Zach Burdon is a student in the Department of Economics, University of Bath, and a former intern (June-December 2022) at the University of Bath Institute for Policy Research (IPR). Dr Charles Larkin is Director of Research at the IPR. This blog is based on a literature review survey paper, produced during Zach’s internship with the IPR.
Traditionally, central banks have issued money for public use only in the form of cash. However, as the use of cash in the economy is dwindling, interest in central bank digital currencies (CBDCs) has massively increased. Policymakers worldwide are now considering implementing a ‘general purpose’ or ‘retail’ CBDC – a digital version of central bank money that is available to households and businesses (rather than financial institutions only). The Bank of England and HM Treasury have recently declared that a digital pound is likely to be needed in the future. A retail CBDC could have substantial implications for the financial system and the wider economy. Therefore, as we outline in a recent paper, it is important that policymakers make careful design choices when developing a digital central bank currency for public use.
Benefits and risks associated with a retail CBDC
A well-designed retail CBDC could have various benefits, including improved financial stability, monetary policy implementation, financial inclusion, domestic and cross-border payments efficiency, and payments safety and robustness. Many central banks also fear the rise of cryptocurrencies and stablecoins, which provide cash alternatives and could compromise the ubiquity of public money, reducing monetary sovereignty. An established retail CBDC is widely considered a disrupting force against the recent explosion in cryptocurrency growth. It would be backed by central bank reserves and could help to cement central banks’ monetary sovereignty.
However, the digitalisation of central bank money also comes with potential risks. A retail CBDC must be designed as an attractive form of payment to ensure that it is widely accepted and used within the economy. Yet, a retail CBDC that is ‘too attractive’ could substitute commercial bank deposits on a large scale and cause disintermediation of the banking sector. In other words, banks may struggle to stay afloat as their importance as ‘middlemen’ in the financial system is reduced, resulting in a massive drop in their revenue. The level of disintermediation that a CBDC would cause largely depends on how it is designed, so it is important that policymakers consider different options carefully.
As we briefly sketch below, there are different levers that can be used to limit disintermediation and other risks associated with the introduction of a retail CBDC, each of which has benefits and drawbacks. Ultimately, design choices will be informed by how policymakers evaluate different risks and opportunities and how they set priorities. For example, there is a growing consideration that banks are no longer ‘too big to fail’, as shareholders and investors now bear the cost of bank failure, not the central bank and taxpayers. The Bank of England recently declared that a major UK bank is able to fail safely, without lasting disruption to the economy, thanks to prudential regulation and a ‘robust resolution regime.’ Thus, although large-scale disintermediation continues to be seen as a major risk, policymakers may accept a degree of disintermediation in exchange for greater CBDC attractiveness and use.
Critical design choices for a retail CBDC
A key design consideration is the level of involvement of financial intermediaries in CBDC transactions. Under a single-tiered CBDC, the central bank would have total control over the entire process. Monetary transmission would be more direct, promoting financial inclusion as fees would be reduced or eliminated. For the same reason, however, a single-tiered CBDC would likely crowd out and reduce the revenue of commercial banks. Moreover, central banks have less experience with end-user interaction. Therefore, an intermediated CBDC is generally considered preferable. This system would involve outsourcing some tasks to financial intermediaries, including commercial banks and non-bank financial institutions, who would likely obtain revenue by charging payment fees. From these fees, commercial banks would be able to retain most of their earnings even if they face a drop in traditional bank deposits.
Another crucial design choice is whether to introduce a remunerated (interest-bearing) or non-interest-bearing CBDC. The latter would essentially mimic cash, lowering the risk of disintermediation as households and businesses are likely to still want to hold bank deposits. However, a remunerated CBDC would improve monetary policy transmission and could be increased or lowered to improve or reduce its attractiveness to the general public. As such, it could also be used to overcome some of the limits of conventional monetary policy. Notably, a remunerated CBDC gives central banks the opportunity to implement negative interest rates as a way to eliminate the ‘liquidity trap’ (a situation where people prefer to hoard cash rather than spending or investing it). However, there are questions as to whether this would be effective if cash continues to exist in the economy.
Central banks must also decide which type of ledger system to run CBDC on. A centralised ledger system would involve opening an account directly with the central bank (or with an intermediary) and would facilitate more and quicker transactions than alternatives. The other option is to use distributed ledger technology (DLT), for example, blockchain, which is the underlying system for Bitcoin. Although this system is decentralised and difficult to hack, it is very energy-intensive and faces issues such as slow transaction speeds.
Finally, policymakers must consider potential trade-offs between privacy and security when designing a CBDC. The CBDC network must comply with regulations aimed at preventing money laundering and other criminal activities, which require financial institutions to verify the identity of their users. However, much of the general public value transactional anonymity, as offered by cash. Central banks must also decide whether to collect (or allow intermediaries to collect) transaction data or allow transactional privacy.
Next steps for CBDC development
Some countries have already implemented CBDCs, and many others have introduced, or are planning to introduce, pilot schemes. Atlantic Council has published a continuously updated Central Bank Digital Currency Tracker, which tracks how close each country is to implementing a CBDC. It also shows which type of CBDC each country is researching and the underlying technology and architecture. Other international projects, such as the mCBDC Bridge project, aim to facilitate and speed up cross-border transactions, a key element of CBDC. Central banks worldwide must cooperate on CBDC design to ensure interoperability on issues including cross-border payments. If not, dollarisation could occur, or private currencies could become prevalent and threaten monetary sovereignty worldwide.
Closer to home, the Bank of England has begun a new consultation on the 'digital pound' that will close on the 7th of June 2023. This is the product of the CBDC Taskforce the Bank formed with the Treasury in April 2021. This working paper and accompanying data represents a major advance in the conversation on public access to retail central bank money and will hopefully trigger a lively policy debate on CBDCs in the United Kingdom.
Policymakers must be aware of the likely impact of each design choice and ensure that CBDC promotes innovation within the payments sphere. A key challenge is to ensure that a retail CBDC is attractive enough to be taken up as a widely used form of payment but not so attractive that it crowds out commercial bank deposits, leading to large-scale disintermediation. Policymakers must also be flexible in introducing and adjusting regulations as the digital currency industry changes. Trials and surveys around CBDC design choices must also continue to enable policymakers to gauge the likely impact on the economy and the response of the general public.
All articles posted on this blog give the views of the author(s), and not the position of the IPR, nor of the University of Bath.
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