On Digital Currencies, Central Banks Should Lead
In recent years, digital currencies have shown considerable promise. Research by the People's Bank of China suggests that the best way to take advantage of these innovations is for central banks to take the lead, both in supervising private digital currencies and in developing digital legal tender of their own. At the PBOC, this effort is underway.
In approaching this challenge, the PBOC must carefully consider how to maintain financial stability, encourage innovation, and properly supervise the issuance and circulation of these new currencies. It must also set up sensible institutional frameworks and macroprudential controls. With the proper safeguards in place, China's central bank can maximize the positive effects of legal digital tender, while minimizing the negatives.
With internet access increasing and encryption technology improving, the conditions are ripe for digital currencies, which can reduce operating costs, increase efficiency and enable a wide range of new applications. Yet they still have some fundamental defects. Their value isn't stable. Their credibility remains weak. They're not yet widely accepted. And of course, there's always potential for negative externalities.
Digital legal tender, issued by central banks, could help resolve many of these problems. Such a currency would be guaranteed by state credit, and could enable synchronized applications both online and off with greater range, convenience and security. Making digital legal tender a reality, though, will require overcoming several challenges.
First, the operating framework must be carefully considered. One option is for a nation's central bank to directly supply legal digital currency to the public, and then manage all issuance, circulation and maintenance services. A second option is to adopt the circulation model of paper money: Namely, the central bank would issue digital currency to commercial banks, the banks would in turn provide deposit and withdrawal services to the public, and together they would work to ensure the normal functioning of issuance and circulation.
At the PBOC, we are inclined toward the second model, for a few simple reasons. Using the existing system would make it easier for a legal digital currency to gradually replace paper money. It would also encourage commercial banks to participate in jointly administering the new currency, thus appropriately spreading risk, accelerating innovation, and better serving the real economy and the needs of the public.
Another challenge is cryptography. Private-sector digital currencies protect transactions with cryptographic algorithms and the use of private-key signatures. Unfortunately, because these currencies enable some degree of anonymity, they're susceptible to asset losses, which often can't be refunded. A legal digital currency must solve this problem thoroughly, both by protecting user accounts with cryptography and by establishing a controlled anonymous system to ensure that transactions can be traceable under certain conditions.
A legal digital currency will also require significant research and development to build market credibility and ensure security and efficiency across diverse applications. Strong technical support will be needed, including a reliable accounting technology, trusted protocols, standardized data formatting and dependable digital-signature mechanisms. A secure means of storing value, such as digital wallets, will also be important. Central banks must carefully consider how to control issuance to ensure a stable value, which will be a key factor as monetary authorities compete to develop the most effective approach.
Finally, legal digital currency could have a profound impact on the financial system. At present, the effects are difficult to predict. But there are some logically possible results. First, as the monetary structure changes, the money multiplier will increase. Second, demand for real currency will continue to decline, and the conversion of financial assets will accelerate. Third, big data analysis will make measuring the velocity of money easier, thus making it simpler to calculate monetary supply and analyze currency structures. Fourth, the cost of know-your-customer and anti-money laundering requirements should decrease, and supervision should become more efficient. Finally, a common financial environment should encourage innovation.
One important concern for the financial system is that legal digital currency will lead to easier disintermediation, which can influence money creation. Due to the swift transformation from deposits to narrow currency that such technology enables, a financial panic, once begun, could spread rapidly. Appropriate mechanisms must be in place to anticipate such scenarios and limit the risks they pose.
Of course, the full impact of a legal digital currency can only be assessed after one is actually in circulation. For now, banks must prudently develop the systems and macroeconomic controls necessary to maximize the positive effects of such a currency, while minimizing the negatives.
Since 2014, under the guidance of Governor Zhou Xiaochuan, the PBOC has attached high importance to the development of legal digital currency. It has been conducting in-depth research on key technologies, legal issues, financial and economic impacts, and the relationship between legal and private digital currencies. Internal and external exchanges and corporations are being strengthened, and a research institution has been created to improve the issuance and circulation system, accelerate the development of prototypes, and evaluate the information technology requirements for such a currency.
In this process, we will take a rigorous and scientific attitude to exploring new approaches and practices, open to any safe and effective technologies and methods. We look forward to cooperating with all sectors of society to make China's legal digital currency a reality.
(This article has been translated and adapted from an essay published in China Finance.)
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