Central bank digital currency: corner cases
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Central bank digital currency: corner cases
The Bank for International Settlements released this week a section of its annual report devoted to central bank digital currencies. To sum up: the existing payments infrastructure is expensive to end users. Crypto assets are a private intervention trying to fill the gap. Central banks, the BIS is saying, should build out their own digital currencies to address the underlying payments problems within the state-backed monetary system. The FT's Izabella Kaminska observed that this starts to look like a watershed moment: it now seems like CBDCs are coming, and it's just a matter of time.
The report comes as the crypto landscape changes rapidly. With CBDCs, central banks are trying to offer a payment medium that incorporates many of the features and innovations of crypto payment experiments. At the same time, they are trying to constrain crypto assets with tighter capital requirements, crackdowns on mining operations, outright bans and so on.
I have previously argued that CBDCs were unlikely to preserve the anonymity of cash, and the BIS report largely supports this view. One possible structure, which seems increasingly likely, is that central banks will hold the financial substance of the relationship, while engaging third parties to handle compliance with know-your-customer and anti-money-laundering requirements. However it works out, CBDCs will be substantially less anonymous than cash.
A broad move out of deposits and into CBDCs would change both the central bank balance sheet and the funding patterns of the banking system. Clearly, sorting this out will be a lot of work. But in this brief post, I want to lay out two general patterns for that adjustment, which I think of as corner cases. The reality will be messier, but it will lie somewhere between these two corners.
Two corner cases
In the current system, the public cannot hold deposits at the central bank. Instead, people deposit funds at banks. Banks in turn hold a fraction of these funds as reserves at the central bank, and the rest in their portfolios of loans and securities.
Assuming a successful future rollout of central bank digital currencies, the public will migrate out of deposits and into CBDCs. The central bank's balance sheet will have to expand: in the current reserve-based system, only a fraction (the reserve ratio) of deposits become central bank reserves. Under a CBDC system, all of deposits will be booked there. Banks, by the same token, will have to either reduce their portfolios or refinance them.
Here are two schematic versions of how that could work. In the first possibility, banks could sell assets, while the central bank buys (different) assets:
This is outright disintermediation of the banking system. For clarity, I show it in three balance sheets, but it need not be that the central bank buys the same assets that the banks sell. Think of the resolution to the 2008 crisis, where the Fed eventually bought newly-issued mortgage-backed securities by inducing a wave of refinancing among the highest-credit US mortgage borrowers. Those new mortgages paid off other mortgages on other balance sheets. So the Fed bought and the banking system sold, but the transaction was not direct.
This disintermediation probably leaves both banks and central banks unhappy, banks because they have to shrink and central banks because they don't want risky assets. In the second possibility, the central bank would instead use the funds from the issuance of new CBDC to refinance the banks, perhaps by lending to them in the repo market:
A long way to go
Such an arrangement seems more likely, in that it requires much less in the way of institutional change. It does not require banks to unwind their asset portfolios, and it allows the central bank to invest only in high quality money market instruments. In fact, it makes the central bank into a kind of money market mutual fund, issuing deposit-like liabilities to fund money market investments. By setting terms on its repo investments, it would give the central bank traction for conducting monetary policy.
But it will take a long time to get there, and a lot could change between now and then.