Central bank digital currencies
Part I: What are CBDCs?
Central banks are currently either testing or planning to issue their own digital currencies, i.e., central bank digital currencies, or CBDCs. Astonishingly, the many threats they pose to our economic freedoms, and thus to our freedoms in general, have been almost completely neglected in public discourse. Central banks, naturally aim for this, because they are (have always been) institutions that want to grow their control over the economy (we will not speculate on the reasons here).
In June 2021, we published a special report entitled: Currency Wars. There we went through both the CBDCs and privative-issued cryptocurrencies and their approaching “battle”. Now, that the battle seems to have started, we decided to make our findings public. This was done especially, to encourage discussion and to warn the populace on the many risks of CBDCs.
In this first entry, we explain what a CBDC is, what different forms can it take and what kind of threats it creates for our banking system.
Let’s dive in.
What is a CBDC?
Central bank money is at the core of modern financial systems. It is comprised of physical cash in circulation and central bank reserves—the deposits of financial institutions at the central bank.
A central bank digital currency, or CBDC, would create another layer of central bank money. In its strictest form, a CBDC is a digital payment instrument, which is denominated in the national unit of account, or currency, which is also a direct liability of the central bank.1
Essentially a CBDC can take two forms. It can be a central bank issued (retail CBDC) digital currency or a central bank-backed digital currency (a ‘synthetic’ CBDC). A CBDC is ‘synthetic’, when it is backed by deposits (reserves) at the central bank.2 Another name for this is wholesale CBDC. A retail CBDC is in question, when it is widely acceptable digital form of fiat money, which can or cannot act as a legal tender.
A ‘synthetic’ CBDC
One can argue that the ‘synthetic’ CBDC (sCBDC) is not an actual CBDC. The basic mechanism of a sCBDC is when private sector payment service providers issue liabilities matched by funds (reserves) held at the central bank.3 The private issuers of digital currencies would act as intermediaries between the central bank and the end users: consumers and firms. Regardless of whether the liabilities of the providers would be fully matched by funds held at the central bank, the end users would not hold a claim on the central bank. This means that these liabilities, and thus the digital currency would not constitute a ‘pure’ CBDC.
‘Essentially, sCBDCs would be “narrow-bank” money, where all deposits would be 100% guaranteed by central bank money (reserves).
However, if such a system would be set up, it would affect the banking system in a detrimental way.
First, fractional reserve banks, where banks hold only fraction of their liabilities and assets are covered by capital or CB reserves, would come under pressure.4 Banks would be likely to lose some customers, pushing them to seek more wholesale funding, such as funding from commercial credit markets like state and local municipalities and brokered deposits. Banks could be forced to raise interest rates on deposits, which would reduce their profits.
The biggest problems would arise in a banking crisis. Because sCBDCs, or CBDC ‘e-money’ holders would be fully covered by central bank reserves, unlike fractional reserve banks, the existence of sCBDCs could easily worsen a potential run on banks thus making the banking crisis worse.
Account-based or a ‘pure’ CBDC
A pure CBDC could be account- or token-based.5
The former (an intangible property) would involve the transfer of a claim between accounts and it would resemble a bank account transfer with the exception that accounts would be within the central bank. In the latter there would be a transfer of a token between wallets. Settling transactions using a token-CBDC (a tangible property) would require external verification of the tokens, which would imply that anonymity, like with transfers in cash, could not be guaranteed.
A retail CBDC would alter the banking system in a radical way.
It is the role of a central bank to monitor and regulate banks and to act as a ‘lender of last resort’ during a banking crisis. With the issuance of a CBDC, the central bank would also become the competitor of commercial banks. It’s rather obvious that this would corrupt the whole financial system.
Commercial banks would be forced to compete the more secure CBDC with higher interest rates and even if the CBDC would be non-interest bearing, it would still offer safety especially in a zero or negative interest rate environment. Banks would thus compete against the CBDC by issuing higher deposit rates, while they would at the mercy of central bankers concerning regulation and guidelines. Serious doubts can be cast whether central bankers could act in an even-handed way in this setup.
However, problems would magnify in a banking crisis.
If the central bank has the backing of a fiscal authority, it can provide banking services—deposits—backed by the taxing power of a government. It's obvious that in this situation, the central bank will offer superior deposit safety in a banking crisis.
Thus, if consumers believe that a commercial bank run is imminent, all depositors will move their deposits to the safety of a central bank.6 Such a flight from commercial banks to the safety of the CBDC could be countered only with strict deposit limits to the central bank. It’s questionable whether such limits could be maintained in a banking crisis as the crisis would, almost certainly, create a political pressure to open the balance sheet of the central bank with a CBDC to all. This would lead to a situation where the banking system would consist of just one bank, the central bank.
CBDC as a political tool
If a CBDC dominates the monetary realm of a country, the central bank would come under heavy political and economic pressure to use its profits and its ability to divert lending towards politically desirable ends, such as “green” initiatives, social, gender or racial equality, universal basic income, or even towards supporters of “politically acceptable” political parties.7 This would lead to a deluge of unprofitable investments and to utter corruption of the banking system.
Moreover, as central banks are only ‘quasi-independent’, the banking system would essentially become controlled by the government. We have detailed the massive risks to economic and civil freedoms this would entail in Q-Review 12/2020. More on those later.
Disclaimer:
The information contained herein is current as at the date of this entry. The information presented here is considered reliable, but its accuracy is not guaranteed. Changes may occur in the circumstances after the date of this entry and the information contained in this post may not hold true in the future.
No information contained in this entry should be construed as investment advice. Readers should always consult their own personal financial or investment advisor before making any investment decision, and readers using this post do so solely at their own risk.
Readers must make an independent assessment of the risks involved and of the legal, tax, business, financial or other consequences of their actions. GnS Economics nor Tuomas Malinen cannot be held i) responsible for any decision taken, act or omission; or ii) liable for damages caused by such measures.
BIS, Bank of International Settlements (2020). Central bank digital currencies: foundational principles and core features. https://www.bis.org/publ/othp33.htm
Kiff, J., J. Alwazir, S. Davidovic, A. Farias, A. Khan, T. Khiaonarong, M. Malaika, H. Monroe, N. Sugimoto, H. Tourpe and P. Zhou (2020). A survey of research on retail central bank digital currency. IMF Working Paper 20/104.
BIS, Bank of International Settlements (2020). Central bank digital currencies: foundational principles and core features. https://www.bis.org/publ/othp33.htm
Adrian, T. and T. Mancini-Griffoli (2019). The rise of digital money. IMF, Fintech Notes, 19/01. https://www.imf.org/en/Publications/fintech-notes/Issues/2019/07/12/The-Rise-of-Digital-Money-47097
Mancini-Griffoli, T., M.S.P. Peria, I. Agur, A. Ari, J. Kiff, A. Popescu and C. Rochon (2018). Casting light on central bank digital currency. IMF Staff Discussion Note, 18/08. https://www.imf.org/en/Publications/Staff-Discussion-Notes/Issues/2018/11/13/Casting-Light-on-Central-Bank-Digital-Currencies-46233
See, e.g., Fernández, Villaverde, J., D. Sanches, L. Schilling and H. Uhlig (2021). Central bank digital currency: Central banking for all? Review of Economic Dynamics.
See, e.g., Fernández, Villaverde, J., D. Sanches, L. Schilling and H. Uhlig (2021). Central bank digital currency: Central banking for all? Review of Economic Dynamics.