29 April 2022

SUERF: Would a retail CBDC achieve its intended purpose?

While an unattractive interest rate or a quantity ceiling may limit the demand for retail CBDC and the transfer of risk to the central bank, these mechanisms would – as Gresham’s law teaches us – undermine the use of CBDC as a medium of exchange. Retail CBDC could thus miss its intended purpose.

The decline in the use of cash, the economy’s increasing reliance on electronic payment systems and advances in new technologies, such as distributed ledger technology (DLT), have prompted central banks and international financial institutions to explore the pros and cons of central bank digital currency available to the public (retail central bank digital currency, CBDC, henceforth).2 In a world where everything is becoming digital, the digitisation of banknotes could almost seem banal. And yet this could have severe consequences for the banking system. Indeed, the substitution of CBDC, free of credit risk, for risky bank deposits could lead to a significant transfer of credit risk from commercial banks to the central bank. It thus seems sensible to limit the demand for and supply of CBDC in order to limit this transfer of risk. The central bank could do this by applying an unattractive interest rate to CBDC, or by setting an individual quantity ceiling for CBDC holdings.

These mechanisms, however, are likely to undermine the demand for CBDC as a medium of exchange and thus the achievement of the intended purposes for issuing CBDC.

In this article, after describing the main purposes for issuing a CBDC, we explain how the unlimited provision of CBDC leads to a transfer of credit risk to the central bank. We then show how mechanisms to limit the demand for and supply of CBDC undermine the intended purposes of issuing a CBDC.

Purposes of issuing a retail CBDC

An array of arguments has been made for CBDC issuance (BIS 2020). The main purposes can be regrouped under three headings: 1) providing the public with a digital central bank money as the use of cash is declining; 2) improving the resilience of digital payments by providing a back-up system; and 3) promoting diversity and sovereignty in payment systems.

On the first argument, Ingves (2018) made the case for an e-krona in Sweden as a way to provide the public with central bank money, as the use of banknotes is in decline. Since a bank deposit is a claim against the commercial bank payable in central bank money on demand, public access to central bank money is a prerequisite for the enforcement of the deposit claim. Without public access to central bank money, the bank’s contractual obligation to redeem deposits in central bank money is impossible to fulfil. Thus, if the use of banknotes declines, CBDC could substitute for cash in this role of providing public access to central bank money.

On the second, the issuance of CBDC may improve the resilience of the payment system. CBDC could serve as a back-up emergency medium of exchange in the event of a disruption to the current electronic banking system. Such a back-up would be superior to cash in terms of speed, convenience and ease of emergency distribution.

On the third, the diversity and sovereignty argument for CBDC relies on its potential to mitigate the anti-competitive effects of some financial innovations. The economies of scale and network effects that could arise with the adoption of new technologies (DLT, big data, and artificial intelligence among them) would tend to foster concentration and work against competitive provision of financial services and of payment systems in particular. As a result, payment systems today are highly concentrated in a few large companies that dominate electronic payment networks, and the importance of electronic payments will further grow with the rise of online commerce. By providing a generally accessible alternative medium of exchange, CBDC would make for increased contestability and diversity in payment systems.

Moreover, if an economy depends heavily on payment systems that are in the hands of foreign companies and regulated by foreign authorities, its sovereignty is at stake. CBDC would be a means of ensuring the sovereignty of at least one electronic payment system as it is issued by the domestic central bank.

Implications for the conduct of monetary policy and the related risk transfer

How would the issuance of a CBDC influence the conduct of monetary policy? The challenge of issuing CBDC in the current monetary system stems from the transfer of risk from commercial banks to the central bank. This risk transfer comes from the coexistence of two kinds of money, i.e., central bank money and bank deposits.

As its name suggests, central bank money is issued by the central bank and consists of cash (banknotes), sight deposits that commercial banks hold at the central bank (reserves), and, potentially, CBDC. Importantly, central bank money is an economic good free of credit risk, unredeemable, as it embodies no credit claim against anyone. Of course, central bank money is not free of valuation risk with respect to domestic goods (i.e., inflation) or foreign currencies (i.e., depreciation).

In contrast, bank deposits are claims issued by commercial banks redeemable on demand in central bank money. Redemption can be made in cash, possibly in CBDC, or by transferring client deposits and thus reserves to another bank. Because their redemption depends on the solvency of the issuing bank, deposits carry a credit risk. They are, however, not (or less) subject to the risk of loss or theft and more convenient to make payments than cash.

How would the demand for CBDC affect the money market? When non-banks request redemption of their deposits in cash or in CBDC, the reserves held by banks with the central bank decrease, which affects money market conditions differently depending on whether excess reserves are small or large. The amount of reserves that banks hold in excess of what is legally required (minimum reserve requirement) or of what banks voluntarily demand for their liquidity management determines the impact of reserve fluctuations on the money market.

When excess reserves are small, the decline in banks’ reserves following an increase in the demand for cash or CBDC by the public leads to tighter money market conditions and higher short-term interest rates. To prevent an undesired tightening of monetary conditions, the central bank needs to accommodate this demand with a corresponding increase in banks’ reserves. This accommodation implies an expansion of the central bank’s balance sheet and, thereby, a transfer of risk to the central bank. Moreover, if the central bank expands its balance sheet by lending against collateral, the choice of the portfolio of eligible collateral will shape the allocation of bank lending in the economy.

When excess reserves are large, the decline in banks’ reserves does not lead to tighter money market conditions and higher short-term interest rates. Thus, the central bank does not have to accommodate the demand for cash or CBDC by non-banks to maintain its monetary policy stance. However, because banks’ excess reserves decline, the central bank loses its ability to reduce subsequently its balance sheet and the risk associated with it in case this becomes necessary. Large excess reserves are the result of previous increases in the central bank’s balance sheet. By reducing excess reserves, the redemption of deposits into cash or CBDC “locks in” the risk on the central bank’s balance sheet...

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