Central Banks Want to Issue Digital Coins But There’s a Major Trade-Off
(Bloomberg Opinion) -- From the Federal Reserve to Bhutan’s Royal Monetary Authority in the Himalayas, central banks are working on digital currency studies or projects. There are several reasons for this. Most importantly, private cryptocurrencies and so-called stablecoins are rapidly becoming popular rivals to traditional money; Central bank digital currencies (CBDCs) would not only keep governments in the game but could help make payments and monetary policy more efficient and direct.
CBDCs have the potential to destabilize everything from traditional banking to the power of the U.S. dollar — and authorities are wary of too much disruption to global financial stability. There is a tricky trade-off: The more limits and oversight get built into state-backed cryptocoins the less likely they are to be used.
Privacy is part of it: Unlike traditional paper money, CBDCs can be constantly tracked because the identity data of owners and their transactions are kept in the blockchain — the cryptographic form and function of all digital coins. It will be up to central banks whether or how closely they keep tabs on people.
For the U.S., CBDCs pose a geopolitical concern. The threat doesn’t come from China’s digital yuan taking the dollar’s place as the world’s currency of choice for international trade. It’s from digital currencies’ ability to shortcut the systems for cross-border payments. The Bank for International Settlements — the central bankers’ central bank — touched on this in a study released on Sept. 30.
Right now, if you want to send dollars around the world — which many people and businesses do daily — you need to use an international payments network, like SWIFT. At some point in the process, your money has to pass through an American-licensed settlement bank. This gives the U.S. power beyond its borders because it can demand that banks refuse to handle any dollar payments for foreign banks (or whole countries). That’s how financial sanctions against countries like Iran and Russia, or bad individuals anywhere, are enforced.
Digital currencies, including ones created and controlled by central banks, bypass all of this. CBDCs could easily be sent across borders directly between any users. They could then be locally exchanged into and out of dollars if someone else in the same country owns greenbacks — which many people and banks do.
That’s not a bad outcome for governments around the world that want to lessen U.S. financial influence. That includes European nations, as Josh Younger, an analyst at JPMorgan Chase & Co., noted in the tail-end of a report on CBDCs in May last year. “For high-income countries and the U.S. in particular, [creating a] digital currency is an exercise in geopolitical risk management,” he wrote. That’s one strong motive for the U.S. to develop its own digital currency. It can’t defend its interests if it isn’t in the game and people everywhere use other digital currencies. The same concern holds for almost all other countries.
But introducing a CBDC creates threats to ordinary banking and financial stability. CBDCs might make a very good alternative to holding cash in bank deposits. Runs on banks could be faster and more ruinous if people can simply swap a private bank deposit for a central bank’s digital cash. People could also decide it’s wiser to hold money in CBDCs if their funds exceed amounts covered by government-backed deposit insurance.
If banks start losing lots of deposits to digital cash that could seriously disrupt their role in the economy and their business models. They would have to look elsewhere for funding that matches their lending: Longer-term bonds, or commercial paper for example. That would likely increase their funding costs and mean they would charge higher interest on loans, or cut back lending. Or both.
There are ways to manage these risks. Central banks can impose limits on how much any individual is allowed to either hold, or transfer at any time. And they possess this information because of the very nature of digital coins. CBDCs can also be made less attractive by applying an interest rate to them that is lower than bank deposits. A central bank could even apply negative rates to its coin at times of potential panic, or if demand for them is higher than it likes.
But there’s the rub: The more you restrict the use of a currency, or spy on its users, or change the costs of owning it and paying for things with it, the less attractive it will be. Private cryptocurrencies are popular partly because they are off the grid of government oversight.
Managing the CBDC threat isn’t necessarily hard. The difficulty lies in deciding how heavy-handed to be.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Paul J. Davies is a Bloomberg Opinion columnist covering banking and finance. He previously worked for the Wall Street Journal and the Financial Times.
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