In central banks, finance ministries, and international working groups, discussions about digital money and central bank digital currency (CBDC) have moved to the fore (BIS, 2020). It seems useful to take stock. What are we actually talking about? What do we know? And what should policymakers do?
Finance has been digital forever – what’s new about ‘digital money’?
‘Digital money’ is a misnomer. Households and firms have long held digital money balances, in addition to notes and coins. Banks have issued digital money – demand deposits – for decades. And central banks have done likewise, issuing reserves, but only to commercial banks.
What has changed in recent years is the ease with which users can access their money and spend it. FinTech and Big Tech have led the way (and banks have followed) towards more transaction convenience, at the cost of sacrificing personal service and privacy. Moreover, blockchain-based technologies which decentralise the storage of information and its trustworthy transmission increasingly allow to cut out the middleman (Petralia et al. 2019).
Initiatives like the EU’s Payment Services Directive 2 or Open Banking in the UK promote new business models. Legislators and regulators still learn how to deal with these models when they exploit synergies between finance, data mining, and scraping; and how to codify property and identity in the mobile phone age.
Does the nature of money change?
Payments may change, but the nature of money does not. Most monies in use are liabilities, typically of the central bank or a bank, even though credit card companies, Paypal, or M-Pesa may intermediate between the issuer and the holder. Securities or real assets on the asset side of the issuer’s balance sheet are the counterpart to these liabilities; they back the money, at least partly.
In contrast, many ‘cryptocurrencies’ – most prominently, Bitcoin – are unbacked bubbles. Bubbles derive value from the hope that somebody will stand ready to pay for the bubble in the future.
What is central bank digital currency?
In addition to banknotes and other liabilities, central banks issue digital money – reserves – but only to a select group of financial institutions. The central bank digital currency proposal, which dates back to the 1980s (Tobin, 1985, 1987), is to eliminate this restriction. Households and firms also should have the possibility to acquire reserves.
‘CBDC’ is a misnomer, again. The innovative part of CBDC is not its digital nature, but broad access. A more fitting name would be ‘Reserves for All’ (Niepelt 2015).
What is the link between CBDC and the blockchain?
There is no direct connection. CBDC is widely accessible digital central bank money; many technologies may be used to deploy it. Digital central bank money could be stored in accounts (as reserves are), on prepaid cards, or on decentralised database structures, to name just a few options (BIS 2018). Of course, the choice of technology would have implications for ease of use, liquidity, privacy features, etc.
Would CBDC have macroeconomic effects?
This depends on the central bank. When issuing CBDC (without simultaneously retiring other liabilities), the central bank gains funds. As a matter of accounting these funds are invested, somewhere.1 By passing the funds to the banking sector, the central bank has the option to insulate bank balance sheets even if households or firms reallocate funds from bank deposits to CBDC. In fact, it can shield not only banks but the whole economy. The result that CBDC need not have any macroeconomic effects holds under broad conditions (Brunnermeier and Niepelt 2019).
It does not hold if CBDC-based payments require more or less resources than deposit-based payments; or if many transactions require deposits and cannot as easily be made with CBDC. More relevantly, CBDC could change macroeconomic outcomes if the central bank chose not to pass the funds through to commercial banks but to invest them elsewhere, for instance due to political constraints (Niepelt 2020).
Would CBDC foster bank disintermediation and bank runs?
Not if the central bank passes the funds raised by issuing CBDC through to the banking sector, as described above. This pass-through policy renders explicit the implicit guarantees in present-day monetary regimes.
The argument that the introduction of CBDC would expose banks to a funding squeeze disregards the asset side of the central bank’s balance sheet. But as a matter of accounting, the central bank must invest funds raised from CBDC issuance somewhere; the decision where to invest is key.
Even if central banks were to opt against pass-through policies, it is not clear that the risk of bank runs would rise. Households and firms can swiftly move funds from bank to government accounts already today (in the US, through Treasury Direct). There is little concern that this could trigger bank runs.
Why consider CBDC at all?
CBDC in combination with policies other than the pass-through policy outlined above would likely have macroeconomic consequences, both positive and negative. Moreover, it would have microeconomic effects.
What opportunities does CBDC offer?
CBDC would spur competition in the payment industry. This would also lower transaction costs for international payments where lack of competition (often due to regulation), not technology is the bottleneck.
CBDC would strengthen the monetary policy transmission channel. Changes in central bank policy rates would more directly feed through to the rates faced by households and firms. Currently, deposit rates barely respond to monetary policy (Drechsler et al. 2017).
CBDC, if adopted, would reduce the ‘too big to fail’ problem. One motivation to support struggling banks derives from the fact that bank failure puts strain on the payment system – a key pillar of the economy. Since payment system failure is not an option, so is bank failure. If many households and firms transacted using CBDC rather than deposits the social cost of bank failure would be lower, and so would be the motivation to provide state support. With less need for state support, regulatory constraints on banks could be relaxed.
CBDC would help maintain monetary sovereignty. It takes a lot for society to abandon the national currency. But if digital payment instruments issued by other monetary authorities (or a private intermediary such as the Libra Association) offer much more convenience or safety, a tipping point will be reached and the local currency will be dumped. Such ‘dollarisation’ is a well understood phenomenon in countries with weak monetary institutions (De Nicolo et al. 2005). Countries issuing their ‘own’ CBDC (without restricting other payment options such as cash transactions) are less prone to suffer from dollarisation and its consequences, in areas ranging from public finances (seigniorage) to national security.
CBDC could reduce the risk of bank runs. With a (partial or full) pass-through policy, the central bank would replace some of the retail depositors that hold bank liabilities. As a large player, it would internalise run externalities and could better stabilise the supply of bank funding.
CBDC would resolve an awkward contradiction in many countries: while the public sector issues the legal tender, legal constraints on cash use effectively prevent households and firms from making larger payments with government issued money. That is, the state prohibits citizens from using the state’s money. With CBDC, households and firms could make all payments with legal tender even if the constraints on cash use remained in place.
Where do the risks lie?
Many risks are political. A longer central bank balance sheet could invite demands from special interest groups (for example, for cheap funding of specific industries). A pass-through policy would also make the distributive effects of the monetary system more transparent. This could strengthen the resistance against bank support. Or, to the contrary, it could lead to stronger support for bank subsidies if they were perceived to relax funding constraints for households and firms.
Other risks are more subtle. Network effects might undermine the user base of cash once CBDC is introduced (Agur et al. 2019), and this might weaken the political support for cash. Some see this as a benefit rather than a risk because the abolition of cash would enable the central bank to lower interest rates far into negative territory without triggering cash withdrawals, thereby empowering monetary policy (Bordo and Levin 2017). Others who believe that cash provides a welcome protection against extreme monetary policies will disagree.
Do the opportunities justify the risks?
This varies from country to country. The tipping point at which society could adopt a foreign currency is distant in some countries and nearer, or more threatening, in others. Some monetary authorities would welcome more foreigners holding the national currency (to generate seigniorage), while others would not because of possible effects on the exchange rate. Lack of competition in the banking sector and limited financial inclusion are important policy problems in some parts of the world, but less pressing in others. Finally, a private sector ‘synthetic CBDC’ (Adrian and Mancini-Griffoli 2019) invested in a portfolio of reserves would affect the demand for national currencies very differently, depending on whether they were included in the portfolio or not; accordingly, the fiscal and monetary implications of the synthetic CBDC would differ across countries.
Whether the opportunities justify the risks also depends on one’s personal views. CBDC should be more attractive to those who favour a strong central bank and less regulation, at the cost of lengthening the public sector’s balance sheet; and to those who reject the notion that central banks should privilege banks.
Do central banks have a choice?
Many central banks may end up with a limited set of options. Although preparations for the launch of Libra have not proceeded according to plan, 2019 has shown that the status quo has ceased to be an option. Central banks and the BIS have understood. Monetary authorities are keen to maintain control over the payment system as well as the financial sector more broadly and to defend the attractiveness of local currencies. Nolens volens, they will try to keep up with developments in the private sector and in other monetary areas; they will introduce ‘Reserves for All’ or promote synthetic CBDCs of their liking (Niepelt 2019).
Adrian, T and T Mancini-Griffoli (2019), “The rise of digital currency”, VoxEU.org, 28 August.
Agur, I, A Ari and G Dell’Ariccia (2019), “Designing central bank digital currencies”, unpublished.
Bank for International Settlement (2018), Central bank digital currencies, Report of the Committee on Payments and Market Infrastructures and the Markets Committee, March.
Bank for International Settlement (2020), “Central bank group to assess potential cases for central bank digital currencies”, press release, 21 January.
Bordo, M D and A T Levin (2017), “Central bank digital currency and the future of monetary policy,” NBER working paper 23711.
Brunnermeier, M K and D Niepelt (2019), “On the equivalence of private and public money”, Journal of Monetary Economics 106: 27-41.
De Nicolo, G, P Honohan and A Ize (2005), “Dollarization of bank deposits: Causes and consequences”, Journal of Banking & Finance 29(7): 1697-1727.
Drechsler, I, A Savov and P Schnabl (2017), “The deposit channel of monetary policy”, Quarterly Journal of Economics 132(4): 1819-1876.
Petralia, K, T Philippon, T Rice and N Veron (2019), Banking disrupted? Financial intermediation in an era of transformational technology, Geneva Reports on the World Economy 22, ICMB and CEPR.
Niepelt, D (2015), “Reserves for everyone—towards a new monetary regime?”, VoxEU.org, 21 January.
Niepelt, D (2019), “Libra paves the way for central bank digital currency”, VoxEU.org, 12 September.
Niepelt, D (2020), “Reserves for All? Central bank digital currency, deposits, and their (non)-equivalence”, International Journal of Central Banking (forthcoming).
Tobin, J (1985), “Financial innovation and deregulation in perspective”, Bank of Japan Monetary and Economic Studies 3(2): 19-29.
Tobin, J (1987), “The case for preserving regulatory distinctions”, Chapter 9 in Restructuring the Financial System, Proceedings of the Economic Policy Symposium, Jackson Hole, Federal Reserve Bank of Kansas City, pp. 167-183.
1 Unless the central bank hands out CBDC for free, as a ‘helicopter drop’.