Central Bank Digital Currency

Central Bank Digital Currency

Some central banks have begun to investigate the possibility of issuing their digital currencies. The development of new financial technologies, the decline of cash, and the advent of digital currencies have all fueled this research. The introduction of a CBDC will influence the role of the Central Bank, as well as financial intermediation. Central Banks currently provide banks and a limited number of other entities with access to their digital account-based Central Bank?money. Cash, on the other hand, is available to everybody, but when cash usage drops, so does access to the security of Central Bank money. However, because of the complexities of the financial system, any adjustments must be carefully evaluated.

The Bank of England has described a CBDC as electronic Central Bank money that:

????????i.???????????Can be accessed more broadly than reserves

??????ii.???????????Potentially has much greater functionality for retail transactions than cash

????iii.???????????Has a separate operational structure from other forms of Central Bank money, allowing it to potentially serve a different core purpose, and

????iv.???????????Can be interest-bearing, under realistic assumptions paying a rate that would be different from the rate on reserves.

Format

For the Central Bank to serve as a central counterparty for all payments being processed using a CBDC, the CBDC should have the following features:

·??????The digital currency is available to the public without restriction and is recognized as a legal tender for the country.

·??????The digital currency could take different forms based on either existing payment infrastructure technology or new crypto technology. In this section, we will not focus on the form of technology used but on the economic impact of introducing a CBDC.

·??????The Central Bank directly guarantees the at-par convertibility of CBDC into cash and/or reserves.

·??????The Central Bank would not provide lending facilities for holders of the digital currency.

·??????The CB may choose to pay an interest rate on CBDC liabilities consistent with the interest rate structure of other government liabilities, and the Central Bank’s broader monetary policy and financial stability objectives

According to many, CBDC could be considered a third form of money next to overnight deposits and banknotes. General-purpose CBDC could be implemented in two alternative technical formats:

1.??????One method is to provide CBDCs to all corporations and households in the form of deposit accounts with central banks. This would not be very new or revolting, but it would be technologically challenging. In the case of India's RBI, for example, the number of accounts registered with the bank will increase from around 1600 to more than 500 million, encompassing the adult population and enterprises with some legal backing. The account so established might function as a regular account, with the standard access- and payment functionality of bank sight deposit accounts, including internet- and app-based services.

2.??????Alternatively, the central bank can offer a digital token currency that operates on a decentralized ledger and hence is synonymous with anonymity, i.e., the central bank does not know who has the issued tokens.

Both systems have advocates. CBDCs with deposits are desirable because they give better transparency and protection against money laundering and other forms of illicit financing. Control over the quantity of CBDC money in circulation would also be possible. However, if CBDCs become widely utilised and totally replace currency, it would be better to preserve anonymous payment, as with cash.

Why CBDC?

Efficient retail payments

CBDC has a variety of advantages in terms of retail payment ease, efficiency, stability, and accessibility. While electronic payments have been feasible for decades based on commercial bank money, delivering electronic payments directly in central bank money may have significant advantages. In essence, if the demand for cash collapses in the absence of CBDC, citizens will no longer have access to the central bank balance sheet. In that environment, faith in the currency would be solely dependent on trust in the financial intermediaries that issue and manage commercial money.

CBDC supports retail payments because: there is a vanishing demand for banknotes; there is less penetration of the banking system in households, which can occur both in least-developed countries (with a generally underdeveloped banking system) and countries with relatively high-income disparities, such as the US (see Rogoff, 2016); and there is an unstable or overly concentrated retail payment infrastructure.

Prevent illicit payment and store of value with central bank money

This motivation of CBDC would not apply if CBDC circulates as anonymous token money even for high amounts. Some who are strongly preoccupied with the privacy of payments and fear that internet retailers and state authorities use payment data to eventually curb the freedom of citizens, will not agree with this specific argument for CBDC.

Transition towards a less-cash society

Individuals would not have access to coins or notes in a cashless society, and all money would be transacted digitally. Notes and coins are not likely to be prohibited, but as the number of digital transactions increases and cash withdrawals from ATMs drops, it appears that the industrialized world is moving toward a less-cash culture.

Any cryptocurrency with the potential to disrupt the payment system is likely to be controlled by the government. In such a circumstance, it may be revealed that a Central Bank-backed digital money is a credible alternative.

Improve cross-border payments efficiency

The current model for cross-border payments relies upon Central Banks operating the RTGS infrastructure within which commercial interbank obligations must settle. There are limitations to this system as there are time lags for cross-jurisdictional payments, during which counterparties are exposed to credit and settlement risk from their correspondents. The study [3] analyses the use of wholesale CBDCs as an alternative approach to cross-border payments and found: ? A jurisdiction-specific wholesale CBDC which cannot be exchanged across borders offers little benefit over the existing model; ? A jurisdiction-specific wholesale CBDC which can be exchanged across borders could significantly improve counterparty credit and payment and settlement risks; ? A single universally accepted wholesale CBDC could also significantly improve counterparty credit and payment and settlement risks. The benefits of these CBDCs include 24-hour availability, anonymity, and eliminating counterparty credit risk for participants. However, all of the wholesale CBDCs were found to perform worse than the existing governance framework. The wholesale CBDCs would lead to a mix of benefits and drawbacks for Central Banks’ future role and oversight. The study did not provide any analysis on cross-border payments for a widely accessible CBDC.

Effect on Monetary Policy

Allows overcoming the ZLB as one may impose negative interest rates on CBDC

For example, Dyson and Hodgson (2016) argue that “if digital cash is used to completely replace physical cash, this could allow interest rates to be pushed below the zero-lower bound.” Rogoff (2016) develops this argument in detail. By allowing to overcome the zero lower bound (“ZLB”) and therefore freeing negative interest rate policies (“NIRP”) of their current constraints, a world with only digital central bank money would allow for – according to this view - strong monetary stimulus in a sharp recession and/or financial crisis. This could not only avoid recession, unemployment, and/or deflation but also the need to take recourse to non-standard monetary policy measures which have more negative side effects than NIRP. Opponents of NIRP will dislike this argument in favor of CBDC, and will thus see CBDC potentially as an instrument to overcome previous limitations of “financial repression” and “expropriation” of the saver.

Interest on CBDC provides an additional monetary policy instrument

Many authors have argued that CBDC widens the range of options for monetary policy, essentially since variable interest rates on CBDC would provide for a new, non-redundant monetary policy instrument that would allow improving the overall effectiveness of the monetary policy. This idea is developed further by Barrdear and Kumhof (2016, 3) who find that “a CBDC regime can contribute to the stabilization of the business cycle, by giving policymakers access to a second policy instrument that controls either the quantity or the price of CBDC in a countercyclical fashion. This second policy instrument becomes especially effective in response to shocks to private money demand and private money creation...” Meaning et al (2017) also analyses how CBDC could enrich the monetary policy toolkit and how it would impact the transmission mechanism, and come to the conclusion that it would all depend on the details of the design of CBDC. Finally, Berentsen and Sch?r (2018, 102) argue that interest on CBDC would simplify monetary policy as the “central bank would simply use the interest rate paid on these accounts as its main policy tool”.

Improve financial stability and reduce moral hazard by downscaling banks

CBDC relate to the vision that CBDC is a tool to make feasible the “sovereign money” idea, i.e., a monetary system in which banks would no longer “create” sight deposits and thus means of payment (Benes and Kumhof, 2012, H?ring, 2018, 214-223, Mayer and Huber, 2014). For example, Dyson and Hodgson (2016) consider that CBDC “can make the financial system safer: Allowing individuals, private sector companies, and non-bank financial institutions to settle directly in central bank money (rather than bank deposits) significantly reduces the concentration of liquidity and credit risk in payment systems. This in turn reduces the systemic importance of large banks and thereby reduces the negative externalities that the financial instability of banks has on society. In addition, by providing a genuinely risk-free alternative to bank deposits, a shift from bank deposits to digital cash reduces the need for government guarantees on deposits, eliminating a source of moral hazard from the financial system.”

Helicopter Money

With a CBDC, the central bank could distribute money directly to individuals or households via digital wallets. This could eliminate the need for intermediaries such as commercial banks, which can slow down the distribution of money and increase transaction costs.

Pitfalls and Challenges

Bank runs into CBDC

During a systemic banking crisis, holding risk-free central bank-issued DBM [CBDC] could become vastly more attractive than bank deposits. There could be sector-wide run-on bank deposits, magnifying the effects of the crisis. Even in the absence of a crisis, readily convertible DBM could completely crowd out bank deposits – putting the existence of the two-tier banking system at risk. In this situation, the efficient flow of credit to the economy would likely be impaired.

The introduction of a CBDC would raise fundamental issues that go far beyond payment systems and monetary policy transmission and implementation. A general-purpose CBDC could give rise to higher instability of commercial bank deposit funding. Even if designed primarily with payment purposes in mind, in periods of stress a flight towards the central bank may occur on a fast and large scale, challenging commercial banks and the central bank to manage such situations

Also, Mancini-Griffoli et al. (2018, 24-25) discuss this aspect of CBDC but conclude that overall, these effects are likely to be muted.

Some steps could be taken by policymakers to limit potential bank runs through adding a notice period for large CBDC withdrawals, limiting the balances available for CBDC for each type of depositor or imposing fees on large balances of CBDC, or removing the requirement for banks to convert deposits to CBDC.

The Central Bank has a responsibility to maintain the public’s confidence in bank deposits. Enabling the exchange of commercial bank money for Central Bank money on demand is fundamental to the design of CBDC. A challenge for a CB would be to enable a secure and stable means of storing money and limiting the risk of destabilizing commercial banks.

Disintermediation of Banks

The attractiveness of CBDC for payment purposes does not only depend on the amount of CBDC that would be remunerated at a fairly attractive level, but also on other features of the use of CBDC as means of payment. It will matter in particular whether account services of CBDC include the services that deposit accounts with commercial banks typically offer, like remote internet access, mobile phones, and cards, periodic payments to other accounts, debit orders, and user-defined maximums for different types of transfers, etc. The ability to link the account with the accounts of broker-dealers that offer a full range of investment services will also be relevant. In any case, the central bank would presumably not offer other advanced banking services (foreign exchange transfers, FX operations, derivatives, etc.). There would therefore still be a difference relative to the breadth of services by commercial banks. The choice between an initially smaller or bigger difference may be driven also by considerations regarding the possible implications on commercial banks. In the long run, this should however not matter, i.e., if the provision of certain services is possible at low unit costs for CBDC accounts also because of the large number of accounts, then the central bank may conclude that it is legitimate to offer these services, even if it competes with commercial banks.

If the services offered by the central bank are relatively comprehensive, then, despite effective control of the total amount of CBDC at a moderate level, still CBDC risks undermining the role of the banking system as a higher share of retail investors will be fine to combine a central bank account with the services of a non-bank financial services firm, and no longer have any bank deposit account. In this case, the length of the central bank balance sheet may remain limited, but the length of the banks’ balance sheet may decrease at the benefit of the non-bank financial intermediation through securities brokers, insurance companies, and mutual funds.

The following system of financial accounts illustrates such a case in which the total quantity of CBDC is well controlled, but where nevertheless the banking system is disintermediated because its sight deposit services are no longer needed. The creation of CBDC is now assumed to be fully at the expense of banknote circulation only, such that it has no effects on the financial accounts of banks (i.e., it is of type CBDC1). The variable SUBST captures the possible disintermediation of the banking system, in the sense that deposit-taking institutions could lose clients, for the benefit of non-bank financial services providers. It is assumed that the benefitting non-bank financial firms would also take over a part of the loan business of banks, maybe focusing on securitizations of loans or syndicated loans or financing of large-scale infrastructure projects, etc. The corporate and government sectors are not again shown as they are assumed to be unaffected.

To what extent would the disintermediation of banks and the shift of business towards non-bank financial intermediaries’ matter? This will also depend on the differences between the regulatory treatment of commercial banks (deposit-taking institutions) and other financial intermediaries since regulation creates clear segregation between the two. The regulator would therefore have to see if any regulatory adjustments may be desirable to react to the changes in financial structure caused indirectly by CBDC (see also section 6 of Juks, 2018). Overall, it should be acknowledged that CBDC will be a further factor contributing to change in the financial system, and to some extent independently of the total nominal level of CBDC, and that this may include effects on the relative competitiveness of banks. However, (i) there are anyway various technological developments that are relevant in this respect beyond CBDC; (ii) per se, change should not be seen as a problem, but as an opportunity. Legitimate worries would relate to disruptive change scenarios which may occur if the change is too rapid and/or industry of systemic dimension and nature is anyway under stress and the additional change factor decisively intensifies this stress.

Comparison of private digital currency innovations with CBDC

International positions towards crypto-assets and CBDCs

Vast literature published in 2018 reflects the intensive global effort to assess the feasibility of CBDCs, given the breadth of models and applications. The lack of standardized definition and specification of a CBDC seems to reflect the early stage of exploration for opportunities and assessment of risks. Studies tended to unveil more risks than were hypothesized at their inception, spanning from technical, legal, economic, security, and operational, to monetary policy. Current systems appear more effective than Blockchain at this stage of maturity.

105 countries, representing over 95 percent of global GDP, are exploring a CBDC. In May 2020, only 35 countries were considering a CBDC. A new high of 50 countries is in an advanced phase of exploration (development, pilot, or launch).

Many countries are exploring alternative international payment systems. The trend is likely to accelerate following financial sanctions on Russia. There are 9 cross-border wholesale (bank-to-bank) CBDC tests and 3 cross-border retail projects.

The financial system may face a significant interoperability problem in the near future.?The proliferation of different CBDC models is creating a new urgency for international standard-setting.

Recognize the potential value of CBDCs

·??????Maintain public access to Central Bank liability in event of declining use of cash: Norway, Sweden.

·??????Facilitate de-cashing: Cura?ao and Sint Maarten, Israel.

·??????Improve cross-border transaction systems: Canada, Hong Kong, Saudi Arabia, Singapore, United Kingdom.

·??????Modernize interbank settlement systems: BIS, Singapore, Thailand.

·??????Address underserved markets: Bahama