Central bank digital currency: More thought needed

The issue of digital currencies has been bubbling away for a few years, even after the initial hype surrounding Bitcoin dissipated in early 2018. I wrote a series of posts in late-2017 pointing out that the Bitcoin rally was unlikely to be sustained. Nonetheless, it has not collapsed into oblivion as I feared possible. Indeed, over the last 15 months the price of Bitcoin relative to the US dollar has traded around the levels which prevailed immediately prior to the peak of the boom in December 2017 (chart). The announcement last year that Facebook was behind a proposal to introduce Libra has given new impetus to the concept of digital currencies, whilst one of the side effects of the current social distancing regime is that many retailers prefer electronic payment rather than handling physical cash.

There are in essence two proposed types of digital currency – one which is operated by the private sector free from central bank interference, whilst the counter proposal is that central banks should engage in this area themselves. Recall that the original idea behind digital currencies was to break away from a money creation process controlled by governments and central banks which were perceived as having debased the value of money by inflating its supply. It is thus ironic that central banks have entered into the debate with increasing urgency in recent years. The cynics argue that this is because the rise of a privately run digital currency would rob central banks of their raison d'être. Central banks argue that the private sector either cannot or will not provide the security that individuals demand of the medium taking the place of physical cash and that it requires some form of oversight to protect the interests of society.

In my view, central banks have not yet made a sufficiently convincing case for the introduction of a digital currency under their control. In a paper issued last month, for example, the Bank of England suggested that a central bank digital currency (CDBC) “could support a more resilient payments landscape. It also has the potential to allow households and businesses to make fast, efficient and reliable payments, and to benefit from an innovative, competitive and inclusive payment system. It could help to meet future payments needs in a digital economy by enabling the private sector to create services that support greater choice for consumers.” All of these are true if the alternative is a privately owned digital currency or a payments system based on blockchain. But in effect we already have a highly developed system of electronic money transfer in the industrialised world based on existing currencies. Payment systems run by the likes of Visa or Mastercard are already highly regulated and the various deposit guarantee schemes in operation across Europe are sufficient to protect most customers against bank default.

A counterargument is that the payments network is a critical piece of the financial architecture where failure could prove catastrophic. The problems faced by Visa a couple of years ago, when the payments system across Europe was knocked out for a number of hours, demonstrated the risks inherent in the system. A CBDC could effectively act as an alternative means of payment in the event of a more prolonged outage. But the introduction of a CBDC would mean a significant amount of disruption to the payments system, which would have to be redesigned. That would entail a lot of effort and cost for a mere backup product.

It also raises a question of where the banking system fits in. In the model proposed by the BoE, banks would be relegated to the role of Payment Interface Providers (PIPs) whose role, amongst other things, is to “provide a user‑friendly interface” to the CBDC platform. But the very existence of banks could be threatened by the introduction of a CBDC. Imagine that customers switch their deposits away from their commercial bank to hold CBDC. Banks could lose low cost stable forms of funding which would threaten their existence, to which they may respond by raising interest rates to counter deposit outflows which in turn would destabilise asset portfolio decisions. In such a case banks would face the potential threat of a huge contraction in their balance sheet, resulting in a fire sale of assets as deposits disappear. As the BIS warned in a more sober paper than that produced by the BoE, the role of banks in providing financial maturity transformation services is “not clear.” Indeed, far from enhancing the stability of the financial system, a CBDC that competes with existing financial institutions could amplify instability if solvency/stability concerns at times of stress prompt a switch away from bank deposits towards the CBDC.

In my view, there are a lot more questions than answers regarding the introduction of CBDC. It is hard to avoid the sense that the debate is at least partly fuelled by the fact that this is a fashionable topic driven by the declining use of physical cash. Moreover, significant technological advances mean that things are now possible which once lay only in the realms of science fiction, and as I noted of blockchain back in 2017 it may be that this particular aspect of the digital currency debate is simply a solution looking for a problem to solve. 

But there is also the possibility that in a world where interest rates are low, and likely to remain so for a long time to come, a CBDC would give central banks more control over the monetary policy transmission mechanism if they can persuade the private sector to give up cash. After all, you cannot impose a negative interest rate on cash because you can simply store it under the mattress, but the interest rate on digital deposits at the central bank could be tweaked at will. It could be that I am missing something but if central banks want us to swap existing financial products for a CBDC it strikes me that they have to make a much stronger case than they have up to now.