Brave New World

Brave New World: Central Bank Digital Currencies

Collin Constantine, Official Fellow in Economics, considers how the rise of cryptocurrencies is forcing a rethink of monetary policy

Collin Constantine

The development of blockchain technology, Bitcoin, and other private digital currencies or cryptocurrencies has led to an intense debate on the corresponding effects on monetary policy; and whether central banks should develop digital currencies. Traditionally, households and firms utilise central bank money (cash) and/ or commercial banks’ money (deposits) to undertake financial transactions.

Typically, we use an electronic payments system, say debit/credit cards, to utilise bank deposits. But since the recent burst of financial innovation, numerous private digital currencies compete with bank deposits and central bank money. Digital currencies are appealing because they are cheaper and less transparent than the traditional electronic payments system.

This new form of competition is potentially problematic for monetary policy and banking. First, the extensive use of private digital currencies may undermine major deposittaking institutions that provide a safe and stable return. This is an especially grave problem during periods of major economic uncertainty (a financial crisis), where the availability of private digital currencies may induce a ‘run on the banking system’, i.e. households and firms may exchange bank deposits for cryptocurrencies. Second, the effectiveness of monetary policy is compromised. Typically, commercial banks borrow central bank money to undertake transactions with other banks at an interest rate determined by the central bank. This is necessary when households and firms at Bank A use their deposits to purchase goods and services from other actors at Bank B. In short, at the end of each day, banks owe each other deposits, and central bank money settles these liabilities. When the central bank raises the cost of borrowing central bank money, commercial banks increase their lending and deposit rates; thus, they raise the cost of using bank deposits in the economy. This is the nexus among bank deposits, commercial banks, and the power of monetary policy. However, as households and firms hold digital currencies, the demand for both cash and bank deposits falls directly. Therefore, as bank deposits dominate fewer financial transactions, commercial banks indirectly reduce their demand for central bank money. It follows that private digital currencies weaken the central bank’s power by directly and indirectly reducing the demand for its currency.

At one extreme, central banks can outlaw the use of private digital currencies to maintain their control over money and banking. But this draconian approach may undermine financial innovation, say, the development of blockchain technology. The tentative consensus is to avoid destroying the sandbox of financial innovation, where China is a well-known exception as it has banned the use of private cryptocurrencies.

Many analysts contend that the development of a central bank digital currency (CBDC) safeguards financial innovation and the power of monetary policy. But we are far from a consensus because a CBDC revolutionises money and banking in the following ways. First, if CBDCs are available to all citizens, then it reduces the private banking system’s power to create money (bank deposits) as CBDCs are safer assets. In other words, if citizens prefer central bank deposits over commercial bank deposits, then the moneycreation mechanism of bank loans to bank deposits is significantly weakened. In one sense, money becomes truly nationalised. Secondly, since commercial banks can create loans and deposits ex nihilo – given a robust demand for commercial bank deposits – private money creation by banks tends to inflate the demand for goods, services, and financial products beyond what economic fundamentals may warrant. It follows that CBDCs stabilise the economy by reducing the banking system’s money creation power, which tends to be pro-cyclical. Thirdly, private banks are no longer ‘too big to fail’ if most citizens hold CBDCs. In the case of bankruptcy, the payments system is maintained without a financial bailout. Fourth, the central bank gains a new policy tool by paying interest on CBDC deposits. Overall, proponents contend that a CBDC promotes financial inclusion and stability and enhances the power of monetary policy.

One concern with CBDCs is that they may produce higher loan rates or reduce the extent of private credit creation by banks. Following the introduction of a CBDC, private banks may raise their deposit rates to attract customers and their lending rates to maintain profit margins. The concern of higher loan rates is still hotly debated, and some advocates suggest that central banks can engage in credit creation.

The Central Bank of Bahamas has launched its own digital currency, the Sand Dollar; and several other central banks are in the process of doing so, for example, the Riksbank – the Central Bank of Sweden. Still, major central banks like the Federal Reserve remain sceptical of the utility of a CBDC or divided about its purpose and rationale. The division of opinion was to be expected as the wave of innovation is still ongoing, and the precise role of a CBDC is still uncertain. But what we know for sure is that the recent wave of financial innovation has led to a rethink of monetary policy and banking and a lively debate about democratising the production and use of money.