Central Bank Digital Currency: To What Effect?

Introduction

Digital currencies are not new to the financial system, but innovations around them are changing how payments are made, what money is, and how banking is conducted globally. Central banks obviously are affected by these changes and they are in the mist of determining where they fit among them; and central bank digital currency (CBDC) is one innovation under study and experimentation.[1] Central banks’ interest in CBDC is in part a defensive reaction to fintech firms’ aggressive efforts to develop private digital money networks. These firms have introduced innovative payments systems that provide fast, easy to use payments products to the public, which also can substitute for bank deposits or central bank money. In response, central banks are considering introducing CBDC which also makes digital payments fast, easy, and central bankers would add, safer. Furthermore, CBDC is sometimes heralded as the means to greater financial inclusion for the unbanked population.

While CBDC has appeal, its full effects on payments, banking and the public are not well understood and if too readily implemented could result in poor and unintended consequences. How digital currencies develop and what course central banks choose in these matters could change the mechanics of the payments system, monetary policy and ultimately the stability of the financial system. Central banks are in the early stages of understanding CBDC, and there is a great deal of speculation and controversy around what role they should play as events unfold.

Central Bank Digital Currency

The Federal Reserve already provides digital deposit liabilities to U.S. commercial banks. However, discussions are now focused on whether it should expand its role in payments by establishing a CBDC in one or both of two ways: (1) digital cash and/or (2) demand deposit accounts. The Federal Reserve could introduce to the public digital Federal Reserve notes — cash. This digital cash would be an alternative and possibly replace physical cash for conducting small value retail payments. It would be a bearer instrument, the same as cash, meet all the conditions of money and be transferable without a third-party intermediary. In today’s jargon, it would be a digital token that could be electronically and anonymously transferred among individuals or businesses.

A second form of CBDC would be a personal or business digital deposit account held directly with the Federal Reserve. Peer-to-peer payments could then be made among central bank depositors or between a central bank and an outside intermediary — commercial banks or other service provider.

The Federal Reserve’s introduction of CBDC would represent a significant expansion of its role within the payments system and potentially be highly disruptive to the banking and payments industry. The universe of central bank depositors could expand exponentially from a few thousand banks and other depositories to potentially millions of individuals and businesses.

Private Digital Money and CBDCs

Nonbank payments operators are growing in prominence and challenging the banking industry’s dominance over the payments system and the issuance of private money. Digital technology enables non-bank firms to create their own brand of digitized private money and to develop payments systems that would change the way commerce is conducted across the globe.[2] Fintech companies like PayPal, Square, and Stripe are using new technologies to facilitate peer-to-peer and business-to-business payments across vast numbers of individuals and businesses.[3] Business and social media platforms that serve hundreds of millions of clients are looking to take advantage of their scope and scale to build global systems in which user and payments data are accessed and processed more efficiently than can be done today. Facebook’s Diem, Apple Pay, Google Pay and Amazon have the capacity to develop international payment networks for its millions of customers, using a concept known as “stable coin” in which account balances are backed by, for example, a real asset or an index of national sovereign currencies.[4] Crypto assets, like Bitcoin, using block chain technology, also have expansive payments capabilities.[5]

These payments systems and instruments while in their infancy, hold the potential to be a form of private money — able to serve as a medium of exchange, store of value and unit of account. As such they would not only disrupt the banking industry but also likely change the mechanics of monetary policy as well as the calculus around financial stability. During economic growth periods, nonbank fintech firms generally have the public’s confidence and would be eager to issue private digital currencies secured with high quality liquid assets. With experience, these companies would likely attempt to expand their issuance of these currencies by holding less-liquid assets as reserves[6], or relying on the size and perceived strength of their balance sheet to, in effect, create their own fractional reserve system.[7]

Such action would necessarily weaken the link between central bank monetary policy and total money flowing through the economy as fintech companies begin to affect the money supply independently of the central bank. Also, as fintech firms become part of the payments system and issue their own digital currencies, they raise the specter of a new source of financial volatility.

CBDCs and Monetary and Financial Stability

The Federal Reserve might mitigate the effects of private digital currencies on monetary policy by issuing its own CBDC that is immediately exchangeable with such currencies. A dollar denominated CBDC would provide the public a ubiquitous, safe digital currency, providing essentially full deposit insurance, and would dominate other private currencies as the national means of payment. [8] This dominance and exchangeability would assure that the dollar remained the unit of account in a digital payments system, whether the payment is with dollars or a private digital currency and would assure that the central bank remained the national monetary authority.[9]

From another perspective, however, the Federal Reserve issuance of CBDC accounts would further disrupt the commercial banking industry’s role as intermediary within the U.S. economic system. The introduction of CBDC would invite a shift of money out of bank deposits into direct central bank deposits, reducing them as a source of low-cost funds to the industry and affecting the relative cost of credit across the economy.

Also, during periods of increased economic strain and uncertainty, CBDC would be the account and currency of choice and the flow of deposits and other sources of funds from banks and fintech payment providers into CBDC could be massive, further disrupting markets and credit flows, complicating both monetary and financial stability goals. During periods of severe economic stress, it is the national currency which the public most often embraces while the privately issued currency fails. [10]

Also, should the Federal Reserve become the central depository of private sector deposits through its CBDC, public pressure will almost certainly build for its mandate being expanded to providing credit to the public, corporations and consumers alike. Credit allocation would become increasingly centrally controlled and politicized with highly uncertain outcomes.[11] It would involve a massive expansion of central bank operations and power, undermining the private sector’s role as intermediary between depositor and borrower that follows from its related role in payments. These are not hypothetical events but reflect trends in the Federal Reserve’s growing role as liquidity and credit provider to corporations and consumers alike following the two most recent financial crises. Therefore, the unknown and potential unintended consequences of expanding the Federal Reserve’s role in payments should cause policy makers to move carefully down this path, if at all, to be certain the cure isn’t more harmful than the perceived illness being addressed.

CBDC and China

Adding to the discussion of CBDC in the U.S. is the announcement in China that it has begun a test phase for launching a national CBDC. The stated purpose for transitioning to a CBDC is to improve domestic payment systems and to contain illicit transactions. However, observers suggest a further motive may be to expand China’s role in cross border payments relative to that of the dollar. There are at least two ways this might evolve: (1) by the Renminbi becoming a global store of value, as a reserve instrument; (2) by being used for international payments, as a medium of exchange[12]. The PBOC’s introduction of CBDC, therefore, lays a foundation for the international use of its digital currency for cross-border payments. Recently, the PBOC joined with several regional central banks and the BIS Innovation Hub in Hong Kong to develop a system that can support real-time foreign-exchange transactions in digital currencies.[13]

These developments are notable enhancements to the renminbi and its place among international payments systems, but they are neither necessary nor sufficient for it to replace the dollar as the preferred means for international settlement. Although China is a key participant in international trade, the Renminbi plays only a minor role in international settlements, accounting for 4 percent compared to the dollar’s 88 percent share[14]. This small role in part reflects China’s controlled economy including its restrictions on capital flows across its borders. So long as such impediments remain, the Renminbi is not well suited to be a reserve currency.

Still, if China continues to extend its economic success relative to the rest of the world and were to allow for the free flow of capital, then the renminbi could become an alternative to the dollar. China is now the second largest global economy and has established a significant international financial presence, with a special emphasis in Asia and Africa. Just as it has grown as an economic global player over a single generation, it is within its grasp to one day be a viable alternative to the dollar or euro for settling global payments. However, if such a role for its currency emerges, it will be accomplished independently of having a CBDC.

Financial Inclusion

According to the 2019 Federal Deposit Insurance Corporation (FDIC) Survey of Household Use of Banking and Financial Services, 5.4 percent of U.S. households (approximately 7.1 million) do not have a checking or savings account and are thus considered unbanked. Surveys show that unbanked individuals are often reluctant to use banks, concerned about high fees and generally distrustful of them. [15] Thus, the idea of a safe central bank digital account, in the form of a CBDC, with modest or no fees and ease of access is appealing to those who wish to eliminate any vestiges of an unbanked group.

To this end, legislation has been proposed to have the Fed provide CBDC accounts to the public. The legislation would require banks to provide CBDC digital pass-through accounts to residents and citizens, and to businesses domiciled in the United States. Account holders could not be charged fees or have balance requirements, and interest would be paid on their balances. In areas with limited access to Federal Reserve member banks, these banks would be required to partner with postal retail facilities to provide services.

Making CBDC available to the public and business would certainly include the unbanked.[16] However, the logistics of offering CBDCs directly or through banks or the local post office would be a significant challenge to all parties involved. Providing a subsidy to assure free access to CBDC and related banking services to the 7.1 million unbanked individuals, as distinct from the broader banking public, would be difficult to accomplish and controversial. It also begs the question of whether a large enough portion of the unbanked public would join such a system to make it worth the cost. While many among the unbanked distrust banks, they similarly distrust the Federal Reserve and the federal government. Thus, while serving the unbanked is a worthy goal, it carries a heavy cost for the benefit of unbanked households that might be reluctant to use it.

The Right to Privacy in Payments

Federal Reserve CBDC accounts could provide the government with unprecedented access to individual financial transaction data, which introduces significant privacy issues into the discussion. It is suspected that China’s introduction of its CBDC at least in part serves this purpose. In the U.S. this will be a key national policy issue as it seeks to balance an individual’s right to privacy against the government’s need to contain illegal financial transactions. Currently, the Privacy Act of 1974 sets standards regarding government access to personal data. As you would expect, however, these statutes were designed in a different payments era and they need to be updated for the changing circumstances.

Again, technological innovations may provide the solutions to the issue. Some of the more interesting proposals would embed decision criteria directly into the CBDC technology design plans. Anonymity of token (cash) CBDC transactions, for example, might be addressed by limiting payments size and collecting data only on the nature of the transaction itself. More detailed information would be collected and stored for larger account transactions, with rights to data determined within a system of pre-defined, need-to-know access criteria. However, technology wouldn’t be sufficient to prevent abuse of these data should the government insist on its need to know. The issue of privacy versus need-to-know is long standing, and like the advent of CBDC and digital currencies more broadly, solutions have yet to be developed to assure the public that the balance is right. [17]

Conclusion

Nonbanks are employing new technologies to break down barriers to entry into the payments system and are challenging central bank monopolies over money creation. The proliferation of nonbank private digital currencies will affect the payments system, banking, and on how monetary policy and financial stability goals are served in the future. Central banks are studying whether to introduce a CBDC in reactions to these trends and their potential effects on the economy. The experiment of CBDC is only just starting and there also are considerable operational, monetary and stability risks that come with its introduction. The extent of the changes under way and the uncertainty around them suggest that central banks need to proceed carefully in determining their role within the payment system. In addressing the issue of CBDC, policy makers need to be clear about their objectives and aware of the consequences, intended and unintended.

[1] “Central bank digital currencies: foundational principles and core features”, Report no 1, Bank for International Settlements (BIS), 2020. The BIS defines CBDC as “a digital payments instrument, denominated in the national unit of account, that is a direct liability of the central bank.”

[2] Brunnermeier, Mankus K., James, Harold, Princeton, Landau, Jean-Pierre, Sciences Po, August 2019. Modern technology makes frictionless, unintermediated peer-to-peer transactions possible using digital tokens. And eventually reshape the role of government-issued public money.

[3] Wack, Kevin, American Banker, April 8, 2021. PayPal executives promised to build a mobile app that will allow consumers to shop at millions of merchants, while also accomplishing most of what they currently do at banks.

[4] Economist Magazine for discussion, “Digital payments: Scaling the peak”, March 27, 2021.

[5] Crypto currencies are virtual currencies that are managed by a private decentralized network rather than by a single authority, like government-issued fiat currencies.

[6] This is the pattern that followed the creation of the money market mutual fund and could be the model for these largest digital networks as they build their payments networks and deposit balances across the globe.

[7] While such currencies may begin with a 100 percent backing of one or several sovereign currencies, over time the issuing company may substitute other riskier assets in their place, which makes the currency less reliable and more susceptible to runs.

[8] In the instance of a decentralized block chain currency, it may not be possible to present the private currency to a central party for redemption into central bank currency. However, since the system is controlled by an algorithm, no central party is free to unilaterally expand its issuance and, therefore, it is less likely to require such redemption to control its growth.

[9] See Brunnermeier, et al.

[10] See Brunnermeier, et al.

[11] Baer, Greg, “Central Bank Digital Currencies: Costs, Benefits and Major Implications for the U.S. Economic System”, Bank Policy Institute, April 7, 2021.

[12] See Brunnermeier et al.

[13] BIS, “Central Banks of China and United Arab Emirates join digital currency project for cross-border payments, Feburary 2021.

[14] Areddy, James T., China Creates Its Own Digital Currency, a First for Major Economy, WSJ, April 7, 2021.

[15] (BIS 2020; Barr, Harris, Menand, and Xu 2020)

[16] Maniff, Jesse Leigh, Inclusion by Design: Crafting a Central Bank Digital Currency to Reach All Americans , Federal Reserve Bank of Kansas City, December 2, 2020.

[17] Katrin Tinn, ​McGill University, Desautels Faculty of Management (Finance), Christophe Dubach, ​McGill University, Department of Electrical and Computer Engineering, and School of Computer Science, “Central bank digital currency with asymmetric privacy”. Also, Nadia Pocher, Andreas Veneris, Faculty of Law — Universitat Auto`noma de Barcelona • K.U. Leuven • Universita` di Bologna Department of Electrical and Computer Engineering and Department of Computer Science, University, “Privacy and Transparency in CBDCs: A Regulation-by-Design AML/CFT Scheme”.