Central bank digital currencies — Design principles for financial stability

Abstract

This paper studies sectoral balance sheet dynamics when a central bank digital currency (CBDC) is first introduced into an economy, and when there is an attempt at a large-scale run out of bank deposits into CBDC. We find that if the introduction of CBDC follows a set of conservative core principles, bank funding is not necessarily reduced, credit and liquidity provision to the private sector need not contract, and the risk of a system-wide run from bank deposits to CBDC is addressed. In addition, under these core principles CBDC can be expected to trade at par with other types of money in all but the most extreme situations. The core principles are: (i) CBDC pays an adjustable interest rate; (ii) CBDC and reserves are distinct, and not guaranteed to be directly convertible into each other at the central bank; (iii) no guaranteed convertibility of bank deposits into CBDC at commercial banks (and therefore by implication at the central bank); (iv) the central bank guarantees to issue CBDC only against eligible securities. The final two principles imply that households and firms can freely trade bank deposits against CBDC in a private market, and that the private market can freely obtain additional CBDC from the central bank against eligible securities.

Introduction

Central banks are increasingly studying the monetary policy and financial system implications of issuing central bank digital currencies (CBDC).¹ This paper focuses on the sectoral and aggregate balance sheet dimensions of an initial CBDC issuance and of sudden large-scale increases in demand for CBDC. In our model, CBDC can be viewed as a substitute for commercial bank deposits, and we consider how the introduction of CBDC into the economy may affect the size and composition of the balance sheets of the central bank, commercial banks, non-bank financial institutions (NBFIs), and households and firms. Our analysis of the scope for CBDC to displace bank deposits following its introduction, and/or to affect banks’ susceptibility to runs from bank deposits to CBDC, will hopefully be useful in future analyses of the financial stability implications of CBDC. Our paper is also intended to be helpful to policy makers who are concerned that the presence of a widely accessible CBDC might be highly disruptive (Constâncio, 2017), and that if it is widely used for transactions it might open the door to rapid bank runs (Broadbent, 2016, Callesen, 2017).

Electronic central bank money is not a new concept. It has existed for decades, most ubiquitously as balances (commonly referred to as ‘reserves’) that are held by commercial banks and other selected financial institutions at the central bank to facilitate electronic settlement in Real Time Gross Settlement (RTGS) systems. CBDC, however, exhibits several distinct features from reserves. We define CBDC as electronic central bank money that (i) can be accessed more broadly than reserves, (ii) potentially has much greater functionality for retail transactions than cash, (iii) has a separate operational structure to other forms of central bank money, allowing it to potentially serve a different core purpose, and (iv) can be interest bearing, and under realistic assumptions would pay a rate that would be different to the rate on reserves.² This definition allows scope for exploring whether CBDC can be used by the central bank as a second policy tool, with either an interest rate rule (where the central bank sets the interest rate on CBDC and allows the quantity to vary) or a quantity rule (where the central bank sets the quantity of CBDC supplied and allows the interest rate to vary) possible.

We consider the most general model of CBDC access, where CBDC is available to all agents in the economy, including households and non-financial firms. In this model CBDC can be used as a medium of exchange and a store of value, much like bank deposits and cash, and could be deemed legal tender by the government. This is an economy-wide CBDC system similar to the model examined in Juks (2018) and Barrdear and Kumhof (2016), the ‘interest-bearing CBDC’ option in Engert and Fung (2017), and also to the ‘co-existence with reserves’ variant in Meaning et al. (2018).³ We are agnostic as to the technology that underlies CBDC — use of distributed ledger technology (DLT) is not assumed. Scorer (2017) sets out why it may not be necessary to use DLT for a CBDC, and also the specific risks and benefits of using DLT for CBDC.

To study the question of how CBDC could affect the size and composition of commercial bank balance sheets, we study two sets of scenarios. First, in Section 4, we trace through the changes in assets and liabilities across balance sheets when CBDC is first introduced. Second, in Section 5, we study an environment where CBDC is already established, and the economy experiences a sudden loss of confidence in the banking sector that results in a large-scale attempt on the part of households and firms to switch their holdings from bank deposits to CBDC.

For the first scenario we show that if a set of reasonable and conservative core principles is followed, the banking sector’s two key functions, the provision of credit to borrowers and the provision of liquidity to depositors, are not necessarily curtailed when CBDC is first introduced. Some bank deposits may disappear, but, to a first approximation, this can occur without affecting the quantity of aggregate credit or aggregate liquidity. Banks and their customers, through their respective portfolio decisions, control the extent to which depositor switching to CBDC affects the size and composition of bank balance sheets. Banks can continue to play their traditional intermediation role. For the scenario of a confidence loss in the banking system, we set out how the likelihood of a run from bank deposits to CBDC can be largely ameliorated through the application of the same core principles.

The core principles are: (i) CBDC pays an adjustable interest rate; (ii) CBDC and reserves are distinct, and not guaranteed to be directly convertible into each other at the central bank; (iii) no guaranteed convertibility of bank deposits into CBDC at commercial banks (and therefore by implication at the central bank); and (iv) the central bank issues CBDC only against eligible securities.

The first core principle is that the interest rate paid on CBDC should be adjustable. As set out in Section 2.1, this allows the market for CBDC to clear without a need for either large balance sheet adjustments or movements in the general price level. The market clearing mechanism does of course depend on whether the central bank pursues a CBDC interest rate or quantity rule.

The second core principle is that CBDC should be distinct from reserves, with the central bank not guaranteeing to exchange reserves for CBDC. As set out in Section 2.2, this addresses the risk of a ‘run by the back door’, whereby a single bank’s commitment to provide CBDC in exchange for bank deposits, together with all banks’ commitment to settle interbank payments in reserves, could, in the absence of this condition, facilitate a rundown in aggregate reserves and deposits when bank customers seek to switch into CBDC by transferring funds to an account at the CBDC-converting bank. This core principle also makes available a new policy instrument related to CBDC, while enabling the central bank to retain control over the quantity of reserves in the financial system, which has traditionally been a key mechanism through which central banks set policy to achieve their targets.

The third core principle is that commercial banks should never have an obligation, only a commercial option, to convert deposits into CBDC on demand. As set out in Sections 2.3 No guaranteed convertibility of bank deposits into CBDC, 5 Digital bank runs?, requiring banks to convert deposits to CBDC on demand opens the door to runs on the aggregate banking system. These aggregate runs could be much faster and at larger scale than in the current system, where physical cash is the only central bank money available to depositors. Such an obligation on banks to guarantee convertibility is therefore highly dangerous. It is also unnecessary, because while the main rationale for this obligation is that it is necessary to ensure parity between bank deposits and other forms of central bank money, parity can be achieved in other ways, as discussed in Section 2.3. Indeed, under our design principles, due to arbitrage, CBDC can be expected to trade at par with other forms of central bank money and bank deposits in all but the most extreme situations.

It has also been suggested that an obligation on banks to always convert deposits into CBDC on demand is critical to maintaining confidence in bank deposits (for example Meaning et al., 2018). We challenge this assumption, noting first that greater vulnerability to aggregate bank runs is unlikely to increase confidence in the banking system, and second that the key pillars supporting confidence in banks are strong prudential oversight, maintenance of adequate capital and liquidity buffers, deposit insurance, and the commitment to clear interbank payments in reserves at parity (and thereby facilitate payments), rather than the promise to always pay out central bank money to depositors.

The fourth core principle, which complements the second and third principle, is that the central bank only guarantees to issue CBDC against eligible securities, envisaged in this paper as government bonds but with eligibility at the central bank’s discretion. This conforms to current practice for the issuance of central bank money, and is therefore conservative rather than radical. What would truly be radical, and highly undesirable, is guaranteed issuance against bank deposits, which would amount to a guarantee of automatic and if necessary unsecured lending to banks.

Our results constitute a material step forward in understanding how the financial stability risks of CBDC can be managed. We focus on the first round effects of the introduction of CBDC and of attempted runs, as they are likely to be independent of the detailed modelling assumptions for a CBDC economy, whereas second round price-mediated effects will vary by model and take time to materialise. Furthermore, in the scenario of an attempted large-scale bank run, first round effects are likely to dominate policy makers’ attention. Nonetheless, valuable next steps in CBDC research include an improved understanding of the second-round effects of introducing CBDC, and developing specific operational designs for implementing the core principles — for example, the design of an efficient mechanism to allow the rate on, or the quantity of, CBDC to adjust in response to supply–demand imbalances. It would also be valuable to explore alternative mechanisms for managing the financial stability risks of CBDC, and their relative costs and benefits. Such work would benefit from detailed analysis of the magnitude of the potential shifts between deposits and CBDC, including the estimation of the interest semi-elasticities and cross-price elasticities of CBDC and bank deposits. In the sphere of monetary policy, recent work by Meaning et al. (2018) and the authors of Sveriges Riksbank (2018) could be extended to explore more new and novel policy tools that could potentially become feasible with CBDC. Analysis of the central bank’s own balance sheet risk from issuing CBDC would also be valuable and could build off existing insights from the literature on quantitative easing.

This paper does not present a case for or against CBDC. Rather, it assumes that a CBDC is being or has been introduced, and then studies the balance sheet and financial stability implications. It does not attempt to evaluate whether the introduction of CBDC presents a net benefit to the financial system and to society. This is still an open question for many central banks, with the answer likely to vary across countries. A few central banks have taken a decision. In 2015, Ecuador issued a US-dollar denominated national digital currency (although the government decommissioned the CBDC in March 2018 after it failed to gain a significant number of users or payment volumes), while more recently the National Bank of Denmark (Gürtler et al., 2017) and the Reserve Bank of Australia (Lowe, 2017) concluded that in their respective economies the potential benefits of introducing a CBDC to households and businesses do not currently outweigh the risks.⁴ China has developed and tested a pilot version of a CBDC, while Sweden has committed to doing so (Ingves, 2018).

The rest of the paper is organised as follows. Section 2 discusses the core principles in greater detail. Section 3 provides an overview of our general model of CBDC and the simplifying assumptions made to facilitate a stylised balance sheet analysis of the model. Section 4 discusses the mechanics and balance sheet implications of the initial introduction of CBDC. Section 5 discusses the loss-of-confidence or digital bank run scenario. Section 6 summarises the key insights of the paper.