Central-bank digital currencies will make the financial system more efficient. But will they make it safer? Maybe, but they could easily end up increasing systemic risk. Depends on the implementation.

I have been discussing what the bailouts of the financial system in response to Covid-19 mean for the future of the financial system. In my last piece, I suggested diversity was the solution.

But there is one topic I didn’t get into in detail, and that is central-bank digital currencies or CBDCs in short.

I’m not going to get into what CBDCs are in any detail, plenty of information out there, only Google or DuckDuckGo away. I list some references at the bottom.

As far as I can tell, the main reason central banks, at least in the democratic world, are contemplating CBDCs is to forestall the emergence of alternative payment systems, especially foreign ones that are outside the control of the central bank. They remember how PayPal came out of nowhere, and by the time it got on their radar, it was too late to do anything about it.

There is one more reason some advance for taking up CBDCs, and that is it allows the central banks to precisely control the money supply, and hence tune the economy in real time to achieve optimal efficiency, prevent crises and ensure stable economic growth. While popular with some sector of the commentariat, I suspect this reason is less important than the first.

Competition is a forceful agent of change, and no matter how reluctant the central banks are to take up CBDCs, I suspect they have no choice.

And that leaves the question of how they affect financial stability?

The obvious implementation is not going to happen

The most obvious way to do CBDCs is simply for the central bank to create money that exists as a token on a blockchain under its own control. Then, the main difference between CBDCs and cryptocurrencies is simply that the central bank controls the blockchain and not algorithms. Cryptocurrency advocates would argue that such a setup is not a blockchain at all, it’s just a database to keep track of digital currency records.

We all might even be able to have direct access to central bank money.

Superficially, such CBDCs sound like a rather nice idea. There would not have been a need for the visible bailouts of the financial system back in March because of Covid-19, and the 2008 crisis could even manage much better. The central banks would have tweaked the money supply and helped banks in need in a much more targeted way, with much less visibility.

The central problem is that if the central bank controls the blockchain, all transactions, savings and lending and all other uses of money take place on the central bank blockchain. The central bank has perfect visibility and control — all deposits are within the central bank and all lending made by it. Of course, the central bank can delegate this to the private sector, but then the banks are reduced to franchisees executing the central banks’ wishes.

There are sound economic and social reasons why that is a horrible idea.

The economic reason is that the central bank will fully control the money, which can be adjusted to suit the country’s economic needs. The central bank both directs total credit in the economy and who gets it. Yes, they can promise they will not take advantage, but at the end of the day the central bank is authorised by the government, and current reassurances do not bind future presidents or prime ministers.

Meanwhile, the central bank becomes the most powerful institution in society. It knows precisely how much money you have and what you do with the money. It decides whether you get a loan on not. Again, they can promise not to abuse this power, but it is not up to them. The politicians will decide.

No sane central bank in the democratic world would implement CBDCs in such a way. A nondemocratic country might well find such a vehicle for social control highly desirable.

The future is hybrid

The highbrow ideas of democracy and social control are not the main reasons why the central banks reject partially displacing existing money with tokens on a blockchain. The objections are more practical.

The central banks really don’t want to be customer facing. Having to set up call centres and be on the irate end of consumer complaints and set up a vast infrastructure, with all the attendant costs, reputation risk and the risk of hacking.

So what is the central bank to do? They just can’t ignore CBDCs, then the private sector will supply its own competitor. The central banks don’t want another PayPal creeping upon them.

There are alternatives being discussed, I will only briefly mention two main categories of alternatives, the references at the bottom discuss the whole flora. See this BIS document for a good overview.

One solution is a hybrid model where financial institutions face clients, and the money they use are tokens on the central bank blockchain. So, regular clients use tokenised digital money, but only access the central bank blockchain by proxy, via their financial institution. Such a setup is not compatible with existing infrastructure, so it will take longer to implement and be more costly, but then would be more efficient than the second alternative.

A less radical solution is an intermediated model, where client facing financial institutions continue to use existing account based setups. The role of the central bank blockchain is then just a more efficient payment system.

While unclear exactly where this will land, the eventuality is not.

It is less clear what CBDCs will do to financial stability.

CBDCs and the stability of the financial system

CBDCs give the architects of the financial system a once-in-a-lifetime chance to retool the financial system. Many things will change, and how the financial authorities go about their job tells us whether CBDCs are stabilising or destabilising.

In the last piece, I advocated diversity as the primary way of achieving financial stability — diversity in financial institutions and diversity in financial regulations.

The main force of financial instability is homogeneity. Of course, no one says it in that way. No. They talk about level playing fields and fairness and crisis prevention and clear rules. All of which push towards homogeneity and hence instability.

So, how could CBDCs be destabilising? We don’t need to look any further than the FSB’s holistic document that I have discussed so often in the series. The vision advocated there is to bring all parts of the financial system under same — uniform — regulatory umbrella, the reason being that the regulated banks did not have problems in March 2020, but the non-bank parts of the system did. So the answer is to make everybody a bank and regulated in the same way. More monitoring and control to ensure they achieve the objectives set by the financial authorities. The realisation of that vision is homogeneity and hence financial instability.

Because CBDCs give the financial authorities the opportunity to make so many changes to the structure of the financial system, if they take their leave from the FSB holistic document, they have the once-in-a-lifetime power to act achieve homogeneity.

CBDCs are then destabilising.

I suspect that is the most likely outcome, (a nameless senior central banking acquaintance told me the hybrid document is the roadmap for the future) but there is an alternative.

How can CBDCs be stabilising?

CBDCs provide two clear directions for diversity.

First, they reduce the cost and improve the efficiency of financial intermediation. If condoned by the financial authorities, new ways of financial intermediation have a rare chance to blossom.

And second, the CBDCs help the financial authorities to better monitor abuse an other activities (like ALM). In other words, CBDCs help them to achieve their micro prudential and market integrity objectives.

That means that financial authorities normally reluctant to allow new forms of financial intermediation — which means almost all of them — have less reason to object.

So, an enlightened central bank could decide to use CBDCs to increase diversity, benefiting everybody. Except the incumbents.

It will be interesting to see how the cookie crumbles.




Several friends and colleagues have commented on this series. Robert Macrae and Nikola Tchouparov gave me excellent comments that significantly improved the pieces. We don’t always, or even usually, agree, and all opinions are mine alone.

I received excellent comments on this piece from Raphael Auer, Giulio Cornelli and Jon Frost, all at the BIS. I thank them from the bottom of my heart. We don’t necessarily agree, and all content is my responsibility only.