CASH MANAGEMENT, MACRO AND MARKETS
Digital currencies, differing motives
Until quite recently, the attitude of many of central banks towards digital currencies ranged from antipathy to hostility. Led by China, most are now warming to the concept – or are even actively developing their own. However, as flow’s Graham Buck reports there are a range of motivating factors behind the change in attitude
Not long before the Global Financial Crisis of 2008, the central banks of Europe and the US resorted to using the official interest rate to serve as the tiller on their economies. A rise or fall in rates would work its way through the bond markets and banking system, ensuring that the desired economic outcome followed on.
More tools needed
That monetary policy abruptly changed after the crisis broke, when banks lowered rates to the point they were barely above zero and the tool lost effectiveness. As the Bank of England (BoE) puts it, there is “a limit to how low interest rates can go”.1 When it needed to act to boost the economy, the UK central bank, along with many others, introduced quantitative easing (QE) via extensive government bond buying programmes. In turn this lowered the interest rate on those bonds, and on other interest rates. In theory, this policy encouraged households to spend more – thereby stimulating the economy.
However, complications arise when QE fails to work its way into the commercial banking system and jump-start the economy. As noted in the Deutsche Bank Research white paper of 30 November ‘Focus Europe: Outlook 2021 – Transformations’, the European Central Bank (ECB) is having second thoughts about the efficacy of QE. “Some members, such as [Jens] Weidmann and [Klaas] Knot have also questioned the necessity and effectiveness of QE, and how it blurs the line between monetary and fiscal policy,” writes economist Michael Kirker.
Figure 1: The rise in Bank of England QE
Source: Bank of England
At the same time central banks were encountering limits on the monetary policy tools available to them, they continued to innovate in the payment service arena. “The history of central banking began with payment services,” explained the Bank of International Settlements in Central Bank Digital Currencies (March 2018).2 “Since then payment-related innovation has always been an integral part of central banking. Modern examples include the establishment of systems allowing for immediate interbank gross settlement and the recent increased emphasis on faster retail payment systems. Central bank digital currencies (CBDCs) represent another such potential innovation.”
Unlike Bitcoin or other cryptocurrencies, CBDCs are, as their name suggests, highly centralised. Presenting recently at EBAday 2020, Ole Matthiessen, Global Head of Cash Management at Deutsche Bank Corporate Bank, summarised the difference. “Bitcoin is a decentralised and anonymous means of recording a digital store of value. A CBDC, by contrast, is a digital representation of banknote that is backed by a central bank. So they’re two completely different things. Bitcoin is a much less secure asset as the backing for it is questionable and its sharp rise in 2020 has been driven by uncertainty caused by the pandemic. Stablecoins come somewhere between the two, as you tend to have more trust in the entity issuing a stablecoin.”
At the moment, commercial banks assess the risk of how much and who to lend cash to among the other services it provides to businesses, institutions and individuals. Funds collected from customers are deposited at its local central bank – the bankers’ bank.
CBDCs, however, provide a means of centralising the money supply rather than routing it through the banking network. Central banks’ actual appetite for dealing directly with consumers has yet to be revealed, but the potential for disintermediation of the banking system as we know it nevertheless presents itself with the development of CBDCs. At the very least the move towards digital payments away from physical cash gives central banks greater control over the money supply and the stability of the financial system.
“With bank accounts paying low interest rates, a CBDC could help disintermediate the banking system”
In her November 2020 essay, The steps required to promote digital currencies, Deutsche Bank Research’s Marion Laboure projects the scenario further, “With bank accounts paying low interest rates, a CBDC could help disintermediate the banking system,” she writes. “People might choose to hold their money directly at the central bank. Obviously, this would disrupt legacy bank franchises and impact financial stability.
“Credit card volumes, interchange fees, payment transaction fees, and deposit interest margins could be seriously affected. This would shake up the current two-tier system and create additional responsibilities for central banks in areas such as ’know your customer’ issues, disputes, monitoring transaction levels, preventing money laundering, terrorism financing, and tax compliance.”
This article provides an updates on CBDC progress so far around the world.
From blowing cold to hot
In the article ‘China focuses on post-Covid goals’ flow reported on how the country’s central bank is fast-tracking its own digital currency. The People’s Bank of China (PBOC), which had originally planned trials of its central bank digital currency (CBDC) in late 2020, brought forward a pilot initiative by several months to April and has announced that its CBDC will be available in time for the Winter Olympics in Beijing, which are scheduled for February 2022.
“President Xi is well aware of the strategic benefits for China in being at the forefront of digitisation,” wrote former UK national security adviser Sir Mark Lyall Grant on 25 November in The Times3 , where he suggested that the BoE should press ahead with reviewing the potential benefits of a British digital currency. “The introduction of a ‘digital yuan’, financing the infrastructure and trade opened up by the One Belt, One Road initiative, would give China the ability to bypass the world’s traditional banking system and then challenge the dollar’s pre-eminent position [as the world’s leading reserve currency].”
China is not the only country to changed tack on digital currencies. This autumn saw the first official launch of a CBDC; on 20 October The Central Bank of the Bahamas announced that the its state-backed virtual currency – dubbed the “Sand Dollar” – was being made available to the country’s 393,000 citizens after a successful pilot last year.4
As the Bank of International Settlements (BIS) has noted5 many forms of CBDC are possible “with different implications for payment systems, monetary policy transmission as well as the structure and stability of the financial system.” However, the two main variants are wholesale CBDCs and general purpose, also known as retail CBDCs. “The wholesale variant would limit access to a predefined group of users, while the general purpose one would be widely accessible.”
The BIS has also monitored the number of speeches6 given in recent years by central bank governors and other senior figures addressing the topic of digital currencies. Earlier this year it issued the chart (Figure 2) below showing how the number of speeches has risen sharply in the past four years and the attitude – initially mostly negative – is steadily becoming more positive.
This sea change was noted earlier in the year by The Economist. In its 23 July leader ‘A shift from paper to virtual cash will empower central banks’ the newspaper suggested that the primary motivation for issuing a CBDC is primarily defensive and the “gradual demise” of cash poses two risks.
- “First, online-payment systems could fail, suffering outages or hacks. To safeguard the integrity of their currencies, central banks hope to offer fail-safe digital alternatives.
- “The second risk is that private-sector systems are too successful, with more people switching to payment platforms offered by big tech firms such as Facebook or Tencent. Many central banks began taking this risk more seriously when Facebook unveiled its [Libra] plans.”
As Laboure noted in her 2 April report ‘Future Payments: Covid-19 pandemic accelerates the rise of central bank digital currencies’ and referenced by flow in ‘Covid-19’s assault on cash’, in early 2020 80% of the world’s central banks were working on a CBDC; 40% were experimenting with proofs of concept; and 10%, mostly in emerging economies, were running pilot projects.” Looking ahead, Laboure says that central banks representing about a fifth of the world’s population are likely to issue a general purpose digital currency within three years.
Figure 2: Central bank speeches on digital currency
A range of motivations
In a 24 November article for The Fintech Times, ‘Asia Marks the Path for Digital Currencies’, Asia Editor Ania del Rosario outlined the motivations of the region’s central banks – all less threatening than aiming to knock the USD off its perch. They include:
- providing a cash alternative;
- promoting financial inclusion
- increasing seigniorage profit (representing the difference between a currency’s face value; and its production and distribution cost);
- implementing monetary policy;
- linking payments to identity; and
- modernising payments for a digital economy
Figure 3: CBDC projects in Asia
Source: Deutsche Bank
On 9 October the Bank of Japan (BoJ) announced plans7 for a first phase of experiments on basic functions core to CBDCs, including issuance and distribution, from April 2021 and a review of ways to issue general-purpose CBDCs. However, the central bank stressed that it viewed CBDCs as complementing and not replacing cash in making payment and settlement systems more convenient and currently has no plans for its own CBDC although it was “important to prepare thoroughly to respond to changes in circumstances.”
The announcement coincided with the issue of a report on CBDCs by the BoJ and six other central banks – the ECB; the BoE; the US Federal Reserve; the Bank of Canada; the Swiss National Bank (SNB); and Sweden’s Sveriges Riksbank – together with the BIS8 . The report set out three basic principles with which all CBDCs should comply:
- coexisting with cash and other types of money in a flexible and innovative payment system;
- supporting wider policy objectives and not disturbing monetary and financial stability; and
- promoting innovation and efficiency.
"The speed of innovation in payments and money-related technologies requires the prioritisation of collaborative experimentation" by the central banks, the report stressed.
At the start of November 2020, the Hong Kong Monetary Authority (HKMA) held its annual Fintech Week at which HKMA’s chief executive, Eddie Yue, provided a progress report on Project Inthanon-LionRock9 , the joint study by the Authority and the Bank of Thailand (BOT) on how CBDCs might be applied to cross-border payments. The project – which also involves the Hong Kong Exchanges and Clearing Limited (HKEX), 19 participating banks and five other corporates – has now moved into a second phase that will consider business use cases in cross-border trade settlement and capital markets transactions.
The HKMA and the BOT also plan to enhance the cross-border corridor network to support the CBDCs of the region’s other central banks. Yue said that banks and large corporates would be included in the trials using actual trade transactions and the project’s findings are likely to be issued in Q1 2021.
Building trust and control
While the US Federal Reserve is reviewing the potential of a cyber-dollar it emphasises that it will only move once the risks of counterfeiting and cyberattacks have been addressed.
“This is one of those issues where it’s more important for the US to get it right than to be the first,” said Fed chair Jerome Powell on 19 October, during a panel discussion at the International Monetary Fund’s annual meeting on CBDCs.10 “Getting it right means that we not only look at the potential benefits of the CBDC, but also the potential risks and also recognise the important trade-offs that have to be thought through carefully.”
Early October saw the publication of the ECB’s report on the possibility of a digital single currency, when ECB President Christine Lagarde declared “Our role is to secure trust in money. This means making sure the euro is fit for the digital age. We should be prepared to issue a digital euro, should the need arise.”11
The ECB report envisages a digital euro as “a central bank liability offered in digital form for use by citizens and businesses [which] would complement the current offering of cash and wholesale central bank deposits.” Laboure adds that effectively its CBDC would:
- be a third form of central bank money which exists next to cash and reserves;
- try to combine the advantages of world reserves, which are already digital but only available to banks), and cash, which is available to everyone, but physical
- be digital and available to everyone.
CBDCs, noted The Economist on 23 July 2020 “also give central banks more control”. It continues, “They could allow for transactions to be easily tracked, perhaps making them more alluring to China’s authorities. In the West, where surveys show that the public cares more about privacy, CBDCs may need to ensure anonymity, without circumventing anti-money-laundering checks.”12
The other point, explains the paper, is that CBDCs make it easier to implement negative interest rates. “Unlike old-fashioned cash, digital fiat can be programmed. For now, rates cannot go too negative, because savers can always demand cash, which by definition offers an interest rate of zero. But if digital cash is programmed to have a negative interest rate, people would have fewer fallbacks and central banks more flexibility.”
Figure 4: Bank of England’s case for a UK CBDC
Source: Bank of England
“In principle, a widely-used digital currency could…enable interest rates to be levied on retail monetary assets”
The BoE’s chief economist, Andrew Haldane, is evidently thinking along similar lines. In March 2020, just as Covid-19 was starting to dominate news reports, the Bank issued a discussion paper13 on CBDCs. While it stated that no decision had been made on whether to introduce a UK CBDC, the paper was accompanied by a graphic of the potential benefits as shown above in Figure 4. More recently, the BoE has reportedly been reviewing the feasibility of negative UK interest rates. In a speech14 given on 18 November to financial industry advocacy group TheCityUK, Haldane suggested that a Brit CBDC could make negative interests more possible.
“On the monetary policy side, one of the most pressing issues for monetary policymakers today is the zero – or close to zero – lower bound (ZLB) on interest rates. At root, the ZLB arises from a technological constraint on the ability to pay or receive interest on physical cash, whether positive or negative,” he commented.
“In principle, a widely-used digital currency could mitigate, if not eliminate, that technological constraint by enabling interest rates to be levied on retail monetary assets. How far it is able to do so will depend on the supply of physical cash to the public, as well as any impact of the new regime on the financial system.”
Will this happen anytime soon? All of this requires collaboration between central banks, global systemically important banks, the clearing system and governments if CBDCs are going to stand up as a credible alternative to cash, with central banks entrusted with a new monetary policy tool.
Summary of Deutsche Bank reports referenced
Future Payments: COVID-19 pandemic accelerates the rise of central bank digital currencies, 2 April, by Marion Laboure
Future Payments: DB at Sibos: CBDCs and the Digital Euro, 8 October, by Marion Laboure
Konzept: What we must do to rebuild: The steps needed to promote digital currencies, 10 November
Focus Europe: Outlook 2021 - Tranformations: 30 November, by various Deutsche Bank economists
1 See https://bit.ly/3lvhMc6 at bankofengland.co.uk
2 See https://bit.ly/36rcydj at bis.org
3 ‘To counter China, Britain needs a digital currency’: The Times, 25 November 2020
4 See https://bit.ly/3lu5PU9 at forbes.com
5 See https://bit.ly/36rcydj at bis.org
6 See https://bit.ly/2HXDtUH at bis.org
7 See https://reut.rs/39vMDTC at reuters.com
8 See https://bit.ly/3mtGKdp at bis.org
9 See https://bit.ly/36pnmbK at regulationasia.com
10 See https://on.wsj.com/3mu4rC6 at wsj.com
11 See https://bit.ly/3ogRVXp at ecb.europa.eu
12 See https://econ.st/2I2XNnG at economist.com
13 See https://bit.ly/33ykmbi at bankofengland.co.uk
14 See https://bit.ly/39JCV0f at cryptonews.com
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