Cryptocurrency maximalists herald the dawn of a new economy with respect to the role digital assets like Bitcoin will play in reshaping finance at large. Some argue that transactions made possible through the use of blockchain technology will uproot fiat money and transplant a crypto-based payment scheme in its place. This idea is not too far-fetched and some parts of it are shared by market makers at the highest level of the world economy, yet in the same breadth skepticism lingers.
For example, Sheila Bair, a former chair at the Federal Deposit and Insurance Corporation (FDIC) in the United States has argued in favor of the Federal Reserve minting a central bank digital currency (CBDC). Her thoughts are echoed by the Reserve Bank of New Zealand who released a lengthy report that dove into the pros and cons of issuing a CBDC. Sweden’s Riksbank is also toying with the idea of using distributed ledgers to help effectively steer monetary and fiscal policy. However, Mario Draghi, President of the European Central Bank (ECB) has publically stated that the Eurozone has no intention of minting a digital euro. His candor is echoed by pundits within both the Reserve Bank of Australia, and the Bank for International Settlements (BIS). Russian central bank officials have argued that “the infrastructure surrounding blockchain is not yet big enough” for a CBDC. A BBVA study published earlier this year found that CBDC’s in Latin America may create positive net effects given countries in the region have traditionally struggled with wholesale payments systems, but cites incomplete regulation as a major obstacle. Not surprisingly, the Peoples Bank of China (PBoC) has moved to extend research of its digital currency project beyond Beijing, in yet another move by China staying at the forefront of blockchain advancements.
What we have then is a mixed bag internationally speaking. It may very well come down to what came first the chicken or the egg. Regulations that preempt a thorough analysis of potential externalities might stifle the blockchain revolution. The space is rife with pundits claiming that governments are deliberately being heterogeneous about how they wish to regulate and perhaps disseminate their own digital currencies. Given the banking sector around the world is closely connecting via SWIFT and other payments schemes, the lack of coordination among policy officials regarding blockchain doesn’t seem to follow the same logic. Others have argued that this is because a CBDC, while increasing competition within the inter-cryptocurrency market, could pit the central banks of the world against their number 2’s namely commercial banks.
Central Banks – a primer
Central banks are the gatekeepers of a nation’s financial system. To achieve this goal, they have several important tools at their disposal. By setting reserve requirements, they dictate how much physical cash commercial banks must hold on a given day, which in turn affects how much these banks can lend out. They use open market operations (OMOs) to buy and sell securities from commercial and other member banks to adjust the liquidity on-hand without altering initial reserve requirements. Lastly, by setting interest rate targets, which are affected by the prime and overnight rates, they can set discretionary interest rates for banks issuing loans, bonds, and mortgages. By lowering interest rates, they can stimulate inflation and prevent a recession. Raising interest rates contracts growth and puts breaks on the economy so runaway hyperinflation doesn’t happen.
Another important function of the central bank is its ability to store large quantities of foreign exchange reserves, usually pegged to the US dollar or Euro which helps domestic producers remain competitive in a global export market. They can also regulate exchange rates to control inflation. In short, understanding the function of central banks is a tricky business, which makes it difficult to properly asses how a digital token might function in a market economy.
There are a number of ways a CBDC could be brought into circulation. The most realistic is one where central banks circulate their own digital asset in tandem with physical cash, and other private cryptos like Bitcoin or Ether. That way the public has a choice whether they want to use one or the other. Many people might not be aware of the fact that most reserve banks already operate a form of restricted electronic money that is used for transactions between the central bank and commercial banks who hold electronic deposit accounts with a given central bank. So firstly, in order to bring the CBDC to life, it would have to be publicly available without restriction.
The second feature of a CDBC would involve the holdings themselves. An account based currency available to the wider retail sector would not be allowed to go negative. In this respect, the CBDC would behave much like physical cash. So we have a digital currency that can be widely accessible, is account based, and interoperable with other assets and financial instruments. But what about distribution?
Geography and the law
An obvious pro of using a digital currency is that it is borderless. Wherever you find yourself on the planet so long as the internet is readily available, regardless of physical or legal constraints – the token is a go. An obvious downside then to physical cash is the time it takes to transport across landscapes, especially ones with difficult topography and restricted or underdeveloped infrastructure. For this reason, replacing cash with tokens might be a cost effective solution. Yet in some jurisdictions, geography aside, central banks do not posses the legislative authority to issue digital currencies. This would require an overhaul of existing rules and processes from within the government of those countries. Even in first world pseudo-supranational entities like the Eurozone for example which has a complex geographic makeup – mountainous terrain with areas of varying elevation and climate conditions – the use of cash still made up almost 80% of all transactions across the region in 2017.
The effective lower-bound and why it matters
Why do we agree to hold cash? When the Great Recession sent shockwaves across the world in 2008, central banks used OMOs to inject liquidity through quantitative easing, namely the printing of money to offset economic fallout. This is made possible by lowering interest rates to near zero. They then used this liquidity to buy illiquid assets from insolvent financial institutions to prevent them from disappearing altogether. But the only reason you or I are willing to accept negative interest rates is because they do not reach a point where the cost of transporting, issuing, and housing physical cash is greater than the negative rate charged on our bank deposits. This in short is what’s known as the effective lower bound. A CBDC then is possible more so if a given central bank chose to issue an interest-bearing token. Anything but will result in a lower bound of zero percent, killing the effectiveness of monetary policy. Depositors like you and I would have zero tolerance for negative interest rates in this case. With this in mind, designing a CBDC would have to bear in mind the effective lower bound, and find ways to account for it. This can be done by removing higher denomination notes (physical or digital representations), or some form of non-par exchange rate between physical cash and the CBDC.
A tale of two banks and the interest that got between them
If the role of the central bank is to steer the domestic economy, the role of commercial banks is to facilitate deposit and savings accounts. Commercial banks in short make their bread and butter by lending. If the central bank issued its own digital variant, that would put it in direct competition with commercial transaction accounts. Especially if it was interest-bearing. The attractiveness of an interest-bearing CBDC would mean that people might chose to hold their deposits directly with the central bank instead of the commercial bank branches they traditionally do business with. With depositors now rushing to open central bank accounts, commercial banks are up the creek without a paddle when it comes to setting interest rates on retail deposits if the central bank decides to hike the overnight rate.
Commercial banks would then find themselves in a precarious position in times of sluggish economic performance at large due to the increased competition from CBDCs and private digital assets already in circulation. The only way for them to compete in this scenario is by offering higher interest rates, which would diminish their revenues on repayment schemes and as such these banks would find themselves essentially priced out of the very business that kept them afloat in the first place. It’s not the fiat replacement with a CBDC that scares banks as much as it is the central bank being in a position to take their customers.
Venezuela is the perfect example of why central banks around the world are reluctant to issue a digital token. President Maduro’s attempts to create a petro-backed digital asset that circulates in tandem with the Venezuelan Bolivar was meant to offer a way for the country to skirt US sanctions and attract hard liquidity. But a recent Reuter’s investigative report found that the Petro is nowhere to be seen. Absent Maduro’s boasting that the Petro ICO raised billions, Hugbel Roa, a cabinet minister closely involved with the concept stated that the project is still in heavy beta. Namely, no use-case for the Petro is even evident, especially not within the Venezuelan community at large. In fact, Rafael Ramirez, former oil minister under Hugo Chavez stated that “the Petro only exists in the governments imagination.” The nefarious design behind the Petro is evidence enough that using distributed ledgers to circumvent established norms and even human rights (Venezuela is on the verge of collapsing into a failed state) is a pervasive stain on the establishment of a tabula rasa for the crypto ecosystem.
The most likely outcome is that we are still several years, if not a decade away from seeing a true CBDC go to market. In the meantime, the establishment of true stable coins, tokens backed by physical assets will likely become the letterhead for settling transactions with reduced counter-party risk until the time is right for the world’s leading economies to retrofit their rosters.
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