MILLENNIALS say: digitalisation is here whether we like it or not.
This means the shrinking role of traditional cash as we know it. New digital forms of money are already emerging. Cash use in Malaysia continues to remain rather high. Notes and coin account for 23% of money supply (MI) and 5% of broad money (M2) at the end of the third quarter.
Still, in an increasingly cashless society, is it timely now for the central bank to issue digital currency (DC)? Indeed, in a cashless society, what does legal tender mean? The central banking community has been considering issues on how to adapt – to fill the void left by the fall in the use of cash.
At the same time, there is the fear that giving consumers direct access to DC could endanger financial stability. How then to balance the role of the state on the one hand, to supply DC and push for financial inclusion and to avoid a situation where a small number of outsized private payment providers get too powerful, and on the other to effectively fight crime (viz. anti-money laundering and counter terrorism financing – AML/CTF).
Equally important, the rise of private electronic payments calls into question the status of central banks as monopoly issuers of official money. If the use of banknotes and coins really declines, the public will be deprived of access to a state-guaranteed means of payment.
Is central bank digital currency (CBDC) the answer to boost competition and act as a back-up in the event private payments fall victim to cyber-attack or bankruptcy? It’s time for some soul-searching.
CBDC is not a well-known or commonly used term. Technically, it’s a new form of digital central bank money intended to serve as legal tender. It’s different from the physical cash (notes and coins) issued by the central bank and from the balances in traditional reserve and settlement accounts at the central bank.
CBDC represents a central bank liability, denominated in an existing unit of account, which serves as a medium of exchange, a store of value, and a means of payment settlement. Most CBDCs are for general purpose usage, although some are strictly for wholesale payment and settlement purposes only.
CBDC has design choices, depending on access (widely or restricted), degree of anonymity (complete to none), operational availability (up to 24/7) and whether interest bearing (yes or no). A variety of forms are also available, whether wholesale or widely accessible. Traditionally, access has been limited to account-based money for banks and related financial institutions.
Cash, on the other hand, is widely available and used. Wholesale CBDC is usually combined with the use of distributed ledger technology for settlement efficiency. To replace cash, CBDC is intended to serve as an alternative safe, robust and convenient payment instrument. There should be substantial benefits depending on the ready availability and popularity of efficient private retail options.
CBDC also needs to satisfy public policy goals, including meeting AML/CTF and tax requirements which can prove challenging. In this regard, on the supply side, central banks have to ensure that CBDC delivers on its basic functions: as a unit of account – a public good that requires price stability; as a convenient means of payment that is efficient, cost effective and protects the consumer; and as a store of value which has to be secure and promotes the efficient allocation of resources.
Impact on policy
Studies by the International Monetary Fund and Bank for International Settlements have concluded that the issuance of CBDC would probably: (i) not change the underlying mechanics of monetary policy implementation; (ii) add new options on offer in the central banks’ policy toolkit; and (iii) improve the impact of policy transmission as a result especially of greater financial inclusion.
CBDC is usually designed to be widely accessible. This should serve the public and financial system well – especially wholesale and retail CBDCs. However, many unknowns remain.
CBDC will have to contend with operational risks arising from disruptions and cyber-attacks. In the event CBDCs become widely used in cross-border transactions, the impact of unanticipated large flows can become an added force, especially in times of generalised flight to safety. These need to be researched, as do the possible effects on interest rates and on exchange rates, as well as the impact of financial intermediation on asset prices and financial stability.
Further, little is known about the influence of digital innovation. This includes monitoring the emergence of private digital tokens that are neither the liability of an institution nor backed by any authority. Volatile valuations can also be worrisome, just as inadequate consumer protection can make them unsafe to rely on as a means of payment or a store of value.
What then are we to do?
Studies I have seen do find that overall, it’s still too early to draw firm conclusions on the real benefits of issuing CBDCs. More deliberation and studies have to be done, paying particular attention to the risks and merits of alternative options.
Deep analysis of technological feasibility and operational costs are also needed.
One thing is certain. It’s rather pre-mature to issue CBDCs now even though it will tend to improve financial inclusion. Before launching any CBDCs, IMF had suggested a three-step conceptual framework to foster more careful and thorough consideration: (i) set criteria to evaluate different money forms; (ii) establish the public policy goals; and (iii) layout the competitive landscape, including novel payments solutions as alternatives to CBDC.
Makes practical sense. Still, there are just too many unknowns, especially on the longer-term impact on the structure and stability of the financial system. Much more needs also to be known about how to mitigate ensuing risks, as well as the effects of CBDCs as they become more widely used globally, including for illegal activities. That said, there is a need to better monitor and allow for digital records and traces, which could help improve the application of rules aimed at AML/CTF (even though this will complicate “know-your-customer” compliance). This is an important area that tends to be often overlooked.
No doubt, CBDC is the next milestone in the evolution of currency. Challenges abound. With proper designs and policies, CBDC can help to enhance financial integrity. But it also entails risks and may even raise the cost of funding for traditional deposit-taking institutions. More research on CBDC is certainly required since its implementation can have deep and difficult cross-border dimensions that do have far-reaching implications for public policy.
Overall, I see a case for CBDC adoption. But not now. Before doing so, central banks will need to examine it much further, and certainly more carefully and creatively. Too much is at stake.
Former Fed chairman Paul Volcker told me the story of Ronald Reagan who had asked his predecessor Arthur Burns to convey a warning: The President-elect’s advisers, led by Milton Friedman, wanted to replace the Fed chairman with a “computer”. But Volcker opposed the idea that a complex monetary system can be governed by simple, mechanical rules, and the idea never caught on.
Today, the Fed remains unpredictable. The central bank’s new leadership may need to consider ways to leverage recent technological innovations to bring on more predictable monetary policy. This isn’t particularly radical: Economists like Friedman favoured the certitude that comes with predetermined rules. His “k-per cent rule” called for the money supply to increase at a fixed rate each year, regardless of politics. Here, even Trump will have no say.
Technological innovations, including blockchain and smart contract, have made Friedman’s vision rather plausible. The story of bitcoin, by far the most successful digital currency, can offer valuable lessons for central bankers. It was issued on a decentralised blockchain. Bitcoin is precommitted to a certain inflation rate, and unless a significant portion of the network agrees, it won’t change.
No more than 21 million bitcoins will be minted, and the inflation rate will halve approximately every four years. This precommitment is effected through the network’s complicated rules, which have prohibitively high costs to change after the fact.
Still, bitcoin isn’t doing well. So far this year, its value has fallen by a further 70% to about US$4,000 on Nov 20. For sure, it won’t be easy to digitalise monetary policy.
Whether CBDC will follow the same fate as bitcoin remains to be seen.
Former banker, Harvard educated economist and British chartered scientist, Tan Sri Lin See-Yan is the author of The Global Economy in Turbulent Times (Wiley, 2015) and Turbulence in Trying Times (Pearson, 2017). Feedback is most welcome.