be a cheap transaction vehicle.

But it cannot be this massive vehicle where your money can boom, boom, boom, right? Flee from a private bank to the government and back and so on. But then it also, if it's a limited amount, it makes it less feasible to be a savings vehicle for people around the world to just flee into the US when they want to avoid their own country's policies.

TG: Well, we've taken it from bitcoin all the way to geopolitics. Everything is geopolitics these days.

AS: No, it is.

TG: Antoinette, It's been absolutely fascinating. We are out of time. Thank you so much.

AS: Thank you.