How do you see the future of finance and decentralised finance? What are, from your point of view, the opportunities and threats lying ahead?
From the central bankers' point of view, the future could be described by the quote: "The dark side clouds everything. Impossible to see the future is.". The thing is that in our efforts to balance between risks and innovations, we very often find ourselves focusing on risks rather than on innovations. This is because the central banks historically served as the lenders of last resort or, in other words, as the systems' ultimate risk-takers. And today, when keeping an eye on preserving the financial stability of the banking system as one of our main tasks, we have also noticed that risk building is taking place outside the regulatory perimeter. Non-banking financial institutions, fintechs and decentralised finance (DeFi) created a new financial ecosystem in which they compete to provide activities traditionally reserved for banks, i.e. deposit/credit/payment.
Personally, I think that DeFi poses nothing new in terms of financial affairs. These are all well-known patterns, such as leverage, instant payments, credit intermediation, etc., that already exist, but what is different this time is: (i) a new technological solution emerging in decentralised and distributed systems and (ii) a shift in the risk. We see this shift as a worrying element, moving the risk from regulated to unregulated entities. In this process of disintermediation of regulated entities, the system is left without safeguards and liability for potential damages, primarily due to its global and non-territorial nature. These unregulated and, for the most part, unknown entities (nodes) are the ultimate risk-takers in this new ecosystem. The most recent example is the Terra/Luna protocol that went into the so-called death-spiral financing and shocked the system, sending ripples to other parts of this new ecosystem.
However, I also believe there is a case for certain simpler functions executed in an automated or decentralised environment such as DeFi. For example, smart contracts, which is a misnomer because these contracts are not smart at all, but perform the basic functions, could be faster, more efficient and reliable than humans are.
How do you see digital money, and more specifically CBDCs, change the course of the financial system?
Digital money has been here for decades, both in wholesale form as public money and retail form as private money, while introducing a Central Bank Digital Currency (CBDC) as retail public money is a new concept that deserves special attention. On the one hand, it could be interpreted as the duty of central banks to provide sovereign money to the public, which is secure, cheap, widely acceptable, convenient, and inclusive. But on the other hand, one of the major threats to its success could be the attractiveness of the CBDC, which may destabilise the financial system by stripping banks of their deposit base. If such disintermediation reduces banks' abilities to do one of their main activities, i.e. to provide credits, then we, as central bankers, would need to find a way to put the money back into the system. Whether directly, which is always politically sensitive, or indirectly by further expanding our balance sheets and potentially creating even more moral hazards. However, CBDC could be a valuable tool for fostering competitive, more resilient, innovative payment systems. Competitive by allowing a broader range of participants to directly compete while simultaneously reducing the capital requirements for those participants; resilient by robust design choices; and innovative by allowing both companies and individuals to directly compete on a level playing field and utilise their productive and innovative capacities on a full scale. Moreover, there is also a clear case for CBDC in the international financial environment, i.e. as a vehicle for providing a faster, cheaper and more efficient cross-border payment system.
What are the greatest challenges facing regulators, and how might they respond?
Regulators are constantly facing challenges when confronted with innovative financial services and products. It is a considerable challenge to resolve whether to stand aside and allow innovations or step in and manage, regulate, or even stop them. Finding the right balance and acting timely is one of the most challenging tasks we face.
But, let me stress that the question today could also be framed this way: "Are all these developments coming from non-banking financial companies, fintechs and DeFi evolution or revolution?" Because one could argue that in the former case, we would still be able to track the evolution of a financial system. The evolution is based on similar existing patterns and mechanisms, and even though we sometimes fall behind the curve as regulators, we can still catch up before risks become excessive or entities too big to fail. However, in the case of the latter, where the potential significant revolution of the financial system materialises, we would most likely be unable to reach our goals within prescribed mandates, capacities and efforts. In this case, we would need a structural shift that is outside the box and is currently too hard to predict where and in what form it will eventually end. In other words, in the case of revolution, we would need to rethink the institutional regulatory perimeters and the scope of our authorities' mandates.
In any case, our response needs to be aligned with the challenges and their non-territorial shape-shifting and unregulated nature we observe. So there is a strong need for global regulatory coordination and cooperation. Otherwise, we could end up in financial fragmentation and regulatory arbitrage, or to rephrase SEC Chairman Gary Gensler, we could end up in the financial version of the Wild West.
How do you nurture the innovation ecosystem in your country? Do government bodies or regulators provide any support specific to financial innovation?
In the area of direct support to innovations, we have established an innovation hub in the Croatian National Bank (CNB) as a contact point and a place to talk with start-ups, fintech challengers or other business entities trying to innovate in the banking and payments area. As already mentioned, when faced with such a considerable amount of innovation in the financial system as we see today, one needs to find the right balance between when to act and when not to act. For instance, our central bank did not propose or pass any laws that would prevent fintechs from providing services or introducing innovations. This is where we stayed silent, but at the same time determined to closely monitor the developments on the market. On the other hand, due to a growing interest of citizens in this type of assets, we also act proactively, and have issued statements to the public and, more precisely, to consumers about the risks associated with crypto assets.
What can regulators, supervisors and legislators do to facilitate the adoption of fintech in Europe? What kind of support do you offer to new start-ups to be guided in the regulatory process?
The Innovation Hub set up by the Croatian National Bank is the contact point where we provide support in applying the regulatory framework within the CNB's areas of competence, i.e. supervision, oversight and licensing concerning innovations related to the provision of banking or payment services. In this way the CNB provides non-binding and informal support to business entities developing an innovative fintech product or service. It is also a communication and information platform where queries are answered, information is provided, opinions are exchanged, and explanations are given related to fintech within the CNB's competence. Here, our intention is to assist in understanding regulatory requirements in light of a growing interest in developing innovation in banking and payment services from financial market participants and other business entities.
Additionally, innovation hubs and regulatory sandboxes across the EU are a good starting point for identifying best practices and aligning regulatory approaches. It is a cooperative and, let's say, a soft law approach. One step further could be the enactment of the common regulatory framework as laid down in the draft Markets in Crypto Assets Regulation (MiCA) that is currently in the process of political negotiations between EU institutions. In both cases, levelling the playing field for challengers and incumbents is strongly desired from our point of view.