In July, the Bank of England published a report on the macroeconomics of central bank issued digital currencies which fleshes out the pros and cons of central banks issuing their own digital currencies. It’s not often that we see these bastions of conservatism speaking out about innovation, but the technologies made possible by Bitcoin have created the toolbox that will allow a sovereign monetary policy to continue to flourish in our increasingly digital world.
The BoE report concludes that the issuance of a Central Bank Digital Currency (CBDC) could permanently raise GDP by as much as 3 percent–from a reduction in real interest rates, distortionary taxes, and monetary transaction costs. Their position puts forward an opportunity for central banks to digitally stabilize the business cycle within an economy.
The world’s financial institutions, which haven’t yet truly joined the digital revolution brought forth by the internet. Over the last century, our banking system has seen innovation, however, the technology it is built upon an antiquated foundation. Continuing to embellish outmoded technology is akin to attempting to increase the performance of a candle. If we had spent our time improving the candle, we would never have created the light bulb. Today we have the ability to start fresh and deliver incredible, new functionalities. With the near elimination of production, replication, and distribution costs, these functions are only possible in a digital medium. They will drastically reduce barriers to financial services and enable the transfer of value as simply and quickly as sending a WhatsApp message.
If you’re holding a paper note in your hand, you’re holding a contract between yourself and a central bank. The value held in your consumer checking account (or any other digital medium), isn’t cash in your possession. Depositing your cash into a checking account, you are lending your money to a financial institution. The number representing this amount in your online checking account is a promise from the financial institution that they will pay back the value which you have lent them. In this relationship, the bank is a trusted third party keeping your value safe. They have been doing this for thousands of years because it works for them. The model enables fractional reserve banking, which increases systemic risk and leaves consumers at the fate of the institution. Banks create new money and are only required to have a fraction (1/10th) of money lent in their physical reserves. If too many people withdraw money from their checking accounts, the bank will become illiquid due to the fact that most of their liabilities have been lent out in the form of debt. We’ve seen this problem countless times before, but most recently in Cyprus, Greece, and Kenya.
With a CBDC, anyone is able to safely hold and transact their wealth as if it were physical cash and without the necessity of a third party. The BoE sees tremendous benefits in this model which allows more base money to circulate in a economy and in turn reducing liabilities in commercial banks. With the ability to transact cash digitally, the need for reconciliation between financial institutions and their associated counterparty risks, as well as the capital required to insure these risks, can be eliminated. There is always the option for central banks to print more physical cash. However, banknotes require storage and a physical exchange for payment. Their very nature makes them expensive and impractical for a globally-connected and digital world.
Bank of America alone spends $1 billion a year to “shuffle paper (cash) around and transport money in armored trucks.” While speaking at “The Future of Global Trade” event in Worms, Germany, I asked a crowd of 200 university students how many of them had been inside their bank in the last 6 months. No hands. Customer support? They do it online. Writing a check? That’s a thing of the past. It’s not only young people who have no need for a bank building. The infrastructure costs of today’s retail networks are so huge that they have raised the barriers to financial services to a level which excludes over 2 billion people worldwide.
Upon the introduction of a CBDC, the BoE predicts many consumers will switch from storing value in bank deposits to holding it in a digital currency. As consumers don’t keep their money in a checking account for the sole perk of a 2% annual interest, they may find greater value in keeping their money in their pocket. In the near future, commercial banks will be looking to the wholesale market to finance a growing portion of their banks. Relying on lending directly from central banks would reduce the spread between the wholesale interest rate on government bonds and that of consumer checking accounts. This offers central banks a more precise tool to better manage economic cycles.
With this report, it’s safe to say that there is now widespread attention paid by central bankers toward the possibilities of issuing their own digital legal tender. It will be intriguing to see the innovations brought forth by institutions best known for their obstinate conservatism. We’ve recently seen Adam Ludwin of Chain address over 100 central bankers at the Federal Reserve about why they should be racing to adopt new cryptofinance technologies. There are now working groups within central banks around the world looking into how it can happen and why it must happen.
In keeping with their history of intransigence, each central bank prefers to be the second to make a move. Who will be first? Innovations in emerging markets are already leapfrogging policy makers in mature markets. In East Africa, for example, policy makers have created an innovative fintech climate where friendly telco policies have lowered the barriers to financial services and demonstrated their commitment to foster a more inclusive economy. In Kenya, there is “an emerging pattern suggesting widespread systemic challenges: questionable governance practices, weak supervision and rampant fraudulent activities.” Kenya and countries like it are fertile ground for such inclusivity. Uniting all financial service providers–banks and the networks that offer mobile money–under a CBDC and reducing systemic risk, emerging markets are enabling their citizens to hold national currency directly and digitally in their pocket.
Disclaimer: Blog posts reflect the views of the respective authors, and do not necessarily represent the official view of Monetas.