This column is a lead commentary in the VoxEU Debate "The Future of Digital Money"
Recent advances in cryptographic and distributed ledger techniques (von zur Gathen 2015, Narayanan et al. 2016) have opened the door to the widespread use of digital currencies. While private initiatives such as Bitcoin, Ethereum, and Libra have led the introduction of these currencies, researchers and policymakers have explored the possibility that central banks could also issue digital currencies, aptly called a central bank digital currency (CBDC), and make them available to the general public. Cecchetti and Schoenholtz (2018) and Niepelt (2020) offer concise yet informative summaries of many of the economic, legal, and technological issues related to the adoption of a CBDC.
CBDCs may be token-based or account-based (see Bank for International Settlements 2018). In a token-based system, the validity of the payment object has to be verified and transactions can be anonymous. In an account-based system, the account holder needs to be verified. Each system has its own advantages and disadvantages over the other. In our paper (Fernández-Villaverde et al. 2020), we examine the account-based version of a CBDC, i.e. a world where citizens hold direct deposit accounts at the central bank.1 With such a set-up, the central bank will be thrown into competition with commercial banks for deposits, and thus will need to confront a key function of the banking system: intermediating between savers and investors and maturity transformation. Many defenders of CBDCs see this development as one key advantage of this new type of money, since, they argue, a central bank open to all will limit future financial crises, bank runs, and bailouts. However, this feature also raises a whole range of intricate and important questions.
What effects will the introduction of a CBDC and the opening of central bank facilities have on financial intermediation? Will a CBDC impair the role of the financial system in allocating funds to productive projects? Or can we reorganise the financial system in such a way that a CBDC will still allow the right flow of funds between savers and investors? Will a CBDC make bank runs disappear and stabilise the financial system?
In a recent paper (Fernández-Villaverde et al. 2020), we seek to answer these questions. We start our investigation from the presumption that, in comparison with commercial banks, a central bank is not skilled in identifying the best investment projects that yield the highest net present value in the market. This lack of skill might be due to the central bank not having a good technology to screen, monitor, and liquidate productive projects. It might also be due to the presence of political-economic considerations that limit the central bank’s abilities to select superior investment projects.
We embed this idea in a version of the classic model of banking by Diamond and Dybvig (1983), augmented by the presence of a central bank. We select the Diamond-Dybvig model because it is a workhorse of modern banking theory and it emphasises the role of banks in maturity transformation. In particular, banks finance long-term projects with demand deposits that may be withdrawn at a shorter horizon. Diamond and Dybvig have shown that the banking system can achieve the first-best, effectively providing optimal insurance against the liquidity needs of depositors, but that bank runs may arise as well. Their framework is thus particularly suitable to understanding how a CBDC affects the scope of a financial crisis.
In our framework, the CBDC takes the form of the public having demand deposit accounts at the central bank. Like a commercial bank, the central bank holds assets to fund these liabilities, but we assume that, in contrast to commercial banks, the central bank cannot invest in long-term projects itself. The central bank instead will need to rely on investment banks and their expertise to invest in these projects by providing them with non-callable wholesale loans. For our analysis and, ultimately, as a starting point for thinking about these issues, we assume that this delegation works without friction: relying on investment banks is just as good for the central bank as having the expertise to invest in these long-term projects on its own, as long as these deposits do not need to be recalled.
Our first main result is an interesting equivalence result that the set of allocations achieved with private financial intermediation (i.e. the first-best allocation) can also be achieved with a CBDC, provided competition with commercial banks is allowed.
This equivalence result might seem to vindicate the views of proponents of a CBDC: the socially optimal amount of maturity transformation can likewise be produced in an economy where the central bank has been opened to all. But our equivalence result has a sinister counterpart. If the competition from commercial banks is impaired (for example, through some fiscal subsidisation of central bank deposits or by changes in the structure of possible bank runs), the central bank has to be careful in its choices to avoid creating havoc with maturity transformation. These insights echo similar concerns raised by Cecchetti and Schoenholtz (2018).
While the central bank is capable of offering the socially optimal deposit contract just as much as commercial banks are, we demonstrate that the rigidity of the central bank's contract with the investment banks leads to different allocations during banking panics. We have assumed that the loan of the central bank to the investment bank is not callable: this assumption now plays a crucial role. It implies that the central bank's indirect investment in the long asset is protected from early liquidation. We show that this, in turn, either completely deters runs on the central bank or makes runs on the central bank less likely than runs on the commercial banking sector. Depositors internalise this feature and will choose to exclusively deposit with the central bank. That is, due to the commitment aspect of the rigid contract between the central bank and the investment banks, the central bank becomes the monopoly provider of deposits.
A monopoly typically generates a new set of headaches, and this monopoly of a central bank is no exception in that regard. The monopoly power of the central bank can endanger the supply of the first-best amount of maturity transformation in the economy by allowing the central bank to deviate from offering the socially optimal deposit contract, ultimately making depositors worse off as a consequence.
Our results can be compared with other recent studies in the literature that have highlighted different aspects of the potential benefits and risks of a CBDC. For instance, Brunnermeier and Niepelt (2019) have provided conditions under which the introduction of a CBDC has no effect on the equilibrium allocation. Their analysis assumes that the central bank and private-sector financial institutions are equally adept at identifying investment opportunities and monitoring loans, assumptions that we find are unlikely to hold in the real world. Additionally, their framework does not account for the kind of maturity transformation that characterises the essence of the banking business: the acquisition of long-term illiquid assets financed by short-term liabilities. Other studies, including Andolfatto (2018) and Chiu et al. (2019), have emphasised the presence of market power in the banking system when considering the issuance of a CBDC. These authors find that an interest-bearing CBDC can lead to a shift of funds out of bank deposits and into the digital currency, which causes a decline in deposits and bank-funded investment. These conclusions crucially depend on a sufficiently concentrated banking system, and maturity transformation is absent in their analysis. Williamson (2019) has argued that, by issuing an interest-bearing CBDC, the central bank can economise on scarce safe collateral, which can be socially beneficial, even though its implementation might undermine central bank independence.
Given our results and the comparison with the existing literature, we conclude that a CBDC and the associated central bank open to all is indeed capable of delivering the socially optimal amount of maturity transformation, liquidity insurance, and reduction of bank runs. However, it also gives an unseen power to central banks. It is not unreasonable to be concerned about the abuse of such power.
Authors' note: The views expressed in this column are those of the authors and do not necessarily reflect those of the Federal Reserve System or the Federal Reserve Bank of Philadelphia.
Andolfatto, A (2018), “Assessing the impact of central bank digital currency on private banks”, Federal Reserve Bank of St. Louis Working Paper 2018-025A.
Bank for International Settlements, Committee on Payments and Market Infrastructures, Markets Committee (2018), “Central Bank Digital Currencies”, mimeo, March.
Barrdear, J and M Kumhof (2016), “The macroeconomics of central bank issued digital currencies”, Bank of England Working Paper 605, Bank of England.
Brunnermeier, M K and D Niepelt (2019), “On the equivalence of private and public money”, Journal of Monetary Economics 106: 27–41.
Cecchetti, S and K Schoenholtz (2018), “Universal Central Bank Digital Currency?”, Money and Banking, 23 April.
Chiu, J, M Davoodalhosseini, J Jiang and Y Zhu (2019), “Central bank digital currency and banking”, Bank of Canada Staff Working Paper 2019-20, May.
Diamond, D W and P H Dybvig (1983), “Bank runs, deposit insurance, and liquidity”, Journal of Political Economy 91: 401–419.
Fernández-Villaverde, J, D Sanches, L Schilling and H Uhlig (2020), “Central bank digital currency: Central banking for all?”, CEPR DP 14337.
Narayanan, A, J Bonneau, E Felten, A Miller and S Goldfeder (2016), Bitcoin and Cryptocurrency Technologies, Princeton: Princeton University Press.
Niepelt, D (2020), “Digital money and central bank digital currency: An executive summary for policymakers”, VoxEU.org, 03 February.
von zur Gathen, J (2015), CryptoSchool, New York: Springer.
Williamson, S (2019), “Central bank digital currency: Welfare and policy implications”, Working Paper University of Western Ontario.
1 Most CBDC proposals are structured around the idea of a “central bank granting universal, electronic, 24x7, national-currency-denominated and interest-bearing access to its balance sheet” (Barrdear and Kumhof 2016, p. 7).