There is growing interest in central bank digital currencies or CBDCs.
A central bank digital currency is a digital form of central bank money denominated in the official unit of account for general purpose users. Rather than a full decentralised version of a digital currency, like Bitcoin, a CBDC falls within the control of a countries central bank, and so is caught within their overall supervision and control. There are many variants of a CBDC, which can take several forms with different properties, depending on its purpose.
Central Banks will we suspect use their “normal” financial stability tests when assessing the merits of a CBDC. Is a CBDC is necessary and desirable for ensuring an efficient and robust payment system and confidence in the monetary system. Confidence in the monetary system means that we trust that the value of money will remain stable over time. This confidence is supported by low and stable inflation, the ability to make payments safely and efficiently and the certainty that money is genuine and its issuers are solvent and will honour their commitments.
Last week, Norway’s central bank issued a working paper on CBDCs. The report, prepared by a Norges Bank, investigated aspects they believe should be considered when assessing the issuance of a CBDC. They said that a decline in cash usage has prompted the bank to think about whether at some future date a number of new attributes that are important for ensuring an efficient and robust payment system and confidence in the monetary system will be needed.
The report states that a CBDC could provide customers with an alternative means to store assets. According to Norges bank, the foundation of a CBDC must also not interfere with the ability of the bank and other financial institutions to provide credit. Norges Bank will reportedly continue to issue cash as long as there is demand for it. The working group has only completed the initial phase of studying a potential CBDC, stating: “It is too early to conclude whether Norges Bank should take the initiative in introducing a CBDC. The impacts of a CBDC – and the socio-economic cost-benefit analysis – will depend on the specific design. The design, in turn, will depend on the purpose of introducing a CBDC.”
Sweden is considering the development of an e-Krona saying the use of banknotes and coins is declining in society. At the same time, technological advances with regard to electronic money and payment methods are moving rapidly. The Riksbank has therefore started a project aimed at examining whether the krona needs to be issued in an electronic form, an “e-krona”. No decision has yet been taking on issuing an “e-krona” or on what technical solution would be used.
The Federal Council of the Government of Switzerland requested a report on the risks and opportunities of introducing its own state-backed digital currency, or so called “e-franc.” The proposal also intends to examine and clarify legal, economic, and financial aspects of the e-franc.
And the Bank of England issued a working paper – Central bank digital currencies — design principles and balance sheet implications. We should note that bank working papers do not necessarily represent the views or policies of the Bank of England. But it provides an interesting perspective of their thought processes.
The report lays out various scenarios of possible risks and financial stability issues of central bank digital currencies (CBDCs) and describes three potential models of CBDC depending on the sectors that have access to CBDC, from a narrow CBDC where access is limited to banks and non-bank financial institutions (NBFIs), to direct and indirect access extended to households and non-financial firms.
The Financial Institutions Access model is limited to banks and NBFIs, where financial institutions can interact directly with the central bank to purchase and sell CBDC in exchange for eligible securities. Financial institutions are not supposed to provide an asset to households and firms, which are entirely backed by central bank money.
The Economy-wide Access model assumes that access to CBDCs is granted to banks and NBFIs, households and firms. In this way, a CBDC can serve as money for all agents in the economy. While only banks and NBFIs can interact directly with the central bank to buy and sell CBDCs, the report says that “households and firms must use a CBDC Exchange to buy and sell CBDC in exchange for deposits.”
Within the Financial Institutions Plus CBDC-Backed Narrow Bank Access model access is again limited to banks and NBFIs. There is at least one financial institution that acts as a ‘narrow bank,’ which provides financial assets to households and firms that are fully backed by a CBDC but that does not extend credit.
Note also that they are agnostic to the technology that underlies CBDC and the use of distributed ledger technology (DLT) is not assumed.
So the three models of CBDC vary in the sectors that have access to CBDC, from a narrow CBDC where access is limited to commercial banks and NBFIs, a moderate step beyond access allowed to the UK’s current RTGS system, to a system where access is also extended to households and non-financial firms. The latter is an economy-wide system. Second, they vary in whether there exist entities that provide deposit facilities that are fully backed by CBDC (as distinct from deposit facilities fully backed by reserves). Economically these entities are narrow banks. The three models together cover a range of plausible CBDC systems.
They show that for the scenarios of initial CBDC introduction for all models, if the introduction of CBDC follows a set of reasonable core principles, then the banking sector’s two key functions, the provision of credit to borrowers and the provision of liquidity to depositors, are not necessarily curtailed. Some bank deposits may disappear, but, to a first approximation, this can occur without affecting the quantity of aggregate credit or aggregate liquidity. Banks and their customers, through their respective portfolio decisions, control the extent to which depositor switching to CBDC affects the size and composition of bank balance sheets. Banks can continue to play their traditional intermediation role.
Next they turn to the question of confidence loss and layout some core principles
The first core principle is that the interest rate paid on CBDC should be adjustable. This allows the market for CBDC to clear without a need for either large balance sheet adjustments or movements in the general price level.
The second core principle is that CBDC should be distinct from reserves, with the central bank not exchanging reserves for CBDC. This addresses the risk of a ‘run by the back door’, whereby a single bank’s commitment to issue CBDC in exchange for bank deposits, together with its commitment to settle interbank payment in reserves, could in the absence of this condition facilitate a rundown in aggregate reserves and deposits when bank customers seek to switch into CBDC. This core principle also enables the central bank to retain control over the quantity of reserves in the financial system, which has traditionally been a key mechanism through which central banks control policy rates.
The third core principle is that commercial banks should never have an obligation to convert deposits into CBDC on demand. Requiring banks to convert deposits to CBDC on demand opens the door to runs on the aggregate banking system. These runs could be much faster and at larger scale than in the current system, where cash is the only central bank money available to depositors. In such a scenario, there could be substantial operational and political economy barriers to the central bank providing sufficient market-stabilising liquidity support. Such an obligation on banks to guarantee convertibility is therefore highly dangerous. It is also unnecessary. One frequently cited rationale for this obligation is that it is necessary to ensure parity between bank deposits and other forms of central bank money. However, that parity can be achieved in several other ways.
They challenge the assumption that banks should guarantee conversion, noting first that greater vulnerability to aggregate bank runs is unlikely to increase confidence in the banking system, and second that the key pillars supporting confidence in banks are strong prudential oversight, maintenance of adequate capital and liquidity buffers, deposit insurance, and commitment to clear interbank payments in reserves at parity (and thereby facilitate payments), rather than the promise to always pay out central bank money to depositors. To see the latter, consider the hypothetical case where banks commit to exchange deposits for CBDC on demand but have little capital or liquid assets, and are not supported by a deposit guarantee. In this case the commitment is not credible and hence cannot be a source of much confidence.
The fourth core principle, which complements the second and third principle, is that the central bank only issues CBDC against eligible assets, principally government securities but with the definition of eligible assets at the central bank’s discretion. This conforms to current practice for the issuance of central bank money, and is therefore conservative rather than radical. What would truly be radical, and highly undesirable, is guaranteed issuance against bank deposits, which would amount to a guarantee of automatic unsecured lending to banks.
So in conclusion, the report found that, after a first approximation, there is no reason to believe that introducing a CBDC would have an adverse effect on private credit or on total liquidity provision to the economy. Although the report does stipulate that further models and research are necessary to make a more concrete determination.
The Bank of England Paper only studies the balance sheet and financial stability aspects of CBDC. It does not attempt to evaluate whether the introduction of CBDC presents a net benefit to the financial system and society. This is still an open question for many central banks, with the answer likely to vary across countries (due to differences in, for example, the service offering of existing payment systems and the prevalence of cash use).
Finally, it’s worth noting that a few central banks have taken a decision. In 2015, Ecuador issued a US-dollar denominated national digital currency, while more recently the National Bank of Demark and the Reserve Bank of Australia concluded that in their respective economies the potential benefits of introducing a CBDC to households and businesses do not currently outweigh the risks, and therefore they have no plans to introduce one.
