Central Banks and Digital Currencies: Midwives and Undertakers

Sometimes the most revolutionary developments and initiatives disguise themselves in the dullest language. This is the case in a paper released by the Bank for Int'l Settlements (BIS) last week entitled: 'Central bank digital currencies: foundational principles and core features.' This relayed the thoughts about central bank-issued digital currencies by the central banks of the US, EU, Japan, UK, Switzerland, Sweden and Canada. It is, quietly, an extraordinary read.

I can summarize its 21 pages like this: 'Central banks need to issue digital currencies because commercial banks are expensive, dangerous and failing. But that's a problem because commercial banks are in no fit state to face competition from us.' In short, central banks find themselves between the Scylla of commercial bank institutional inadequacy and the Charybdis of actual commercial bank failure. If they are to be midwives to digital currencies, will they thereby find themselves undertakers of the current commercial banking structures?

Now that China's PBOC has made a (very small) experimental digital Rmb drop in Luohu, Shenzhen to trial/encourage consumer use of its digital Rmb, the time is fast approaching when this dilemma will have to be faced. Time is probably not on their side.

When these central banks ask themselves why they should develop central bank digital currencies (CBDCs), they itemise a list of the shortcomings of the commercial banking system which they seek to guide and protect.

1. As commercial banks retreat from local communities, including cutting back on ATM infrastructures, they may not longer provide reliable continued access to central bank money. 'In jurisdictions where access to cash in in decline, there is a danger that h'holds and businesses will no longer have access to risk-free central bank money. Some central banks consider it an obligation to provide public access. . . . A CBDC could act like a 'digital banknote' and could fulfil this obligation.

2. If commercial banks no longer reliably provide access to cash, economies are increasingly dependent on their electronic systems staying up. If they crash (as they have, and will)? 'Cash acts as a backup payment method to electronic systems if those networks fail. if access to cash is marginalized . . . a CBDC system could act as an additional payment method.'

3. And anyway, commercial banks' electronic networks act effectively as a new and unlegislated tax on consumers and producers. 'Payment systems benefit from strong network effects, leading to concentration and monopolies. . . when a small number of systems dominate high barriers to entry and high costs (especially for merchants) can occur. '

4. CBDCs can sure improve system of cross-border payments 'which are often slow opaque and expensive. An interoperable CBDC could play a role in improving cross-border payments.. . . Designing a CBDC that is convenient for cross-border payments could help adoption.'

5. Commercial banks have developed a very poor record in denying financial support for crime and terrorism. 'Central banks are expected to design CBDCs that include Anti-Money-Laundering and counter-terrorism financings'.

6. Commercial banks are inefficient vehicles to pass on central bank monetary stimulus. So CBDCs could be used 'to stimulate aggregate demand through direct transfers to the public (so-called “helicopter drops”), possibly combined with “programmable monetary policy” (eg transfers with an “expiry date” or conditional on being spent on certain goods).' More generally: 'Theoretically, a remunerated CBDC [ie, an interest bearing CBDC] could pass on policy rate changes immediately to CBDC holders.'

7. If CBDCs were universally available, and linked to a digital identity system, they could also be 'used to facilitate fiscal transfers.'

As a charge sheet against our legacy commercial banking industries, by the people who know them best, this is absolutely damning: commercial banks are unreliable, expensive, increasingly unwilling or unable to perform the infrastructural functions economies need, unable to act as effective policy mediators, but prone to subverting public goods.

Yet the central bankers pass over the fundamental shortcoming of the legacy commercial bank structure: the promise implicit in the deposit contract - that savings will always be returned, with interest - is necessarily delusional, since it denies the ineradicable realities of liquidity and credit risk. But central banks don't need to point this out: indeed, stepping in when the impossible promises of the deposit contract are exposed is why central banks exist in the first place.

Having assembled such a charge sheet against their commercial banks, the central banks' problem with CBDCs is all too obvious: if they succeed, who would possibly want or need, or pay for, a commercial bank? Or, as they put it:

'There is a risk of disintermediating banks or enabling destabilising runs into central bank money, thereby undermining financial stability. Today, the public can (and have in the past) run into central bank money by holding more cash, but such runs are very rare, given the existence of deposit insurance and bank resolution frameworks that protect retail depositors. There is, however, a concern that a widely available CBDC could make such events more frequent and severe, by enabling “digital runs” towards the central bank with unprecedented speed and scale. More generally, if banks begin to lose deposits to CBDC over time they may come to rely more on wholesale funding, and possibly restrict credit supply in the economy with potential impacts on economic growth. '

Yes indeed: if central banks are to be midwives to their digital currencies, they must stand by to be the undertakers for the legacy commercial banking system.

And so to China. The People's Bank of China is blazing the trail on CBDCs, having started research on them in 2014, and then initially trialling their use for transfers between companies and finally, two weeks ago, trialling the CBDC for consumer use via a small (c. Rmb 10mn) drop in Luohu, Shenzhen. In this latest trial, the Shenzhen government distributed the money via lottery, with around 50,000 winners able to download a digital wallet and spent its electronic contents at 3,000+ merchants in Luohu.

This is, and remains, a tiny experiment, and continues the aim of testing and gradually expanding the current infrastructure supporting China's CBDC. Prior to this latest expansion, the electronic infrastructure to handle China's CBDC had reportedly expanded to 30 cities, and had handled around $160 million worth of payments from over three million transactions. When we consider that in September, China's new Rmb bank lending came to Rmb1.92tr, and aggregate financing amounted to Rmb 3.3tr, it is obvious that this CBDC has a long way to go before it mounts any sort of challenge to China's current financial system.

However, there are historical, political and technological reasons why we could expect China to be the forcing ground for CBDCs that do substantially re-shape financial systems. The historical reasons are obvious: People's Bank of China is well named, because until approximately 40 years ago, that is exactly what it was - to all intents and purposes China's monopoly bank, controlled by the state, operating separate lending businesses in different provinces, and allocating credit according to national and local political urgencies. It was, quite simply, The Bank - so returning to something like that role via a CBDC is not such a big historical leap as it would be in the West. Politically, too, of course, the prospect of disintermediating the commercial bank system holds less philosophical import for (soi-disant Communist) China than for the (soi-disant) free market West.

Technologically, too, developing the infrastructure for a broadly capable CBDC is unusually easy for China, because: a) in Shenzhen it has the world's only technological cluster plausibly comparable to Silicon Valley and b) China, via its surveillance & control infrastructure, already has at hand the sort of country-wide electronic ID system which a broadly-capable CBDC would require. Constructing a comparable ID system would pose considerable political (and therefore practical) difficulties in some Western societies.

And this is surely the unspoken final worry motivating the BIS's collection of central bankers: that, given the all-too-noticeable shortcomings of the West's legacy commercial banking structures, it is quite possible that China's early embrace of CBDCs will result in China's financial infrastructure 'leap-frogging' the rest of the world's financial systems. If so, the competitive economic advantage this would confer on China would be extraordinary, and demand a response. So quite possibly, what we are witnessing is, finally, the long-overdue eclipse of the post-Enlightenment banking structures with which the rise of free market capitalism is inextricably entwined.

Just as well, then, that the BIS's paper is so very dull.