Bank of England consultation paper is too coy about the consequences of a CBDC

The main reason that central banks are cautious about issuing central bank digital currencies is that they threaten to undermine the source of funding of the commercial banks, and therefore their ability to lend. It is hard to see how this risk can be avoided.

It is not surprising that the Bank of England, like other central banks, is taking a close interest in the privately issued digital alternatives to its privileged position that have proliferated since Bitcoin was first unveiled in 2009 – and especially the Stablecoins, backed by holdings of fiat currencies or commodities, that have sought to mimic fiat currencies on digital asset trading platforms. 

On 12 March the Bank issued a discussion paper on a central bank digital currency (CBDC). The clue is in the name: a CBDC would, in essence, be central bank money in digital form. It is a potentially revolutionary step because the only way in which consumers and businesses can hold central bank money right now is in physical form: notes and coins. All the money in their bank accounts is lent to the bank they use. It is commercial bank money, not central bank money.

Which is why one of the biggest risks with a CBDC is that consumers and businesses would choose to hold deposits in central bank rather than commercial bank money, undermining the funding of the entire commercial banking system. With no funding from depositors, commercial banks could make no loans to borrowers. The central bank would have to do it instead. Is balance sheet would balloon to a size that dwarfs the impact of Quantitative Easing (QE).

As the consultation paper notes: “If significant deposit balances are moved from commercial banks into CBDC, it could have implications for the balance sheets of commercial banks and the Bank of England, the amount of credit provided by banks to the wider economy, and how the Bank implements monetary policy and supports financial stability.”

 Doubtless some at the Bank of England are tempted by the prospect of the central bank dominating the manufacture of credit (commercial bank money) as well as central bank money. But it would mark a revolution in how the entire financial system operates, which the consultation paper is at pains not to endorse. The promise that a “any CBDC would be introduced alongside — rather than replacing — cash and commercial bank deposits,” is intended to be reassuring. 

The paper says a CBDC does not have to be issued on to a Blockchain network, and that is obviously (and trivially, in this context) true. But for all the Blockchain-based issuance and trading platforms that have emerged, and so far struggled to take off, a CBDC is precisely what is likely to drive their ultimate success. 

At the moment, their participants can trade on-platform in payment tokens only (such as Stablecoins). To gain access to fiat currency, they have to come off the platform and re-enter the conventional payments system paraphernalia of correspondent banks and real-time gross settlement systems (RTGSs). Which explains much of their limited impact.

The consultation paper envisages an alleviation of that problem rather than a solution. It describes a “platform” that the Bank would introduce and operate alongside its existing RTGS system. Banks and others – the paper uses the terms “payment interface providers” – would connect to the platform to provide payment services to consumers and businesses in CBDC. 

These “payment interface providers” would provide – in the jargon created to reassure banks that their occupation in money transmission is not gone – “overlay” services such as “smart contracts” (to, say, pay dividends or interest payments on a particular date to investors) or “programmable money” (to trigger pay-outs if certain conditions are satisfied). 

But it is hard to see how this re-intermediation of banks disintermediated by a CBDC can be contrived and made stable when £1 of CBDC equals £1 of bank deposit. To use the CBDC to make payments, whether on blockchain networks or not, consumers and businesses will have to hold it. That means selling commercial bank money for central bank money or, to put it more plainly, moving liabilities from commercial bank balance sheets to the balance sheet of the central bank. 

The consultation paper implies that the Bank can prevent a rapid shift of money from bank deposits into CBDC. The commercial banks can offer higher rates of interest on retail deposits, for example, or seek (inevitably more expensive) funding in the equity, fixed income or money markets. Both options have obvious consequences for their net interest margins (unless they pass on the higher costs to their borrowers, which would price commercial bank credit out of the respectable end of the market). 

No wonder the Bank of England insists in the consultation paper that the proposed platform is an “illustration” that nobody should take too seriously at this stage. Because it is hard to see how, if the Bank of England chooses to issue a CBDC, it can avoid going the whole way and becoming the primary source of credit in the economy. If you think the central bank is powerful now, imagine how powerful it will be then. 

Written by Dominic Hobson – Co-Founder Future of Finance
April 2020

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