Your Local Bank Could Be the Central Bank
The financial community, increasingly divided over the future of digital currencies, is looking to monetary authorities and regulators for signals. The problem is that those signals are decidedly mixed.
The European Central Bank is discussing putting restrictions in place, with governing council member Ewald Nowotny describing the hype around them as "dangerous and dubious" in an interview this week. International Monetary Fund Managing Director Christine Lagarde, by contrast, claimed recently that cryptocurrencies could soon become mainstream: "In many ways, virtual currencies might just give existing currencies and monetary policy a run for their money." Lagarde is right, but few central banks seem prepared. Banning technological development without providing a modern alternative to fiat money is doomed to fail.
The advantages of digital currencies over fiat money are clear. Digital currencies are also virtually costless and instantaneous, while transactions in fiat currencies can take up to several days; annual transaction costs have now reached over $2 trillion worldwide. Bitcoin, with its decentralized ownership ledger, was the first to capitalize on this; similar digital currencies have since proliferated.
The Bank of International Settlements, known as the central bank of central banks, is not known for making waves; but its recent report called on monetary authorities to consider options for a central bank cryptocurrency (CBCC). The urgency is clear. If the market gradually shifts transactions into privately issued money, as expected to take advantage of the efficiencies, central banks’ monopoly on seigniorage revenues -- the profit banks make from issuing a currency -- would be threatened; and so would their ability to conduct efficient monetary policy.
Still, there are decisions to be made. Central banks already issue two kinds of currencies -- digital reserves for financial institutions and hard cash for the rest us. From this point of view, creating a new digital currency that can be deposited in a bank account or exchanged in cash is thus relatively unproblematic. The key decision, according to the BIS, is whether access to such a currency should be limited to financial institutions, and whether the transfer mechanism should be anonymous or not:
All central banks may eventually have to decide whether issuing retail or wholesale CBCCs makes sense in their own context. In making this decision, central banks will have to consider not only consumer preferences for privacy and possible efficiency gains -- in terms of payments, clearing and settlement -- but also the risks it may entail for the financial system and the wider economy, as well as any implications for monetary policy.
In practice it is difficult to envisage a sustainable digital currency that would not be accessible to all; cryptocurrencies are increasingly attractive to the general public. As for privacy, a decentralized ledger, on top of the security advantage it brings, makes the anonymity attached to cash transactions technically possible, and is thus nothing new. The BIS acknowledges as much:
While it may look odd for a central bank to issue a cryptocurrency that provides anonymity, this is precisely what it does with physical currency, i.e. cash. Perhaps a key difference is that, with a retail CBCC, the provision of anonymity becomes a conscious decision.
Some might argue that an anonymous payment network would run against the current trend in anti-money-laundering regulation, where the origin of invested cash is carefully vetted to avoid criminal or tax evasion activities. Technically, there is nothing to prevent central bank digital currencies from being fully traceable. Even a decentralized ledger (where transactions are recorded digitally across many computers) only provides the potential for anonymity but does not guarantee it. But if there is no desire for anonymity, then there would be no need for the ledger to be decentralized. The logical outcome would be for central banks themselves to offer retail services, taking deposits from the general public. The BIS considers this possibility:
We argue that the main benefit that a consumer-facing retail CBCC would offer, over the provision of public access to (centralized) central bank accounts, is that the former would have the potential to provide the anonymity of cash. In particular, peer-to-peer transfers allow anonymity vis-à-vis any third party. If third-party anonymity is not of sufficient importance to the public, then many of the alleged benefits of retail CBCCs can be achieved by giving broad access to accounts at the central bank.
A central bank e-minting monopoly would fundamentally change the structure of the banking system, leading to an increased monetary basis and seigniorage. Any temptation to abuse the enhanced minting monopolies would be reduced not by new technology but by the competitive alternatives offered by other countries’ digital currencies, or even, if necessary, old-fashioned valuable commodities.
The introduction of CBBCs that are traceable would also bring about a revolutionary transformation of the financial system architecture. This is, quite obviously, the opposite of the libertarian ideology underpinning the original cryptocurrencies. It would also accelerate the dismantling of the banking system as we know it.
With central banks offering retail services, commercial banks would lose deposits, and with it their ability to lend. It would curtail or end the role of the money multiplier -- whereby banks lend more than they receive in deposits, thus increasing the overall money supply -- in the economy, and so necessitate massive monetary creation to maintain levels of liquidity in the market. Lending would increasingly be made by regulated specialized funds.
Whether or not retail deposit central banking comes to pass, central bank cryptocurrencies would result in important changes to the way monetary policy is made and the structure of the financial system. They would allow for negative interest rates to be imposed, reduce the financial system’s leverage and allow bank runs to take place almost instantaneously. They would remove a large part of the income of traditional banks and clearing institutions, raising questions as to their business model sustainability and potentially leading to future job losses that number in the hundreds of thousands. Critically, it would allow government, if it so decides, to breach the veil of anonymity in any transaction.
Abraham Lincoln famously referred to the privilege of issuing money as the supreme prerogative of government. Indeed, in many ways the debate over digital currencies is similar to the situation that led to the central banks to overtake the private issuance of money two centuries ago, or the ban on gold hoarding during the Great Depression. If history is any guide, central banks will reassert their minting monopoly by prohibiting private currencies and making the national e-minted ‘fedcoins’ the only legal e-tender. Whatever they decide, remaining on the sidelines is no longer an option.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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Therese Raphael at firstname.lastname@example.org