Understanding the drivers of change

On top of these shifting foundations, the adoption of digital money will have far-reaching ramifications, with some transitions being easier to grasp than others. Amongst a large and diverse range of considerations that came up as we conducted our research, we believe the principal drivers of change will include:

• The demands and expectations of the users of money, whose digital experiences are becoming increasingly sophisticated.
• The regulations and international standards governing money.
• Competition in the financial services industry, including the competitive impact of emerging decentralised finance (DeFi).
• The technologies that facilitate the creation, exchange, and management of money.
  

The Demands and Expectations of the users of money

Digital money will thrive only if it serves the practical needs of citizens, businesses, and institutions, including governments. To be widely accepted, digital money systems will have to deliver tangible improvements to the lives of everyday people. The expectation is increasingly that money can be moved whenever, however, from wherever and to wherever a user wants it at low cost, if not for free. The big drivers of change, therefore, may be prosaic, with the future of money being digital so long as it is cheaper, quicker, better, and importantly, safer.

Of these, the most important consideration is safety. Whatever form money takes in the future, it must be perceived as safe to be trusted by users. That means them having faith that their money will be accepted for purchases, worth tomorrow what it is worth today, and able reach its destination as expected, when expected – secure from theft, fraud, disruption, and loss.

There will be added impetus too if, as seems likely, digital money enhances the availability of actionable insight. If data can be used to make monetary mechanics more secure, and more useful, then digital money will win out.

Regulation and International Standards

The future depends in large degree on the stances taken by governments, central banks, and regulators including the European Banking Association (EBA), European Central Bank (ECB), and European Securities and Markets Authority (ESMA), the UK Financial Conduct Authority (FCA) and Prudential Regulation Authority (PRA), and the US Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC).

While governments are typically keen to encourage innovation and competition in financial services, and innovation is already happening, central banks and regulators have other objectives that can sometimes trump innovation.

For some regulators, their primary objective is prudential, that is to maintain financial stability. As part of this, they will seek to ensure operational resilience by, for example, ensuring that payments operations can continue in the face of threats such as cyberattack and resilience issues.

Elsewhere, consumer protection is another important objective. Here the focus is on protecting consumers from frauds and scams, and also on enabling access to financial systems and ensuring fair treatment by regulated institutions. Similarly, they seek to ensure that the financial system is not abused by 'bad actors’ for the commission of financial crime, including terrorist financing.

Given that sanctions are increasingly used as a tool of foreign policy, regulators also want to ensure that financial firms have the data and systems required to implement sanctions swiftly.

Regulatory bodies, therefore, are challenged with striking a balance between supporting innovation, competition, and access, whilst also ensuring that required controls are in place to protect the system and its users.

Competition in Financial Services

The payments ecosystem used to be relatively simple, with banks transferring money from one individual or business to another, enabling both non-card and card transactions. In these cases, infrastructure was provided by a small number of card schemes and other common infrastructure providers, owned by banks. These then connected with central banks, facilitating the movement of funds and, importantly, underpinning trust in the system.

Regulators have been seeking to engineer competition in payments, and financial services more broadly, for some time now. As a result, work has been done to lower the barriers to entry and promote innovation. In this way, they hope to increase the choice available to customers and reduce their reliance on a relatively small number of institutions.

These attempts have only had mixed success, however, with some barriers to entry, such as the cost of deploying new infrastructure and building scale, persisting.

This is now changing.

The arrival of new innovators, the growth of FinTech and the role of larger tech firms and ‘platform businesses’ continues to build momentum, with the adoption of alternative methods of payment increasing, particularly when integrated smoothly with other services, such as lending and eCommerce marketplaces. This has put pressure on the historical revenues of established providers, who are ‘upping their game’ in response.

However, this competition has largely been running on the same payments ‘rails’ as historical services. Now, a new field of play is emerging in the form of Decentralised Finance (DeFi), with alternative options for customers seeking both familiar and novel financial services. DeFi represents the leading edge of a rapidly evolving field of design that seeks to harness emerging technologies like blockchain, and distributed ledger technologies more broadly. While the market level adoption of these solutions is currently nascent, the rapid growth of this space is being driven by a cadre of increasingly innovative and sophisticated solutions, which should not be overlooked.

Moreover, the scale of infrastructure change arriving over the next decade will be unprecedented, with new payments infrastructures being deployed across the UK, Europe, the US, Asia, Africa and the Middle East. New global payment messaging standards are also being rolled out internationally, and central bank digital currencies (CBDC) are in development across more than 110 nations, heralding a fundamental re-architecture of the existing financial ‘rails’.

Advances in Technology

Digital money would be nowhere without advances in technology. While innovation does not render change inevitable, it makes it possible, despite a range of hurdles which must be cleared. Some of these will be easier to overcome than others, made trickier to navigate both by their relative complexity, and as a result of inertia and forces of vested interest that impede change. Such problems will be overcome once the tangible benefits of solving them are widely acknowledged to outweigh both real and perceived obstacles.

A key enabler of change in the world of money is distributed ledger technology (DLT), of which blockchains are a leading expression.

Currently, digital money blockchains are most often associated with decentralised, loosely regulated cryptocurrencies. However, in truth the future of all types of digital money – including CBDCs – may rest on blockchain infrastructure, other DLT-based innovations, or one of a host of innovative follow-on technologies that characterise the web3 revolution.

We are already witnessing the application of DLTs in starkly different contexts. Government coins and independent cryptocurrencies perhaps represent the opposite extremes of this spectrum, with stablecoins and reward coins serving other specific purposes in between. All are currently being developed on the same underlying technologies.

These technologies use cryptography to secure – critics may say hide – the nature and provenance of the data they store. However, not all blockchains are the same and there are some important differences when it comes to the ways in which different constructs manage participation and privacy.

For example, the public blockchains underpinning Bitcoin and Ethereum are open to anyone who wants to participate and do not have a central authority controlling access. Anyone can become a node in the network and validate transactions, add blocks to the chain, and participate in the consensus process that validates transactions. In contrast, permissioned or ‘private’ blockchains set restrictions on who can access and participate in their networks. Typically operated by a single centralised entity or consortium of companies, they require permission to join and are, by their natures, not fully decentralised.

Another major difference between public and permissioned blockchains is in the way they handle privacy. Permissioned blockchains tend to address the need for confidentiality in ways that public chains do not, since private chains have a defined set of participants, and often employ further elements of data segregation (for instance so that data relating to a transaction is only shared with parties to that transaction). Public blockchains, by contrast, are generally designed to be transparent, with all transactions visible on the network. While each version may appeal to a different use case, both will have applications in the future of money.

The importance of cryptography

In a blockchain, transactions in the ledger are recorded in blocks, which are digitally connected to one another to form a chain. Each block contains a cryptographic hash – a fixed length string of characters representing the data held in the previous block – creating an algorithmic link between the blocks, resulting in an immutable record of all transactions on that specific chain. To ensure the integrity of these transactions, public-key cryptography is used to ensure every transaction is digitally signed by its originator, building confidence in the validity and integrity of data.

In this way, cryptography sits at the heart of the blockchain, helping to ensure data security and integrity through the creation of a ‘tamper-proof’ ledger – one that is resistant to hacking, fraud, and other forms of malicious activity.

This is a technology that continues to evolve. The Bank of England, which has published a consultation paper examining the case for a ‘digital pound’, has said that its CBDC may not be on a blockchain.

Wider Technology Advances

As institutions come to grips with the technological considerations associated with the future of money, FinTechs will more than likely continue to be the engines of early-stage innovation. In collaboration with other entities – including firms from across financial services and other sectors – collaboration will flourish as new innovations are analysed, viability is tested, and, where appropriate, value is delivered at scale.

The success of digital finance may depend in large part on such breakthrough innovation. Take, for example, proof-of-ownership technologies such as non-fungible tokens (NFTs). To date, NFTs are best known for their applications in the areas of fine art, music, and other media – from trading cards to short videos of basketball dunks – but their potential is far broader. Financial assets, including mortgages, business loans, equity, and bond investments may in future rely, at least in part, on the same underlying NFT technologies as these more fringe use cases. There may also be opportunities in corporate finance and asset management waiting to be uncovered and exploited.

Elsewhere, quantum-computing, currently still in the early stages of development, has potential to material impact the development of payment systems. The extraordinary processing power of quantum systems could, for example, provide a solution to the energy intensive processing requirements of DLT infrastructures that limits the scalability of current systems. It is also likely to be at the heart of a new encryption battleground as both the attackers and protectors of data seek to apply the technology across the payments ecosystem.

Meanwhile techniques involving artificial intelligence (AI) and advanced analytics will find a range of valuable uses when applied to the payments data flows as part of a future financial system. For example, how institutions view and analyse money flows , for example, to inform our understanding of sustainable supply chains, provide insights into customer behaviours and business performance, and deliver improved standards of financial crime risk management, albeit in a balancing act with data privacy concerns.

Other tangible advances in technology include the emergence of so-called ‘smart contracts’ – pre-programmable agreements designed to self-execute once certain specified conditions are met – though mainstream adoption is yet to materialise. When it does though, a parent will be able to program a digital currency to be used only by their child and only, say, for spending on certain essentials like food and clothing but not, for example, alcohol. Programmable money may also find applications in loyalty schemes, multi-party highly manual transactions such as home buying, tax collection and the delivery of other government services, including grants and loans.

Additionally, ‘near-field communication’ (NFC) technology, which already facilitates payments for goods and services without the need for a physical payment card to be present, will be integral to the smooth operation of digital-money networks. NFC-enabled devices, such as smartphones, are already commonplace in developed and developing economies and are becoming increasingly ubiquitous in communities up and down the social scale right around the globe. This technology also underpins the use of digital wallets, which are rapidly becoming a critical point of competition for consumer attention across all areas of commerce.

Big technology firms and platform businesses are giving significant focus to delivering superior customer experiences around the provision of contactless payments and wallet applications integrated into smart phones and smart watches. While curbs are being introduced, vast amounts of valuable data are also collected from customers that can be used to better understand their needs and enrich their experiences. It remains uncertain whether those firms will seek to obtain their own banking licences – or even if they want to – but, nevertheless, they will continue to play an important role in the future of money.

Coming up: We outline how we developed a scenario framework to analyse the future of money and begin to explore four scenarios.