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Central banks' uneasy embrace of digital currencies


The author thanks Martin Chorzempa, Joe Gagnon, Ángel Ubide, and Steve Weisman for helpful comments.


Move over bitcoin, the big players are here. Volatile and energy intensive, this faddish digital asset was never going to make it as fully-fledged money. Meanwhile, banks and financial technology companies have been gradually bringing their more practical payments services into the digital age. In 2020 Facebook raised the stakes with its Libra (now renamed Diem) proposal for a multi-currency-based “stablecoin.” And now most central banks around the world are thinking about creating some form of central bank digital currency (CBDC) that would be widely used by the general public.

At one level, this flurry of activity may seem puzzling. What need does a CBDC address? It’s not as if paper money is becoming obsolete. Even though usage may be declining—in Sweden, for example, physical cash is used in just one out of every eight retail transactions, fueling the Riksbank’s enthusiasm for a digital currency—the value of dollar bills has nonetheless more than doubled in a decade—and the value of euro and renminbi banknotes has grown almost as strongly.

Yet all three leading central banks—the European Central bank (ECB), the US Federal Reserve, and of course the People’s Bank of China—are exploring their options. Both the Fed and the ECB are at the research stage. Fastest out of the traps has been the People’s Bank of China: In its pilot scheme, hundreds of thousands of packets of digital currency, each worth RMB200 (about $30), have been distributed in selected cities over the past few months. (At the other end of the size scale, the Central Bank of the Bahamas has fully launched its digital currency, quaintly called the “sand dollar.”)

For the retail user, a CBDC is likely to look and perform much like the already well-established and widely used smartphone (or contact card) payment methods. (CBDCs will have nothing like the volatile pricing and high transactions costs associated with first-generation cryptocurrencies like bitcoin.)

When asked why they are studying CBDCs, central banks’ responses do not cluster around a single reason. Safety or robustness of the payments system, financial stability, efficiency of payments, implementation of monetary policy and the goal of greater inclusivity in accessing payment systems by lower income populations—all seem to be considered at least somewhat important.

Lacking a single vision of what they want to accomplish, central bankers seem to be afflicted by a generalized unease. Though scenarios can be only vaguely delineated, shifting sands in the payments and monetary landscape suggest to central banks that, if they do not provide a digital currency, they could find themselves isolated and weakened in unfamiliar ways. Having sufficient control over the retail payments system might, they suppose, prove to be essential for ensuring the stability and efficiency of the monetary and payments system.

Yet, as they recognize, there could be some downsides. To glimpse the quandary of central banks over potential risks and opportunities, consider a few practical questions that come to mind.

How much of this fuss has been triggered by Facebook’s announcement a couple of years ago of a consortium to create a digital currency? Why are the central banks not leaving it to the likes of Facebook to deliver this kind of service?

Central bankers have acknowledged that Facebook’s move was a wake-up call: The speed with which consumers have moved over to cards and phones for their payments may herald a big change in the payments landscape, giving “big tech” a dominant role. What if such a firm were to go bust, crashing the payments system and causing wholly unanticipated losses to millions? Avoiding such a nightmare scenario is one strong motivator for central bankers to act.

But didn’t Facebook’s plan for a digital coin envisage that it would hold its value against a basket of national currencies, thereby being a “stablecoin,” thanks to being fully backed by a reserve of safe assets?

Alas, financial historians can point to countless examples of firms that began with such promises but eventually reneged. Protecting the integrity of the payments system is, for most central bankers, an even more essential reason for prudential regulation of banks than the goal of protecting depositors from losses.

Is the move by Chinese regulators to rein in the expansion plans of Ant, the financial affiliate of ecommerce giant Alibaba, part of the same story, and not just a tiff between their founder Jack Ma and the Chinese authorities?

Indeed, it would miss the point to see these Chinese events as just a matter of pique, personalities, or political rivalry.

Even without a financial services role, the concentrated economic power amassed by firms like Alibaba and Facebook thanks to network effects has already raised multiple public policy concerns. These concerns will escalate if such firms also begin to process the bulk of their customers’ payments, provide financing, and hold their working cash balances. (Ant Financial already delivers retail digital payments services to well over a billion Chinese customers). Somecentral bankers have such questions in the back of their minds as they contemplate providing an alternative retail payments system to outflank these firms.

I liked Facebook’s expectation that its stablecoin would accelerate the access of poor people all over the world to basic financial services. In particular, wouldn’t it be good to have an international payment mechanism that costs migrants far less than the 5 to 10 percent they now pay for remitting badly needed resources back to their impoverished families in low-income countries?

Indeed, what’s not to like about lower-cost international retail payments? Some central bankers worry that convenient access among the general public to international digital cash might undermine the ability of small countries to operate a national currency at all.

Maybe losing the ability to have its own currency would not be a bad thing for a country that is unable to manage its monetary affairs in a socially optimal manner.

Be that as it may, the ECB for one has suggested that the amount any individual could hold of a future ECB digital currency might be restricted, and that the restrictions for nonresidents might be tighter than those for residents. That would reduce the risk of “dollarization” or “euroization” in other countries, albeit also lose the benefit of lowering the cost of international payments.

Wait a minute: Are you saying that the central bank would know how much of the stablecoin I hold? What about my right to privacy?

Central bankers will want to balance privacy issues with the need to contain money laundering and terrorist financing. Thus, even if every transaction is not traced, it is likely that a central bank digital currency would have less privacy than notes and coin.

Does that mean central bank digital currencies will use blockchain technology to keep records of transactions?

Distributed ledger technology could be used (and is in several of the pilot CBDCs), though not necessarily. There certainly won’t be the apparatus of energy intensive “mining” that is a feature of bitcoin (a product unlikely to feature at scale in retail payments). Depending on the chosen technological design, though, CBDC payments could be linked to more complex contracts, such as deferring payment of a service until delivery. Such “added-value” products are unlikely to be offered by central banks, but they could be added on by other financial service providers, especially if the CBDC is being rolled out by a private sector provider, as is likely to be the case.

What does that mean then, a private central bank digital currency?

That is one option, namely that private firms (most likely including banks) would handle the customer-facing aspects of the CBDC. After all, banks are already more equipped to deal with large numbers of account holders than are central banks.

Might that kind of CBDC be more attractive than a traditional checking account at the bank? Would the emergence of CBDCs thus reduce banks’ ability to mobilize loanable funds?

The fear that a CBDC could drain resources from banks, especially in times of uncertainty, has exercised many central bankers; central bank lending to the banking system might play a larger offsetting role as a consequence. If a ceiling is placed on each person’s CBDC holdings, or if interest rates on a CBDC are negative, this problem would be less likely to emerge.

Ah ha! So is that the plan: to abolish paper currency and replace it with a digital currency that carries a negative rate of interest—a new kind of tax?

Some theoreticians of monetary policy have indeed contemplated the advantages of being able to charge interest on cash holdings in times (like the present) where, although aggregate demand in the economy needs the boost of cheap financing, interest rates cannot go too much lower given the ability of firms to switch into cash holdings. Still, I think it is fair to say that few central bankers are really focusing on this potential.

I am beginning to see that there are many dimensions to this CBDC story. It’s more complicated than I supposed and very far from being an unproblematic upgrade for paper currency. I trust paper money as a kind of abstract collective entity. But with these CBDCs, it looks like a computer system directly or indirectly under the control of the central bank will be involved in mediating all of the transactions. That’s new.

The world of payments continues to evolve rapidly. Active involvement of central banks is inevitable, but it remains to be seen how much social value CBDCs will really add.

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