5 min read

Why Should a Central Bank Issue a Digital Currency?

Simon Taylor

In this blog post Simon Taylor explores the concept of a Central Bank Digital Currency and why you would want a DLT (or “Blockchain”) like architecture for such a system.

[vc_row][vc_column column_width_percent="100" overlay_alpha="50" gutter_size="3" medium_width="0" shift_x="0" shift_y="0" z_index="0" width="1/1"][vc_column_text]Last week the Bank of England launched a whitepaper discussing the benefits central bank issued digital currency (CBDC) namely;
  • Reductions in real interest charged by commercial banks
  • Reduction in the cost of the using the payment system for participants (interchange)
  • Understanding the exposure and risk of commercial banks against each other to prevent future shocks
  • 3% Uplift in GDP through exchanging CBDC for Government Debt (bonds)
In this blog post I explore the concept of a Central Bank Digital Currency and why you would want a DLT (or “Blockchain”) like architecture for such a system.[/vc_column_text][/vc_column][/vc_row][vc_row][vc_column column_width_percent="100" overlay_alpha="50" gutter_size="3" medium_width="0" shift_x="0" shift_y="0" z_index="0" width="1/1"][vc_column_text]

A Crazy Idea That Might Just Work

A Central Bank Digital Currency (CBDC) makes a ton of sense if you take the time to look at what BoE is actually saying. Your view will depend on a number of things like (for hardcore Bitcoin folks) whether you believe a central bank should even exist, your existing view of the blockchain subject and understanding of how central banking works. To make an argument for central bank digital currencies the key is understanding;
  1. What their policy objectives are
  2. How the Central Bank Issues Money today
  3. How they’re proposing to issue it tomorrow
I’m going to outline these as best I can, in the hopes of promoting a discussion in the industry about how we might move toward a Central Bank Digital Currency (CBDC)

1) Central Bank Policy

The Bank of England has a number of responsibilities including keeping interest rates low, keeping the price of the currency stable, ensuring banks are lending within safe guidelines (micro prudential) and ensuring the entire system is safe (macro prudential). In addition they maintain the notes and coins for the country as well as the electronic payment systems (such as those you would use to buy a house like CHAPS).

Recent Policy Objectives

In the years since the financial crisis, central banks have reduced interest rates and printed money in an attempt to stimulate the economy and prevent a worsening recession. The downside is that the reduced interest rates often can’t be passed on by banks to you and that printing money by buying government debt is a blunt instrument. What’s more as interest rates lower zero, new ways of stimulating the economy are needed. In addition the debt burden of countries (such as the UK) is being impacted by interest rate they have to pay on that debt (no big surprise there). Anything that could reduce that debt burden would in turn give governments wriggle room to stimulate the economy (either through lower taxes or direct investment). The Bank of England in it’s paper outline that a Central Bank Digital Currency (CBDC) could be more effective than traditional QE (buying government debt) in stimulating the economy. I also believe the guess work of micro and macro prudential policy making would be far simpler with a CBDC. The next two sections contrast how Central Banks issue money today vs how it would work with a CBDC and what the benefits of moving towards CBDC might be.

2) How the Central Banks Issue Money today

The normal business of printing money (Quantitative Easing) is that commercial banks sell Government debt (Bonds) they already had to the central bank. Note that because the debt (bond) is now held by the central bank that debt isn’t going to be panic sold, so it’s risk is lower. Because it’s risk is lower the interest rate the Government has to pay on that debt decreases. Freeing up money for a Government that would otherwise be spending on interest repayments. The bank funds buying Government debt from commercial banks by printing money. Money as created today pays no interest (that’s important and keep it in mind, for every pound you have in your pocket, nobody is making money holding that on your behalf).

Recording That Money Got Printed

In addition to printing paper money the central bank performs a “Book Entry”. This is where money is deposited directly in the accounting system of a commercial bank. Think of this as a glorified spreadsheet, the Bank of England says “here is five pounds” and the computer system at both the central bank and the commercial bank records +£5 in an account for the commercial bank. The central bank is effectively spraying that money out immediately, rather than holding it themselves on your (or other bank’s’) behalf. This duplication of records is a key concept for what follows, but keep in mind that somewhat like an email. If I send you an email you have a copy, I have a copy but there is no one original record. This is different to a coin, when I give you a £1 coin, you have it and I do not. Indeed, this is the brilliance of Bitcoin. It created digital uniqueness.

An Inefficient System…

Digital Uniqueness isn’t a problem if money just went from the central bank to commercial banks and back. You’d have a pretty nice hub and spokes and it should be really easy to reconcile (match up) everything with today’s technology. All of those copies aren’t an issue if there is a controller in the middle that see’s it all. However, this is where it gets a little more complicated because of our friend Fractional Reserve Banking. Commercial banks are required to hold ~10% of all deposits (your money) with the central bank or in hard currency (cash) – which remember, isn’t paying interest to anyone. The other 90% not held by the central bank or as cash can be loaned out to someone else. Consider that 90% of the money is circulating through the financial system we create a web of interconnected loans (banks lending to each other, lending to companies, lending to governments and back again), and what’s more the overwhelming majority loans are created through promissory notes. In other words “I promise to pay you back”, and your bank “creates money” and puts it into your account by crediting your account because you promised to pay back.

…Is Difficult to Manage

So now you have a system where the central banks are creating money, they lend it to commercial banks, who lend it to the economy and also make up their own money that they lend, who then lend money from other banks who made it up. Then at the end of the day someone has to try and figure out who owes who what. Now remember our email problem too, there is no unique record for all of this.

Then The Key Question; Centralise or Decentralise?

Having all the money in one database is the same as having all the money in the United Kingdom in one bank account. It makes too big to fail in 2008 look like cake; tasty cake. In order to get visibility of all of the interconnected “broad money” floating around outside of the central bank balance sheet a distributed system is needed that can see inside all of the commercial banks. Whilst the BoE isn’t actually proposing a CBDC for this reason (they’ve limited it to central bank money not broad money)… I’m proposing that to understand all of the money in the economy, a distributed ledger technology is preferable to one central database. One central database with all of the pounds wouldn’t actually capture all of the new pounds that have been created by commercial banks. For their part the BoE also calls out the resilience risk running a CBDC themselves would present.
“Since the operation of computing servers exhibits increasing returns to scale, the cheapest alternative for running a CBDC system would clearly be a fully centralised architecture, but this would come with increased resiliency risks that are likely to be deemed unacceptable

3) How CBDC Would Be Issued

The Bank of England is not proposing to use Bitcoin, nor is it proposing to directly replicate how Bitcoin works. Comparisons with Bitcoin are therefore not helpful to understand what they actually *are* researching. Imagine instead of every bank maintaining their own ledger (computer). There is a ledger (computer) that operates as one big shared computer inside every bank.

A Way to Think About It

Think of it as like cutting a piece of A4 paper into 24 pieces and asking everyone to look after their bit. Attacking the whole thing is a lot harder because there isn’t one place to attack. By it’s nature though, having split up the paper you’ve made ensuring everyone is up to date and has the right information harder. The consensus mechanisms and programmable transactions in distributed ledger tech lend themselves to solving this problem. This is noticeably different from one central database pushing out to all the others. It’s noticeably different from all the databases using APIs or some other messaging service to connect. This is one database that’s effectively operated in part by all the participants.

Benefit 1: A 3% Uplift in GDP:

The report notes that if a central bank issued CBDC instead of today’s process, in return for banks selling their government bonds (debt), the central bank would make money holding deposits (net interest). This is unlike paper money which does not bear interest. In other words the central bank would charge commercial banks a small fee for holding the deposit at the central bank. The proceeds of this then become available…
“,as profits made from the central bank’s net interest margin are remitted back to the government, thereby making any given stock of debt more sustainable”
In other words, the Government debt is partially of paying for itself with the interest payments creating the new currency makes. It’s sort of like an offset mortgage but for a government who could then (for example) cut taxes to stimulate the economy. Secondly, they note that because central bank issued currency is the only thing exchangeable for that debt (bond) the risk of a panic sale is dramatically reduced because it’s now central bank backed! This makes the bond “safer” in the eyes of investors, which again would impact the interest rate a government had to pay. Then:
“Because the interest rate on government debt, by arbitrage, anchors the economy’s entire interest rate structure, this translates, […], into lower borrowing costs for private borrowers, with obvious benefits for capital accumulation and economic growth”
In other words, the real interest rate to you and me would drop, impacting your mortgage payments or other debt payments and potentially allowing you to spend money rather than service debts.

Benefit 2: Measuring and Managing Money in Supply

If you can measure the amount of money on a shared ledger, you can also set rules about how people can create it and move it round the system.
“A key feature of distributed-ledger payment systems is that the entire history of transactions is available to all transaction verifiers, and potentially to the public at large, in real time. CBDC would therefore provide vastly more data to policymakers, including the ability to observe the response of the economy to shocks or to policy changes almost immediately. This would be helpful for macroeconomic stability management.”
Whilst the BoE doesn’t cover it in their report I’d also highlight that if you architect it in the right way you could actually measure the broad money supply effectively too, ensuring the distributed ledger technology used by the central bank is in some way part operated by the commercial banks themselves.

Benefit 3: Commercial Banks Get Settlement Finality

“A CBDC system […] would allow final settlement directly between payee and payer, across the central bank’s balance sheet. Counterparty risk is therefore avoided altogether, so that collateral need not be posted to guard against it. This would free up significant amounts of collateral for non-settlement transactions. To the extent that there is a shortage of good collateral in financial markets today, as some commentators have suggested, this could have important macroeconomic and financial stability benefits.”
In other words. Banks today have to post up collateral in case their transactions fail,typically this is in something that doesn’t return a lot of value (like government debt). The money they’ve spent on posting that government debt can’t be spent elsewhere in financial markets making more money. The cost of “margin” or collateral for big banks is phenomenal and getting rid of this would be a huge boon for those commercial banks who have struggled to do anything but make less money than they did last year since 2008. This is a silver lining on the horizon and a revenue story for them, finally.

Benefit 4: Efficient Payment systems

Instead of using existing payment systems to clear and settle, if a type of consensus is doing reconciliation and settlement, expensive “interchange” and payment types could be removed, which would take a tremendous amount of friction out of the market. Again many commentators missed this economic value. The BoE also points to increased competition in in the provision of transaction services
“With a lower entry hurdle to becoming a transactions verifier in a distributed system than to becoming a member bank in a tiered system, we would expect more intense competition in the provision of payment services. To the extent that existing systems grant pricing power to member institutions, this should ensure that transaction fees more accurately reflect the marginal cost of verification (net of any public subsidy, if one were to be provided), and allow more rapid adoption of new technologies that sit on top of the payment infrastructure”

Benefit 5: Competing with Commercial Banks

“From the perspective of households and firms, CBDC would be economically equivalent to the establishment of an online-only, reserve-backed, narrow bank alongside the existing commercial banking system and, as such, would represent an expansion of competition in the market for deposit accounts. This should again lead to a more rapid adoption of innovative technologies and account offerings. “
Commercial Banks are turning away depositors current interest rates, there simply isn’t the profit to be had that there once was. The result is that the most vulnerable in society have nowhere to put their money, and that in times of stress we risk a run on the banks (see: Northern Rock). What’s more of the BoE does follow through with more open access to central bank deposits a whole range of innovative new services could be offered on top of what is effectively commoditised banking at the central bank. So if you’re a fintech startup, the central bank might one day be the “Bank as a Platform” (BaaP) you’ve been looking for.

Other ideas not discussed

In the paper the BoE throws away the idea of a “citizens dividend” – in other words you or I receiving the interest from central bank deposits (instead of it offsetting government debt interest rate payments). This is a tremendously interesting concept that may even help the perception that bankers are all in it for themselves and capitalism is a fix. The reaction to so called “neo liberalism” which is seen as benefitting the rich and has led to the rise in populist votes such as Brexit, Trump and likely many more to come.

How to Transition?

A shared ledger, could run alongside the existing systems and the Central Bank could incentivise adoption by issuing Central Bank Digital Currency at a better rate through that system than any other. In other words, there is a good financial reason for commercial banks to adopt CBDC. That system would also be available to non bank participants (e.g. Payment Service providers), something today’s CHAPS system would struggle with. In 2012, the BoE was doing £745Bn per day in transactions across it’s settlement systems. That’s 37% of GDP every single day. There isn’t an existing digital currency (especially a decentralised one) operating at scale in a live setting that can achieve that. BUT… There are plenty of ways you could take the best of DevOps and the Best of the Shared Ledger concept and make that possible, it just won’t be easy. Engineering systems that move 37% of GDP daily can be incredibly complex. It’s clear there’s a long way to go before this thinking is fully rounded but to me, there is also real potential within it. Rather than rubbishing the notion of a Central Bank Digital Currency, financial services companies and vendors should take a good look at what might be possible and how they might benefit. Assuming you believe we don’t all adopt Bitcoin tomorrow,and if you work in a bank or a vendor to banks you should take this development very seriously. If you made it all the way here, well done! If you want to know more please reach out to simon@11fs.co.uk[/vc_column_text][/vc_column][/vc_row]

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 Simon Taylor
About the author

Simon Taylor

Simon leads client engagements for 11:FS , building teams and delivering new products and services to market. He is an expert at making the fintech approach work inside a large banking environment.

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