Deputy Governor of the Bank of England: If central bank digital currency completely replaces physical cash, it will result in negative interest rates in reality

Introduction: If the central bank's digital currency only reduces the demand for physical cash, it may make the small payment system more efficient; but if it completely replaces physical cash, it will result in actual negative interest rates.

Ben Broadbent, Deputy Governor of the Bank of England. Born on February 1, 1965, he received a bachelor's degree in economics from Cambridge University in 1988 and initially worked for the UK Treasury. After obtaining a doctorate from Harvard University in 1997, he became an assistant professor at Columbia University. From 2000 to 2011, he served as a senior economist at Goldman Sachs, during which time he published a large number of works on macroeconomics and monetary policy. On June 1, 2011, he was invited by the Bank of England to become an external member of the Monetary Policy Committee. On July 1, 2014, he was officially appointed as the Deputy Governor of the Bank of England in charge of monetary policy.

The topic of currency is a very cautious one for central bank officials. On the one hand, such topics as what is currency, why does currency exist, who regulates the supply of currency and how it is regulated seem to easily cause heated debates. On the other hand, the particularity of "digital currency" determines that this is an area that attracts attention and research, and the Bank of England is no exception.

Three issues related to digital currency

The three questions we will explore today are: What are the main innovations of private sector digital currencies (such as Bitcoin)? What is central bank digital currency? What are the economic implications of introducing digital currencies?

The first question needs no elaboration, as there are already many articles on this subject, including two articles published by economists at the Bank of England. The main point is that the important innovation of Bitcoin is not that it is a new unit of account (it is very likely that in the future we will use Bitcoin to make payments instead of pounds, dollars or euros), but its settlement function, namely the so-called "distributed ledger". "Distributed ledger" is a digital record of "who owns what", but unlike traditional database technology, it has no central administrator and no central data storage. The ledger is replicated on many different nodes in a peer-to-peer network. "Consensus algorithms" are used to ensure that each node's copy of the ledger is exactly the same as the copy on other nodes. Therefore, we can regard a series of copies as a single shared ledger. Asset owners must use cryptographic signatures to debit their own accounts and credit others' accounts. Therefore, "distributed ledgers" cannot be forged. The first use of "distributed ledgers" resulted in the creation of Bitcoin, a virtual currency associated with money laundering and online drug markets, but is increasingly being used by legitimate businesses and emerging financial services entrepreneurs around the world. The emergence of “distributed ledgers” allows transfers to be verified without going through a trusted third party. When such third-party institutions do not exist or the cost of multilateral information verification is huge, the significance of settlement between “distributed ledgers” will be highlighted.

The central bank exists as such a third party, and it only has such a function for a special asset - central bank currency (that is, the deposit reserves of commercial banks in the central bank). But this function is the core of the origin and function of the central bank. If private sector digital currency uses technological means to replace third-party clearing, the central bank's existing counterparties will do the opposite. In this way, in principle, the central bank will have two possible choices, either to acquiesce to the development of private sector digital currency and maintain the current clearing system arrangement of the central bank, or to increase the number of central bank counterparties outside the existing system. "Distributed accounting" makes the latter easier, which may mean that the central bank only needs to add a group of counterparties (mainly non-bank financial institutions). This may even mean some more dramatic plots, where every market participant (including individuals) can directly access the central bank's balance sheet. Although the private version and the central bank version of digital currency will use the same technology and the same name, they are completely different, and the two are in a relationship of one gaining and the other losing.

As for the economic impact of digital currencies, it depends on the design of the Central Bank Digital Currency (CBDC), especially the degree to which it competes with commercial bank deposits, the main form of money in the economy. As individuals, we already have claims on the central bank through cash. If CBDC can only replace cash, without interest and other functions of commercial bank accounts, people may still keep most of their money in commercial banks. But even so, some money will still flow out of existing bank deposits, and the more similar the CBDC is to bank accounts, the more obvious this loss will be. Some people think that this loss is countercyclical: resources flow out of banks in depressions and return to banks in booms.

The transfer of deposits from commercial banks to the central bank will have two important effects. First, it will be safer to deposit funds in the central bank. Second, it will damage the bank's initial credit-granting capacity. This is the crux of the problem. Currently, small deposits are mainly used to provide liquidity loans and cannot be sold on the open market. If a large number of such deposit accounts are closed at the same time, banks will immediately lose their source of liquidity funds and will rely more on the wholesale market. Funds in the wholesale market are quite unstable during economic crises, which will eventually lead to banks reducing their credit support for the real economy. Some people suggest that the central bank issue its own digital currency and expand the scope of the central bank's currency supply through a broad "distributed ledger" to respond to the challenge of digital currency from the private sector. But we believe that it is more important for the central bank to consider how such a move will affect bank financing and credit supply.

Private Sector Digital Currency

Bitcoin’s key innovation is not “digitization,” or storing account balances electronically. At least in developed countries, the vast majority of money is held in bank accounts, not in cash. Banks have long used computers to record account transactions and balances. If digital money were just a series of 0s and 1s on a remote electronic device, and a stand-in for a bank account, it would not be a breakthrough, nor would it have lasted so long. According to statistics from Coinbase, a website that specializes in Bitcoin transactions, in the United States, a rough estimate of more than $5 billion in goods and services were traded in Bitcoin in 2015. For a country with annual consumer spending of $12.5 trillion, such a tiny proportion is almost negligible. In the eyes of most economists, it is almost impossible for Bitcoin to become a widely used transaction tool.

Furthermore, the value of Bitcoin is extremely volatile. It is important to realize that Bitcoin has significant built-in advantages. Similar to a public computer language, if everyone uses a unit of account, then everyone benefits more. This gives Bitcoin a head start over existing currencies. Transitions can indeed happen by accident - hyperinflation and the collapse of the banking system will degrade existing currencies and people will eventually look for alternatives. Usually, currency alternatives only appear when existing currencies decline. Because new currencies sometimes appear as administrative decisions and in an orderly manner, such as the creation of the euro. Even so, people are used to using existing and trusted currencies (usually the US dollar) rather than a completely new unit of account.

Since "digital" and "currency" are not surprising, what exactly inspires human interest and attention to it? That is "decentralized virtual clearing and asset registration", an innovative clearing mechanism. Bitcoin holders use a computer system called "distributed accounting" to replace independent third-party clearing. "Distributed accounting" encourages users to verify transactions for themselves and other traders. Since everyone in the system has the right to verify and everyone can see the verification results, there is no need for a trusted central clearing party.

In principle, this technology can be used in many areas, not just for the trading and registration of financial assets. A recent official report from the UK suggested that "distributed ledgers" may eventually be widely and diversely used in government services, including taxation, welfare distribution, and corporate registration management. If so, there are also many potential uses for "distributed ledgers" in the non-financial private sector. However, what interests the private sector is the settlement function of "distributed ledgers" for financial assets (almost all financial securities, including stocks and bonds), and more and more companies are interested in exploring business opportunities from it.

Taking stock trading as an example, "distributed ledger" is not only replacing third-party central clearing, but a complex system with multiple institutional levels, including custodians, brokers, clearing houses, etc. Each institution has its own unique functions, and there is a certain settlement risk in each processing process. Each institution needs to keep its own records for the same transaction behavior. It is difficult to know the combined cost of these services, but a recent study estimates that in G7 countries, the cost of securities clearing and settlement is about 54 billion pounds per year. "Distributed ledger" will replace these middlemen and provide traders with safer, more reliable, high-quality and low-cost services.

Central Bank Digital Currency

As we all know, most money exists in the form of commercial bank deposits, and most economic transactions involve the transfer of funds between bank accounts. If both parties to the transaction open accounts in the same bank, then things are simple and clear. But if different banks are involved, then there needs to be an inter-bank fund transfer arrangement. Deposit reserves solve this problem, which is why the central bank is also called the "bank of banks" and deposit reserves are also called "final settlement assets." The inter-bank fund settlement function is the core function of the central bank and the reason why the central bank came into being.

CBDCs could place these reserve deposits on a “distributed ledger”. If “distributed ledgers” can make securities transactions cheaper and safer, in theory they should do the same for currency transactions. While it is not clear whether savings deposits are as large as those that are listed and traded, the scale of the economies of scale accommodated by the current monetary settlement system is huge. This is the advantage of having a single trusted third party - no need to interact with too many intermediaries. Today, new technologies can and are reducing the front-end costs of the existing payment system. Online bill payment is one example: the more online payments, the fewer branches banks need. But this does not involve changes to the back-end of the payment system (that is, the trading facilities of central bank money). Compared with securities settlement, in such transactions, “distributed ledgers” replace fewer middlemen.

However, things will not stop there. The point of new technologies is not only to make asset transactions more efficient, but also to expand the scope of access to these assets. If there is a platform that makes it easier for existing participants to trade central bank currencies, why can't more people enjoy this convenience? In the current large-value real-time payment system (RTGS), some non-bank financial institutions already participate in the Bank of England's Regular Facilities. Currently, the Bank of England is evaluating RTGS, which includes arguments for whether to allow more institutions to enter the system in the future. "Distributed ledgers" seem to make this process easier, and the Bank of England's balance sheet can be opened to more financial institutions, and even further, to non-financial institutions and even households and individuals. This means that each of us can open an account directly at the central bank.

Central Bank Digital Currency and Narrow Banking

Whether CBDC will become a real bank account or electronic cash in the future is undoubtedly an important question. If it only reduces the demand for physical cash, it may make the small payment system more efficient; if it completely replaces physical cash, it will have the effect of negative interest rates in essence. As long as it can bring some nominal benefits, the competitive threshold of all other forms of currency is almost the same. CBDC with cash functions will mean replacing this zero-interest central bank liability with something else. However, the really significant impact will occur when CBDC is compared with commercial bank deposits. The key is not the huge amount of money involved, but the completely different types of assets behind the two. The transfer of resources between the two will have an important impact on the relative supply and price of these assets.

For commercial banks, the scale of liquid assets they hold is far smaller than their liabilities, and more assets exist in the form of loans. However, loans lack liquidity because there is no corresponding secondary market to buy and sell such loans, and there is no possibility of cashing out at least in the short term. When banks intend to do so, such as requiring early repayment of loans and reducing loan amounts, it will cause great damage to the real economy. The combination of three factors, namely, the change of deposit and loan terms, current liabilities, and illiquid assets, has caused the inherent fragility of bank balance sheets. If a run occurs, banks will be unable to cope with it. In addition, coupled with the economic costs of deleveraging, this is why the central bank will regulate and endorse banks through deposit insurance and providing final loans.

In contrast, the central bank's balance sheet is mostly liquid assets (most of which are government bonds). The transfer of deposits from commercial banks to the central bank will cause the entire banking system to narrow and become "narrow banking", that is, assets and liabilities have the same liquidity. In principle, this will make the entire system safer, there will be no bank runs, and there is no need for deposit insurance. "Narrow banking" has a long history. Classical economists Adam Smith and David Ricardo both advocated such a banking system. During the Great Depression, some economists at the University of Chicago suggested ending the partial reserve system and implementing the full reserve "Chicago Plan" (proposed by famous economist Irving Fisher and others in the 1930s, its core content is to require banks to provide 100% reserves). There were similar calls during the 2008 international financial crisis. However, most supporters of "narrow banking" believe that it should be implemented through regulatory orders, rather than by the central bank directly absorbing deposits. However, in 1987, James Tobin believed that in order to avoid dependence on deposit insurance, a deposit-type current account should be created in the central bank, and the public should be allowed to handle deposits and check transfers through this account. The "Tobin Plan" has two merits: first, it is recommended to set up branches of central bank deposit accounts similar to "distributed accounting" in post offices; second, he does not advocate the nationalization of all deposits, on the grounds that the cost of transferring commercial bank deposits to the central bank is huge, especially it will harm the lending activities of commercial banks.

Similarly, when the economy is in a recession, bank deposits are more likely to be transferred to CBDC if there are other options, and banks are less likely to obtain funding from the market. A notable feature of the financial crisis was that wholesale funding markets were more volatile than deposits. This is why regulators have since required banks to increase the proportion of deposit funds in all funding. It is difficult to determine the extent of these effects. CBDCs that are only cash substitutes will have a greater impact on cash demand than on bank deposits, and their impact on the macroeconomy will be limited. If the central bank's balance sheet is only expanded to non-bank financial institutions and not to non-financial institutions, the above problems will not arise. But if the central bank's balance sheet is expanded to companies and households, and CBDC becomes more and more similar to bank deposit accounts, the problem will become serious. CBDC is not just a technical consideration related to the security and cost of monetary transactions, but a financial policy involving macroprudential.

Conclusion

The concept of "digital" is ubiquitous but has no clear meaning. It seems that everything is labeled with this label, even though some of them have little to do with computer technology and are simply to export a sense of fashion. It is not clear whether "digital currency" is the best description for things like "bitcoin" or their "stand-ins" in central banks. The term behind it - "distributed accounting", that is, decentralized virtual clearing and asset registration, may be more accurate. It provides a new way to trade and hold assets, including currency.

Ironically, however, some of the problems that digital currencies may cause have existed for a long time. Some Bitcoin supporters see it as a way to circumvent the central bank. In a sense, they are the successors of the 19th century "free banking" supporters. Other supporters see "distributed ledger" as an opportunity for the central bank to expand its role, advocating that the central bank include more entities as counterparties through CBDC. If the function of CBDC is not much different from that of a bank deposit account, it will mean a shift in the financial system to "narrow banking", which is also a long-debated issue in the economy: Should banks create liquidity? Is the maturity change of deposits and loans inevitable in a market economy? We need to realize that the possible impact of CBDC goes far beyond the technical scope of "efficiency of the payment system". Not only that, we have more things to consider, which is why CBDC is listed as a priority item on the research agenda of the Bank of England, and why the Bank of England encourages more academic groups to participate in the ex ante research of this major decision. ■

The author is Deputy Governor of the Bank of England and the People's Bank of China's European Representative Office.