Digitalisation has fundamentally changed the nature of social, economic, and informational interconnectedness, and so does the digital age revolutionise money and payment systems. We can now hold money on our mobile phones and transfer wealth across peer-to-peer networks to counterparties anywhere in the world. As a result of these developments, the barriers defining traditional currency areas (Mundell 1961) may break down.
What is a digital currency area?
We define a digital currency area (DCA) as a network where payments and transactions are made digitally by using a currency that is specific to this network. By ‘specific’, we mean either one or both of the two following characteristics:
- The network operates a payment instrument, a medium of exchange, that can only be used inside, between its participants. So, even if the network still uses official fiat currencies as unit of account and to back the payment instrument, that instrument cannot serve for transactions and exchanges outside the network. Typically, that is the case for some large issuers of e-money when their systems are not interoperable with others. Today, the main example is China, where both Tencent and Ant Financial have developed such networks with hundreds of millions of users, but with no mutual connection or interoperability.
- The network uses its own unit of account, distinct from existing official currencies. As an example, Facebook has recently announced the launch of Libra. It is designed to be a digital representation of a basket of existing currencies and therefore will define a new unit of account.
Analogies and differences from the traditional OCA concept
Obviously a DCA is very different from an optimal currency area (OCA) as defined in the literature.1 An OCA is typically characterised by geographic proximity and the ability of participants to dispense of the exchange rate as an adjustment tool. In turn, that implies some commonality of macroeconomic shocks and a sufficient degree of factor mobility. By contrast, DCAs are held together by digital interconnectedness. When participants share the same form of currency, whether or not it is denominated in its own unit of account, strong monetary links develop. Price transparency is greater inside the network, price discovery is easier, and conversion to other payment instruments is less likely and sometimes technically impossible. These monetary links further create an incentive to accumulate balances in the network’s currency.
Beyond those differences, however, DCAs and OCAs have strong similarities. They both emerge for the same fundamental reason: to minimise transactions costs and, more generally, frictions in exchange.
How does a DCA emerge and what keeps it together?
DCAs tend to arise on integrated, multi-sided commercial and social platforms in a digital economy. The business models of those platforms are based on economies of scale and scope created by the intense exploitation of data and the complementarities between different activities.2
Adding a payment function significantly strengthens those complementarities because payments and social and messaging activities rely upon the same network externalities. A common digital currency may in fact be the only way that network participants can fully exploit all the benefits of interconnectivity.
A decisive evolution occurs when the network allows for payments to be made directly between participants and are not limited to the purchase of goods and services. Those bilateral payments are made possible by mobile technology. Debit and credit cards, even when contactless, can be used only for purchases. They do not allow for direct transfer of money between individuals. Mobile money does. This is where technology matters. The emergence of mobile payments is a major driver in the formation of digital currency areas.
Digitalisation and the international monetary system
Digital networks are large, in fact larger than many national economies. They are not bounded by national borders. In the future, the international monetary system could possibly be structured around digital currency areas. Even if this does not happen, digitalisation could reshape international monetary relations through increased currency competition and new ways to internationalise existing currencies.
New currency competition
In a digital world, it becomes easier for (new or existing) currencies to compete with each other for two reasons. First, a currency supported by a digital network may be able to quickly achieve broad domestic and international acceptance. Second, switching costs – a traditional obstacle to currency competition – are lower. There are programs available on mobile devices that can be used to manage currency transformations. Several fintech companies already offer accounts in which one can swap across and pay with more than a dozen currencies. Existing and future applications should allow for easy and instant computation of relative prices and conversion of monetary balances from one currency to another as well as automatic arbitrage.
Digital currency competition will be starkly different from traditional currency competition. It will no longer be based mainly on macroeconomic (inflation) performance, which Hayek (1976) argued is the most important determinants of a currency’s adoption. DCAs will compete across many dimensions. Some networks may offer different types of automated conditional payments (‘smart contracts’) or interoperability with other financial services. Competition among digital currencies will effectively be a competition among bundles of information services provided by each network.
One dimension of particular importance is privacy. DCAs’ currencies could differentiate themselves by how the networks manage users’ data. Some networks could intensely exploit or sell users’ data, whereas others may prioritise absolute privacy.
Digital currency areas may lead to a less stable monetary architecture. If switching costs are low, people may be part of several different DCAs simultaneously, using each for a specific purpose, even if they are all attached to the same unit of account. While it is easy to switch away from a digital currency, though, the additional informational and social connectivity provided by digital networks promotes greater cohesion of DCAs, above and beyond the cohesion of traditional currency areas. The competition among exchange media within a network of economic activity may no longer be ‘winner-takes-all’ in nature, at least in its initial phase.
There are, schematically, two ways through which a currency can internationalise: by becoming a global store of value, as a reserve instrument; or by being used for international payments, as a medium of exchange. Historically, the two roles have progressively converged. However, different paths and strategies are conceivable for a currency to gain international status and use in the 21st century. Analysing the current dominant position of the dollar in the international monetary system, some economists emphasise its function as a reserve asset, based on the size, depth, and liquidity of US financial markets. Others (e.g. Gopinath et al. (2016) give more importance to its role in the denomination and settlement of international trade and transactions.
The distinction becomes relevant and important in a digital environment. Becoming a reserve asset is demanding as, in particular, it implies full and unconditional capital account convertibility. However, if international status can be achieved through trade, a country that is home to large digital networks could find new ways for its currency to gain international acceptance by exploiting the integrating effects of a DCA. Digitalisation may thus serve as a powerful vehicle to internationalise some currencies as media of exchange.
Symmetrically, other countries may be exposed to more intense currency competition from foreign currencies through cross-border payment networks.
Existing cross-border systems are currently pure infrastructures. They use domestic currencies as the medium of exchange and unit of account. However, that may change. As the example of Libra shows, private networks may be created that would give access to new and specific units of account to people in many countries. Even official currencies may progressively penetrate other countries' economies if supported by a strong digital network.
Importantly, while small economies (especially those with high or unstable domestic inflation) are susceptible to both traditional and digital dollarisation by a stable digital currency, economies that are economically or socially open to large DCAs will be uniquely vulnerable to digital dollarisation. As the importance of digitally delivered services increases and social networks become more intertwined with the ways in which people exchange value, the influence of large DCAs in smaller economies will grow.3
The best defence against digital dollarisation may be for countries to issue their own currencies in digital form by creating central bank digital currencies (CBDCs). CBDCs are hotly debated from the perspective of monetary policy and financial stability. However, they may have a more fundamental justification: to adapt domestic currencies to the new state of technology and, in the process, to protect them from outside competition based on digital superiority.
New boundaries in the international monetary system: A paradox
One may think that digitalisation will lead to ‘world global currencies’. But it may not be the case. Because digitalised money is inseparable from other essential features of digital networks, it will be subject to specific frictions.
Digital currencies encompass a wide range of payment and data services. The provision of those services will face unequally stringent types of regulation in different countries. One key issue is privacy. Approaches to regulation in Europe, the US, and China are very different. Differing regulatory frameworks may make it difficult for network operators to fully exploit economies of scale and scope provided by big data. It may be impossible to use the same digital currency in different jurisdictions.
This could be the ultimate paradox of digitalisation. Technically, digitalisation will break barriers and cross borders. But, because of its many inseparable dimensions, it may ultimately lead to an increased fragmentation of the international financial system.
Adrian, T (2019), “Stablecoins, Central Bank Digital Currencies, and Cross-Border Payments: A New Look at the International Monetary System”, remarks at the IMF-Swiss National Bank Conference, Zurich.
Brunnermeier, M K and D Niepelt (2019), “On the Equivalence of Private and Public Money”, Journal of Monetary Economics (forthcoming).
Gopinath, G, E Boz, C Casas, F J Diez, P-O Gourinchas, and M Plagborg-Moller (2016), “Dominant Currency Paradigm”, NBER Working Paper No. 22943
Hayek, F A (1976), Choice in Currency.
Issing, O (1999), “Hayek – Currency Competition and the European Monetary Union”, BIS Review 1999/66.
Mundell, R A (1961), “A Theory of Optimum Currency Area”, American Economic Review 51(4): 657-665.
Landau, J-P and A Genais (2019), Digital Currencies: An Exploration into Technology and Money, Report to the French Minister of Economy.
 The classic reference is Mundell (1961).
 The BIS (2019) notes that digital platforms base their businesses on a “data-network-activities” feedback loop: user data are used to provide services that drive network activity and thus adoption, creating more user data.
 Adrian (2019) outlines risks akin to digital dollarisation, remarking that digital money makes storage of foreign money safer and cheaper as well as making transactions easier.
 Brunnermeier and Niepelt (2019) provide conditions under which the introduction of CBDC has no adverse effects on the macroeconomy and financial stability.