Analytics, Banks, Direct Speech, Financial Services, Latvia

The development of technologies opens vast opportunities for further expanding financial services, inter alia progress is and will be observed with respect to money as well. There are new possibilities of developing various forms of money, promoting money circulation and its velocity.Opportunities also arise for amending and improving monetary policy and making the monetary policy transmission mechanism more effective; who knows, maybe during the recovery after the next crisis the central banks might use digital currency rather than asset purchases traditionally used up to now. This article will look at future opportunities that the central banks have started to think about: they are interested in them, they have published research papers about these issues, and they have made the first experiments.

Any central bank should go hand in hand with technology development to prevent materialisation of some visionaries' dreams that as a result of the passivity of central banks, the physical money will gradually disappear from circulation and merely cryptocurrencies issued by private issuers will be found in the digital wallets of people. The victory of private money would imply triumph of the private sector over the government; but let's leave this issue for other, more philosophically focused/oriented articles. As long as central banks exist, they will have to closely follow and adapt to the development of technologies.

Researchers have so far come up with two ways of storing central bank digital currency. The central bank digital currency could be stored on the accounts opened with the central bank, i.e. account-based, or on digital devices, i.e. value-based. Both types/forms of central bank digital currency can exist irrespective of who is the digital currency distributor to the ultimate owners: the central bank or banks.

As a small digression, I would like to remind the readers that currently the money deposited as deposits with banks is called "cashless money", and payment cards can be linked to the above deposits; this money, however, is no digital currency.

If in the future the central bank digital currency is chosen for good, let's have a look at the difference between the account-based and value-based digital currency issued by the central bank. Account-based storage means that the digital currency is transferred to its future owner by crediting it to the digital currency account opened for him/her with the central bank. The would-be owner will be able to obtain digital currency if he/she exchanges his/her cash or bank deposit for digital currency at the central bank or via banks: that will be the initial issue of digital currency. When a holder of digital currency transfers digital currency to the would-be owner's digital currency account, the latter will obtain digital currency in the secondary market. Most probably the owner of digital currency will have a card issued by the central bank, similar to the current bank debit cards and credit cards. The card will be valid for making purchases at shops and on internet, but you won't be able to withdraw digital currency and hold it in your hand like you do with a banknote from an ATM as digital currency will not exist in a material form. Obviously it will be possible to withdraw cash with the card: by exchanging digital currency back to cash or to a bank deposit.

Value-based storage of digital currency in digital devices means that the digital currency will be stored in the respective device rather than on an account. It will be possible to upload money on your digital device at the central bank or via banks, but the digital currency owner will have no account with the central bank. Such solution would be more like the wallet we carry in our pocket or bag. To make payments, the owner of digital currency will have to carry the digital device with him/her and protect it like cash in the wallet: if the digital device is lost, the digital currency stored on it is gone, too. The digital device might be in the form of a card, similar to Riga Card, where we can upload money and then spend it, a virtual contactless card, mobile application or any other innovative solution.

With respect to the technology and payment system development, account-based digital currency storage implies direct links with all traditional payment systems and payments. For digital currency payments, integrated solutions will be required to ensure fast and easy exchange of digital currency for the traditional one and vice versa. The POS card readers at shops are "oldtimers" of technologies; obviously a more user-friendly central bank digital currency card would be a virtual contacless card, integrated in a mobile phone, or a mobile application, with settlements via the mobile phone. If the digital currency storage is value-based in the digital devices, its circulation is relatively isolated from the payment systems. This form of digital currency is more similar to cash. To make settlement, both transaction parties are likely to use a card reader or mobile application communicating only with the two parties involved in the transaction. Money could be uploaded on such a card at ATMs or special card readers by transferring money from the card holder's bank account or digital currency account with the central bank. There should also be the reverse possibility: to transfer currency from the digital device to one's bank account or digital currency account with the central bank.

The major difference of both systems could lie in the payment anonymity and security. In the case of account-based digital currency, the security level is high, but one should be aware that payment details and transaction parties will be registered (like in cashless payments in banks at this stage). Meanwhile, in the case of value-based digital currency, the security level is lower, but the degree of anonymity is high, like in payments with cash. In the case of account-based system payments, both transaction parties are known, the transactors' identities are checked, so there wouldn't be too many identity theft cases. Moreover, the potential for the digital currency theft can be restricted by introducing different limits, like it is currently done for debit cards and credit cards, payments in internet banks, etc. In the account-based system, the origin of the currency is important. As to the digital currency in digital devices, the major factor in settlement verification is sufficient amount of funds in the digital device held by the payer, while the payer's personality and the origin of currency is less important. Certainly, there can be different degrees of anonymity that can even co-exist, just like cash and bank accounts do.

But what could that imply for future monetary policy? For monetary policy that actually means even broader opportunities, its effectiveness would increase. If the central bank digital currency is account-based, the scope of monetary policy opportunities is quite large. A positive or negative interest rate can be applied any day, and it makes the monetary policy transmission path shorter than it is now: the central bank will set the digital currency holding rate for the currency holders, while the forward guidance will have a more pronounced effect on the behaviour of businesses and consumers. If the storage of digital currency is value-based, it is highly unlikely that, just like in the case of cash, the interest rate could be applied to digital currency stored in digital devices.

If the digital currency is account-based, it will be easier to introduce transaction limits, tailoring them to the particular customer. But if the digital currency is stored on digital devices, we might not be aware of whether the currency holder is an individual or a business: limits should differ in such a case. The central bank might be willing to apply different interest rates to different digital currency holders, e.g. for euro area banks storing money with the central banks above the minimum reserves, a negative annual rate of -0.4% is applied to the excess amount, while for households and businesses the normal rate on the account balance is 0%. In case of account-based digital currency, the central bank could apply different interest rates to different groups of account holders, but in case of digital devices, the account holder's belonging to any group might be unknown.

Settlement speed and payment execution costs will be important factors for future development. The account-based system will be cheaper and faster, as it will be supported by the leading-edge technologies and other payment systems and it will benefit from its larger transaction amount. As to digital devices, they could be used mostly for retail transactions due to the high risk; the digital currency holders themselves might not be willing to risk having larger amounts on the digital device.

Irrespective of what new digital technologies will appear, the central banks will also have to change. The use of cash in payments is expected to decline, with the private sector trying to develop and introduce new, innovative and more user-friendly types of payment. Looking at a broader scale, from the point of view of operational security and monetary policy implementation, the account-based central bank digital currency seems to be a more beneficial option, enabling to apply the interest rates set by the central bank, diversifying them by different groups of account holders. Meanwhile, from the point of view of economic agents, it could make the central bank and monetary policy closer and more understandable to them... 

Most probably there is still quite a time ahead for that to happen, and there will surely be a pilot project of some more daring country to check the viability of the central bank digital currency. The decision on issuing the central bank digital currency has to be well-considered, having assessed risks to the financial system stability.