What CBDC Is (Not) About: Part III
The low-impact scenario
Note: This is the third post of a series about central bank digital currencies, or CBDC. Part 1 establishes that CBDC is not about the technology, but rather about a fundamental reshaping of the very structure of our monetary and financial systems. Part 2 provides a simplified representation of how the monetary system currently operates. In this post, we will explore the potential implications of introducing a CBDC, starting with the 'low-impact' scenario.
Tl;dr: The magnitude of the power shift from the private to the public sector will depend on the design, implementation, and market reception of CBDC. Failure to gain meaningful usage will result in only marginal changes in the current monetary system, with a theoretical gain of influence over monetary policy being nullified by the current interest rate environment.
Envisaging different scenarios
The exact implications of introducing a CBDC are unknown. Too many interdependent variables and poorly-understood relationships can give rise to unpredictable second-order effects, with potentially disastrous consequences for the financial system and the economy. [1]
However, it is possible to explore, at a high level, the relative magnitude of the power shift mentioned in Part 1 and the resulting implications based on different scenarios. For our purposes, let's consider the following:
Scenario 1 (low impact): CBDC fails to gain meaningful usage and remains an odd curiosity.
Scenario 2 (medium impact): CBDC establishes itself as an important complement to private payment systems and forms of money.
Scenario 3 (high impact): CBDC crowds out all other forms of money and becomes the dominant payment instrument.
For each scenario, we will consider a set of factors (including monetary policy, bank disintermediation, balance sheet size and exposure, money supply composition, and financial stability) to determine the extent to which existing power dynamics and relationships will evolve. Given the restricted space offered by this format, I have attempted to limit the discussion to the most pertinent consequences for each scenario. A separate post will be reserved for each scenario to allow for proper discussion while keeping the article length at a reasonable level.
Today, let's start with Scenario 1 where CBDC has been offered to the public but has failed to catch on: consumers and businesses continue primarily using private forms of money.
Competition is hard - even for central banks
Absent stricter banking regulation, the central bank is subject to the same competitive forces as everyone else in the market. Public money on its own is not a sufficient differentiator, particularly in 'normal' times (i.e. no acute financial crisis) where most people wouldn't really know the difference, anyway. Instead, users first and foremost value convenience, speed, and ease of use – features which public sector services are not necessarily most renowned for.
In the very competitive payments market, it is thus plausible that CBDC lacks a sufficiently compelling value proposition for warranting users to switch from well-established private solutions. For a historical precedent, I would like to remind the reader of the Bank of Finland's Avant smart card system that was briefly mentioned in Part 1: despite offering anonymity and a means of electronic payment in public money, it did not manage to gain sufficient traction and was eventually phased out once debit cards became less expensive.
Little impact, little change
Consistent with the title, the 'low-impact' scenario doesn't lead to major changes in the monetary system – but it nevertheless does have some implications.
Balance sheets and the composition of the money supply remain largely unchanged: commercial banks carry on with their day-to-day activities and M1 continues to be dominated by bank deposits, the primary form of private credit money in the economy. [2] As a result, the commercial banking sector is only marginally affected and retains its dominant position in the management of the money supply. Funding and capital markets continue to operate as usual, with no spillover effects on asset prices and market structure.
However, the mere existence of an interest-bearing CBDC – even if only sparsely used – could prompt commercial banks to keep their deposit rates more tightly aligned with the CBDC rate. [3] This would potentially endow the central bank with greater (because more direct) influence over bank deposit rates than the current setting allows. In an environment characterised by negative real interest rates, however, this change is only of limited utility. Furthermore, a negative interest rate policy could not be credibly enforced as long as cash and zero-interest bank deposits remain available.
New channels?
There are two further developments I can think of that might have meaningful long-term implications but are unlikely to materialise at scale.
First, CBDC and the associated payment system may be used by non-banks as an easier-to-access, faster, and potentially more cost-efficient alternative for wholesale settlement. This would establish a parallel settlement system outside of the banking sector but under the purview of the central bank. In this case, I would expect commercial banks to fight for their lunch and aggressively lobby against such a development.
Second, CBDC provides a new distribution channel for direct stimulus – both fiscal and monetary – that circumvents the intermediation role of the banking sector. However, the effectiveness of such a transmission mechanism is debatable if the system is barely used by households and businesses.
It ain't no power shift
The low-impact scenario will have, as the name suggests, little implications for the structure of our monetary and financial systems. Commercial banks remain the main managers of the money supply via private credit creation, and the theoretical gain in influence over bank deposit rates is effectively nullified by the realities of the current interest rate environment
Past experiences suggest that this scenario is far from unlikely to happen. The key lesson is that CBDC needs to compete with private alternatives on features valued by the market (i.e. speed, ease of use, cost) if it wants to gain meaningful traction. Failure to do so will result in CBDC becoming a peculiar (and costly!) monetary curiosity, mainly for the textbooks, that risks eventually being phased out for lack of usage and utility.
In any case, the power dynamics will have changed very little, if anything.
In the next two posts, we will explore the remaining scenarios where, in the most extreme case, a 100% reserve system is established under which the central bank is akin to a central planner that allocates capital according to political agendas.
Footnotes
[1] This helps explain the general risk aversion of central bankers and their, shall we say, rather cautious approach toward 'innovation'.
[2] Central banks use different aggregates to compute the total money supply. Definitions and measures vary, but generally amount to the following:
Base money (M0): in our parlance "public money" – composed of currency in circulation (physical bank notes and coins) as well as electronic bank reserves.
Narrow money (M1): includes M0 as well as on-demand bank deposits and e-money. The biggest component of M1 tends to be bank credit.
Broad money (M2+): includes M1 as well as other liquid financial assets that are used as 'quasi-money'.
[3] They would likely pay a slightly higher rate to prevent customer outflows.