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Central bank digital currency – necessity, challenges or opportunities?

Ivars Tillers Economist, Latvijas Banka, 29.09.2020.Print version
For some time now, we hear regular talk of the digital euro European central banks should have in the digital era. Moreover, it even sounds seemingly self-evident. However, the creation of a new form of money should not be an objective in itself, but it must serve the overarching goal of creating a more convenient, versatile, secure and risk-resilient "money service" for exchanging goods and services in the economy.

Why, in contrast to other areas, including the strategic ones, where the private sector is more efficient than public institutions, the state should be involved in creating digital money? This is what the article will be about, and this increasingly important topic will be discussed in depth at the international conference "Money and public security" hosted by Latvijas Banka on 25 September 2020.



Since the time when the Bitcoin project demonstrated the viability of sustainable, decentralised and secure value transfer system created by the private sector, businesses and their associations have been extensively involved in designing and development of digital money products. Development trends experienced in this area provide preconditions for the materialisation of a proposal contained in a book by Friedrich Hayek, The Denationalization of Money (1976), i.e. private currencies should also compete for market acceptance: the invisible hand of the market would allow for a more stable product developed and maintained by a private company and most appropriate for both savers and borrowers win. One of criticisms of Hayek's idea addresses the assumption that the most stable currency would win market acceptance.


This criticism applies a fortiori to the form of digital money since history of technological development gives us examples proving that technological aspects not always play the major role in the competition of various formats, standards or operating systems. Sometimes particular factors play an essential part, i.e. the first product placed on the market gets a wider user base, recognition, distribution advantages and takes precedence over other products since an increase in the number of users per se pushes up the product value. This suggests that the invisible hand of the free market, i.e. when the public chooses the most stable private digital money from the range of digital money products, may not work. Thus, a potential emergence of a private digital money monopoly, when market forces fail to deliver, cannot be ruled out.


Despite the hierarchical structure of state, possible distortions and decision-making flaws, monetary policy in a money system controlled by a state or a union of states is, in principle, the best possible approximation to equal representation of the economic interests of citizens. Irrespective of the quality and user-friendliness of the digital money product created by a private monopoly, the "monetary policy" of such a money product will ultimately be aimed at the interests of the majority of shareholders of a private business, which would not always be consistent with the interests of a state or a union of states.


The entry of global players into the field of money creation together with a user base consisting of billions of individuals poses a strategic risk to countries. With central banks adhering to approaches that have stood the test of time over the course of history, such developments could lead to changes in the status quo as to what is used as "money" in the economy. This would imply that dollars, pounds or euros issued by central banks could lose their function of being "money" and become a "currency-backing asset". Money requires backing until the money holders assign value to banknotes (both paper and digital) per se and have confidence in the future stability of the currency. Over a longer timeframe, backing is no longer necessary to ensure confidence and becomes a restrictive burden instead. Similar to what happened in the case of abandonment of the gold standard, central banks may face the situation where digital money issued by global corporations is decoupled from backing, thus depriving countries of the ability to regulate money supply to meet the best interests of their economies. 


Currently, demand deposits in current accounts of banks are the most used form of money for payments. Credit institutions could also seek ways of reducing this balance sheet liabilities item by selling digital money, which would not be directly linked to the central bank's currency anymore.


Forms of central bank digital currency

If the creation of the digital form of central bank currency is of strategic importance, why was it not introduced "already yesterday"? Money is an area where a lot of interests intersect, including those of various state authorities. Therefore, hasty reforms without proper preparation and assessment of all possible scenarios can have unwanted and unexpected side effects. Equally, any specific technical solution for the central bank digital currency remains another worthwhile topic to discuss and explore.

Two potential forms of central bank digital currency could be value- or account-based digital currency. From a user's perspective, handling digital currency stored in a device could be similar to cash handling, i.e. off-line transactions between two devices could also be carried out, just like cash is transferred from one wallet to another. Meanwhile, the use of central bank account-based digital currency would be the same as using a bank account via internet banking and in mobile applications. From a user's experience viewpoint, we already use "digital money".

Unlike paper banknotes, the value-based digital money would not be subject to any physical restrictions. The stored amount of digital money would not impose any burden as to saving and transferring large amounts of money, whereas in the case of cash the features like maximum denomination of banknotes, their physical size and weight have a role to pay. At the same time, such an approach also entails the risk that this form of digital money will also be convenient for illicit transactions, which cash circulation restrictions seek to combat. A question also arises about the ways to control cross-border flows of the digital counterpart of cash without compromising privacy of digital devices. The above control is part of the strategy aimed at combating money laundering, the financing of terrorism and international crime.

To prevent digital money stored in a device from being used to circumvent the restrictions imposed on cash circulation, such restrictions should probably be included in the functionality of digital wallets. These restrictions should be similar to those already placed on cash by many eurozone countries, i.e. transaction ceilings, bans on the use in certain transactions, etc. If payments with this form of digital money were subject to various restrictions and burdens since its creation, there is a risk of designing a product the public does not want to use or considers it an inferior alternative to the existing forms of money. This could lead to an unacceptable situation where currency created by central banks has differing values. A failure of developing an unsuccessful product or the creation of a payment instrument particularly well-suited for illicit transactions would damage the reputation of a state or a group of states introducing digital money.

If the introduction of digital counterpart of cash gives rise to concerns about an uncontrolled use of large amounts of money for money laundering and the financing of terrorism as well as weakening of cross-border money flow control, the creation of central bank account-based digital currency which could be used by all economic agents without limitations, can fundamentally change the current monetary system since the availability of such a new form of digital money would likely trigger a transfer of large amounts of money from banks to central bank digital currency (particularly in times of the financial sector turmoil).


"Chesterton's fence" problem of the fractional reserve system

The introduction of central bank account-based digital currency available to all economic agents without limitations can, in practical terms, also mean a monetary reform. This type of central bank digital currency can lead to demise of the current fractional reserve system [1] in which banks, within limits set by regulations, can issue new money in a form of bank deposits. When considering innovation and reorganization fundamentally changing the existing arrangements, it is appropriate to follow the Chesterton's fence principle to avoid unexpected side-effects of the reform. Speaking figuratively, this means that before tearing down a seemingly unnecessary fence one has to explore its history, the reasons why it was erected in the first place and provide arguments to support its demolition why it is not functional anymore or why the reasons behind its erection are obsolete today. History, advantages and increasing contradictions are briefly summarised below.


The fractional reserve system evolved on a basis of contractual relationships between banks and their customers – depositors and borrowers – long before the era of digital technologies. The central bank is an integral part of this system. Along with issuing banknotes and coins, which was the major form of money, the central bank operates as the bank for banks leaving the retail role to credit institutions – during the era of paper-based accounting it was virtually impossible to open and service accounts for all economic agents. The focus of the central banks on the regulatory role is essential as the credit institutions in the fractional reserve system as well as the whole system itself has an intrinsic risk of instability. Without regulatory framework and supervisory authority the outbreaks of confidence crises can take place even in the absence of any fundamental factors.


With data processing and transmission technologies developing, a demand deposit with a bank has transformed from mostly a money saving instrument into a fully-fledged form of money, thus relegating cash as a form of money to second place. This transformation of the role of banking has implications on the whole economy. While during the pre-digital era the impact of the banking crisis on the economy mostly took the forms of the loss of savings and the dry-up in lending, today the crisis of the banking system extends to the basis for functioning of the economy – payments.


Since the time the demand deposit in a current account  replaced cash as the major form of money used for payments, the functioning of the banking system is of crucial significance not only for money depositors but also for making payments and circulation of money in the economy. Currently the interest earning time deposits as a savings instrument and demand deposits in current accounts, which have become a major form of transaction money in the economy, are equally exposed to the credit institution risks. Within certain limits non-cash money is covered by credit institution capital as well as minimum reserves. Meanwhile, for the purpose of making bank customer sentiment less volatile and protecting small and medium-sized non-cash balances, the Deposit Guarantee Fund acts as an insurance mechanism. However, it does not take all economic agents, e.g. large enterprises and local governments, under its wing.


When money is issued via the lending mechanism through credit institutions, this yields a market-based instead of central bank-managed allocation of funds in the economy. For as long as this mechanism functions efficiently, the central bank's balance sheet is small, the risk of the asset portfolio is low and easy to control as well as it contains low-risk standardized instruments. Given that the market-based bank lending plays the role of a "money-printing machine" of the economy and the central bank performs its regulatory functions via monetary policy, it is not subject to political pressure concerning the amount and allocation of the money issued and consequently also less exposed to the risk of losing independence.


The monetary policy transmission mechanism in the euro area has been impaired for a long time already. Together with the unprecedented policy of negative rates central banks have to implement the quantitative easing issuing money directly into the economy through various asset purchase programmes. Small balance sheets of central banks belong to the past, and it seems that the "non-traditional" monetary policy instruments have already become an integral part of the central bank toolbox.


If the demand deposit in bank checking account is also the dominant form of transaction money, and the rest of the economy is unable to use the payment infrastructure maintained by the central bank without intermediation of banks, requirements with regard to the bank stability are progressively tightened, thus increasing the regulatory burden on banking. The contradiction between the necessary risk-taking that is an integral part of bank lending and the increasing requirement for the stability of financial system could be one of the key reasons why, despite the accommodative monetary policy, bank lending to the economy remains sluggish.


If economic agents chose to use central bank digital currency in payments instead of current form of bank non-cash money, credit institutions would lose the ability to "finance" loans by creating new deposits on the borrower's account recovering the liquidity outflow in the interbank market. However, this would not cease the bank lending as such: the banking sector would have to raise money from external sources in full amount (e.g. from central banks). Thus, prior to the introduction of central bank digital currency, arrangements should be made to ensure that appropriate regulation and supervisory mechanisms are in place to allow for an efficient flow of funds in the economy and refinancing, e.g. facilities providing credit institutions with central bank funds on a daily basis, securitisation of bank loan portfolios creating low-risk assets eligible as collateral in central bank monetary operations.


Benefits of introducing central bank account-based digital currency to an account

A universally available central bank digital currency would let the economic agents of the non-banking sector to shape the risk profile of their money holdings. A choice between a risk-free digital money and an interest-earning deposit with a bank would become available. A deposit with a bank would become a well-considered investment decision rather than a necessity imposed by the diminishing role of cash when its use is deliberately limited and the only currently available non-cash form of money is the demand deposit with a credit institution. Basically, it would be kind of a monetary reform resulting in a sovereign money system where the notions of "money" (central bank currency) and "money deposit with a bank" would regain their former meaning.

In order the payment services, which are critical to functioning of the economy, and the bank lending, which inevitably leads to risk exposure to some extent, could fit "under one umbrella" of banking business, an increasing regulatory burden on banking is placed. There are risks of disruptions in lending and rising of funding costs of the economy during the transition from the fractional reserve to the sovereign money system; however, since the access to digital currency and payment infrastructure would be separated from the credit institution risk, the credit institution regulation could become somewhat less complex and lending would be eased in the long run.

The central bank digital currency would let the monetary policy makers to implement a countercyclical policy in a more direct way. An argument of similar nature was made by Irving Fisher in the past in support of the monetary reform project in the USA or the Chicago plan, claiming that a reform would allow for a much better control of credit cycles. Direct regulation of inflows of funds into the economy would be more efficient than, e.g. the countercyclical buffer[2] . At the same time, however, there is a risk that authority to more directly regulate the amount and allocations of funds in the economy would expose the central bank to political pressure.

The introduction of central bank digital currency may pave the way for a discretionary policy[3] , providing an opportunity for the central bank to regulate money supply to certain economic sectors. When banking sector prefers lending to the sectors that might yield the highest profit at a certain level of risk in respect of which banks and monetary policy makers may have diverging opinions, regulation of money issuance through expanding or reducing the purchase or pledging of bonds covered by assets of a particular sector, would enable more accurate management of funding allocation to the economy as compared to the prudential policy tools. This approach, compared to steering of interbank money market rates and leaving the decisions of channelling of funding entirely to the market, would prevent the formation of credit bubbles in a particular sector more effectively, while maintaining funding for the rest of the economy at the same time.

The central bank's monetary policy would reach the economy more directly and would open the way for utilising new monetary policy instruments. If cash withdrawal possibilities were reduced following the introduction of central bank digital currency (along with declining popularity of cash, it would likely be more expensive to get cash due to its volume effect), a negative rate might be applied to central bank account-based currency, resolving the zero lower bound problem of nominal interest rate. A possibility to implement the "helicopter money" [4] instrument in a technically simpler way would also open up, thus ensuring that accounts of individuals are credited instead of providing money to the economy, e.g. through government spending.

Evolution of data processing technologies lowered the costs of opening and servicing of accounts, thus enabling the central bank to maintain accounts of all economic agents. After the accounts in the central bank would be available to all economic agents, banks most likely will experience a money transfer to the central bank. To sustain the outflows,  banks will require a considerable liquidity buffer. During the transition period following the introduction of central bank digital currency, the central bank would have to refinance banks with longer-term instruments or provide refinancing with short-term instruments over a very long period. However, if the process is duly managed, it would not lead to disruption of bank lending.

Finally, central bank digital currency is not just a flight of fancy of economists, and a number of banks are working on the creation of this form of money. According to the survey of 66 central banks conducted by the Bank for International Settlements, 80% of them are working on central bank digital currencies. The ECB and the national central banks of the Eurosystem are also carrying out research involving the analysis of technical, macroeconomic and legal issues necessary to implement a project of such magnitude. Therefore, it cannot be ruled out that we may be able to use safe and convenient ECB digital euros even in the not-too-distant future.


Literature

"An ECB digital currency – a flight of fancy? ", Speech by Yves Mersch at the Consensus 2020 virtual conference, 11 May 2020

Codruta Boar, Henry Holden, Amber Wadsworth, "Impending arrival - a sequel to the survey on central bank digital currency ", BIS Paper, No 107, (2020)

Klāvs Ozoliņš, "Naudas digitālā transformācija I: ievads vēsturē", Latvijas Banka, 2020

Deniss Fiļipovs, "Vai būs kriptoeiro?", makroekonomika.lv, 2018

Egils Kaužēns, "Centrālā banka un digitālā nauda. Futūristisks skats nākotnē", makroekonomika.lv, 2017

Egils Kaužēns, "Kas monetārajai politikai der labāk – elektroniskā, digitālā, virtuālā vai fiziskā nauda?", makroekonomika.lv, 2017

Ivars Tillers, "Kā rodas nauda mūsdienu monetārajā sistēmā? Centrālās bankas loma un iespējas", makroekonomika.lv, 2016

[1] The credit institution regulatory framework requires that a certain share of deposit liabilities and other comparable items are backed by money issued by a central bank – reserves. Currently, the minimum reserve ratio set by the European Central Bank (ECB) is 1%.

[2] Although the countercyclical capital buffer rate is considered as an instrument of financial stability rather than the macroeconomic policy tool since the risks to the financial and macroeconomic stability arising from the credit cycle are closely correlated, this instrument, while pursuing one objective, also attains the second one.

[3] Acknowledging that ECB has a role to play in protecting the environment and fighting climate change the ECB has already opted for supporting funding of environmentally-friendly projects within the APP framework. Despite the absence of an explicit environmental target in the APP, ECB has purchased green bonds under both the CSPP and the public sector purchase programme (PSPP).

[4] An accommodative monetary policy permanently increasing the money stock or giving money as a grant to individuals, which was figuratively called by Milton Friedman as dropping money from a helicopter.




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