Central bank-issued digital currencies (CBDCs), existing alongside deposits and physical cash, would strengthen the financial system by creating a channel through which central banks could provide capital to non-financial institutions directly. That’s the view of John Dwyer, senior analyst at Celent's securities and investments practice.
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John Dwyer, Celent |
The disintermediation of commercial banks would make failures less destructive, meaning even the biggest banks might no longer be considered too big to fail.
A digitally issued currency could also be programmed to deteriorate in value over time, incentivising spending and therefore speeding up inflation, at a time when central banks are struggling with deflationary forces, says Dwyer in a recent report.
Keonne Rodriguez, senior manager for digital at Synechron, argues that, in a sense, central banks have already embraced digital currencies. “Central banks are not physically printing notes, the cash is just numbers on a spreadsheet — it is digital. So I am sure they are at least looking at the benefits of going that extra step and using a distributed ledger.”
Dwyer argues it is the problem of the Zero Lower Bound (ZLB) — the movement of interest rates towards zero — and even the migration of rates into negative territory that could encourage central banks to take that extra step. Central banks exert greater influence over economies when interest rates are high, and are therefore weaker than ever before — and getting weaker, he says. Yet the task of increasing inflation is increasingly pressing.
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Keonne Rodriguez, |
Central banks have been relatively innovative in recent years, notes Dwyer, belying their reputations for cautious conservatism. Interest rates were reduced at an unprecedented rate across developed markets in response to the financial crisis in 2008, which has taken them into negative territory in several jurisdictions. Authorities were also quick to formulate plans for quantitative easing, which has been tweaked in several ways in an attempt to increase its efficiency. The ramping up of the monetary base in the US, from approximately $800 billion in 2008 to around $4 trillion now – a fivefold increase – and the willingness to take commercial banks' assets in exchange for increased reserve assets, further demonstrates authorities’ commitment to finding creative solutions.
But these policies now look unequal to the task facing central banks, meaning they will be looking for new strategies to fulfil their goals. And this, argues Dwyer, makes the issuance of digital currencies more than just a mere hypothetical possibility.
Real prospect
Central banks themselves have already acknowledged the possibility of CBDCs. The Bank of Canada has been widely reported to have explored the possibility of creating a version of its currency on the blockchain, while the Bank of England published a paper in July, The Macroeconomics of Central Bank-Issued Digital Currencies, analysing the implications of such a policy and ways it could be implemented.
The BoE concluded: “A system of CBDC offers a number of clear macroeconomic advantages, with few obvious large costs.” It found such a policy could deliver steady state output gains of almost 3% for an injection of CBDC equal to 30% of GDP, “and sizeable gains in the effectiveness of systematic or discretionary countercyclical monetary policy.”
A significant portion of that would come from efficiency gains, in the financial sector and beyond. Julian Korek, managing director at Duff & Phelps, says: “In the current system institutions work with separate ledgers and reconciliation is a significant cost. On the blockchain everyone is using the same ledger which is much more efficient.”
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Julian Korek, |
However, the BoE paper acknowledged that, with no historical experience to draw on, and a complete absence of data for empirical work, important questions remain unanswered, including what impact this measure might have on bank deposits.
It is also difficult to see how central banks could push digital currencies onto economies that remain unprepared from an infrastructure perspective to handle them. Neither is the public necessarily ready for digital currencies, with considerable mistrust prevalent among the general population.
Korek says: “A digital currency issued by a central bank would certainly have an advantage over something like bitcoin in terms of public acceptance. But it would face the same challenges in terms of being vulnerable to fraud and criminality.”
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Mike Shaw, LNRS |
Mike Shaw, vice president of global market development at LexisNexis Risk Solutions (LNRS), adds that while there are a number of implications for central banks issuing digital currencies, the considerations are very similar to those arise for the broader financial community. “There are concerns around KYC and financial transparency related to virtual currencies.” The underlying technology of the blockchain is intriguing for banks and the broader financial community, adds Shaw – especially the ability to monitor transactions and the potential for increased efficiency. “But there is a little more concern around the anonymity that exists in virtual currencies today,” he says.
These concerns should be worked out in time, and LNRS is working on ways to bring KYC and AML compliance to the cryptocurrency universe.
In due course, CBDCs could actually enhance transparency, says Dwyer, providing authorities with more real-time granular information on where that currency was is in the economy, including who was spending it, and what it was being spent on. This would provide policy makers with the means for bottom-up analysis on the velocity of money, allowing for targeted policy stimulus, and providing real-time macro-prudential and micro-prudential data for regulators of banking and capital markets, says Celent.
Who needs cash?
CBDCs would also allow central banks to limit, or even remove entirely, physical cash from the financial system. That is appealing because it should make negative interest rates more effective and allow them to stimulate the economy directly, potentially using fiscal policy levers, while increasing growth by raising the velocity of money.
A CBDC that was not directly fungible would allow a carry tax to be imposed, whereby the purchasing power of the digital currency would erode over time, thereby encouraging spending and raising inflation. Such a solution has long been considered in academic circles, but has been dismissed as unworkable. But a CBDC would change that, allowing for the simple implementation of a carry tax, says Dwyer.
Perhaps most controversially, CBDCs would also allow central banks to pursue a policy of “helicopter money” — the distribution of large sums of newly created currency to the public in order to stimulate the economy during deflationary periods. The policy, first discussed by Milton Friedman, has been “increasingly and openly discussed such that its implementation appears inevitable,” says Dwyer, as a way to ensure money issued by central banks ends up in circulation, and is not hoarded by banks.
Many remain sceptical whether central banks would go down this path. Korek says: “Governments have tried to stimulate economies like this before and it never ends well. There was the Loan Guarantee Scheme where the government underwrote the majority of loans made by banks. But this type of initiative invites fraud. The central bank would need a proper distribution channel, which it would need to build. And as it is also the bank regulator, it would have a conflict of interest.”
But central banks could still embrace digital currencies, without pursuing all the possibilities they present. For many it is a question of when, not if.
David Pearce, founding member of the NXT Foundation, believes central banks will ultimately embrace digital currencies, as will the broader financial community, because the technological proposition is too compelling to ignore. “The financial community has been adding layer upon layer of antiquated protocols, some of them dating back to the renaissance. The blockchain allows them to cut through all that,” he says.
Rodriguez at Synechron notes that central banks have already been innovative, especially the Fed. “Look at how it approached the Automated Clearinghouse (ACH) system, which was an amazing innovation. It didn’t build the product itself, it relied on third parties and championed the solution. That is how I expect it to approach digital currencies. The information age is about openness and collaboration, so I expect to see public and private sector cooperation. This evolution will be bottom up, not top down.”