Central-bank digital currencies: proceed with caution

Peter Bofinger argues that introducing central-bank
digital currencies would need to be subject to very careful consideration.

While Facebook’s Libra
is confronted
by ever stronger headwinds, a new competitor, the so-called central-bank
digital currency (CBDC), is entering the arena of digital money. While this
idea has been discussed by several central banks for some time now, it has been
boosted by recent announcements by Chinese central bankers. On August 10th Mu
Changchun, deputy chief of the payment and settlement division of the People’s
Bank of China, said:
‘People’s Bank digital currency can now be said to be ready.’

Different types of CBDC
have been mooted (see table). Account-based
CBDCs would make it possible for private households and corporations
to open an account with the central bank. This could be designed as an
all-purpose account for anyone, with unlimited uses (retail CBDCs). But CBDCs could
also be designed as a pure store of
value, which would only allow transactions between the central-bank
account and a designated traditional bank account. Such accounts could be
organised as retail CBDCs but access could be restricted to large investors and
providers of payments platforms (wholesale CBDCs).

Token-based CBDCs (‘digital cash’) are imagined as an alternative
to cash for peer-to-peer transactions. They could be designed as prepaid cash cards
issued by the central bank, without the user having an account with the central
bank.

A typology of CBDCs

These CBDC variants
challenge existing money, financial-assets and payments providers:

• Token-based
  CBDCs would compete above all with private providers of digital-payments
  products (such as credit-card companies, Paypal and Alipay).
• All-purpose
  CBDCs would compete with traditional bank accounts.
• Store-of
  value, account-based CBDCs would compete with time deposits of commercial banks
  but particularly with ‘safe assets’ and above all government bonds.

With the issuance of
token-based CBDCs, but also with all-purpose CBDCs for anybody, central banks would
compete with private suppliers of payments networks and commercial banks.

Such a change in the
competitive environment could only be justified were a significant market
failure to be identified. The Swedish Rijksbank argues:
‘If the state, via the central bank, does not have any payment services to
offer as an alternative to the strongly concentrated private payment market, it
may lead to a decline in competitiveness and a less stable payment system, as
well as make it difficult for certain groups to make payments.’

Effective
competition policy

But the solution to
these problems is not necessarily that the central bank becomes a provider of retail-payments
services. Rather, this calls for an effective competition policy and comprehensive
supervision of payments providers. And one has to ask whether the central bank
would be an adequate institution for screening, monitoring and supporting
customers, as well as developing new retail-payment technologies.

In addition, all-purpose
CBDCs for private households and companies could raise serious problems for the
financial-intermediation mechanism.
If bank customers decided to shift significant parts of their deposits to the
central bank, the deposit base of commercial banks would be reduced. This gap would
have to be filled by the central bank, which would in turn require sufficient
eligible collateral on the part of the banks.

If such accounts were
to gain in popularity, the central bank would increasingly find itself in a situation
in which it would have to refinance private loans and decide, indirectly or
directly, on the quality of private borrowers. In the end a ‘full money’ (or 100
per cent reserve) financial system could emerge, in which commercial banks
would lose the ability to create credit independently. Contrary to its advocates,
this would massively throttle or even eliminate a central driver of economic
momentum.

Safe assets

While fully-fledged CBDCs
for private households and firms would be associated with serious challenges
and risks for the whole financial system, there are no obvious market failures which
could warrant such innovation. This raises the question of whether the
introduction of CBDCs should be limited to ‘store of value’ CBDCs (sov-CBDCs).
Such central-bank balances could not be used for payments to third parties but
only for transfer to one’s own account at a commercial bank.

With store-of-value
CBDCs the central bank would not compete with payments providers. The
competition with commercial banks would be limited to short-term time and
saving deposits, without depriving banks of their liquid deposit base. Above
all, such CBDCs would provide a safe asset, which in this form could not be
created by private actors. Sov-CBDCs would be comparable to cash as they would
provide a 100 per cent guarantee of nominal value, which cannot be guaranteed by
bank accounts—according to the Bank Resolution and Recovery Directive, depositors
with assets in excess of €100,000 must be bailed in if their bank gets into
trouble—or government bonds.

The attractiveness of
this asset would be largely determined by its rate of return. Treating it as a digital
substitute for cash, a zero interest rate would be appropriate. In this case,
the substitution processes from traditional bank deposits to CBDCs would be
limited. In addition, a lower limit of €100,000 for sov-CBDCs could be
justified, as bank customers with lower deposits are protected by national
deposit-insurance schemes.

Overall, such CBDCs would
increase the stock of ‘safe assets’ that are of great importance to the players
in the financial markets. This is also not without risks, however, as the
introduction of a new safe asset could be detrimental for countries with a
poorer bond rating. Moreover, in periods of crisis such CBDCs could lead to
digital bank-runs, which would further destabilise the system.

Synthetic CBDCs

The narrowest version
of CBDCs comprise store-of-value CBDCs restricted to providers of payments
services as a collateral for their depositors (‘stable coins’). The designers
of Libra plan to use bank deposits and government bonds as collateral. But, as indicated,
the stability of bank deposits in a crisis is limited. As for government bonds,
massive sales by Libra would likely result in price losses. These problems
could be avoided if suppliers of stable coins could use CBDCs as collateral. Adrian
and Manicini-Griffoli speak
of synthetic CBDCs (sCBDCS).This model is
already being practised in China, where Alipay is obliged to keep its accounts
with the central bank.

In principle, this
could result in ‘narrow banks’, which on their asset side only maintained
balances with the central bank and concentrated on the function of payment-service
provider. These would be opposed by ‘investment banks’, operating the
traditional credit business and offering longer-term, interest-bearing
deposits. Compared with all-purpose CBDCs, this arrangement has the advantage
that the payments system is operated by private suppliers and not by the
central bank. But there is also the risk that the banking system loses the
ability to generate loans and a full-money financial system develops.

The introduction of
CBDCs, in whatever form, should be subject to very careful consideration. There
is little to suggest today that central banks should play an active role as
payment-service providers, as would be the case with the introduction of token
CBCDs and all-purpose central-bank deposits. Not least, there would be the
danger that this would be used by states to achieve even closer monitoring of
their citizens.

An interesting innovation, however, would be if CBDCs could only be used as a store of value. Such an asset could only be created by the central bank and it would be particularly interesting for companies and investors who would be confronted with a bail-in in the event of a bank insolvency. Such CBDCs could serve as collateral for payment-service providers issuing a stable coin. But since this could lead to considerable changes in the way the entire financial system functions, no hasty steps should be taken here either.

This article is a joint publication by Social Europe and IPS-Journal