(May 28th, 2023)
By (Florian Gaszner, Equity Analyst)
Edited by (Ascanio Cicogna, Head of Research)
Introduction:
CBDCs are digital currencies issued by the Central Bank of the given country. The value of a CBDC is linked to the country’s official currency. As people generally shift away from physical payments, banks and financial institutions process far more transactions digitally. These digital currencies are considered by some to be the next step in the evolution of money. CBDCs are similar to stablecoins, which are private, stabilized cryptocurrencies pegged to a certain currency, commodity, or financial instrument. The difference is that stablecoins are decentralized, while CBDCs are state issued. 87 countries, representing 90% of global GDP, are currently researching and planning to issue some form of CBDCs. There are many reasons for the increased interest from central banks in CBDCs, which include plummeting cash usage, growing interest in holding digital assets, or the rising global payment systems. While there are multiple upsides to CBDCs, they do come with certain risks.
Figure 1: Number of CBDC’s under
research and development.
Source: CBDC Tracker (cbdctracker.org)
Upsides:
Decreasing costs is a pivotal argument for CBDCs, as financial-service providers spend hundreds of billions of dollars on shifting towards digital finance. While these new assets may significantly decrease spending of financial institutions, they must be measured against the costs of developing the infrastructure that CBDCs require. Besides, digital currencies could prove to be beneficial in increasing the efficiency of countries’ electronic payment systems, as well as decrease inequality in the financial system. Since around 1.4 billion people around the world are unbanked, these digital currencies might serve as a potential outlet for financial inclusion. Furthermore, digital currencies can increase the level of security by ensuring that transactions are finalized even without a formal bank account, which would notably reduce the opportunities to commit fraud. Being a tool to create fully insured deposit accounts can also be considered an upside of a potential introduction of CBDCs. The IMF states that introducing Central Bank Digital Currencies can improve monetary policy transmission.
Overall, a well-regulated CBDC issued by an exceptionally credible central bank has the potential to give grounds to new classes of safe assets, as they could preserve value in adverse economic ecosystems. These arguments, however, must be monitored with caution, as CBDCs could pose potential risks to the financial system and macroeconomic stability.
Questions and potential risks:
As discussed above, CBDC’s have a potential to significantly impact financial stability. They might result in central banks competing with private financial institutions for deposits, which may have a larger fallout, impacting the availability of bank credit. CBDCs are traceable, which implies that they are taxable. This could become an obstacle in voluntary adoption and usage. Privacy issues arising from traceability are also a concern among economists. Through CBDCs, central banks would have access to unprecedented amount of user data, which, in wrong hands, could be used to obtain security-sensitive details on people and institutions. By designing a system to separate transaction validation into phases that require access to certain aspects of the data, the Boston Federal Reserve and MIT have provided a partial remedy to the risks of centralized data collection.
There is also a lack of technological stability to back up the usage of digital currencies. In January of last year, Eastern Caribbean DCash went offline for two months due to technological difficulties. Cyber-security concerns and other operational technological issues must be strictly measured in order to eliminate privacy and integrity related threats. It might be more difficult to develop the ecosystem for digital currencies than the relative payoff for doing so. For these reasons, some nations, including Canada, have decided to postpone the development of a digital currency. Besides the aforementioned concerns about CBDCs, many argue they may pose an additional risk to the financial system, by increasing the probability and pace of bank runs.
With increased pressure on banks due to the emergence of digital bank runs, there are fears that CBDCs could offer yet another attractive outlet for depositors to move their assets in times of panic. Though many argue that a shift towards a more centralized digital financial ecosystem would result in a more stable economy, central banks must consider several risks when issuing these digital tokens. They need to issue an amount low enough such that they do not cause a run on the banking system, but high enough such that they do not become peripheral. BoE suggested a cap of $25.000 in its plan and decided not to pay interest on their new digital pound. The ECB suggested a limit of $3270. The IMF recently stated that “the materiality of CBDC risks on the financial system should be further evaluated”.
A study on digital bank runs conducted by MDPI discusses the risk of a digital bank runs based on interest paid on CBDC loans. The figure below shows the transfer of commercial bank deposits to CBDCs, given certain levels of interest and financial system risk, while the color coding shows the relative risk of a digital bank run, with green being the lowest and red being the highest.
Figure 2: Matrix showing relation between risk in the
financial system and interest in CBDC’s.
Source: CBDC Tracker (cbdctracker.org)
It is hard to neglect the relative risks of introducing CBDCs, including higher and more volatile capital flows. A recent research paper by the IMF explores the effects of issuing CBDCs in an open economy. The paper discusses the implications of the introduction of digital currencies in an international context. In the closed-economy models explored previously by economists, the findings showed that CBDCs could amplify the risk of potential bank runs and have a significant impact on capital allocation. In the open-economy model, along with the issuance of such currencies comes an additional effect on the capital outflows from the domestic economy. This may result in balance of payments crises as well as increased volatility in exchange rates. Another factor that could escalate the effects on the economy is large technological corporations using CBDCs on their respective platforms.
A study conducted by Centre for Economic Policy Research (CEPR) examines the characteristics of the French Great Depression of 1930-1931. During the French Great Depression, government-backed savings accounts (Caisses d’épargne ordinaires or CEOs) provided a safe alternative to depositors. CEOs were savings institutions that benefited from the guarantee of the government and were not allowed to lend or provide payment services. Since the liquidity of CEOs was similar to that of bank deposit accounts, people with a CEO account had an incentive to withdraw their capital and transfer it to their CEO account in times of uncertainty.
Figure 3: Number of accounts per capita in CEO pre-crisis (1924) vs growth rate of bank branches between 1925 and 1928:
Source: Monnet et al. (2021).
During the French Great Depression in 1931, the French Parliament decided to increase the ceiling of CEO accounts for both individuals and firms in an attempt to protect depositors. This turned out to worsen the banking panic at the end of the year, and thus the overall damage to the economy. The difference in interest rates between bank deposits and safe CEOs did not affect the allocation of capital significantly in the pre-crisis period, but it certainly amplified the magnitude of bank runs during the crisis, as interest rates paid on CEO deposits were generally higher than on bank deposits. This did not affect bank deposits in normal times as banks provided additional services that CEOs could not.
Conclusions:
As many nations are exploring the potential introduction of CBDCs, it is important for regulators and central banks to look at the potential risks associated to these assets. Finding optimal ceilings and interest rates on these accounts could prove to be effective in preventing serious damage to the financial system. As central banks start introducing their digital currencies, economists will have a clearer view on how these accounts should be structured and how they will affect the allocation of capital in the economy.
Citations:
What is Central Bank Digital Currency (CBDC)? (2023) McKinsey & Company. Available at: https://www.mckinsey.com/featured-insights/mckinsey-explainers/what-is-central-bank-digital-currency-cbdc (Accessed: 27 May 2023).
Popescu, A. (2022) Cross-border central bank digital currencies, Bank runs and capital flows volatility, IMF. Available at: https://www.imf.org/en/Publications/WP/Issues/2022/05/06/Cross-Border-Central-Bank-Digital-Currencies-Bank-Runs-and-Capital-Flows-Volatility-517625 (Accessed: 27 May 2023).
Riva, A., Ungaro, S. and Monnet, E. (2021) Bank runs and Central Bank Digital Currency, CEPR. Available at: https://cepr.org/voxeu/columns/bank-runs-and-central-bank-digital-currency (Accessed: 27 May 2023).
Wüst, K. et al. (2020) Design choices for Central Bank Digital Currency, CEPR. Available at: https://cepr.org/voxeu/columns/design-choices-central-bank-digital-currency (Accessed: 27 May 2023).
Eurosystem report on the public consultation on a digital euro (no date) Report on a digital euro. Available at: https://www.ecb.europa.eu/pub/pdf/other/Eurosystem_report_on_the_public_consultation_on_a_digital_euro~539fa8cd8d.en.pdf (Accessed: 27 May 2023).
FANTI, G., LIPSKY, J. and MOEHR, O. (2022) Central Bankers’ new cybersecurity challenge, IMF. Available at: https://www.imf.org/en/Publications/fandd/issues/2022/09/Central-bankers-new-cybersecurity-challenge-Fanti-Lipsky-Moehr (Accessed: 27 May 2023).
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