Central Bank Digital Currencies and Maturity Transformation

The impact on commercial banks

Evamarie Augustine
Jun 16 · 4 min read
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Photo by Eric Prouzet on Unsplash.

COVID-19 has strengthened the case for using central bank digital currencies (CBDC). From providing the ability to automatically deposit stimulus funds to those who may not have a bank account to eliminating the germs found on paper currency, CBDC offers an alternative.

While many digital currencies (bitcoin, ether, and litecoin) exist, a CBDC is the digital form of a country’s fiat currency. Similar to paper money or coins, a country’s digital currency would be backed by the full faith and credit of the issuing government, a contrast to more traditional cryptocurrencies like bitcoin and ether, which are decentralized networks based on blockchain technology.

Several countries have created cryptocurrencies. However, many other central banks are exploring CBDC, including the Bank of England, the European Central Bank, and the Bank of Canada. The People’s Bank of China is perhaps the highest-profile example of a central bank taking steps toward issuing one of these digital currencies.

There are many opinions, positive and negative, regarding CBDCs. While controversial, central banks did deal with the public at some points in time. Following World War II and the disappearance of the gold standard, the distinction between central banks and commercial banks became more prominent.

The nationalization of many central banks was influenced by post-war economic conditions and included countries of all political ideologies. The advent of blockchain technology and the ability to transact on the internet has changed the logistics of banking, whereby a physical location is no longer needed.

The implications to the commercial banking industry are vast. Whether the CBDC is held directly at the central bank or held at a specially designated account at a commercial bank, the impacts on maturity transformation are the same, according to a recent white paper by the Federal Reserve Bank of Philadelphia.

Such a currency would make the bank a competitor to financial intermediaries, “a deposit monopolist, attracting all deposits away from the commercial banking sector” according to the paper.

Maturity transformation, whereby banks take short-term sources like deposits and use them for long-term financing, such as mortgages, is a major source of income for commercial banks. A CBDC could essentially give consumers the option of having a bank account directly with a central bank, potentially endangering maturity transformation for commercial banks. In this case, the central bank would be a competitor for the assets commercial banks use to make long-term loans.

Maturity transformation can pose issues in the event of a bank run, where a large number of savers attempt to withdraw money at the same time. As the probability of default increases, more individuals try to withdraw their funds. In recent times, the vulnerability that commercial banks face due to maturity transformation became rather evident during the Global Financial Crisis.

Consider the following: a central bank competes with commercial banks for short-term deposits, yet doesn’t make long-term investments.

“This implies that the central bank’s indirect investment in the long asset is protected from early liquidation by this, either completely deterring runs on the central bank or making central bank runs less likely than runs on the commercial banking sector. Depositors internalize this feature and exclusively deposit with the central bank,” according to Central Bank Digital Currency: Central Banking For All?

In the event of a bank run, a commercial bank would need to liquidate long-term investments to satisfy short-term needs. The central bank, however, does not have the ability to call on long-term assets.

By their nature, central banks have the resilience to avoid financial panics, and at the same time, would “destroy the competitive forces that discipline central banks,” according to a working paper published by the Federal Reserve Bank of Philadelphia.

Many experts disagree, emphasizing the need for governments to embrace fintech and replace fiat currencies with digital alternatives.

“CBDCs are a reaction to the rise of cryptocurrencies and the realisation by central banks that existing payment rails for fiat currencies are slow, inefficient and technologically outdated, and that the private sector alone may not be able to fix this,” Nic Niedermowwe, co-founder and CEO of Prime Factor Capital, told Forbes.

A partnership between a central bank and private enterprise could offer a possible solution.

Tommaso Mancini-Griffoii, who works for the International Monetary Fund as deputy division chief in the Monetary and Capital Markets Department, stated during an episode of Money Movement that the “idea of creating a CBDC solely backed by a central bank’s reserve and completely under the control of a central bank, is outdated,” according to Cointelegraph.

Countries currently exploring CBDC include China, which has begun testing its digital currency in four provinces. The Banque de France has successfully tested a sale of securities of a digital euro, as well as exploring the use of a digital euro in interbank settlements, and integrating a CBDC in the clearing and settlement of digitized financial assets. Turkey has also been working on a digital lira, with testing expected to be finalized by the end of this year.

The implications of COVID-19 have been far-reaching. Will the U.S., the world’s largest economy, move toward issuing a CBDC as a result of the global pandemic?

Markets are in constant flux, and the only thing certain is continued uncertainty. To learn more, visit quantumeconomics.io. This information is for educational purposes only and should not be construed as trading advice. Past performance is not an indication of future results.

Quantum Economics

Analysis. Advisory. Money Management

Evamarie Augustine

Written by

Musing about markets, motherhood, mental health, and more (evamarie.augustine@gmail.com)

Quantum Economics

Quantum Economics is a publication for all those who wish to gain a greater understanding of why markets move, what influences them, and how you can get ahead of it.

Evamarie Augustine

Written by

Musing about markets, motherhood, mental health, and more (evamarie.augustine@gmail.com)

Quantum Economics

Quantum Economics is a publication for all those who wish to gain a greater understanding of why markets move, what influences them, and how you can get ahead of it.

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