Why Central Banks Are Piloting Monetary Policy Tools for Blockchain

In many ways, it’s no longer a question of when blockchain technology will go mainstream across financial services. It’s becoming a question of when regulations will catch up for its use.

But when, or even if, cryptocurrency policy frameworks are brought to life, many observers from the traditional financial space are asking: what happens next — and how do any resultant fiscal policies get implemented across on-chain and tokenized asset environments?

That core question of policy implementation in a tokenized financial setting is one that a recent collaboration between the Federal Reserve Bank of New York and BIS Innovation Hub, Project Pine, sought to answer, the results of which were released on Wednesday (May 14). It demonstrated that central banks can effectively implement monetary policies using blockchain-based smart contracts in tokenized asset environments. It was able to successfully automate traditional monetary policy tools, such as adjusting interest rates and managing reserves, in simulated scenarios.

After all, traditional monetary policy tools may struggle to operate efficiently in tokenized markets without adopting new technology. To study this, Project Pine built a flexible toolkit prototype for central banks using smart contracts, which are blockchain-based computer programs that execute financial transactions automatically once predefined conditions are met.

The project explored the ways monetary policy could be implemented programmatically in a system with tokenized money and securities. It found, by developing a prototype of a central bank toolkit with smart contracts and testing it, that it was feasible.

“Project Pine is a first step in showing that monetary policy implementation is possible in a tokenized world,” the whitepaper’s authors wrote.

The findings come against a backdrop where major traditional players have already announced plans to register money market funds on blockchains, and the U.S. Securities and Exchange Commission (SEC) has said Monday (May 12) that it is eying regulatory changes to accommodate on-chain securities and other crypto assets.

Read also: What Treasury Teams Can Learn From Central Banks’ Tokenization Projects

Tokenized Financial Products and Blockchain Infrastructure

The mainstream integration of tokenized financial infrastructures could mark a profound shift in how assets are traded, managed and regulated.

Tokenization transforms assets including real estate, commodities, stocks, bonds and even intellectual property into blockchain-based digital tokens. This can enable things such as fractional ownership, as well as enabling greater liquidity, transparency and accessibility compared to traditional financial instruments.

The New York Fed’s primary ambition with Project Pine was straightforward yet critical: to demonstrate how central banks could practically and effectively use smart contracts to manage monetary policy within tokenized financial infrastructures.

Tokenization effectively bridges traditional finance and cryptocurrency markets, which can create new hybrid opportunities. This convergence is already manifesting in real-world examples.

“Banks are in the state where they are thinking about blockchains as public infrastructure that they need to rely on,” Chainalysis Co-founder and CEO Jonathan Levin told PYMNTS. “Back in 2014 … cryptocurrency only meant blockchains that had native cryptocurrency tokens. Today, people are putting all types of financial instruments on the blockchain.”

As recently as Wednesday (May 14), the investment firm VanEck announced the VanEck Treasury Fund, Ltd. (VBILL), its first tokenized fund.

“By bringing U.S. Treasuries on-chain, we are providing investors with a secure, transparent, and liquid tool for cash management, further integrating digital assets into mainstream financial markets,” VanEck Director of Digital Assets Product Kyle DaCruz said in the announcement.

Read more: Crypto’s Institutional Future Could Hinge on Solving the Risk Puzzle

Designing Monetary Policy Tools for Blockchain

Project Pine’s prototype toolkit was designed with input from advisers from seven central banks, including the Federal Reserve Board of Governors, the European Central Bank and the Bank of England. The resulting system, built on a permissioned blockchain platform using Hyperledger Besu and Ethereum-compatible smart contracts, specifically sought to address central banks’ unique operational needs.

The project prototyped blockchain-based tools for paying interest on reserves, executing asset swaps, creating or absorbing reserves temporarily through collateralized loans and outright purchasing or selling assets. Each of these tools utilized ERC-20 tokens — widely accepted digital standards — to represent money and securities. This toolkit allows the central bank to swiftly alter monetary policy conditions, such as interest rates or collateral requirements, directly through smart contracts.

The system’s visualization tools were able to help allow central bank advisers to clearly track and analyze interactions within market scenarios. For instance, during a simulated market crisis, the toolkit demonstrated rapid response capabilities by automatically adjusting collateral haircuts, managing collateral substitutions and deploying new emergency facilities, all in real time.

Still, while Project Pine has demonstrated the feasibility and benefits of central bank smart contracts, it is still an early exploration. The paper’s authors stressed that more research is needed, particularly around multi-currency toolkits and interoperability between tokenized and traditional financial systems.