31 Jan 2020

Theory of Dominant Money. Part II The rise of sovereign digital currency (CBDC)

The age of digital money

by Joseph Huber

In technical terms the new era is about the digitisation of money. Digital money is any transferable currency unit in the numerical form of binary digits that are processed electronically. Until some years ago, digital money just referred to cryptocurrencies. Their emergence has triggered the entire hype surrounding anything ‘digital’. In the meantime the term also refers to account-based central-bank currency and bank­money, as well as to mobile money, notwithstanding the differences between the processing of conventional account balances, mobile money units and cryptographic tokens managed by means of distributed ledgers and archived in a blockchain.

Digitised money has substituted itself for the preceding scriptural money already to a large extent. Banking corporations today operate on huge IT-infrastructures. Digitisa­tion also heralds the end of solid cash. Cash may not fully disappear everywhere in the next twenty years, but cash will sooner or later be gone, or be discontinued by decree when maintaining the infrastructure of coins and banknotes for ever fewer and smaller transactions would make losses.

Providers of e-money and cryptocurrencies promise to be faster and cheaper than transactions within the current banking system. On the other hand, and regarding the speed of payments, banks and PSPs have not missed out on new developments. Real-time transfer of deposits within a currency area is now available (including the TIPS system for payments in and among euro countries). This can also be expected in other international transfers in a not too distant future. Ripple and other cryptocurrencies that are presently used as a vehicle in international transfers might lose the compe­ti­tive advantage they have in this regard.

The proposed Libra cryptocurrency claims a processing capacity of 1,000 tps (trans­actions per second). Such indications, however, tend to vary considerably. Bitcoin’s performance is reported from actually 4–7 tps to theoretically 277 tps. New blockchain network techno­logy is said to achieve much higher transfer rates. PayPal performs a real statistical average of 190–200 tps. Visa and Mastercard manage many more, indica­tions varying from 1,700–2,000 tps, theoretically up to the tens of thousands. China’s upcoming centralised digital currency is said to offer 220,000 tps.[1] Speed is of immediate monetary relevance, because faster circulation of money has the same effect as an addition to the stock of money at constant use frequency.

On the other hand, there are growing concerns about the technical safety of digitised money. Banking IT infra­struc­tures and crypto trading platforms have proven to be vulnerable to hacker attacks. Important amounts of money, worth billions of dollars, have been stolen that way. In reaction to this, ever more, and more cumbersome, security precautions are imple­men­ted, spoiling the expected greater ease and conve­nience of using online banking and digital money.

An innovative feature of crypto money that previous types of money did not have is to link ‘smart contracts’ to digital transactions or the digital identity of transactors. Smart contracts can be programmed to be self-executing, in that the conditions are deter­mi­ned under which a specified money transfer can or must occur, or must not.[2]

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The rise of sovereign digital currency (CBDC)

A basic prerequisite for the central banks to regain monetary control is re-expanding the sovereign money base by launching CBDC.[3] Traditional cash needs a modern successor, and the obvious successor to cash is digital currency (DC) issued by a state’s monetary authority. Pioneering central banks and international financial institutions – among them the Bank of England, the Swedish Riksbank and the Basel Bank for Inter­national Settlements – started conceptual works on CBDC in 2015/16.[4]

Depending on the legal status of a central bank, CBDC is, or is close to being, sovereign DC, in contrast to private digital monies. A survey conducted among 63 central banks examining DC in 2019 found that the major advantages to be expected from DC are higher efficiency of domestic and cross-border payments, closely followed by impro­ved monetary policy implementa­tion and enhanced financial stability.[5] Another survey found that more than two thirds of central banks expect DC to foster trust in the money system and monetary authorities.[6]

Such expectations are not plucked out of the air. The more DC is in circulation, the more this contributes to restoring monetary control, which cannot be said of any other currently existing monetary perspective. DC is in fact overdue and will bring in its wake the necessary tidal change in the composition of the money supply, re-expanding the weight of base money, thus strengthening the quan­ti­ty lever for the transmission of base-rate policy, and thereby gradually regaining more control over money creation and the continual re-adjustment of the stock of money.

As a further advantage, DC is safe and secure base money, not a second- or third-level money surrogate. In a crisis, DC need not be saved. DC can certainly re- or devalue in terms of the forex rate or purchasing power, but as a means of payment it cannot disappear as a balance sheet item, as happens with bank­money in a banking crisis if the banks are not rescued. There is also no more counter­party risk in payments. The costs of handling DC can be expected to be lower than the costs of handling reserves and bankmoney at the same time. The costs of financing DC for the banks can be expected to be about the same as those for financing cash. Not least, an expanded DC base generates increased seigniorage to the public benefit.

DC in succession to solid cash as well as the gradual substitution of DC for bank­money can be likened to the paper money reform of the 19th century when national legal-tender notes replaced private banknotes and regional state notes. An introduction of central-bank DC includes the continuation of the traditional monopolies on treasury coins and central-bank notes in the extended form of a monopoly on digital legal tender denominated in the official currency. This does not preclude the existence of private monies conforming to well-defined rules.

A comprehensive changeover from bankmoney to central-bank money could actually be done in a smooth transition process that converts bankmoney into sovereign central-bank money overnight and from then on phases out old bankmoney claims and liabilities in a process of several years, depending on maturities of outstanding bank credit to non-banks.[7] In 2012, US congressman Kucinich from Ohio introduced a bill on the matter (the NEED Act, developed by the American Monetary Institute) and in June 2018 a Swiss referendum was held on extending the note monopoly of the National Bank to money-on-account, or other digital types of money respectively. Both initiatives failed to win a majority.[8] The international debates particularly in the run-up to the Swiss vote made clear that vested interests as well as, say, persistent paradigmatic ‘default settings’ do not allow such a step anytime soon.

Instead, what has now definitely made it on the agenda is the approach of introducing sovereign DC into coexistence with second-level bankmoney and third-level money surrogates. The final ‘wake-up call’ for sovereign DC, as B. Coeuré of the ECB Executive Board put it, was the 2019 Libra project and the announcement by the People’s Bank of China that they are preparing to launch a digital renminbi for public use.

Seven options of introducing CBDC

Currently there are seven possible approaches to implementing DC, that is, seven possible types of DC:
– Direct access to an individual central-bank account
– Custodial access to central-bank account balances
– DC as mobile money
– Central-bank issued cryptocurrency
– Synthetic DC as a stablecoin based on central-bank money
– Indirect DC as e-money issued 1:1 against central-bank money
– Indirect DC as 100%-reserve bankmoney.

These categories result from (1) whether it is about an account-based solution or mobile central-bank money or cryptocurrency, (2) whether the access to DC is direct or indirect, and (3) if indirect, whether the respective PSP or bank acts as a custodian of customers’ DC or as an intermediary that changes paid-in cash and reserves 1:1 into their e-money, promising to re-convert the money on demand.[9]

Direct access to an individual central-bank account
Central-bank transaction ac­counts of a select clientele of wealthy families and major companies were not unusual until about the 1940–60s when they have been discontinued. By contrast, central-bank transaction accounts for particular public bodies have been maintained. Since the crisis of 2007/08 demands for a ‘central bank account for everyone’ are raised time and again, and have so far been rejected each time by the central banks.[10] Account-based DC for use by non-banks would be transaction accounts only. Present-day central-bank accounts of banks, by contrast, serve bank transactions as well as refinancing operations with the central bank.

A central-bank account for everyone would require expanding the central-bank payment infra­struc­­ture. Alternatively, an additional, but affiliated payment infrastructure for non-bank DC transactions would have to be set up. It is unclear whether to hint at a related high effort is a serious argument or an excuse. An extended central-bank payment infrastructure was among the initial options of the Swedish e-krona concept. It might happen, however, that account-based solutions, including the following, will soon be succeeded, or even leap-frogged, by central-bank issued mobile money or cryptocurrency.

Custodial access to central-bank account balances
F
uture DC can also be held in trust by non-bank PSPs on behalf of customers. The customers would not get access to the central-bank balance sheet, but respective PSPs would act as fiduciaries by using a central-bank account as an omnibus account for customer transactions. (Basically, also banks could act as DC custodians). This was among the original ideas of sovereign money reformers. The payment system would still be provided by the central banks, while the PSPs would be users of the system like banks and state bodies.

The Dutch Ons Geld foundation has developed a plan for public depositories, using a treasury transaction account run at the central bank.[11] This is certainly feasible. However, care should be taken to ensure that the institutional arrangement exclu­des any collision of interests. A PSP office and the tax office should not be under one roof.

Lietuvos bankas, Lithuania’s central bank, provides access for non-bank PSPs to its payment system CENTROlink. PSPs can hold reserves on behalf of their customers, with the proviso to segregate their own central-bank account from the central-bank accounts run for their customers. That option of custodial DC is reported to meet with interest at home and from customers in other euro countries.[12]

DC as mobile money
A special DC approach has been developed in Latin American countries: mobile money, that is, DC issued by the central bank and designed to be used by the entire population with the help of a special mobile-phone app. As is the case in many emerging economies, large sections of the population are unbanked but use mobile phones. Mobile money is expected to be a door opener for financial inclusion and general digitisation. Mobile money comes close to the idea of ‘digital cash’, in that transfers are carried out real-time and directly from one ‘mobile wallet’ into another without a payment inter­me­diary in-between. Mobile money is neither conventional account-based money (in a central-bank account) nor a crypto token. The mobile wallets, money units and transfers are encrypted, but using mobile-phone technology, not DLT/blockchain technology. Mobile money thus represents a third technical form of DC in addition to money-on-account and crypto tokens.

Among the pioneering countries were Ecuador and Uruguay. In Ecuador, the mobile money issued by the central bank is called dinero electrónico (denominated in US dollar, adopted as the domestic currency since the year 2000). In 2015, IN-Switch, a company that offers mobile-phone financial services, provided a mobile money system on behalf of the national central bank. The system also includes the three mobile phone companies in the country as well as a number of banks and other com­panies that act as mobile money agencies and operators of personalised mobile wallets.[13] The agencies also change cash into mobile money, or vice versa. Transfers of dinero electrónico are interoperable with bankmoney transfers and international transfers.

Uruguay made a test run with mobile DC, called e-peso, in 2017/18.[14] Several thousand firms and persons were involved. Users had a mobile-phone e-peso app. The mobile-phone PSP IN-Switch managed registered users, wallets and transfers. Another agency did the conversion of cash into e-pesos, or the reverse. The test run was rated a success soon to be implemented on a nation-wide scale.

Similar mobile money systems now also exist in other Latin American and Caribbean countries, in sub-Saharan Africa and South-East Asia.[15] In most cases, however, it is not possible to determine from the sources whether these systems work on the basis of central-bank issued mobile DC, or whether they are based on cash conver­ted into bankmoney (like M-Pesa), thus representing third-level mobile e-money.

Central-bank issued cryptocurrency
This means that central banks originate crypto tokens denomina­ted in the official currency, monetarily comparable to the conventional note issue, but technically of a different nature. The flash idea of a ‘Fedcoin’ has been around since 2014/15. The Bank of England commissioned a study which, however, was not followed up.[16] In Lithuania, the central bank has run an experiment with LBCoin, a blockchain-based collector coin, to be offered to the public in 2020.[17] Another such approach (E-hryvnia) was tested in Ukraine from 2016–18.[18] The two biggest Western central banks, the US Fed and the ECB, have so far been reticent about developing DC as a crypto token. The new ECB President, Chr. Lagarde, however, has repeatedly expres­sed an open mind on the matter, and the Governor of the Banque de France, Fr. Villeroy de Galhau, has initiated a pilot on a central-bank cryptocurrency.

Overall, progress on central-bank cryptocurrency has picked up considerably since 2018, apparently led by China that is preparing for a roll-out of the ‘digital renminbi’. This is not only about a new type of sovereign money, but also about introducing a nation-wide digital identity for every citizen. In March 2019 the central bank of the Bahamas started its ‘Project Sand Dollar’, a pilot (‘sandbox’) using central-bank crypto tokens paired with a national identity system.[19] Con­ven­tional banknotes have serial numbers, but generally no one knows with whom a specific note happens to be. By contrast, mobile and crypto tokens and their respective holders can potentially always be identified. This raises questions of privacy policies that will thoroughly have to be dealt with.

Synthetic DC
Synthetic DC is one type of indirect DC, a second-level crypto token, a stablecoin, based on central-bank money.[20] Some authors use ‘synthetic CBDC’ as an umbrella term for all types of e-money-like digital units regardless of issuer and technical form (account-based, mobile money, crypto token). In this place, ‘synthetic DC’ is just about a stablecoin 1:1 covered by base money.

At the international level, the stablecoin idea is about a supranational crypto­curren­cy under control of the national central banks whose money would be involved in the scheme. In this sense, M. Carney, governor of the Bank of England until March 2020, has proposed a ‘synthetic hegemonic currency’, based on ‘a network of central bank digital currencies’.[21] Apparently this is a response to the Facebook-initiated project of a supranational stablecoin (Libra), and another attempt to turn IMF drawing rights, hitherto just units of account, into a real means of payment.

Indirect DC as e-money issued 1:1 against central-bank money
Another type of indirect DC is e-money issued by a non-bank institute (in the EU a licensed e-money institute) and covered 1:1 by central-bank money or, to a degree, sovereign bonds and other high-grade securities. The approach presupposes granting to those institutes access to the central bank. If not, the PSPs would need an intermediate trustee (a bank, as a rule) that has access and cooperates with an e-money institute. This will certainly burden the financial viability of the model.

An example of indirect DC involves Chinese internet corporations and payment service providers AliPay (Alibaba) and WeChat (Tencent). Their payment instru­ments have so far been based on bankmoney. The People’s Bank of China now requires them to replace the bankmoney with central-bank reserves, thereby con­ver­ting Alibaba’s and Tencent’s e-money into indirect DC. That way, the Chinese PSPs are being switched from third-level providers of e-money based on bank­money to second-level providers of indirect DC based on central-bank reserves.[22]

Indirect DC as 100%-reserve bankmoney
This version of indirect DC takes recourse to the approach of 100%-money of the 1930s, also known as 100%-reserve banking or full reserve banking. With this approach, customers still have conventional bank giro accounts, the balances of which, however, are 100% covered by central-bank money, rather than by a fractional base of reserves. If the full reserve partly consists of government bonds or other high-grade securities, the approach is called narrow banking. Approaches to 100%-reserve banking and narrow banking have experienced a certain revival after 2007/08, also under the heading of ‘safe accounts’.

Among the DC versions discussed by Bank of England researchers, ‘indirect CBDC’ belongs in this category.[23]
The Narrow Bank (TNB) in the U.S. wants to offer 100% reserves-covered safe accounts to its customers. But the Federal Reserve has at first refused to open a central-bank account for TNB. When this proved untenable, the Fed refused to pay TNB the usual deposit interest granted to other banks (then 2.45%). To be continued.[24]
Approaches to 100%-reserve banking are not really future-oriented in that they reproduce the current system of split-circuit reserve banking, even if at a higher level of reserves than is the case today.

The viability of the approaches to synthetic and indirect DC depends either on deposit interest paid by the central bank (which is debatable in principle and can in fact not always be assumed) or comparati­vely high user fees (which is competitive only in special cases), or the admissibility of investing some of the paid-in money into sufficiently profitable financial assets. The latter option waters down the safety promise of indirect and synthetic DC.

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It is quite possible that the above list of approaches to DC needs to be revised soon. Things are developing fast. The information provided by various sources is not always clear regarding the monetary status of the means of payment explored or proposed. As far as the list will stand, the seven approa­ches basically do not exclude each other, but they will certainly not all be implemented in a country either. Furthermore, it is unclear whether there will be a succession, say, from account-based approaches at the beginning to crypto tokens thereafter, or whether account-based solutions will be leap-frogged by mobile DC and central-bank crypto tokens. Time will tell.

With all of the seven approaches the central bank retains full control over the stock of DC, and attains enhanced overall monetary control the bigger the share of DC in the entire money supply will grow. Of equal systemic importance is the question of whether a particular type of DC enables direct transfer (P2P) from one account into another of the same type, or directly from mobile wallet or crypto wallet to another such wallet, similar to traditional cash which is transferred directly from hand to hand without involving another means of payment. As far as PSPs and other FIs are involved, they act as opera­tors, not as payment intermediaries like banks when transferring bankmoney using interbank payments in reserves. Of course, the use of different types of DC, and their coexistence with bankmoney and solid cash for an indefinite period, implies that the PSPs and other agencies concerned also act as moneychangers, converting one type of money into another, thus achieving inter­opera­bility in the entire payment system.

The P2P criterion applies to the approaches of direct and custodial access to DC, to DC as mobile money, and to central-bank issued crypto tokens. In the other cases – synthetic crypto DC and indirect DC as 1:1 e-money – the respective stablecoin or e-money is transferred directly too, but used in lieu of central-bank money. With 100%-reserve banking direct P2P continues between the banks only, while customers still obtain a conventional bankmoney entry as a promise of cash.

All approaches – except for direct individual access to central-bank accounts – have the advantage for the central banks of not involving them too much in the operational details of payment transactions, leaving this to the PSPs (possibly including banks if they wished to offer such services). By using private payment know-how, the approa­ches to custodian, synthetic and indirect DC are comparatively easy to implement within a relatively short time. However, the snag here is, also including 100%-reserve bankmoney, that the 100% or 1:1 base-money cove­rage might again be softened over time, which would be a relapse into fractional reserve practices.

Overall, the approaches of direct and custodial access to central-bank account balan­ces, DC as mobile money, and central-bank crypto tokens are preferable to synthetic and indirect DC. 100%-reserve bankmoney is the least appealing approach in that it retains the split-circuit bank­money regime (which also raises technical problems of maintaining really full coverage at any time).

The majority of central banks themselves prefer a type DC that is universally accessible and usable (like cash), and value-based rather than account-based, that is, some sort of mobile or crypto token. Most central bankers also think the payment infrastructure – in a way analogous to the present RTGS systems – ought to be run or immediately controlled by the respective central bank, while the payments should be managed by the banks and service providers.[25]

Why there is no future for bankmoney in the long run

Contrary to current appearances, the long-term prospects for bankmoney are not bright. The upcoming rise of digital currency can be assumed to be the beginning ebb tide for bankmoney. In a monetary system increasingly based on sovereign DC, bank­money and banks in their role as trusted third parties, as creators and annihilators of bank­money, and as monetary intermediaries of payments made in bankmoney, will increasingly be redundant.

Current EU law does not provide that banks act as PSP or as e-money institutes. Rather, PSPs and e-money institutes are a less regulated alternative to the expensive money and payment services of banks. Even if banks would run a PSP or an e-money institute as a separate unit under their corporate roof, by analogy with MMFs or investment trusts, or if banks wanted to act as CBDC custodians for customers, in all these roles banks are no longer creators of their own bankmoney.

Bankmoney developed through the vulnerable practice of fractional reserve banking, using giro accounts for the clearing of payment claims and liabilities, in place of imme­diate settlement, and leaving the money with the banks and the customers with largely uncovered credits of basically uncertain reliability. Bankmoney developed that way, stands with it, and will go down with it – which, however, should not be mis­under­­stood. The rise of sovereign DC is about the end of bank­money in the long run. It is not about the end of banking. Banks and non-bank FIs offer numerous useful and partly indispen­sible functions in the areas of money and currency manage­ment, payments, lending, invest­ment banking and wealth manage­ment. These functions that are now based on bankmoney can just as well be fulfilled using DC.

Why not bank-issued mobile money or crypto tokens?

Might banks not issue mobile money or crypto tokens of their own? With regard to mobile money, and in countries with ubiquitous use of bank accounts, a bank cannot really expect advantages from replacing or complemen­ting bankmoney with mobile money on the basis of bankmoney. The mobile money units would remain liabilities on the balance sheet of the issuing bank, rather than transferring that liability to other banks as is the case in a reserves-based interbank transfer. Ensuring acceptance and inter­operability of the mobile monies of different banks would be similarly problematic as for the private banknotes in the 18. and 19. centuries. A bank might also consider issuing third-level e-money or a stablecoin 1:1 against bankmoney. Again, what would be the point of swapping bankmoney for such an equivalent, with both types of money still representing a liability of the respective bank?

This is all the more so as banks cannot assume that their mobile money, e-money or stablecoins would enjoy the same privileged central-bank and government support as bankmoney. Without the bankmoney privilege, banks were no longer different from e-money institutes and other financial institutions in general.

With a bank-issued synthetic DC covered 1:1 by base money the situation is different, but not too different. Synthetic DC involves full financing in central-bank money, com­pared to just fractional refinancing of bankmoney. This would contribute to putting an end to the present business model of bankmoney based on a small fraction of reser­ves. Banks face a quandary here anyway. By offering new types of money, they compete against their own bankmoney. This would only make sense if the banks one day had to conclude that it was better to give up on bankmoney rather than going down with it.

Alternatively, large banks, or consortia of large banks, might consider issuing an uncovered cryptocurrency of their own, assuming central banks and governments would put up with it. Such a currency would almost certainly be confined to special user groups, and here too the question of inter­operability arises. With the public in general, however, a bank-issued crypto­currency does not have better chances to take off as a universal means of payment than already existing private cryptocurrencies.

From a macroeconomic and political point of view, replacing bankmoney with crypto coins, e-money and mobile money denominated in a private ­currency, or worse, in the official currency, is not an answer to the problems of monetary and financial excess dynamics rooted in out-of-control money creation. To the contrary, uncovered private monies continue and exacerbate these problems. The hype about uncovered private cryptocurrencies may continue for many years as long as the authorities continue to let things slide. But crises will recur, making clear that such ‘coins’ may be another gambling excitement while not really being useful as a means of payment of reason­ably stable acceptance and value.

Generally, all private monies encounter difficulty in becoming widely accepted if they do not enjoy support by central banks and government. Private monies without such state warranty cannot develop into truly universal means of payment, and they are unlikely to survive the crises that will unavoidably come their way. This can be seen from many examples from the times of unregulated paper money, which ended with the introduction of nationally standardised legal-tender notes. This time, the situation will accordingly be remedied by standardised sovereign DC.

The tragicomedy of bankmoney: private money turned para-sovereign

The struggle between sovereign and private money is an ongoing issue interwoven in the monetary tide changes discussed in this paper – sovereign money struggling to maintain its ruling position, issuers of private monies trying to dethrone the incumbent and seize the monetary power for themselves.[26] The two important historical cases in point are private banknotes and private bank deposit money. Today again, private cryptocurrencies are potential base-level challengers to the national currencies.

According to what is known, monetary units of account were developed by the admini­stration of the rulers in remote antiquity in Mesopotamia and Egypt. Later on, since money was introduced in the form of coins almost 2’700 years ago by king Croesus of Lydia, the coins bore the rulers’ stamp, and money continued to exist as an element of what developed as public or state law, as distinguished from private or civil law. Money creation, or licensing and controlling private money issuance, became the prerogative of ancient and feudal rulers and modern nation-states. An exception was the time after the fall of the Western Roman Empire when private monetarii had captured the monetary prerogative, until Pippin III and his son Charlemagne restored monetary sovereignty in the second half of the 8th century. The reason behind was not only the rulers’ striving for power and gain, but also the functional necessities of managing and financing state structures.

The sovereign monetary prerogatives comprise three components:
1. Determining the currency as the realm’s monetary unit of account
2. Issuing the money or several types of money denominated in that currency
3. Benefitting from the seigniorage, i.e. the gain from money creation.

The monetary prerogatives are in line with other preroga­tives of constitutional importance, such as lawmaking, jurisdiction, territorial admini­stration, taxation, and the use of force. No well-run state will deliberately leave these prerogatives to foreign or private powers.

Many an interested party, however, wants to do away with money as a creature of state law, by re-declaring money as a creature of civil law and private contracts. The sovereign monetary prerogative is apparently too tempting in terms of profit, might and pride, not to try taking over as much of it as possible. In modern monetarised and financialised societies being in control of money – its creation, first uses and its ongoing allocation thereafter – means wielding superior power, second only to legal command power and the authority to issue directives.

As a result of bankmoney’s rise to dominance in the course of the 20th century, of the three components of monetary sovereignty only defining the official currency unit is still intact, while most of money creation and seigniorage-like benefits (in the form avoiding financing costs) has been ceded to the banking sector. Central banks, by origin bank of the state, have turned into bank of the banks. Systemically relevant banks have, as a matter of fact, a support guaran­tee by the respective central bank in its much expanded role as anytime refinancer of last resort. Central banks fulfil this role today ‘whatever it takes’, as put by former ECB President Draghi in a proverbial phrase, for example in the form of huge-volume QE for banking and finance.

Governments in turn have now taken on the role of bankmoney guarantor of last instance. Since the 1930s, bankmoney has legal deposit insurance, provided by the banks themselves (on a rather small scale) and by the government (on a large scale). Governments stand ready to bail banks out if necessary, for example in the form of recapitalising threatened banks. In the meantime even customer deposits are legally subject to bail-in (enforced conver­sion of customer deposits into bank equity) to keep insolvent banks afloat.

Bankmoney would have perished as a private means of payment at the latest around 1930 and the Great Depression, had it not been supported to an ever greater extent by the national central banks, collaborative treasuries, and government guarantees. To put it more accurately, bankmoney actually did perish as a purely private means of payment at that time, in that central banks and governments began to take responsi­­bility for the commercial existence of the banking sector in general and what is now called systemically relevant banks in particular. Bankmoney and central-bank reserves, thus commercial banks and central banks, have become intimately inter­twined and interdependent, representing a genuinely private bank­money regime backed by the central banks and warranted by government, a system in which the state follows the lead of banking and financial corporations, and genuinely private bankmoney has accom­p­lished para-sovereign status.

Among the reasons behind that development was the recurrent experience of severe banking and financial crises, prompting concern about the national money supply, which in fact is the supply of bankmoney, and keeping the bankmoney in circulation to keep the economy going. Rather than thinking about the way of functioning of the present money and banking system, politicians and central bankers have chosen time after time to save the private bankmoney privilege, falling to the illusion of being able to make banks safe by ever more and tighter bureau­cratic regulation. Among recent examples is the Dodd-Frank-Act from 2010 that comprises almost a thousand pages, including, among many other things, ring fencing and living wills. Another example is the Basel rules on the liquidity and solvency of banks. Such measures remain ‘inside the box’ and will help as little today as they did not help much in the past. Liquidity risk is the constitu­tive characteristic of fractional reserve banking. Also beyond liquidity risks, the possi­bility of bank insolvencies and banking crises cannot be ‘regulated away’, because balance-sheet mismatches cannot be precluded, however diligent calculations may have been, but overthrown by mis­beha­viour in other business matters and unforeseen events. Rather than trying to make banks risk-proof, which is ‘mission impossible’, the adequate strategy is to make sure there is safe and secure money and let banks be the financial firms they want to be – except for being creators of bankmoney.

It’s a tragicomedy. The comedy is private bankmoney posing as sovereign. The tragedy is the widespread presumption of second-level bankmoney creation to be under central-bank lead and control, the system overall thus being supposed to represent a sovereign currency system rather than the para-sovereign bankmoney regime it actually is. This kind of complacent misperception surfaced once again on the occasion of the announcement of the Libra stablecoin planned for 2020. Politicians of all stripes all of a sudden rediscovered monetary sovereignty as something to be defended against private challengers, obviously unaware that most of the nations’ monetary sovereignty has been ceded to the banking sector and para-sovereign bankmoney – which really provokes laughter and tears at the same time.

Paving the way for sovereign digital currency  

Two problems – one fictitious, one real

The introduction of central-bank DC, even though side by side with bankmoney, is setting the path of the coming monetary tide change. The now still dominant political perspective, however, remains undecided and ambivalent in terms of monetary sovereignty. This will invite inroads against DC, detours, even standstill, perpetua­ting to a degree current monetary and financial problems for another period of time. Establishing the long-term path towards a composition of the money supply in which sovereign DC will be dominant cannot be taken for granted. For example, one would not expect firms and people to prefer DC over bankmoney under conditions of business-as-usual when there is no sense of heightened uncertainty, if banks pay some deposit interest on bankmoney, while none or less is paid on DC, and far-reaching state guarantees for bank­money are maintained.

In the current discussion about DC two problems, or say, worried expectations, are repeatedly brought to the fore. One is fear of banking disintermediation, the other is fear of a bankrun. The disinter­mediation concern is based on the assumptions that customer deposits are loanable funds and banks are financial intermediaries that take up their customers’ bank­money, to use that money for funding their own bank lending and proprietary investment. If DC is introduced – so the train of thought – this will reduce the share of bankmoney in the money supply, which in turn might result in a reduction or even shortage of inexpensive customer deposits to fund bank activities.

That kind of problem existed to a degree in the past when cash still dominated the money supply and did not yet represent a subset of bankmoney creation. Those days are long gone. Today, banks are not financial intermediaries and disinter­mediation is a fictitious problem. Financial intermediaries are non-bank FIs such as MMFs, pension funds, invest­ment trusts, securitisation vehicles etc., for the most part working on the basis of bankmoney and other money surro­gates. The text­book models of a money or credit multiplier by way of the banks’ alleged financial intermediation do not corres­pond to the real world, whereas it is true that there is a credit multiplier in non-bank finance on the basis of bankmoney. Non-bank FIs often belong to a banking corpo­ra­tion, but as separate entities, which neither turns a bank into a financial intermediary, nor a non-monetary FI into a bank.

Thinking of non-bank deposits as a source of bank financing is one of a number of ‘old habits’ in money and banking theory that die hard. Customer deposits, i.e. bankmoney, cannot be used by a bank as loanable funds.[27] To make payments, no matter whether on behalf of their customers or for proprietary purposes, banks need central-bank reserves and still some vault cash. Bankmoney, however, cannot be changed into reserves, nor can reserves be passed on to customers. Savings or time deposits are deactivated bankmoney, out of circulation as long as they are deposited there.

Accordingly, customer bankmoney does not fund bank credit, but bank credit creates bank­money which can only be used by non-banks. The bankmoney is not taken from somewhere, but written into a customer account ‘out of thin air’, as the saying goes, in connection with extending bank credit to that customer. The central-bank reserves for the fractional re-financing of the bankmoney are borrowed by the banks on the interbank money market and from the central bank. Furthermore, a bank A can achieve a one-off unilateral inflow of reserves, in that it wins over customers of other banks to transfer their bankmoney to bank A. This results in a one-time transfer of reserves from those other banks to bank A.

The real problem, if any, is that changing bankmoney into DC involves full re-financing of the DC, as is the case with solid cash today. Even if the full re-financing of DC is spread over all banks in the banking sector, banks will face somewhat higher refinan­cing costs, corresponding  to the refinancing of cash today (while the cost of handling DC is lower than the cost of handling solid cash). With DC, on the other hand, banks can act as intermediaries indeed, borrowing DC from their customers on favourable terms (which cannot be done with bankmoney, but was formerly done with cash).

The second DC concern is fear of a landslide bankrun. That fear is shared by 82% of central bankers.[28] It must be noted, however, that the bankrun problem, as real as it is, is the problem of bankmoney, not of DC. Banks have always operated on a partial base of reserves, historically vault cash, today central-bank reserves. The threat of a potential bankrun is structurally inherent to this reality; and will continue as long as banks borrow from others so as to lend to others, and the more so as long as they create bankmoney.

With the introduction of DC side by side with bankmoney, bankruns are not more of a threat than they have been throughout the centuries. On the contrary the problem will diminish to the extent to which safe and secure DC replaces bankmoney. Credit and investment risks as such, however, will of course not disappear. Equally, national currencies can re- or devalue, and capital flight from a badly managed national currency may occur. In all this, however, DC will remain what it is: base-level legal tender, a safe and secure means of payment that cannot disappear like bankmoney by proving to be an empty balance-sheet promise.

Within the present bankmoney regime, the bankrun problem is talked down, while it is impro­perly exaggerated in the debate on DC. A bankrun only threatens if there is a banking crisis. Under conditions of business as usual today, the lower cost and conve­nience of bank­money is given a greater weight than the safety of solid cash. With DC this will not change dramatically, especially not, as mentioned, if banks pay deposit interest and central banks and government maintain their support and warranty for bankmoney.

An ill-conceived overreaction to the exaggerated bankrun question is rationing DC, for example by putting a ceiling on the amount of DC available to the public, or a limit on single payments allowed in DC, as is presently the case with cash. In a bank­run situa­tion, the limited availability of DC will be just as counter-productive as is the limited availability of cash in such a situation today, because it is the awareness of the limited availability of base money which actually incites a bankrun. Moreover, any sort of artificial rationing of DC might threaten the 1:1 parity between DC and bankmoney.[29]

The answer to the bankrun question is straightforward: As a design principle of DC, a respective central bank ought to give a conversion guarantee to change bankmoney into DC. More precisely speaking, the guarantee is to provide enough DC to facilitate the change of bankmoney into DC according to market demand.

The central-bank support that has been deemed appropriate for bankmoney since 2007/08 in order to prevent worse can hardly be refused when in a possible future banking crisis central-bank money is in demand not only from banks, but also from the public in the form of DC. What is not possible with paper money (providing large amounts of it literally overnight) can easily be done with DC. A central-bank conversion guarantee would require much less than the flood of reserves created for the banks by way of QE programs in the last decade. Rather than inciting a landslide run on bank­money, a central-bank conversion guarantee will help pre-empt it, because the guaran­tee, and the knowledge of a central bank’s ability to honour the guarantee, reduces the urgency of conversion, thus avoiding a panic that might otherwise arise. Ceterum censeo: the bankrun problem is a problem of bankmoney, not of DC. DC is in fact the remedy to that problem.

DIGITAL CURRENCY DESIGN PRINCIPLES

When introduced, DC encounters a number of competing types and forms of money.  The question of whether and how DC will prove successful in this environment largely depends on the design principles according to which DC is implemented. The relevant design principles cannot also be discussed here in detail.[30] Never­theless, the design principles conducive to the dissemination of sovereign DC shall at least be mentioned:

<> No group restrictions on access to DC. As a successor to cash, DC needs to be a univer­sal means of payment used by all actor groups for whatever transactions.

<> As far as account-based DC is involved, it ought to be integrated with interbank reserves into one circuit, including banks and non-banks alike. Reserves and account-based DC represent the same type of central-bank money. Monetary policy, rather than being ‘watered down’, would be more effective.

<> Full convertibility between bankmoney and DC in either direction…

<> …including a conversion guarantee by the central bank. This comes down to ruling out rationing of the DC supply.

<> State warranty of bankmoney to be gradually reduced and ultimately removed.

<> Public bodies gradually increasing the use of DC.

<> As to the channels of DC issuance, open-market bond purchases and central-bank credit to banks need not be the only emission channels. Modified central-bank accoun­tancy would enable to disburse DC as a citizens dividend or, alternatively, as genuine seigniorage to the treasury – the amount of which to be deter­mined by the central bank according to monetary criteria only.[31]

<> Holding DC and other types of base money should basically not be interest-bearing. (Credit is interest-bearing, not the money). If, however, banks offer deposit interest on liquid bankmoney, then, to avoid undesirable fluctuations into or out of DC and bankmoney, the central bank might consider paying the same or a similar rate on holdings of DC.

A further principle is ruling out so-called negative interest (NI). This is not systematic­cally part of a DC design, but belongs in this context nevertheless, because quite a few economists support DC to get rid of cash and thus be able to impose NI across the board. Strictly speaking, NI is neither interest nor can it be passed off as a fee. Rather, if NI is levied by the central bank from the banks, this represents a hidden tax on money in legal twilight, disbursed to the treasury as a part of the central-bank profit. If NI is levied by the banks from their customers and not immediately transferred to the treasury, this represents an illegal private tax on money to the benefit of the banks’ profit account.[32] The effect is counter-productive. Rather than stimulating additional expenditure, as is questio­nably hoped for, NI triggers heightened savings efforts.

Finally, what about third-level money surrogates? To MMF-shares, 1:1 CCs, e-monies and stablecoins (other than second-level synthetic DC) the following rules, partly already existing, should apply:

<> Issuers are to maintain a 100%-coverage in underlying paid-in money at all times, or, as a minor share of the coverage, high-grade assets purchased with paid-in money.

<> Paid-in money and purchased assets must be denominated in the domestic currency.

<> Issuers of third-level monies are to pursue a passive currency regime. Any active policy, such as for example the pur­chase of securities with own third-level currency, must be ruled out.

<> All private monies and currencies are to be denominated in a currency unit of their own, not in the official unit of account, even if pegged to it and 1:1 covered by it.

Despite foreseeable frictions related to the coexistence of DC and bankmoney, introducing DC is a step in the right direction, that is, the pending tidal change from bankmoney to central-bank DC. By comparison, the problems inherent to the present near-complete rule of bankmoney and other new money surrogates are still much bigger. It is about time to recall the sovereign monetary prerogatives.

Footnotes:

[1] Mathew 2018, Tapscott/Tapscott 2016, Groß/Herz/Schiller 2019 628, Heasman 2019.

[2] OMFIF/IBM 2019 7, pp.26.

[3] The term CBDC has been introduced by M. Kumhof, for example in Barrdear/Kumhof 2016.

[4] Cf. Barrdear/Kumhof 2016, Bech/Garratt 2017, BIS 2018, Bordo/Levin 2017, IMF 2018, Kumhof/ Noone 2018, Meaning/Dyson/Barker/Clayton 2018, Sveriges Riksbank 2017, 2018, 2018b.

[5] BIS 2019 9–10.

[6] OMFIF/IBM 2019 6, 13.

[7] Cf. Huber/Robertson 2000, AMI 2010, Positive Money 2011, Dyson/Graham/Ryan-Collins/Werner 2011, Dyson/Jackson 2013 part II, Dawney 2017, Huber 2017 143–179.

[8] For the NEED Act see https://www.monetary.org/images/pdfs/HR-2990.pdf, AMI 2010; for the Swiss referendum https://www.vollgeld-initiative.ch/english, Dawney 2017.

[9] The systematics used here builds on distinctions introduced by Hess 2019 and Kahn/Rivadeneyra/ Wong 2019 14–17.

[10] Schemmann 2012.

[11] Wortmann 2019.

[12] Juškaitė/Šiaudinis/Reichenbachas 2019 8. The authors refer to the Lithuanian option of custodial DC as ‘synthetic’, following a different terminology that does not help clarify the differences between custodial DC, indirect DC, indirect full-reserve bankmoney, and synthetic DC.

[13] Groppa/Curi 2019 6–8, 16, www.inswitch.com/nationwide-mobile-money-system.

[14] Licandro 2018, IMF Country Report No. 19/64 on Uruguay, Feb 2019, p.16, inswi

[14] https://www.gsma.com/mobilefordevelopment/mobile-money/tch.com/imf-report-defines-uruguayan-central-banks-epeso-as-successful.

[15] GSMA 2018, www.gsma.com/mobilefordevelopment/mobile-money. https://www.inswitch.com/about-inswitch/

[16] Danezis/Meiklejohn 2016.

[17] Juškaitė/Šiaudinis/Reichenbachas 2019 15.

[18] Juškaitė/Šiaudinis/Reichenbachas 2019 16.

[19] OMFIF/IBM 2019 18.

[20] Cf. Adrian/Mancini-Griffoli 2019 12–15, 2019b, 2019c.

[21] Carney 2019 15.

[22] Mu Changchun, deputy director-general of the PBoC’s Institute of Digital Currency, said on Alibaba’s Alipay and Tencent’s WeChat Pay in a recent speech: ‘We just change their payment instruments from the commercial banks’ deposit money to the central bank’s money. … We are not changing their use cases, their service will remain the same.’ EJInSight Blog, Nov 8, 19, Blockchain not suitable for China’s digital currency.

[23] Kumhof/Noone 2018 18–20.

[24] Levine 2019.

[25] OMFIF/IBM 2019 7, 24, 27, pp.32.

[26] Also see Galbraith 1995 [1975], Goodhart 1998, Goodhart/Jensen 2015. Graeber 2012 46–71.

[27] Jacab/Kumhof 2018, Huber 2017 59–67, Werner 2016, Ryan-Collins et al. 2012 12–25.

[28] OMFIF/IBM 2019 pp.28, 30.

[29] Cf. Bjerg 2017, 2018.

[30] For a discussion of DC design principles cf. Meaning et al. 2018, Sveriges Riksbank 2017, 2018, 2018b, Ingves 2018, Kumhof/Noone 2018, IMF 2018, Bjerg 2017, 2018, Huber 2019, Bindseil 2019.

[31] Mayer 2019.

[32] Cf. Huber 2019b.

xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx

ey er s counter-productive as is the limited availability of cash in such a situ require much less than the flood of reserves created for the banks by way of QE programmes in the last decade. Rather than inciting a landslide run on bankmoney, a central-bank conversion guarantee will help pre-empt it, because such a guarantee reduces the urgency of conversion. Ceterum censeo: the bankrun problem is a problem of bankmoney, not of DC. DC is in fact the remedy to that problem.

Digital currency design principles

The introduction of DC will be characterised by the competing variety of monies and the resulting struggle for dominance. The outcome largely depends on the design principles that prevail for implementation. The relevant design principles cannot also be discussed here in detail. This has been done elsewhere.[30] Never­theless, the design principles conducive to the dissemination of sovereign DC shall at least be mentioned:

– No group restrictions on access to DC. As a successor to cash, DC needs to be a univer­sal means of payment used by all actor groups for all types of transactions.

– As far as account-based DC is involved, it ought to be integrated with interbank reserves into one circuit. Both represent the same type of central-bank money. What currently is an account-based ‘excess reserve’ just for banks ought to be part of the stock of account-based DC used by the banks and non-banks alike.

– Full convertibility between bankmoney and DC in either direction…

– …including a conversion guarantee by the central bank. This comes down to ruling out rationing of the DC supply.

– State warranty of bankmoney to be gradually reduced and ultimately removed.

– Public bodies gradually increasing the use of DC.

– As to the channels of DC issuance, open-market bond purchases and central-bank credit to banks need not be the only emission channels. Slightly modified central-bank accoun­tancy would enable to disburse DC – the amount of which to be deter­mined according to monetary criteria only – as a citizens dividend or, alternatively, as genuine seigniorage to the treasury.[31]

– Holding DC and other types of base money should basically not be interest-bearing. If, however, banks offer deposit interest on liquid bankmoney, then, to avoid undesirable fluctuations between DC and bankmoney, the central bank might consider paying the same or a similar rate on holdings of DC.

A further principle is ruling out negative interest (NI). This is not systematically part of a DC design, but belongs in this context nevertheless, because quite a few economists support DC to get rid of cash and thus be able to impose NI across the board. Strictly speaking, NI is neither interest nor can it be passed off as a fee. Rather, if NI is levied by the central bank from the banks and not immediately transferred to the treasury, this represents a hidden tax on money in legal twilight. If NI is levied by the banks from their customers and not transferred to the treasury, this represents an illegal private tax on money to the benefit of the banks’ profit account.[32] The effect is counter-productive. Rather than stimulating additional expenditure and growth, as is questionably hoped for, NI triggers heightened savings efforts.

Finally, regarding third-level monies (MMF-shares, 1:1 CCs, e-monies and stablecoins other than second-level synthetic DC) the following rules, partly already existing, should apply:

– Issuers are to maintain a 100%-coverage in underlying paid-in money at all times, or, as a minor share of the coverage, high-grade assets purchased with paid-in money.

– Paid-in money and purchased assets must be denominated in the domestic currency only.

– Issuers of third-level monies are to pursue a passive currency regime. Any active policy, such as the pur­chase of securities with own third-level currency, or running coverage of less than 100%, must definitely be ruled out.

– All private monies and currencies are to be denominated in a currency unit of their own, not in the official unit of account, even if pegged to it and 1:1 covered by it.

Despite foreseeable frictions related to the coexistence of DC and bankmoney, introducing DC is a step forward, coming to a degree with the advantages mentioned above. By comparison, the problems inherent to the present near-complete rule of bankmoney and other new money surrogates are still much bigger. It’s about time to recall the sovereign monetary prerogatives.

 

Original posted on Sovereign Money, January 24, 2020

Footnotes:

[1] Mathew 2018, Tapscott/Tapscott 2016, Groß/Herz/Schiller 2019 628, Heasman 2019.

[2] OMFIF/IBM 2019 7, pp.26.

[3] The term CBDC has been introduced by M. Kumhof, for example in Barrdear/Kumhof 2016.

[4] Cf. Barrdear/Kumhof 2016, Bech/Garratt 2017, BIS 2018, Bordo/Levin 2017, IMF 2018, Kumhof/ Noone 2018, Meaning/Dyson/Barker/Clayton 2018, Sveriges Riksbank 2017, 2018, 2018b.

[5] BIS 2019 9–10, Boar/Holden/Wadsworth 2020, 4.

[6] OMFIF/IBM 2019 6, 13.

[7] Cf. Huber/Robertson 2000, AMI 2010, Positive Money 2011, Dyson/Graham/Ryan-Collins/Werner 2011, Dyson/Jackson 2013 part II, Dawney 2017, Huber 2017 143–179.

[8] For the NEED Act see https://www.monetary.org/images/pdfs/HR-2990.pdf, AMI 2010; for the Swiss referendum https://www.vollgeld-initiative.ch/english, Dawney 2017.

[9] The systematics used here builds on distinctions introduced by Hess 2019 and Kahn/Rivadeneyra/ Wong 2019 14–17.

[10] Schemmann 2012.

[11] Wortmann 2019.

[12] Juškaitė/Šiaudinis/Reichenbachas 2019 8. The authors refer to the Lithuanian option of custodial DC as ‘synthetic’, following a different terminology that does not help clarify the differences between custodial DC, indirect DC, indirect full-reserve bankmoney, and synthetic DC.

[13] Groppa/Curi 2019 6–8, 16, www.inswitch.com/nationwide-mobile-money-system.

[14] Licandro 2018, Bergara/Ponce 2018, IMF Country Report No. 19/64 on Uruguay, Feb 2019, p.16, https://www.gsma.com/mobilefordevelopment/mobile-money/tch.com/imf-report-defines-uruguayan-central-banks-epeso-as-successful.

[15] GSMA 2018, www.gsma.com/mobilefordevelopment/mobile-money. https://www.inswitch.com/about-inswitch/

[16] Danezis/Meiklejohn 2016.

[17] Juškaitė/Šiaudinis/Reichenbachas 2019 15.

[18] Juškaitė/Šiaudinis/Reichenbachas 2019 16.

[19] OMFIF/IBM 2019 18.

[20] Cf. Adrian/Mancini-Griffoli 2019 12–15, 2019b, 2019c.

[21] Carney 2019 15.

[22] Mu Changchun, deputy director-general of the PBoC’s Institute of Digital Currency, said on Alibaba’s Alipay and Tencent’s WeChat Pay in a recent speech: ‘We just change their payment instrument from the commercial banks’ deposit money to the central bank’s money. … We are not changing their use cases, their service will remain the same.’ EJInSight Blog, Nov 8, 19, Blockchain not suitable for China’s digital currency.

[23] Kumhof/Noone 2018 18–20.

[24] Levine 2019.

[25] OMFIF/IBM 2019 7, 24, 27, pp.32.

[26] Also see Galbraith 1995 [1975], Goodhart 1998, Goodhart/Jensen 2015. Graeber 2012 46–71.

[27] Jacab/Kumhof 2018, Huber 2017 59–67, Werner 2016, Ryan-Collins et al. 2012 12–25.

[28] OMFIF/IBM 2019 pp.28, 30.

[29] Cf. Bjerg 2017, 2018.

[30] For a discussion of DC design principles cf. Meaning et al. 2018, Sveriges Riksbank 2017, 2018, 2018b, Ingves 2018, Kumhof/Noone 2018, IMF 2018, Bjerg 2017, 2018, Huber 2019, Bindseil 2019.

[31] Mayer 2019.

[32] Cf. Huber 2019b.

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