BIS Working Paper on Central Bank Digital Currencies

The Bank for International Settlements has published this new work paper on central bank digital currencies. Below is an excerpt from the Conclusion section of the paper and then a few added comments. I added underlines for additional emphasis.

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"This paper has examined the rise of central bank digital currencies, a new payment technology that may soon be available in a number of countries around the world. We have presented a novel CBDC project index (CBDCPI). We have shown that this index is higher in jurisdictions with higher mobile phone usage and higher innovation capacity. Especially retail CBDCs are more likely where there is a larger informal economy, and wholesale CBDCs are more advanced in economies that have higher financial development. We have also noted that CBDC projects differ starkly across countries, both in their motivations and their economic and technical design. Many central banks are pursuing models where a CBDC is a direct claim on the central bank, but with private intermediaries. To better understand these differences, we have zoomed in on three advanced cases, namely those of the People’s Bank of China, Sweden’s Riksbank and the Bank of Canada."

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My added comments: Readers will note that this new paper appears to imply that we may be closer to seeing a central bank or banks try to implement some version of a central bank digital currency than has been the case up to now. They specifically mention three "advanced cases" in China, Sweden, and Canada. We do continue to note however, that we still do not see any indication that there is any widespread plan for implementation of some kind of central bank currency very quickly. We see this in the final paragraph of the conclusion section:

"Going forward, events such as the Covid-19 pandemic highlight the value of access to diverse means of payments, and the need for any payment method to be both inclusive and resilient against a broad range of threats, just as cash is (see Auer et al (2020)). While it is difficult to anticipate the range of challenges ahead, central banks will continue to take a long-term view and carefully consider the role of CBDCs in a range of potential future scenarios."

Another point to note in this paper (which we see over and over again in similar papers on this topic) is the statement that none of these central bank digital currencies are intended to replace cash. Here is that statement from the conclusion:

"Yet our overview has also shown some key common features. In particular, none of the designs we survey is intended to replace cash; all are intended to complement it."

There is no doubt that many are suspicious that central banks do want to create a "cashless society" and it is true that a cashless society would make it easier for central banks and governments to track financial  transactions and would be a potential threat to financial privacy for the individual. However, no study I have seen on this topic has ever included a stated goal of the elimination of the use of cash and many studies done by central banks specifically state the it is not possible to eliminate cash nor desirable for a variety of reasons. Most studies talk about a central bank digital currency as a complement to cash just as this paper does.

Overall, we still do not see any indications that there is a broad movement underway by central banks to quickly implement central bank digital currencies. A few may be closer to trying something. The Federal Reserve in the US has announced plans to enter in a multi year study on central bank digital currencies with no decision made yet on how it might be implemented or even if it would be implemented. Central banks consistently mention a number of significant potential problems and obstacles to implementation including the impact on commercial banks, the impact on personal financial privacy, and various potential cyber security issues. In addition, problems trying to use blockchain in any system that needs to process millions of transactions quickly is also a problem. 

In summary, there is nothing in this new BIS work paper that would suggest anything is different than we just reported in this recent article on this topic. If and when any major western central bank actually moves to implement some kind of central bank digital currency, it does not appear they will making any kind of major change to the existing monetary system. These currencies would just be another version of their existing national currencies which are mostly "digital" now anyway rather than actual physical notes. 

It would be a significant change in our view here if central banks allowed individual citizens to hold bank accounts directly with the central bank to hold their national currency in whatever form it might take (CBDC or otherwise). We will watch for any change like that over time. 

Claudio Borio (BIS) - On Money, Debt, Trust, and Central Banking

One of our goals here is to try and provide links to information and resources that discuss the concept of money and monetary systems. On the one hand, most people probably don't think much about a discussion about "What is Money" or "What Monetary System Works Best". In the US for example, most people just think of the US dollar as their money and the monetary system is based on the US dollar and run by banks and the Federal Reserve. On the other hand, a growing number of people are interested in learning more about these kinds of issues.

In this recent article appearing in the Cato Journal by Claudio Borio, he takes a deeper dive into this topic. The article is a bit technical in spots, but also includes some time honored core principles that are critical to anything that wants to viewed as money; and monetary systems that attempt to administer the issuance and exchange of money to conduct business activity. Below are a few excerpts followed by the Conclusion Section of the article. I added the underlines below for additional emphasis.

(Claudio Borio - Head of the Monetary and Economic Department - BIS)

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"My focus will be on the monetary system, defined technically as money plus the transfer mechanisms to execute payments. Logically, it makes little sense to talk about one without the other."

. . . . 

"First, two properties underpin a well-functioning monetary system. One, rather technical, is the coincidence of the means of payment with the unit of account. The other, more intangible and fundamental, is trust. In fact, a precondition for the system to work at all is trust that the object functioning as money will be generally accepted and that payments will be executed. But a well-functioning system also requires trust that it will deliver price and financial stability."

. . . . 

"Society needs an institutional infrastructure to ensure that money is widely accepted, transactions take place, contracts are fulfilled and, above all, agents can count on that happening. Even the most primitive communities require generally agreed on, if informal, norms and forms of enforcement. Putting in place the corresponding supporting institutions — or institutional technology — in a way that ensures trust is a major challenge. And the challenge naturally becomes more complex as societies develop."

. . . .

"At the very least, a well-functioning monetary system has two properties. 

First, technically, it will exploit the benefits of unifying the means of payment with the unit of account. The main benefit of a means of payment is that it allows any economy to function at all. "

. . . .

"Second, and more fundamentally, a well-functioning monetary system will enjoy the solid trust of participants. To be sure, trust that people will accept the corresponding instrument as a means of payment and that the transfer will be effective are absolutely necessary for the system to function at all. But a well-functioning system requires more. It requires trust that the value of the instrument will be stable in terms of goods and services, as fluctuations generate uncertainty, and trust that its value will not change strongly in one direction or the other."

. . . .

"A new and controversial payment scheme — cryptocurrencies — illustrates some of the difficulties in generating trust through a fully decentralized system that does not piggy-back on existing institutional arrangements. This is so quite apart from the issues concerning scalability, finality, and incentives to verify, discussed in detail in this year’s BIS Annual Economic Report (BIS 2018).28 The above analysis points to another problem that can undermine trust, as also mentioned in the report: the lack of elastic supply. Hence the cryptocurrencies’ extreme price volatility: changes in demand are fully reflected in the price. The volatility undermines the cryptocurrency’s role as a unit of account and as a means of payment. Not surprisingly, prices are still quoted and sticky in terms of national currencies."

"The problem cannot easily be solved. A fully unbacked currency in elastic supply will not succeed in gaining the necessary trust. Alternatively, seeking to tie it to the domestic currency would require some agent to arbitrage in possibly unlimited quantities between the two, just as when central banks seek to keep exchange rates stable. And simply backing it with a sovereign asset or means of payment on a demand-determined basis would not do either. Not only would it defeat the purpose of having a cryptocurrency in the first place, as it would explicitly piggy-back on sovereign money. As in the case of any mutual fund unbacked by a supply of liquidity and a lender of last resort, it would also be vulnerable to runs (breaking the buck) — the equivalent of having to break the promise of convertibility. Moreover, in all probability it would not to be profitable without taking on significant risk to pick up yield, which would increase the probability of such a run."

. . . .

"The previous analysis suggests that the concepts of price and financial stability are joined at the hip. They are simply two ways of ensuring trust in the monetary system. Inflation, deflation, and price volatility induce instability in the value of money — and its close cousin, debt — in terms of goods and services, undermining its means-of-payment (and store-of-value). Financial instability effectively undermines it through the threat and materialization of default, which can bring the payments system to a halt when bank deposits are involved. Price and financial instability amount to broken promises."

. . . .

"Finally, studies indicate that financial booms tend to misallocate resources, not least because too many resources go into sectors such as construction, which depresses productivity growth persistently once the boom turns to bust (Borio, Disyatat, and Zabai 2016 and references therein). Furthermore, a large amount of empirical work indicates that the financial busts that follow booms may depress output for a long period, if not permanently. It is hard to imagine that interest rates are simply innocent bystanders. At least for any policy- relevant horizon, if not beyond, these observations suggest that monetary policy neutrality is questionable."

. . . .

"Strong monetary system anchors are crucial. As argued in more detail elsewhere, putting them in place requires action on two fronts. It calls for effective regulation and supervision. This must be so both in relation to banks (and other financial institutions) assessed on a stand-alone basis (the so-called microprudential perspective) and with respect to the system as a whole (the so-called macroprudential perspective). And it calls for monetary policy regimes that secure long-term price stability while taking advantage of any room for maneuvering to respond to financial stability threats."

. . . .

Conclusion

"The monetary system is the cornerstone of an economy. Not an outer facade, but its very foundation. The system hinges on trust. It cannot survive without it, just as we cannot survive without the oxygen we breathe. Building trust to ensure the system functions well is a daunting challenge. It requires sound and robust institutions. Lasting price and financial stability are the ultimate prize. The two concepts are inextricably linked, but because the underlying processes differ, in practice price and financial stability have often been more like uncomfortable bedfellows than perfect partners. The history of our monetary system is the history of the quest for that elusive prize. It is a journey with an uncertain destination. It takes time to gain trust, but a mere instant to lose it. The present system has central banks and a regulatory/supervisory apparatus at its core. It is by no means perfect. It can and must be improved. But cryptocurrencies, with their promise of fully decentralized trust, are not the answer.

Paraphrasing Churchill’s famous line about democracy, “the current monetary system is the worst, except for all those others that have been tried from time to time.”

Please click here to read the full article in the Cato Journal

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My added comments: As you can see from the underlined portions of the text above, it is critical that anything that wants to be viewed as money has the widespread trust of the population in general. Without that, it is doomed to failure eventually. This seems obvious, but examples of projects and monetary systems that failed to obtain this vital trust abound both in history and around us today. 

I encourage readers to read the full article by Claudio Borio. It is an analysis of how the present system values the public trust in the monetary system and the ways it attempts to maintain that trust. It is clear when you read this article that monetary officials understand that if they lose general public trust in money and the monetary system, it is very difficult to get it back as history has shown many times.

Also, another thing I have learned is that if you want to offer up anything as money with hope of achieving wide scale adoption by the general public, you must be able to convince the public it is trustworthy above all else. You can have the greatest theoretical concept for money or a monetary system ever devised by man, but if you cannot convince the public at large to trust it, it won't matter and it will fail eventually.

Added notes: The comments in this article about cryptocurrencies are interesting in light of the announcement by Facebook to launch the Libra. The second paragraph above related to cryptocurrencies seems to me to be directly pointed at something like the Facebook Libra even though the Libra plans to have full fiat currency backing for each coin. As I read it, that paragraph suggests Libra will just be "piggybacking" on existing national currencies and that it could be vulnerable to a bank run under some conditions.

Also, the BIS has just issued a new report that looks at the pros and cons of "Big Tech" like Facebook entering into the financial services industry.