The case for central bank controlled digital currencies

I argue in this writing that central bank controlled digital currencies will soon challenge Bitcoin. The main motivation thereby is to allow for sustained and significant negative interest rates.

Negative interest rates are needed for a continuation of demand targeting monetary policies. Implementation of negative rates is however severally restricted by the presence of paper cash that earns 0% interest.

Bets on interest rates

Borrowing or lending money is also a bet on interest rates. Rising interest rates make an earlier borrowing a good deal, since one got money cheaper than it would cost getting it now. The opposite holds for the lending. By similar argument falling interest rates benefit lenders and harm those who already borrowed.

Below chart shows that outstanding bets on interest rates are rather significant, but does not imply any net wealth effect of bets, since for every debtor there is a creditor.

We have however special creditors esp. since “Quantitative Easing”: The central banks. The Fed and the like purchased both public and private debt in significant quantities. Purchasing debt is economically equivalent to lending the money to the debtor and becoming the creditor.

A central bank is a very special creditor since it prints the money. Printing additional money is at no cost to a central bank since it has no obligation to convert it to Gold or anything else. Absorbing loss on bets is therefore at no cost for a central bank.

The worst that can happen to the central bank is that it would need to explain a nominal loss to the government, which should not be a challenge as it is not obliged to generate profit and losses can be covered with newly printed money, also arguments how its loss benefits the rest of the economy can be easily constructed.

Profit on bets of the central bank however strengthens its position. The profit generated is a welcome source of government funding which central banks proudly offer as if it was a good measure of their work. See Ben Bernanke on QE profits here.

The securities purchased by the central bank increase its negotiation power should the central bank had an issue to settle with an indebted market participant, which is often the government. This is visible on the surface in case of the ECB that is able to relatively benefit or punish EUR governments through allocation of its asset purchases.

With the central bank we have a huge market participant that gains power with falling interest rates but is not harmed by rising rates.

Why interest rates keep falling since decades

While working at the trading desk of a big investment bank I learned the most important rule of financial markets:

Markets tend to move such that it hurts the majority.

This is simple to see on the long run: Markets do not create wealth, they distribute it. A winning majority would require additional wealth created, but there is nothing that prevents a winning minority.

It is not that simple on the short run: Inflated asset prices can create the illusion of increased wealth of the majority, until only a minority of them tries to cash out.

Back to interest rates: Since central banks are immune to losing bets, we have no longer an equal magnitude of pain associated with both directions of interest rate moves.

• Falling interest rates hurt all in debt and benefit all creditors including the central bank.
• Raising interest rates benefit all in debt but does not hurt one big creditor the central bank. A majority, those in debt, would win.

Since the majority can not win on the long run, we should see the first alternative materialize in trend (after central banks were relieved the obligation to convert money into Gold or anything else). Indeed, we have seen a trend of falling interest rates for decades, end even more since QE.

How to sustain a negative interest rate?

The zero interest rate line poses an obstacle to continuation of this trend. The problem is that there is an asset that preserves nominal value: Cash. Cash earns guaranteed 0% interest.

The central bank can drive interest rates below 0% for bank deposits, but not for paper cash. Sub zero deposit rates present a cost to banks that they can not forward to consumer, since consumer would rather take out their deposit in cash than to accept significant saving costs. Going further below zero would endanger banks’ profitability or trigger bank runs. None of them is an option that sustains the current system.

To perpetuate the current state of affairs, the central bank needs to get rid of paper cash. The war on cash is already ongoing supported with arguments of fighting tax evasion and money laundering. Those are valid arguments, but much less significant than the vested interests to perpetuate the current monetary system.

Central bank controlled digital currency

A digital currency offers the perfect tool to continue or improve on current trends:

• A distributed ledger can be designed to offer better controls of tax evasion and money laundering than paper cash. This is the case even with current Bitcoin.
• Currency in circulation could be easily audited.
• Money distribution could be better targeted (helicopter money).
• Negative interest rates on a digital currency could be implemented deterministically through a consensus rule that links token value with its age.

Since we have the technology and strong motivation of incumbents, I believe it is only a matter of time until central bank controlled digital currencies will arrive.

The road forward

Bitcoin will be challenged and the potential traction of central bank issued digital currencies should not be underestimated. We will see an intense competition of these concepts. I remain confident that Bitcoin, due to its uncompromising rule set and design, will achieve its destiny and become the global reserve currency on the long run.

A domestic or domain specific digital currency might prevail parallel to Bitcoin provided it offers even better usability in its domain. People will trade off negative interest rate for better usability and to avoid the market risk of the reserve currency.

I thank Dr. Saifedean Ammous for his feedback on this writing.