On Tuesday the Bank of Japan (BoJ) issued a paper about central bank digital currencies (CBDC). Numerous central banks have published reports, but most cover slightly different areas, gradually expanding the range of topics. The BoJ focused on retail CBDCs because it considers that wholesale CBDCs, those targeted at institutions, do not raise significant issues since these organizations already have central bank deposits.
Retail CBDC options
Central banks have a reasonable number of levers in designing a CBDC.
An important question is whether cash and commercial bank deposits would be exchangeable for a CBDC at a 1:1 ratio. If the ratio is one, then under stress conditions there would be a flight to quality. Alternatively, the bank could limit CBDC supply which would enforce a scarcity premium.
A related decision is whether or not a CBDC would be interest bearing. That depends in part on its purpose. If the currency is intended purely as a payment instrument, then interest is unnecessary. If the role is to serve as a bank deposit, then it would need to offer a return. Also, the decision is not binary. A central bank could offer zero interest rates when the main rate is positive. And if the primary rate is negative, the CBDC rate could also be sub-zero.
A central bank could issue a CBDC direct to consumers or via commercial banks. The currency could be account based or token based. In the case of the account-based option, blockchain or DLT is not needed, and there would be less anonymity. For the token-based option, DLT is more likely, and that creates more privacy possibilities.
Impact of CDBC
It’s often asserted that if CBDCs exist then consumers will no longer use bank deposits. This is more likely to happen if a CBDC offers a positive interest rate. But it could also squeeze out commercial deposits during low-interest-rate periods.
It’s the indirect effect of crowding out bank deposits that’s the real risk. If commercial bank deposits decline significantly, then banks can’t lend as much. The problem is that lending involves judging the risk and returns of projects. And that’s the core skillset of a commercial banker rather than a central banker. Hence the reduction in deposits and lending capacity could “distort efficient resource allocation in the economy”.
Another impact is that if central bank deposits expand as a consequence of issuing a CBDC, then it may need to reconsider its own balance sheet and the types of assets it holds.
Commercial bank alternative
The BoJ also considered the possibility of commercial banks issuing their own payment instruments. (This is similar to a retail version of JP Morgan’s announcement re JPM Coin). The BoJ considered two scenarios. In one case deposits serve as collateral and hence deposit insurance is needed. Under this scenario, the BoJ questioned whether there’s a need for a CBDC at all.
The second commercial bank option would be to have the payment instrument fully backed by safe assets. But by tying up assets, commercial banks reduce their ability to lend which increases the risk of distortion.
The other commonly cited concern is that in a crisis, consumers will switch bank deposits into CBDC. The BoJ pointed out that to some extent this could happen already because using online banking, people can transfer balances to other banks.
Furthermore, the money flowing into the central bank gives it more ability to provide liquidity to troubled banks. However, the BoJ acknowledged that during a turmoil there’s an asymmetry of information and sometimes it’s hard to supply liquidity appropriately and immediately.
Impact on monetary policy
If a CBDC is interest-bearing, then the interest rate is the effective floor for market rates. However, if the central bank wanted to limit the impact on commercial banks, it would make delicate judgments about the appropriate interest rate. That would make it harder to use CBDC interest rates purely for monetary policy purposes.
Another argument is that CBDC could be a tool for negative interest rates. (The IMF published research on the topic last week). This would encourage a flight to cash. The BoJ also noted that if the nominal value of a CBDC was reduced, that could prove somewhat unpopular.
If CBDCs were not interest bearing, then it would make it easier for large entities to avoid negative interest rates by merely switching to CBDCs.
Data and money
Today many credit cards and digital payment systems have loyalty rewards. These rewards, in essence, involve an exchange of data for a discount, with the purpose to find out who is shopping in a store. Increasingly digital money, some information about transactions and the customer are becoming intermingled. Hence the BoJ concludes that when considering a CBDC one also needs to consider data and information aspects.