We have been asked this question a few times. Bitcoin, the archetype of all the cryptocurrencies was conceived to remove the need for a trusted third party. Central Banks are trusted third parties themselves. They are actually the trusted third party par excellence. So why are they playing with ideas around cryptocurrencies? Sounds like they are having an identity crisis.

Bank Of England

In a paper published by the Bank of England this is fantastically clarified. The main purpose of a Central Bank Digital Currency (CDBC) would be to increase the range of counterparties who can bank directly with Central Banks and to encourage the implementation of a distributed ledger technology.

Ideally everyone could hold an account at their Central Bank. The access to CBs balance sheet would be limited to accounts in the newly created digital currency in order to avoid major stability issues. Or arguably so. CBDC would become a powerful instrument of monetary policy and a unique source of data for policymakers.

The issuance and distribution of the new currency could happen through CBDC-financed acquisition of government bonds. Hence the amount of Government debt held by the Central Bank would increase, decreasing the state’s debt burden and lowering Government bonds interest rates, which could in turn translate in lower lending rates for private borrowers.

Moreover, as anyone could hold an account at the CB, CBs purchases of bonds would inject money directly into the economy, instead of being intermediated by commercial banks.

The adoption of a digital currency would also encourage the implementation of Blockchain-like infrastructures, and in turn lead to an improved resiliency of the systems, would open payment services to a renewed and wider competition and could produce the cost-efficiencies estimated in this joint report from Oliver Wyman, Santander Innoventures and Anthemis.

On the other side, CBDC would represent a safer alternative to banks’ deposits. Commercial banks back their deposits with illiquid and risky assets. Loans, for example, cannot be readily redeemed and bear the risk that borrowers won’t repay them. Deposits with commercial banks are all but risk-free as a consequence, if not for the share of them which is covered by Government guarantees. On the contrary, Central Banks (still) invest in liquid, risk free, assets, such as Government bonds. Hence a preference for CBDC would move money out of the banking system and could even trigger a bank run.

The authors of the paper “do not claim to have evaluated this risk exhaustively“ but estimate “that minimum capital adequacy requirements, together with the voluntary buffers that banks optimally add to avoid the penalty for breaching them, are sufficient to make deposits effectively risk-free.
​…which is pretty arguable and reminds of John Kay’s comment that “banks entered the crisis with capital generally in excess of regulatory requirements”.
Narrow Banking

If the new currency was in shorter supply than the public seeks it, its value would raise compared to its physical alternative. Thus the relevance of the CBDC in the money supply would increase well beyond the Central Bank’s initial purpose. In our opinion banks’ manoeuvrability would be seriously impaired by such an initiative. Banks’ cost of capital would raise in order to account for the difference in risk compared to deposits in CBDC, while Government bond rates would be further lowered by Central Bank’s issuance of digital currency.

The spread between short term and medium/long term rates – in which banks make most of their profits – would narrow down as a consequence.

Private banks will have to raise lending rates and engage in riskier investments to remain profitable. This higher risk would in turn generate a higher preference for CBDC, getting banks into a vicious circle.

A limited supply of CBDC would limit such an issue …not!
​If there is anything we learnt from bimetallism, it is that pegging the two currencies would be highly ineffective. ​

The mentioned vicious circle would end up impairing banks ability to collect and lend out money, eventually setting our economies on the path to the end of the Fractional Reserve Banking (FRB).

If FRB was replaced by a form of Narrow Banking, how would the money supply be determined? The first possibility would be to leave it to Central Bankers. In fact they are not as greedy as commercial bankers.

…they are neither better at seeing risks ahead though. It would take a bad memory not to recall the consequences of the Great Moderation, underwritten by Greenspan’s put and supported by Ben Bernanke. Or to not recall Bernanke’s Semiannual Monetary Policy Report in July 2007, when he stated that “Overall, the U.S. economy appears likely to expand at a moderate pace over the second half of 2007, with growth then strengthening a bit in 2008” right as we headed into the Great Financial Crisis!

If Central Bankers are not a valuable alternative neither, we might resort to creating a set of rules for the purpose as Monetarists invoked (Friedman’s k-percent rule). Possibly having the money supply governed by an algorithm or by a computer.

And if that was the case, we would end up with a currency transacted on a Blockchain-like network and issued according to an algorithm …which accidentally sound very similar to Bitcoin and similar cryptocurrencies integrated into their blockchain​.

This is a stimulating hot subject, let us know what you think about it.

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