BIS Annual Economic Report 2020 Box III.A The payment system, trust and central banks Why do we pay? We pay because we are not trustworthy in the eyes of most. To quote John Moore and Nobu Kiyotaki: evil is the root of all money. In this world, the payment system can be a force for good. The payment system started with debt as people traded only with those they knew and trusted. Trade with strangers required a method to substitute for a public record of reputation. Societies coordinated on using physical objects, such as shells, gems or precious metals. It was agreed that the transfer of these objects by one individual to another would forever extinguish the debt claim of that individual held by the other. In technical terms, the payment was considered final. Finality is defined as the irrevocable and unconditional transfer of an asset in accordance with the terms of the underlying contract. The exchange occurs at a legally defined moment and cannot be reversed.‚ Legal rules characterise the circumstances under which a payment is final. Without it, one cannot trust that a transfer of (bank) funds necessarily constitutes a payment. Once societies adopted a monetary convention, rulers quickly realised they could gain from controlling the supply of money. Merchants trading coins knew the issuer, as rulers minted their profile on a side of each coin. The value of this money was backed by the degree of trustworthiness of its issuer. However, absent sound governance, rulers could not be trusted, and debasement was not uncommon. Demands for sound governance and a more efficient payment system were often reasons to establish a central bank. In many countries the public authority gave special issuing rights to an existing private bank. The institution then acted as a banker to commercial banks. This two-tier system is the epitome of the current account-based monetary system. The central bank underpins the two-tier system in at least three key ways. First, the central bank provides a medium of exchange (or means of payment) that also serves as the unit of account. A common unit of account greatly simplifies the measurement of relative prices. As a result, exchange of goods and services can be done more efficiently. Second, the central bank provides the infrastructure that, together with a sound legal framework, facilitates swift and final settlement of debt in central bank money. Central bank money plays a key role in the final settlement of claims: in the case of cash, for many of the smallest transactions by consumers and businesses; and in the case of bank reserves, for the settlement of large and time-critical interbank transactions, which ultimately support all payments in the economy. Central bank money provides “ultimate settlement” because claims on the central bank are typically free of the credit and liquidity risks associated with other settlement assets. This is particularly relevant, as the finality of payments made with some digital assets relying on decentralised validation protocols has been questioned. Third, the central bank is the ultimate source of trust in the system. It provides trust through its role as an operator of core infrastructures such as wholesale systems. Moreover, the central bank acts as a catalyst for change and as an overseer, promoting safe and efficient payment arrangements. N Kiyotaki and J Moore, “Evil is the root of all money”, American Economic Review, 92, no 2, pp 62–6, 2002. ‚ See Committee on Payment and Settlement Systems, The role of central bank money in payment systems, August 2003; and C Kahn and W Roberds “The economics of payment finality,” Federal Reserve Bank of Atlanta, Economic Review, Second Quarter 2002. Today’s payment systems: key facts Access, costs and quality Today’s payment systems, like other large (digital) marketplaces, are diverse, complex and the result of a long evolution. To start with, the difference
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