Could digitalisation of finance lead to more disruptive international capital flows? – Bank Underground

Simon Whitaker

Digital currencies and the tokenisation of financial assets could speed up the movement of money and assets between institutions and across borders. Historically, the liberalisation of capital flows led to debates about the impact on macroeconomic and financial stability. Bouts of instability – for example the 2008 global financial crisis – provoked calls to put ‘sand in the wheels’ of financial markets. In this blog I argue there is no reason why lubricating capital flows through digitalisation should herald a new era of financial instability. But the architecture of the global financial safety net may need to evolve to contain risks to the international monetary and financial system.

Mundell (1963) pointed out years ago that the effectiveness of macroeconomic policy depends on the mobility of international capital flows. The easier it is to move money and assets across borders the harder it is for policy to insulate the domestic monetary and financial system from foreign shocks. During the 1970s, when capital markets were liberalised and exchange rates allowed to float there were debates about whether that might be destabilising. Tobin (1978) (echoing concerns expressed by Keynes in the 1930s) characterised financial markets as being ‘efficient’ only in a mechanical sense: ‘transactions costs are low, communications are speedy, prices are instantaneously kept in line all over the world, credit enables participants to take large long or short positions at will or whim. Whether the market is ‘efficient’ in the deeper economic informational sense is very dubious.’ Tobin was concerned even then that it was too easy for speculative bubbles to form in asset prices that did not reflect their true economic value and so suggested throwing ‘some sand in the wheels of our excessively efficient international money markets by imposing a tax on all foreign exchange transactions.’ But Milton Friedman had long disagreed: ‘Despite the prevailing opinion to the contrary, I am very dubious that in fact speculation in foreign exchange would be destabilising. Evidence…seems to me to suggest that, in general, speculation is stabilising rather than the reverse…’.

Proponents of throwing sand in the wheels (eg Stiglitz (1989) and Summers and Summers (1989)) have a specific market setting in mind. ‘Noise’ traders can drive a wedge between the market price and the fundamental value of the underlying asset. Increasing transaction costs weeds out these disruptive traders. But in the Friedman camp (eg Schwert and Sequin (1993) and Kupiec (1996)), the market is occupied by a sufficient number of ‘fundamental’ traders who stabilise the market by moving prices towards fair underlying values. Higher transaction costs discourage both types of traders. Any beneficial effects from less noise trading could be offset by a reduction in fundamental-based trading.

We are now on the cusp of a further liberalisation of financial markets with the development of digital currencies, digital tokenisation of a range of financial assets and their exchange on unified ledgers: putting grease rather than sand into wheels of financial markets. The Friedman camp would suggest that making it easier for people to hold a wider range of assets in their portfolios and to adjust their portfolios more cheaply would be a stabilising factor. Individuals can better diversify against risk and asset markets are more liquid. The Tobin camp would warn that it could make it easier for financial markets to deviate from fundamentals, particularly at times of stress.

The empirical evidence is mixed. De Grauwe (2000) and Ilzetzki et al (2023) point out that despite the liberalisation of capital flows and huge expansion of daily flows in the foreign exchange markets since the early 1980s, exchange rates among major currencies have not become more volatile. Most foreign exchange transactions relate to hedging activity rather than speculation. Others, eg Deng et al (2018) find putting sand in the wheels could work in an immature market, but can backfire in a more developed market. Micro evidence across a range of markets (Matheson (2011) and Burman et al (2016)) is more consistent with lower transaction costs reducing price volatility. And we observe that bubbles and crashes are common in real estate markets, where transaction costs (including taxes) are extremely high compared to securities transaction costs.

So it’s not obvious that the digitalisation of global finance heralds a new era of financial instability. But there have been examples in recent years, explored below, of technological advances in trading and payment technology being associated with market disruption, which has then prompted regulators to improve the plumbing of financial markets.

In the Flash Crash on 6 May 2010, US equity prices experienced extraordinarily volatility. A key lesson learned was that algorithmic trading strategies can quickly erode liquidity and result in disorderly markets. This led to the recalibration of circuit breakers by regulators. With much more serious implications, technology contributed to the unprecedented speed of runs on US banks in 2023, triggered by the failure of Silicon Valley Bank (SVB). The Financial Stability Board (2023) will be reviewing whether existing public sector backstops are adequate for the range of potential failure scenarios illustrated by SVB. The lesson from these episodes is that the plumbing and structure of financial markets must keep pace with the technology.

These examples indicate how financial systems, like other networks, may be prone to periodic instability. Increased integration of a network can be double-edged from a stability perspective (Haldane (2009)). Within limits, connectivity acts as a shock-absorber. Links in the system help distribute and disperse risk. But when shocks are sufficiently large, connectivity may instead serve as a shock-transmitter. Programmability – the ability to encode specific rules and automated actions directly into the digital tokens – could generate new forms of contagion between asset markets.

Calibrating how much cross-border capital flows might increase in response to new technology is hard. There are empirical estimates from specific financial markets on how lower trading costs have affected trading volumes. But the range of elasticities is very large (Table A). And new technologies can lead to new business models with very non-linear effects. Table A illustrates the uncertainties, assuming the cost of cross-border payments is halved, which is the G20 target. Wholesale cross-border capital flows could increase by between eight and more than 200% of global GDP.

Table A: Impact of lower transaction costs on capital flows

(a) Based on range of elasticities in Matheson (2011) from studies of different financial markets.

Notes: Cross-border wholesale flows in 2023 were $145.6 trillion and retail flows $44.5 trillion.

Even if technology lowers the costs of moving assets across borders, it’s not obvious that capital flows would increase as households and companies may not want to exploit that. In a frictionless world, models world would predict that investors should hold the world market portfolio. But despite rapid falls in costs already, for example through exchange-traded funds, home bias – the tendency to hold more domestic assets than seems optimal – is a persistent feature of international capital markets. That may be because while costs of investing overseas have fallen, global asset markets have become more correlated. If markets fluctuate in parallel the diversification advantages of holding foreign assets will be much smaller. So what looks like a home ‘bias’ may be perfectly sensible even with low transaction costs.

If capital flows across borders did increase, to affect exchange rate dynamics you need to assume that capital flows interact with financial market imperfections to determine exchange rates in addition to economic fundamentals (Gabaix and Maggiori (2015)). There is empirical evidence to support that. For example, swings in capital flows between advanced economies and emerging market economies (EMEs) have been associated with exchange rate volatility (Gelos et al (2019)). And the International Monetary Fund (IMF) has developed a capital flow management framework to help EMEs deal with excessive movements in exchange rates and other asset prices arising from capital flow pressures. Historically capital flow liberalisation has often been followed by financial crises in EMEs, as their financial systems had not yet developed sufficiently deep and liquid markets to absorb surges in fickle foreign capital. 

The key insurance mechanism for the global financial system is termed the ‘global financial safety net’ (GFSN), which comprises countries’ international reserves, bilateral swap arrangements between central banks, regional financial arrangements, and at its core, the IMF. Policymakers need to be alive to the potential extra strains that could be placed on this insurance mechanism if technology permits more elastic capital flows that threaten financial stability. The IMF (2024) has calibrated a scenario in which vulnerable countries adopt forms of digital money that make them even more vulnerable to capital outflows. The extra demand on the GFSN could be up to $1.2 trillion, compared to a total firepower of around $18 trillion.

So just as the plumbing of specific financial markets has to evolve in the face of new technologies, so the architecture of the global financial safety net may also need to adapt to faster and larger flows of capital.

Simon Whitaker works in the Bank’s Global Analysis Division.

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